Steel for Fuel: Hitting the Sweet Spot on Risk, Return, and Scale for Investors and Customers

A version of this article was published on Greentech Media on December 7, 2018.

By Ron Lehr and Mike O’Boyle

On December 4, two major utilities – Pacificorp and Xcel Energy – made startling announcements indicating that U.S. coal is truly dying or dead.  Pacificorp’s own analysis of its coal fleet indicated that rapid retirement of a majority of the coal capacity would save customers money, while Xcel Colorado announced its intention to reduce its carbon emissions by 80 percent from 2005 levels by 2030, going carbon-free by 2050.

Fast-falling costs of new wind and solar plants precipitated this trend – in 2018 they are already cheaper than operating many fossil generation plants.  Under these conditions, utilities face a dilemma: Retiring coal units early for economic reasons benefits consumers, but shareholders lose an earning opportunity.

But this clean energy transition, if managed well, creates opportunities for utility managers to reduce risks and increase shareholder earnings.

With regulatory approval, utilities may increase equity earnings by shifting capital from uneconomic generation plants requiring very large fuel inputs toward plants that run on free fuel, such as solar and wind.  Xcel Energy, an eight-state utility holding company that has cut carbon emissions 35% since 2005 and targets 55% renewable energy by 2026, branded this strategy “steel for fuel.”

Stakeholder perspectives on steel for fuel

Utility operating cost savings derived from substituting “steel” in the form of new wind and solar generation for “fuel” costs passed along in rates that powers aged, obsolete and uneconomic power plants can provide substantial savings to customers.  And if unpaid investments in early-retired plants are refinanced with securitized or ratepayer-backed bonds, consumers can reap substantial additional savings for paying off obsolete investments.

Once constructed, operating a fossil plant requires continuous fuel supply and delivery.  Fuel costs commonly constitute a large portion of consumers’ bills, treated as an expense for regulatory recovery and usually passed through to consumers through line items on consumers’ bills known as energy or fuel cost adjustments.  Reducing the fuel portion of consumers’ bills also helps to insulate them from fuel cost volatility, risks, and potential liabilities.

For shareholders, early plant retirements with unpaid investment balances left on utilities’ books can threaten earnings per share and share price values, unless regulators agree to allow unpaid investments to be paid by consumers by creating “regulatory assets” – but these unproductive assets carry the risk that regulators could change their minds about whether to allow recovery “of and on” these assets.

Turning this unproductive capital into productive, clean generating assets can simultaneously address shareholder risks and benefit customers and the environment.  This financial transition involves careful consideration of a range of factors examined in a series of issue briefs from America’s Power Plan, including how and which utility costs are recovered, how depreciation schedules for uneconomic assets are adjusted, whether undepreciated retired plant investment balances can be refinanced with cheaper capital from corporate debt or ratepayer-backed bonds, and a more detailed brief addressing equity shareholder perspectives in trading steel for fuel.

Utility Investment Incentives– “Steel for Fuel” Risks, Returns, and Scale

Utilities create value for their shareholders when regulated returns on investment, determined in each rate case, exceed capital costs invested to create returns.  Investment risk, return, and scale can be analyzed to determine whether utility investments create value for shareholders.

Risks like regulators disallowing rate recovery due to asset mismanagement can create or destroy value by impacting returns investors require to account for risks.

While risk and return are commonly analyzed to determine profitability, investment scale also impacts investment risk.  When determining the value of “steel for fuel” investments, early results show the scale of renewable project investments can be substantial enough to maintain or improve shareholder outcomes, more than offsetting investments remaining in early retired fossil plants.

For example, Xcel’s Rush Creek Wind Farm investment, and related transmission infrastructure, will total about $1.2 billion, larger than undepreciated investments remaining in its retired coal plants.  Xcel’s approved plan to retire two coal plants at Pueblo included new clean energy investments of about $2.5 billion.

The risks of investing in new wind and solar projects are common to all generation projects, including future demand uncertainty, site selection and development, technology obsolescence, project financing, construction and commissioning, transmission interconnection, and operations.  In addition, solar and wind projects are subject to resource assessment risks, wildlife impacts, system integration and operations costs, and weather and resource forecasting for system planning and operations.  For utilities that engage in “steel for fuel” transition, these risks are likely to decline as project developers learn through continued deployment of these resources and financial risks decline with experience.

Reliance on large, centralized generation plants dependent on considerable fuel inputs is shifting with new economic and policy realities of renewable energy.  Numerous utilities including Southern CompanyXcel EnergyConsumers EnergyDTE, and MidAmerican, have voluntarily announced that they will rapidly adopt a clean energy or low-carbon portfolio, often accelerating coal plant retirements at significant savings to customers.  “Steel for fuel” is an increasingly appealing method for hitting the sweet spot on risk, return, and scale for investors.

Utility Options– Moving from “Fuel to Steel”

Some utilities are providing options for addressing fuel risks to their consumers by shifting from fuel to steel as a business and investment strategy – but by acquiring and owning new wind and solar projects, utilities can provide advantages to both their consumers and shareholders.

Most utility acquisitions of wind and solar generation plants have been accomplished through power purchase agreements (PPAs) for power produced from generation that is built, owned, and operated by independent power producers (IPPs).  These contracts result in utility expenses, not investments, so regulators may allow cost recovery of the contract expenses, but do not typically allow utilities to earn returns in excess of costs.

Xcel Energy has pioneered a “growth and environmental” benefits strategy by adding wind farms and solar projects to their utility-owned generation portfolios, while retiring ageing coal plants.  These plants are obtained through the utility’s integrated planning process, with state regulatory approval, and result from bidding that produces both plants owned by Xcel’s operating utilities and by third parties under PPAs.

Xcel touts support from their customers and stakeholders for executing this business strategy, due to cost savings from substituting renewable energy for fossil fuel generation and benefits to shareholders as their operating utilities own a portion of new renewable projects that replace old fossil investments.  In a recent earnings callwith investment analysts, CEO Ben Fowke noted that the utility could “. . . invest in renewable generation in which the capital cost could be more than offset by fuel savings.”

When utilities undertake an effective planning and bidding approach to reinvesting in new clean energy, recent competitive bids have revealed very low wind, solar, and storage costs, reinforcing favorable consumer economics of steel for fuel.  Competitive bidding can reveal the lowest-cost projects available in markets for new generation resources, if undertaken in a positive and fair manner.  A mix of IPP and utility ownership is vital, so bidding IPPs and potential utility-owned assets are both subject to competitive pressures.

Financial Analysts’ Assessment of Steel for Fuel

Financial analytical firms are taking notice of the “steel for fuel” trend, evidenced by Credit Suisse Equity Research’s recent categorization of Xcel’s switch from fuel to steel as a “win-win”:

With fuel costs as a pass-through expense (no return earned) for regulated utilities, utilities have a built-in incentive to build more renewables.  Replacing fossil fuel generation with wind resources reduces the fuel portion of a customer’s bill and substitutes it with recovery of and on capital investment in wind turbines (and solar panels). This strategy, which was pioneered by [Xcel Energy] under its “steel for fuel” program, is under consideration by [CMS Energy Corporation] and others. Win-win situation for regulators, consumers, and environmental groups, striking a balance between supporting state RPS goals and stabilizing customer rates.

Other analysts note that steel for fuel provides opportunity for investment that is equal or better than maintaining investment in old equipment because it substitutes capital investment on which utilities an earn equity returns for fuel expenses which are passed through to consumers’ rates without earnings potential.  Popular investment advisory firm Motley Fool recently touted Xcel as a renewable energy stock to consider adding to investment portfolios.

From an equity investor perspective, that substitution is a positive earnings indicator.  Regulatory risks, due to holding old assets or requirements to gain regulatory permission for investment in new assets, are considered about equal.  But these regulatory risks can be managed successfully if approached with advance consultation with stakeholders, as Xcel’s experiences in Minnesota and Colorado have proven, generating positive earnings for its “steel for fuel” investments.

Substitute earnings for expenses

New wind and solar plants are rendering uneconomic the continued operation of ageing fossil units.  This financial transition creates opportunities for utility equity shareholders to both reduce their investment risks and increase potential earnings. By substituting “steel for fuel” utilities can substitute investment with earnings potential for fuel expenses on which no earnings are allowed by regulators.

This model of financial transition implicates shareholders, consumers, utility managers, regulators, and renewable generation project suppliers.  Regulators have a key role in striking a correct balance of these interests that can unlock streams of savings and benefits that can be shared.