Capital Costs Challenge Industry

July 6, 2007

Ken Silverstein, EnergyBiz Insider

Utilities are bustling. But the continued increase in power demand also means the industry will have to build new plants. And the demand for engineering, procurement and construction services also translates into higher capital costs -- a factor that could weigh on their credit ratings if those expenses cannot be passed through to their customers.

Standard & Poor's Ratings Service says that capital costs are rising because the global demand for infrastructure-related items is on the rise while domestically, companies must invest in pollution control equipment as well as new generation and transmission. Altogether, the power industry has seen capital costs for new generation climb by more than 50 percent in the past three years.

"As a result, it is possible that with declining reserve margins, utilities could end up building generation at a time when labor and materials shortages cause capital costs to rise, well north of $2,500 per kilowatt for supercritical coal plants and approaching $1,000 per kilowatt for combined-cycle gas turbines," writes Aneesh Prabhu, credit analyst for the ratings agency, in a new report on the subject.

Regulated utilities will strive to get these higher costs embedded in the rate structure and to do so in pre-approved agreements with state utility commissioners. Some states are already headed in that direction, says Prabhu, although those regulators have other forces pulling at them and can only bend so much. Many are now reviewing rate hike requests so that the price of power reflects the true costs of the underlying commodities. Some are also coping with expiring rate caps and nearly all are dealing with extensive spending on environmental protections.

If those regulated companies have cost recovery mechanisms, they can mitigate the major risks posed by large-scale construction projects. However, they will have to manage the overall risks during the construction process to avoid cost overruns, says Prabhu. He points to the Elm Road project being developed by Wisconsin Energy and Madison Gas & Electric, which will have to absorb the cost of some environmental compliance if they can't keep them to what was agreed in the pre-approval process. Other utilities, meanwhile, have chosen to address these issues by jointly pooling their risks.

Unregulated generation companies can't pass through to ratepayers the costs of their capital investment. Instead, they must rely on market prices. Obviously, those regions around the country experiencing the most growth will fare the best.

S&P says that many of those "merchant" operations will use project financed-debt, pointing to the 695 megawatt Longview plant being developed by GenPower and First Reserve Corp., a global private equity firm. Others will have to ensure that all of the planned capacity is fully contracted before the first shovel goes into the ground. That's what LS Power's Plum Power project has done. The 665 megawatt pulverized coal plant has an investment-grade bond rating.

Good Times

A lot of attention has been given to the nation's bidding for limited natural resources such as oil and natural gas. Less focus has been placed on the pressure to acquire the hard assets needed to fuel power production. China, for example, is estimated to account for 40 percent of the world cement supply and 25 percent of the global steel supply, all in 2005, according to S&P. The effect: steel prices have risen 20 percent since December 2005.

Meantime, labor costs are on the rise. Those expenses are roughly double that of 2001, says S&P. It's largely a function of the aging workforce whereby older and more experienced skilled workers are retiring and are being replaced with younger ones who do not have a depth of knowledge. Productivity has therefore fallen.

"And it could get worse: In the engineering sector, over 45 percent of labor will be eligible for retirement over the next five years," says credit analyst Prabhu. "At the same time, strong global labor construction demand is leading to shortages of skilled labor, especially in the energy sector, which threatens the schedule and in-service dates of projects."

While the utility industry now has to deal with high construction and labor costs, it is on the verge of boom times. Credit upgrades outpaced downgrades by 2-to-1 last year. And this year, many major companies may experience their biggest annual earnings growth in the last 30 years. In fact, utility stock indices are enjoying their best years in a long time and are outpacing the S&P 500.

So power companies are well prepared to take on their expected future outlays that include everything from environmental compliance costs to those tied to infrastructure and specifically transmission, distribution and generation. Overall, interest rates are low and banks have loosened their grip on the money, although they have enhanced their due diligence. Companies are also selling assets in an effort to keep their debt-to-capitalization ratios in line and to maintain investment-grade credit.

All told, infrastructure spending for both transmission and generation has gone up about $6 billion in the last year. Power supply shortages on the West Coast and the New England region necessitate that even more generation gets built, as well as the transmission to accommodate that growth.

"The companies and the utility industry overall are in good shape," says Barry Abramson, senior utilities analyst for Gabelli & Co. in Rye, NY. "I'm not concerned about a ramp up in capital spending. The industry really has solid financials and there is also solid regulatory support for these new investments."

Utilities are now the beneficiaries of good economic times. But such prosperity has brought forth rising capital costs. Companies are preparing for the challenges and are taking concrete steps to mitigate their risks.

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Ken Silverstein
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