Contractors operating in the energy sectors will experience the greatest opportunities due in part to the passage of the US Energy bill helping to boost capital spending. Large scale capital investment in power infrastructure was flat or declining since 2000 due to regulatory and post Enron attention. Much spending since that point was redirected as Operations & Maintenance efforts within many utilities.

US power markets require new capacity additions to match demand driven by population growth, population migration, and residential construction market growth. The bill provides multiple incentives for additional power generation to feed energy demand that ultimately creates transmission and distribution construction. Coal fired plants, nuclear power plants, and natural gas lines are the big winners for tax incentives which will encourage additional capital spending. Alternative energy will experience $2.75 billion in tax incentives, however, the measure requiring 10 percent of all energy generation from alternative sources failed. The bill repeals portions of the Public Utilities Holding Company Act (PUHCA) of 1935 that restricted industry mergers and foreign investment. In addition, the repeal opens the door for energy company consolidation and potentially significant capital investment to take advantage of economies of scale and infrastructure asset optimization. This activity is expected to stimulate construction of new gas and electric transmission systems to achieve operational performance improvement and is supported through a series of tax and depreciation related incentives.

The water/wastewater and sewer market will see modest spending growth due to a highly fragmented marketplace, municipal and/or political influences, and aging infrastructure demanding solutions beyond the means of many system owners. Of the 16,000 sewer and waste systems across the nation providing wastewater services, many were predominately built between 1950-1970’s or even earlier and are beyond their useful life expectancy. Since 1972, the federal government pumped $72 billion into the construction of publicly owned sewage treatment facilities, and the systems that serve them in part due to the passage of the Clean Water Act. Population migration and growth as well as the residential construction boom place additional strain on strapped systems. In areas of the country where growth has outstripped the water supply, unusual challenges have emerged where recent water restrictions and conservation efforts in some western states have proven too effective. These utilities have lost revenue forcing staffing changes or requests for increased rates to cover system operation cost. The solutions to this challenge are not pleasant for most system operators. For design and construction firms, there is significant potential if methods for funding the necessary construction can be resolved.

The telecommunication markets are experiencing pockets of rapid growth after construction spending fell off a cliff in 2001. Nationwide, FMI expects the recent increases in construction spending will again cool off after 2005/2006. One resource, The National Cable Television Association (NCTA) estimates that the efforts to install new or replace existing lines with fiber are approximately 90 percent complete as of year-end 2004. Segments experiencing more rapid growth over the last 2 years relate to wireless broadband and efforts to finish the fiber based infrastructure to homes and businesses. As this work is concluding, we do not yet see a spark for a significant increase in spending but enhancements to the performance of existing infrastructure will continue to garner attention and construction spending.

Power Construction Forecast

Construction spending in the power market is expected to exhibit the fastest growth rate of the three utility segments studied. FMI estimates in Exhibit 2 that in 2004 the US Power industry construction put in place at $32.8 billion. Spending is expected to grow 24 percent from 2004 to $41.5 billion in 2006. Year over year growth will hover between 12 and 15 percent through 2009. Within power construction, there are three main components: generation, transmission, and distribution. Much of the short-term rapid growth in spending will come from the generation component. Distribution’s growth is largely a function of housing starts and any rehabilitative or replacement construction necessary to support system integrity. Its growth rate is expected to continue. Transmission is more problematic to forecast as there are regulatory and other barriers, including who will fund this construction that remain unresolved. The recent passage of the US Energy bill will provide a portion of the spark accelerating the growth projected.

There are approximately $14.5 billion in tax incentives available from this bill that will be paid out over 10 years. Local Gas Distribution Companies (LDC) and electric utilities specifically have access to $1 billion and $1.24 billion respectively for tax breaks to shorten the depreciation schedules for transmission and distribution lines. This change in depreciation schedule should introduce greater flexibility in decisions to undertake capital spending and the non-cash nature of this expense should result in additional incentive to undertake construction.

Power producers utilizing nuclear energy have numerous incentives for both the construction of new facilities as well as the decommissioning of aged plants. Companies retrofitting or developing new Coal fired power production plants will benefit from $1.6 billion in tax credits for "clean coal" investments. A nine-year Clean Coal Power Initiative will be funded by an additional $1.8 billion with the intent to reduce emission levels to that of natural gas. Tax credits for solar, wind, landfill gas, and trash combustion technology of $2.75 billion will benefit renewable energy producers.

The growth in generation is driven by demand. The Department of Energy (DOE) expects electrical energy demand to grow from 3,481 billion kilowatt hours in 2003 to 5,220 billion kilowatt hours in 2025. The annual electricity sales growth rate during that period is projected to average 1.6 percent in the residential sector, 2.5 percent in the commercial sector, and 1.3 percent in the industrial sector. The DOE estimates that 43 gigawatts of inefficient capacity will be retired with an estimated 281 gigawatts of new capacity brought on line by 2025. Demographic trends, migration patterns, and population growth are driving this change. The Southeast and the West will see the greatest capacity additions due to their rapid population growth. The DOE estimates that the Southeast will account for 30 percent of total energy demands in 2025 and it will require a similar share of new capacity additions. The West accounts for 20 percent of the nation’s capacity and will bring on line 25 percent of the additional capacity. These two regions are expected to predominantly bring coal fired generation and renewable energy generation online. A total of 87 gigawatts of coal fired capacity will be brought online and the Southwest and the West will account for 31 and 35 gigawatts respectively. All of this generated power has to get to consumers through transmission and ultimately distribution system which will benefit from upgrade over the coming decade.

In terms of renewable energy, the Southeast is expected to bring on line slightly more than four gigawatts of new renewable energy generation and the West is expected to bring on line five gigawatts of a total of 15 gigawatts across the nation. State programs are the key drivers of alternative energy and we expect growth, even through congress failed to pass a measure that would require energy producers to source a minimum of 10 percent of its energy from alternative generation. Alternative Energy Biomass, wind, & geothermal are the fastest growing sources of renewable energy. Both wind and biomass sources of energy are expected to triple in billion kilowatt hours in output by 2025. Geothermal is expected to double in output. This renewable energy presents unique construction challenges as these sites are frequently not located where the population is and any power generated must be transported. The opportunity for unusual, difficult, or other challenging projects will exist presenting opportunity for firms to pursue work which will likely have fewer competitors chasing it.

Natural gas storage, transmission, and distribution will all see increases in construction spending. Natural gas pipeline construction expenditures are projected to double from $1.3 billion in 2005 to $2.7 billion in 2006 and $3.1 billion in 2007, according to a report released last month by the Energy Information Administration (EIA). The liquefied-natural-gas (LNG) market will drive the growth. (See Table 1.) Sempra Energy currently has proposals in Louisiana, California and Texas for LNG related facilities. The proposed Texas plant, for example, would process 1.5 billion cubic feet a day of LNG. Depending on LNG facility permitting and potential increase of demand for cleaner fuel, this gas will have to be transported to other locations which will again demand the construction of infrastructure. By 2007, clean burning natural gas fired plants are expected to surpass nuclear power in US utilization. Many of these units will be introduced to help meet the demands of urban renewal as housing and commercial buildings are refurbished. Natural gas fired power production requires the building of infrastructure to get the gas to the facility, which are frequently located very close to where the power demand originates. These lines are high pressure, highly engineered, expense to construct, and frequently in urban settings. The opportunity for utility contractors to demonstrate skills in successfully completing this type of construction will offer both margin and revenue growth potential over the next 5 years.

Water Supply Forecast

Aging and inferior infrastructure, environmental regulations, and rapid population increases are the key drivers of the water supply market. The Environmental Protection Agency (EPA) predicts $277 billion is necessary over the next 20 years to repair or replace ageing pipes and relating equipment. The Clean Water and Drinking Water Infrastructure Gap Analysis describes a potential 20 year funding gap for drinking water capital, and operations and maintenance costs, ranging from $45 billion to $263 billion, with capital needs alone reaching $161 billion. Proposed cuts by the Bush administration only worsen the outlook for states to keep up with the water infrastructure and Clean Water Act requirements. Nationwide, the cost of water has increased between 100 percent and 400 percent in the last 10 years depending on region of the country. This increase in water rates is directly related to serving customers farther and farther out on the system and as water usage grows, even relatively wet areas of the country on the eastern seaboard and northeast are facing challenges. The predictions sound dire, but this market continues to demonstrate modest growth rates. The demand for construction far exceeds the financial capacity to fund it and until this issue is resolved, there are no dramatic growth projections in this type of construction.

FMI forecasts growth of 6 percent in 2006 and 7 percent in 2007 for the water-related markets described in Exhibit 3. Total forecasted water supply construction will total $10.8 billion in 2005 and will increase to $13.7 billion by 2009. The passage of adequate funding at the federal level and a mechanism to fund this infrastructure at the local level is desperately needed to update the water and wastewater infrastructure across the nation. The Bush administration has proposed a 33 percent reduction in federal funding for fiscal year 2006 reducing this figure to $850 million. This funding level is widely seen as inadequate for the estimated needs of $10 to $20 billion forecasted to upgrade existing infrastructure over the next 20 years and stands at approximately 10 percent of the total estimated national requirement.

Across the nation, there are 75,000 national drinking water systems serving 250 million people in the US. It is estimated that an $11 billion shortfall exists in order to replace existing water systems to reach federal water regulation requirements. The Senate Environmental and Public Works Committee Water Infrastructure Financing Act of 2002 provided funding for the drinking water through a State Revolving Fund (SRF) of approximately $15 billion. Unfortunately, only 8-10 percent of the funding has been distributed to large metropolitan systems who have the oldest systems in the greatest need of upgrade. Utility construction spending growth will continue to fall below demand due to this lack of funding but the sourcing of work and the buyers of services will remain highly fragmented and locally influenced. Small to medium sized contractors will remain highly competitive for this type of work and only lose this positioning when large projects are undertaken that stretch the internal capacity for these utilities to manage it or the local community to supply the necessary construction labor or expertise.

Sewage & Waste Disposal Forecast

Despite challenges including increased regulation and aging infrastructure, the sewage and waste disposal segment will see growth of 7 percent in 2006 and 8 percent in 2007. (Exhibit 4) The continued driver that will result in the prioritization of potential work in this segment will include the Total Maximum Daily Loading (TMDL) established and updated by the EPA. The TMDL measures the amount of pollutants that these aging systems can expel into clean bodies of water and will continue to influence the prioritization of work. The Clean Water State Revolving Fund (CWSRF) is just one financial resource that will fund projects implementing or amending their TMDL. Nationally, the CWSRF issued over 9,000 loans since its inception in 1988 and has in excess of $34 billion in assets. The CWSRF currently supports funding of over $3 billion worth of water quality projects annually.

In 2005, FMI estimates approximately $15.5 billion was spent on put in place construction which will rise to between 7-8 percent per year until reaching $20.6 billion in 2009. This growth in spending, while healthy, is inadequate. Some finding from other industry research:

• The EPA estimates demonstrate a national investment need of over $390 billion over the next 20 years to replace existing systems and build new systems to meet growing demand
• The Water Infrastructure Network, a group of water and wastewater providers and engineers, estimate an annual investment need of $12 billion for all sewer treatment facilities
• An EPA gap analysis describes a growing annual funding gap for wastewater between $13 billion and $37 billion
• A similar Congressional Budget Office (CBO) gap analysis also describes a similar capital construction demand range

All research conducted supports a conclusion of significant capital spending shortfall versus demand. Federal funding from 1995 to 2004, which makes up less than 10 percent of the total spend was steady, ranging between $1.2 and $1.35 billing annually. Unfortunately, 2005 saw the first federal wastewater-funding cut in 8 years, resulting in only $1.1 billion made available. The current administration has proposed further cuts in spending for fiscal year 2006 with the current appropriation calling for only $730 million, a reduction of 33 percent from fiscal year 2005.

Telecommunications

The telecommunications market has experienced larger swings in construction spending, ranging from 47% increase in one year to -31% reduction in another year, than nearly any market. The dramatic reduction between 2002 and 2003 left many contractors poorly positioned with excessive equipment and other resources that had predominately been employed in telecommunications construction. There will be no return to the glory days but modest growth is fueling more optimism in this market segment. FMI forecasts in Exhibit 5 describe telecommunications construction spending growing at 4 percent a year from 2006 through 2009. In 2005, construction spending of $14.5 billion shows an increase of ten percent from prior year. Spending will remain relatively flay through 2009 reaching $17 billion.

The competition for Fiber to the Home (FTTH) and the provision of broadband services will continue to put debt sensitive Baby Bell companies in a challenging position. Competition from incumbents, such as Verizon and Sprint will continue. Cable companies such as Comcast will remain strong with the integration of Voice Over Internet Protocol (VoIP) phone service. As of third quarter 2004 2.7 million people subscribed to cable telephone services. By 2010 it is expected that 11.5 million people will subscribe to VoIP services. This growth has historically pushed more spending resulting in more than $100 billion being spent since 1996 to turn cables hybrid fiber-coaxial infrastructure into a robust service providing Video-On Demand, digital cable, VoIP phone service, and high-speed internet access. In November of 2004, the Federal Communications Commission (FCC) found that VoIP was not subject to traditional state regulation. Cable companies now face different regulatory and taxation rules from phone companies which results in different competitive advantage for these firms who are now competing against each other. This has served as a significant threat to regional telephone companies phone service offering and customer base, especially as cable technologies are much faster than DSL technology services provided by many telephone companies. The bundled services from cable companies are better positioned to leverage the use of phone, internet, cable, and e-mail into a single system and a single bill.

Wi-Fi, fixed wireless, and satellite technologies will continue to gain market share and visibility as demand for wireless communication access expands in use. Wireless communication use in the U.S. has increased from 55.3 million subscribers in 1997 to 194 million subscribers in 2005. Today, more than half of the U.S. population has access to wireless communication services. Fixed line voice telephone service is still the predominant form of voice communication due to quality and dependability. Yet competition and quality of wireless and VoIP technology is rapidly growing at highly competitive rates. Although growth in wireless and VoIP application has accelerated in the last year, total market share over the long-term may stall due to quality and reliability perceptions.

Despite the growth in users, the long-term outlook is very cloudy for large capital investment in traditional cable or fiber based communications infrastructure. Future capital investments will be directed toward non-construction spending such as hardware and software and upgrades rather than complete systems upgrades. Additionally, new technology will be used to further leverage current infrastructure to keep up with the use of web and office applications on handheld devices will require service providers to update technology to process large data exchanges. Contractors providing traditional construction services to this market should look at their local marketplace for indicators of where this type of construction is headed as it will be very different for different regions of the country.

Conclusions and implications

Population growth and aging infrastructure will drive opportunities for utilities contractors operating in the segments of power, water/wastewater & sewer and telecommunications. Demographic growth trends are one of the main drivers of this type of construction and all contractors in these segments should clearly understand the long-term implications to their business. Demand for construction services in these markets is unparalleled yet funding challenges will restrict the amount of capital spending put in place. Overall, this entire market is expected to exhibit reasonable growth with geographic pockets of activity demonstrating high growth. In addition, there will be more opportunities for construction service providers to offer value added services and escape the highly competitive bid markets which are all too common for this type of construction. One example that has the potential for the supply of value added services by contractors is the use of alternative financing vehicles like Public, Private, Partnerships. These vehicles allow local municipalities to secure financing for infrastructure without the traditional requirements to sell bonds or raise taxes. These efforts will introduce a different procurement approach for construction services due to the nature of the financing for infrastructure projects. Contractors offering services to various types of utilities are positioned in a market poised for growth, with significant untapped demand for construction services, in a market where local and medium sized contractors are highly competitive.

This study and article was completed through the efforts of Mark Bridgers, Stevan Simich, and Ted Reynolds. Stevan Simich works with contractors and engineers providing primary and secondary research needed to make sound business decisions. Ted Reynolds provides strategy consulting services to utilities, utility contractors, and engineering firms.

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