Seismic Omen

Deck: 

Fukushima shockwaves hit America’s nuclear renaissance.

Fortnightly Magazine - May 2011

Radiation leaks from Japan’s Fukushima-Daiichi nuclear plant following the March 11, 2011, 9.0 earthquake and subsequent tsunami have had a chilling effect on the global nuclear industry, forcing investors and governments to re-examine their energy policies.

In the United States, the Fukushima crisis prompted the Nuclear Regulatory Commission (NRC) to conduct an immediate review of 27 operating reactors (out of the 104 currently running), thereby raising the specter of costly modifications to the aging facilities (average age 20 years) and a redesign of plants on the drawing board.

Several countries, including Italy, Germany, France, India, and even China, have imposed temporary moratoriums on nuclear reactor construction. Until a post-mortem analysis of Fukushima-Daiichi is completed, the global nuclear industry will continue to face the possibility that operating plants might have design defects. It’s conceivable that both operating plants and those under construction could require additional major capital expenditures in order to comply with any new regulations.

The financial markets find nothing more distasteful than uncertainty (you don’t know what you don’t know). What we do know is that a number of plants were designed to withstand earthquakes of 7.0 to 7.5—as much as two orders of magnitude smaller than the March 11 quake.

Analyzing the implications of seismic risks and incorporating lessons learned from Fukushima might add months or even years to construction programs. It’s also conceivable that some projects may be scrapped entirely. NRG Energy, Inc. (NRG), for example, said it would temporarily cap its investment in the South Texas Nuclear Plant (STP) until results of the Fukushima investigation are available. (Notably, Tokyo Electric Power Co. (TEPCO), owner of Fukushima-Daiichi, has a conditional agreement for a partial ownership stake in an expansion of the plant.) And Exelon Inc. (EXC), one of America’s largest nuclear utilities, has expressed concerns that a reactor construction moratorium and incorporation of lessons learned from Fukushima will make the next generation of nuclear power plants more costly than anticipated.

Can America’s nuclear renaissance survive this challenge?

Re-living TMI

The Fukushima-Daiichi situation seems likely to affect the U.S. nuclear power industry in ways that are similar to the effects of the Three Mile Island (TMI) accident in 1979. A history review, therefore, might be instructive for plant owners and utility investors.

Before the TMI accident, companies engaged in large nuclear construction programs enjoyed capital market premiums; their stocks traded at higher price-to-earnings (P/E) multiples and their credit ratings were typically higher than their non-nuclear brethren. Commonwealth Edison, a triple-A utility, had 12 nuclear units under construction. Arizona Public Service, owners of the Palo Verde plant in Arizona, had five plants underway.

The reversal of political fortunes for what was then a fully regulated industry was a clear setback. The anti-nuclear age had begun, and companies now faced unanticipated local opposition, resulting in prolonged construction delays and huge cost overruns—in some cases as much as a ten-fold increase in costs. Political antagonism intensified over the next two decades. Companies that managed to complete nuclear plants met considerable resistance to incorporating these new assets into utility rate structures.

Before the TMI accident, the rating agencies believed that utilities were bankruptcy-proof, and based their financial criteria and ratings accordingly. TMI, however, represented a major turning point for utilities building nuclear power plants. Between 1980 and 1984, 51 reactors were canceled. The post-TMI decade gave rise to new accounting concepts (e.g., phase-ins, securitization, rate shock, etc.), with write-offs endangering many companies’ equity. Credit ratings plunged from a double-A to triple-B within months. Having many projects well into the construction phase, the industry had little choice but to engage in costly financing against a hostile social and political backdrop.

An industry that was once thought to be virtually bankruptcy proof now faced the possibility of insolvency. After all, there hadn’t been a utility bankruptcy in more than 50 years. Investors believed that utilities were legally entitled to earn a regulator-established rate of return on their newly completed assets, nuclear or otherwise. Thus, utilities were bankruptcy proof—or so it was believed.

The 1980s were financially damaging to the industry, especially companies building nuclear plants. Balance sheets and loan covenants were pushed to the limits, and common stock dividends were frequently reduced or eliminated. Utilities were no longer safe havens, shattering the premise that utility common stocks were very low-risk investments, suitable for widows and orphans.

Financial Fallout

When Consolidated Edison (ED) omitted its common stock dividend in 1974, the market reaction was devastating. Its credit rating was cut to non-investment grade and the stock fell to $12 per share from $18, because after 89 years of paying a common dividend, the unthinkable happened.

The one thing a utility never did was reduce or eliminate its common dividend; investors bought utility stocks primarily to get those dividends. Utility stocks were viewed as bond surrogates. There was a tacit understanding in the investment community that canceling a dividend was unthinkable, since utilities had to frequently sell new issues of stock and bonds to finance the expansion of their generating and distribution systems. Utilities, regulators and politicians realized that the dividend-paying ability of utilities was vital to their ability to access the capital markets. Given the capital-intense nature of the utility business, no company would dare to take the bold step to cut or eliminate their common dividend for fear that doing so would cut off access to the capital markets. Investors believed it could never happen. But it did—and more than once.

During the 1980s, bondholders and regulators demanded that utilities retain as much cash as possible to satisfy expanding capital outlays, largely for nuclear plants. As a result dividend cuts and omissions occurred with increasing regularity. Nuclear projects pushed capital spending and external financing requirements to the limits. Construction projects exploded in size, seemingly overnight, from millions of dollars to billions of dollars, and completion dates were delayed by years. Texas Utilities (TXU), once a triple-A utility, saw the cost of its twin-unit Comanche Peak nuclear station rocket to $11 billion from $3 billion, with in-service dates moved out 10 years, to 1990 and 1993. (TXU had broken ground on Comanche Peak in 1974.) Its credit rating dropped to triple-B by the time the plant was finished.

But TXU got off easy compared to some utilities—such as Public Service Company of New Hampshire (PSNH).

Based on a strict interpretation of the New Hampshire Public Utility Commission’s rate-making rules, the New Hampshire Supreme Court issued a ruling disallowing PSNH a return on its unfinished Seabrook nuclear plant, effectively shutting the utility’s access to the capital markets and leaving it illiquid. PSNH would be the first utility bankruptcy in over 50 years.

Legal challenges and stall techniques by Seabrook adversaries—primarily the Clamshell Alliance, but also utility regulators and local politicians, including Massachusetts Gov. Michael Dukakis—forced PSNH to file for Chapter 11 protection. At the time, PSNH was the largest bankruptcy in U.S. corporate history. Seabrook was ultimately completed 10 years later than expected at a cost approaching $7 billion for a single unit.

And no discussion of the nuclear industry would be complete without mentioning Long Island Lighting Co.’s (LILCO) Shoreham nuclear plant project. LILCO announced construction plans in 1969, with a projected cost in the $65 million to $75 million range, and a 1973 in-service date. By 1973—still six years before the TMI accident—cost overruns had pushed the estimated final price tag to $2 billion, as LILCO increased the plant size from 540 MW to 820 MW.

EES North America

Due to mounting anti-nuclear protests, physical construction didn’t begin until 1974. When the plant was completed in 1984 its cost had zoomed past $6 billion. By then, it was the post-TMI era, and the world wasn’t favorably disposed to nuclear power. Opposition to Shoreham was escalating. Following TMI, the NRC issued rules requiring all nuclear power plants to devise evacuation plans in collaboration with state and local governments. In 1983, Suffolk County lawmakers voted 15-1 against developing such a plan, arguing that the county couldn’t be safely evacuated. In addition, the governor, Mario Cuomo, ordered state officials not to approve any LILCO-sponsored evacuation plan.

LILCO vigorously fought the non-participation initiative from 1985 to 1989. However, it was evident that Shoreham couldn’t satisfy the criteria laid out by the NRC for a full power operating license. After a long battle, an agreement was reached with New York State to acquire LILCO and allow the utility to recover its nearly $6 billion Shoreham investment. A newly created New York State entity, the Long Island Power Authority (LIPA), was empowered to purchase the plant and other LILCO assets. The transaction was signed, sealed and delivered in 1998, almost 30 years after the project was first announced.

TXU, PSNH and LILCO are merely three stories from the post-TMI era. This list is by no means complete, but it illustrates the risks associated with nuclear power—an ironic legacy for a “renaissance” industry.

Seismic Risk

Today, approximately 20 percent of the electricity generated in the United States is derived from nuclear plants. Notwithstanding government inducements toward other forms of alternative energy, such as solar, wind, geothermal and biofuels, nuclear must remain on the energy resource menu in order to maintain the degree of reliability Americans have come to enjoy.

President Obama and Secretary of Energy Steven Chu are trying to bolster public acceptance of the technology, even in the Fukushima aftermath. In order to reassure the public, beginning next year, the NRC plans initially to conduct a seismic risk evaluation of 27 nuclear power plants (see Figure 2).

The selection of reactors to be examined initially for seismic vulnerability is more interesting for the facilities omitted from the list rather than those included, specifically nuclear reactors in California, which are close to the San Andreas Fault: Diablo Canyon #1 and #2 (owned by Pacific Gas & Electric) and San Onofre #2 and #3 (Edison International).

The entire West Coast lies along a series of earthquake faults known as the Pacific “Ring of Fire,” including the well-known San Andreas fault. The Ring of Fire refers to a region in the Pacific Ocean basin subject to frequent volcanic and earthquake activity. It’s horseshoe shaped, running from Christchurch, New Zealand right through the Pacific Rim, and down the western coasts of North and South America.

In September 2010, a magnitude 7.1 earthquake occurred about 25 miles west of Christchurch, causing substantial damage. Japan is located on the Ring of Fire, as are Washington State, Oregon and California. About 90 percent of the world’s earthquakes—and 80 percent of the largest—occur along the Ring of Fire.

However, the West Coast is not America’s only seismically active region, and several new reactor projects are located near geologic faults in the eastern half of the country (see Figure 3). Although these might not be susceptible to tsunami risks, their proximity to fault lines is raising new questions about earthquake risks.

The Fukushima-Daiichi crisis provides a painful reminder of just how unpredictable earthquakes are and how controversial nuclear power remains. In the days just after the March 11 earthquake, Rep. Edward Markey (D-Mass.) called on the NRC to review the safety of all nuclear reactors either planned or currently in operation. Markey commented that “the U.S. should not be offering (loan) guarantees. Such backing for new nuclear plants is just like a toxic asset… [T]he U.S. needs a seismic shift in our approach to nuclear reactor safety.”

Markey has a long history of taking an anti-nuclear position, but the Fukushima political fallout isn’t limited to just him. In New York, Governor Andrew Cuomo immediately called for a shutdown of the Indian Point plant north of New York City. The Sierra Club, a long-standing adversary of nuclear power, launched its objection to the proposed Calvert Cliffs nuclear plant in Maryland. Entergy, which is suing the State of Vermont over last year’s decision to deny a license extension for the Vermont Yankee plant, now faces questions about the safety of the plant’s design—the same GE Mark 1 boiling water reactor technology as that at Fukushima-Daiichi. And more broadly, anti-nuclear organizations like Greenpeace are saying the Fukushima crisis demonstrates why nuclear power should be phased out.

To those who remember the financial crisis after the TMI accident, these reactions are disconcerting. Will they frustrate, if not derail, the industry’s willingness today to undertake large-scale nuclear projects?

No Bailouts

The energy industry is unlike most of industrial America. It suffers from a hypersensitivity to ever shifting-regulatory, social and political sentiments—not a good thing given its long construction and capital commitment cycles.

The Obama administration has stated that nuclear power is an integral part of the nation’s clean energy future and is needed to maintain electric reliability and lower our dependence on foreign oil. The president’s view is painfully pragmatic. He clearly recognizes that the 20 percent of the electricity generated in this country by nuclear energy can’t be replaced overnight, regardless of how aggressively we pursue alternatives.

If anything, we are late in the process of replenishing existing nuclear generating capacity. As recently as February 2011, the president stated, “On an issue that affects our economy, our security, and the future of our planet, we can’t continue to be mired in the same old stale debates between left and right, between environmentalists and entrepreneurs.”

The Department of Energy has approved $8.3 billion in conditional federal loan guarantees for construction of the first nuclear power plants in nearly three decades. The loan guarantees are designed to act as a financing catalyst. Southern Company (SO) is the initial recipient of loan guarantees that are intended to aid in funding twin units at the existing Vogtle nuclear station in Georgia. The DOE echoed the administration’s view that they were hopeful that Vogtle would be “the first of many new nuclear projects.” The DOE, the administrator of the loan guarantee program, stated that the department is “actively engaged in advanced work on three other transactions and has begun analysis on four more beyond that.” While not specifically identifying the three projects up for review, according to industry officials the facilities are in Maryland, South Carolina and Texas.

Southern, together with two partners, is planning to add two additional reactors at the Vogtle site at an estimated cost of $14 billion. The company anticipates that the reactors will be finished by 2016 and 2017, respectively. The reliability of these dates now bears questioning, because while construction might be physically possible, it might not be politically possible. There is a slim margin for error, politically speaking. The importance of these completion dates shouldn’t be underestimated because they are the only reactors scheduled to come on line while President Obama is still in office—assuming he wins re-election in 2012. His successor might or might not continue federal support for nuclear power.

As a means to induce investors and mitigate company construction risk, Obama’s 2011 budget proposal would add $36 billion in new federal loan guarantees to the money already earmarked for such guarantees—raising the total to $54.5 billion. While this initiative has been criticized by conservatives and liberals alike, the utility industry says the allocation is well below its needs, which it places at a minimum of $122 billion.

However, the federal loan guarantees aren’t bailouts; as presently structured they fall substantially short of funding the next generation of new reactors. At best, the guarantees are characterized as a vote of confidence in nuclear power.

The Energy Policy Act of 2005 provides, among other provisions, for “Standby Support for New Reactor Delays.” The law offers protection to offset the financial impact of delays beyond the industry’s control that might occur during construction and during the initial phases of plant startup for the first six new reactors. The bill provides for 100 percent coverage of the cost of delays for the first two new plants—but that coverage is limited to a maximum of $500 million per reactor—and 50 percent coverage, up to $250 million per plant, for each of the next four units.

Given the controversial nature of the technology and the formidable opposition, investors and utilities ultimately might find the current level of guarantees decidedly inadequate. For example, NRG recently said that it would consider limiting pre-construction activity at the South Texas nuclear station; it already has committed $350 million to the venture. The project is officially moving forward, but it’s possible the future of units #3 and #4 may come into question in response to new regulations following Fukushima. And Old Dominion Electric Cooperative, holder of a minority stake in the North Anna #1 and #2 reactors in Virginia, recently announced its decision to withdraw from North Anna #3. It should be noted that this decision was made just days prior to the Fukushima accident. It may have been a prescient move given that the NRC has reportedly placed North Anna seventh on its list of the most quake-prone nuclear reactor sites in the U.S.

Rethinking the Renaissance

The NRC has received 19 applications for new nuclear reactors. Time will tell whether or not these plants will receive final approval from the NRC and get built or be canceled by the project owners because they find the anti-nuclear public sentiment insurmountable and the costs prohibitive. The anti-nuclear constituencies have already begun to rally around the wagon. Experience has shown that anti-nuclear groups have staying power and will use every regulatory and legal means to halt a project. The net effect of such intervention is to delay in-service dates and increase plant costs. A handful of companies, knowing the hurdles, might be determined to pursue their plans, but we have to wonder whether those utilities with projects in the licensing pipeline aren’t having second thoughts, given the devastating Fukushima nuclear accident.

One investment bank report (by UBS analysts Per Lekander and Stephen Oldfield) says that Fukushima will be more damaging to the nuclear industry than Chernobyl—because it cast “doubt on whether even an advanced economy can master nuclear safety.” The report suggests that as many as 30 life-extension projects will be scrapped directly as a result of Fukushima. While new reactor designs with passive cooling systems might be more capable of surviving a Fukushima-type disaster, the perceived risk of nuclear construction is now much higher than it was before March 11.

John Rowe, chairman of Exelon, one of the nation’s largest operators of nuclear power plants, recently stated that Fukushima “is going to impose significant costs, perhaps material costs, before we are done.” The question for utilities and investors now is this: Do these capital intensive ventures, having protracted construction cycles, make economic sense for shareholders? How prudent is it to risk capital on an asset that won’t provide cash flow for a decade or more? Old foes are already speaking out and some new ones have surfaced. How will their revitalized opposition affect project schedules and costs? And given the role that spent-fuel cooling ponds played in the Fukushima disaster, uncertainties about nuclear waste have grown substantially. Is the disposal of spent fuel rods an off-balance sheet liability and hidden expense?

These issues shouldn’t be lost on company managements, and they aren’t likely to be lost on investors. Current estimates place the cost of building a new nuclear plant in the $5 billion to $12 billion vicinity, depending on the facility’s size. These projections could prove to be conservative given the roughly 10-year construction period.

So to recap: A postmortem of Fukushima will expose new nuclear plants to many uncertainties, including the possibility of added safety requirements. The anti-nuclear movement will gain strength from this accident, thereby forcing companies to reexamine the prudence of proposed nuclear construction plans. The capital markets are highly sensitive to political trends extending through various cycles—recall the demise of PSNH and LILCO. As projections currently stand, only the first nuclear plants will be shepherded by President Obama, leaving a large political void for the next plants.

In this landscape, it’s hard to conclude anything but that Fukushima represents a disaster for the global nuclear power industry. It might add complexities and costs to relicensing, life-extension and uprating projects, and could spell the end of America’s nuclear renaissance.