What Is The Future Of Generation? The Path Ahead

8.21.12

Andre Begosso, Senior Executive, Accenture Daniel Krueger, Managing Director, Accenture Terry Maxey, Senior Executive, Accenture

Accenture believes, however, that this expected increase in capacity is overstated. Less than 30 percent of the planned 52 GW expansion is under construction today -- and just 10 GW or so of that is dedicated to baseload generation. Assuming that about 20 GW of new capacity (net of retirements) actually comes on line during this period, reserve margins of approximately 20 to 25 percent in 2011 are expected to decline to about 15 percent by 2014. And while a 15 percent across-the-board reserve margin would be acceptable, the erosion of reserves -- and the investments required to boost them to acceptable levels -- have varied significantly from one region to another. As a result, forecasts show that many markets, including Texas, California, the Upper Midwest and others can all potentially fall below minimum required reserve margin levels within the next years.

Building capacity in the face of unprecedented industry volatility

While power development has never been an easy business in the United States, three factors are now converging to create an even more complicated industry environment.

• Uncertainty. "Uncertainty" is a common theme among all the possible power generating options today. Take coal power, for example. While global demand is escalating, stricter environmental regulations -- coupled with lower natural gas prices -- will likely make it difficult for coal power generators to sustain the economic viability they have enjoyed for decades. Additionally, the interest in renewable forms of energy and technological developments such as the introduction of plug-in hybrid vehicles may soon reshape demand curves.

• Lack of investment incentives. Over the years, the industry has embraced different waves of construction policies and incentives that ensured a reliability of supply. More recently, the recession and its resulting loss in load have put reserve margins in a comfortable territory. As a result, companies have had few incentives to build new baseload generation capacity. With the average age of the current baseload fleet at 35 years, the United States desperately needs investment in new baseload generation. Yet, current market trends are not spurring much investment activity. And even if they were, today's wholesale markets could not support the investment and development of new generation.

• Complexity. In the industry today, structural flaws inhibit the ability of a pure locational marginal price-based power market to send the long-term price signals that are necessary to support merchant baseload investment. Environmental legislation, supply security, renewable portfolio standards and demand side management are issues that make the resolution of these structural flaws even more difficult. That said, there are opportunities to inject true demand proxies (e.g. state participation in markets) or to provide state-sanctioned development backing so that long-term baseload generation equations adequately respond to issues of supply and demand.

Amid the industry's volatility and uncertainty, executives are struggling with how to achieve long-term resource adequacy. Because of the complexity of the regulatory environment and differences in the electricity markets in each state, no single solution exists. Instead, the market is considering three distinct approaches:

• "Laissez Faire" approach. In this scenario, as reserve margins decline, power prices would increase to the point of scarcity and attract new investments. New generation would be built until all economic rent was extracted and a new equilibrium point was reached. Short-term supply gaps would likely be filled by demand side management and new natural gas generation. Over the longer term, the expanded role of gas generation would drive up the market's "heat rate" and "spark spread" to create the scarcity pricing that is necessary to usher in the construction of new power plants.

  There are two potentially significant problems with this approach. The first involves timing. It may take years for the market to institute the scarcity pricing needed to drive new investment. Also, developers and utilities face long construction lead times. Given that many are still not creditworthy enough to get financing, it is unlikely they would be able to secure the funding needed to build the capacity that is needed in the near term. The second involves public support. To create scarcity price signals, reserve margins may need to dip well below the acceptable levels for reliability. That would be unpalatable for consumers and regulators and could have repercussions on the overall US economy.

  
  
  

• Capacity mechanism approach. In this scenario, capacity mechanisms based around an ideal target portfolio and reserve margin would be established by a central-planning entity such as a state regulator or Regional Transmission Organization, rather than by the market. Payments funded by the Load Serving Entities (and ultimately by the electric customers) would provide the long-term investments for new generation.

  Setting capacity payments is not easy, since such payments are tied to the estimated cost of building new units that would meet reserve margin and target portfolio requirements. With considerable upward pressure on engineering, procurement and construction costs, as well as uncertainty about future environmental standards, these costs are difficult to estimate. Additionally, capacity payments are often too low to foster investment in new generation. This was the case in New England and for PJM Interconnection, where capacity markets were able to fund only the maintenance of existing generation. Other states, including Connecticut and New Jersey, are now developing new capacity instruments to encourage investments in new generation. This is welcome news. However, the lack of homogeneity across states may make the implementation of a true capacity market more complicated.

• Re-regulation approach. This approach is based on the premise that some states -- discontented with the failure of deregulation to lower power prices -- would take steps to create a "re-regulated" environment. In such cases, individual utilities would need to demonstrate not only the need for investment in new power generation, but also a plan to recover investment costs.

  Currently, Accenture does not believe that any fully deregulated state will actually turn back the clock on competition. However, in states where market transitions are less advanced, regulation might come back into favor. This seems to be happening in Virginia. In December 2007, the state's main utility, Dominion Virginia Power, floated a proposal to end rate caps and return to a cost-of-service based model that would allow the utility to build new generation. This was, in effect, an invitation for the state to embrace a regulated model, rather than relying on the newly formed capacity markets in PJM Interconnection to incentivize new generation.

  Another possible outcome of re-regulation might be the creation of hybrid market models. Such models would develop new supply from a blend of utility and contracted merchant plants. The clear winners in these hybrid model scenarios would be the regulated utilities in the affected states, since the growth opportunities for merchants would be significantly reduced. The major problem with this approach is that new generation would be built based on the need and the ability of utilities to gain recovery of the investment; the incentives might encourage utilities to overbuild.

Accenture believes there will be a correction of existing generation prices before the next building cycle begins. Longer lead times, combined with higher costs associated with building new generating facilities, have led industry executives to revalue their existing plants. But the gap between the building and buying options is still wide enough to encourage asset transactions instead of new building, particularly when it comes to gas-related assets. When the gap between building and buying assets closes, new generation will be built.

Despite the possible scenarios outlined above, Accenture believes that new generation will be built under different regulatory compacts and using different market solutions. One thing, however, is certain: The industry is unlikely to put all its eggs in one basket. Ultimately, a mix of plant types will be pursued, including gas baseload, coal, (longer-term) nuclear, and renewables. The first wave of new plants will most likely be constructed by regulated utilities. For their part, unregulated generators will try to ride the wave of market heat rate and spark spread since they will be unwilling to commit to new construction without creditworthy, long-term off-take agreements.

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