Busting the Transmission Trusts

Deck: 

Creative destruction is coming, and it can’t be stopped.

Fortnightly Magazine - February 2013

Over the next 20 years, the shape of our power grid will change—radically, in fact, as current indications suggest that federal regulatory reforms soon will give broader and clearer authority to state governments to influence what gets built.

And this restructuring will matter greatly, affecting both resources and risk.

On the resource side, over the last 100 years, we built a grid that enabled coal to generate half of our electricity—more than that in the heartland, less in the West Coast and Northeast regions. Likewise, the grid pattern of tomorrow will decide whether and how we get power from oil, coal, gas, hydro, nuclear, wind, or solar energy sources.

But the risk-reward equation will change even more. The reforms now planned will make the transmission industry much more competitive—though still regulated. But more important,  the changes ahead will allow a much broader set of investors to participate in the opportunity to earn regulated, but attractive financial returns—the sort of revenue stream that hitherto has been largely reserved for the utility sector. In spite of all the resistance—and thanks largely to federal regulators—the United States is engaged in the kind of creative destruction of an oligarchical business that has been the hallmark of its long-term economic vitality.

Welcome to the Machine

The U.S. power grid is a complex machine, and it can be changed only via an intense and obscure political and regulatory process.

Up to about 1990, the grid was essentially run by regional oligarchies of large and small utilities, some overseen by state regulators, others co-opting state regulators. Since 1990, the federal government has tried to open the grid up to new participants:   independent transmission companies. Then, starting in 2010, the federal regulators opened the grid further by taking away some of the ROFRs (rights of first refusal) to build transmission that the incumbent utilities have had for decades. This reform was aimed at encouraging not just small independents, but also large utilities—who could now move out from their native-load regions to compete with incumbent utilities in other regions in the difficult business of developing and building new transmission.

These changes are profound, and they will affect the pattern of electricity production in the United States. Natural gas plants will displace much of the old coal-fired system, and, in the states that care about climate change, renewable energy—wind and solar—will complement natural gas as the base sources of power. These are good changes: gas is cheap, it pollutes less than coal; and renewables are becoming cheaper, and they’re emission-free. The transformation of the U.S. power sector, enabled by transmission reform, will add to economic growth and vitality, and will lay the foundation for a higher-tech, 21st-century grid.

Many of the changes in the grid are still to come. The incumbent regional electricity oligarchs are fighting and will continue to fight the process, but in the long run they will lose. The United States is one of the few countries that continuously disproves the “iron law of oligarchy.”1 As it transforms its grid, the United States will once again show that it’s willing to blow up uncompetitive business structures in pursuit of progress, as it has done in a series of trust-busting initiatives that started under Theodore Roosevelt 110 years ago, and including the astounding destruction of the telephone monopoly in the 1990s. This courageous and historic propensity is taking aim at the electric transmission business. These breathtaking acts of political and regulatory creative destruction have had dramatic and positive effects on the nation over the years. As Daron Acemoglu and James A. Robinson write in their seminal work, Why Nations Fail:“[W]hile economic institutions are critical for determining whether a country is poor or prosperous, it is politics and political institutions that determine what economic institutions a country has. Ultimately, the good economic institutions of the United States resulted from the political institutions…” (p.43).

The grid is an economic institution of foundational importance to the American economy, and as such has always fallen prey to efforts by oligarchs to capture it. Because of its importance, it should be governed by political institutions. By its very nature, it is an interconnected meta-machine over which electrical commerce amounting to hundreds of billions of dollars per year is conducted. It knits the United States into three large networks—West, East, and Texas. Such a huge network breeds oligarchies as naturally as railroads and telephony did in earlier periods of American history. And those oligarchies adopt (using Why Nations Fail terminology) “extractive behaviors”—attitudes of entitlement to society’s surplus and corresponding rules from their allies in the political sphere—that are the bane of economic growth and dynamism.

History shows it’s never easy for political institutions to put an end to such wealth-extracting practices. But one of the long-term and enduring distinctions of the United States has been the willingness of its political institutions ultimately to enforce competition on its oligarchical industries. To take but one timely example, the U.S. enactment in the 1930s of the Glass-Steagall Act smashed the financial oligarchy in 1933. The removal of that act in 1998 was a short-lived victory for a new breed of financial oligarchs, but they themselves undermined it by their reckless behavior in the 2000s. The enactment of the Dodd-Frank Wall Street Reform Act of 2010 is another manifestation of the admirable American tendency to bring oligarchs back to heel.

Now, it’s time for the electric transmission sector to go through this all-American process.

The Meaning of Order 1000

The bold regulatory change that will become the equivalent of the Glass-Steagall Act of electricity is FERC Order 1000, which among other things is intended to allow state governments to make changes in the grid in pursuit of state public policy objectives. While Order 1000 has a number of targets, it aims primarily at two issues of particular importance to the argument being developed here. First, it’s aimed at making transmission development easier for states to direct, which is important for the development of renewable energy in particular. Since a federal renewable policy hasn’t emerged, and since not all states want to pursue large-scale renewables aggressively, Order 1000 provides a mechanism for developing the grid in the pursuit of state policy goals. Second, it’s aimed at opening up the grid for transmission development competition by removing some of the preferential treatment that incumbent utilities have enjoyed for decades, in the form of ROFRs.

The federal government has long claimed jurisdiction over the grid because it’s the conduit for interstate commerce in electricity. Federal jurisdiction has coexisted uneasily with a lack of federal involvement in paying for the grid. Essentially, state-regulated electricity utilities (and their consumers) paid for the grid, but FERC claimed jurisdiction over it. While there are federal electricity transmission domains, mostly in the West, there’s never been a national electricity plan, in which the federal government decided how to build out the grid and then paid for it. If there had been such a plan, we might have a coast-to-coast electricity superhighway by now, similar to the interstate highway system that was built in the 1950s and 1960s. Instead, we have a grid essentially built out from the cities by electricity’s oligarchs.

Under Order 1000, state law or a combination of laws from multiple states can direct transmission development. Depending on how a state operates, it can compel or incentivize companies to build out the grid for any state policy purpose, whether it’s to connect renewables, or stimulate state economic development, or get access to cheap energy generated elsewhere. For example, Vermont and northern New York share a huge common border, and lots of commerce and movement along that border, yet practically no electric trade. One wonders why. Part of the answer is that the electricity system is a product of transmission decisions made over the decades, and no one decided to build a robust connection between Vermont and New York. The one line operating today, a 115-kV uncontrolled AC tie, was built decades ago. Even a cursory glance at the map would indicate that a high voltage connection between Burlington and Plattsburg, N.Y., across or under Lake Champlain, would provide a valuable anchor for both states’ electric infrastructure. To provide steady energy and electric capacity from New York to Vermont, a new line with control technology should be built.

Another reason a large New York-to-Vermont connection was never built is that electric transmission development in the United States is a peculiar business. New York and New England are historically different control areas, and planning processes between the two electric regions have never been coordinated. Utilities have state charters, not multi-state charters, so it would’ve been presumptuous for Vermont utilities to ask too much of New York, and vice versa. Only in the late 1990s, when federal regulators began pushing for open access to interstate transmission lines and more electric commerce, did new development companies begin to view seams such as the one between New York and Vermont as business opportunities, rather than insuperable regulatory obstacles and hassles. With Order 1000, Vermont and New York, separately or together, could enable transmission companies to build a better transmission line simply because it was deemed consistent with the policies of either state, or both of them.

In a business where transmission decisions were made within a relatively closed system by an oligarchy, this is a big change indeed.

Selecting Future Projects

Given these changes to FERC regulations, how might these reformed transmission development rules be put into practice? Consider Vermont’s neighbor, Massachusetts. Surveys of Massachusetts voters have consistently shown that the public supports renewable energy. The existing New England grid can’t provide access to enough renewables to meet the commitment to renewables passed by the Massachusetts legislature—i.e., the Green Communities Act of 2008 (GCA). Thanks to the GCA, enacted in Gov. Deval Patrick’s first term, the Bay State has a large and expanding sustainable and clean tech energy sector. Its universities are providing the intellectual horsepower, its financial entrepreneurs are providing the seed capital, and the state government is providing the legislative and regulatory framework within which clean and sustainable energy can continue to thrive. But transmission constraints prevent large-scale renewables—mostly located in Maine, New Hampshire, New York, eastern Canada, and offshore sites—from reaching the market.

Legislation enacted in 2012 seeks to take advantage of the changes in FERC Order 1000, and begins the push for implementing a more progressive transmission development system where the importance of building out the grid is recognized as integral to meeting state RPS policy goals. It would allow the state to procure renewable energy and energy efficiency technologies on a large scale, including the price of transmission, in order to bring down the per-MWh cost. Solar and efficiency projects are implemented at a local level, but it’s the implementation of hundreds of local projects—not few dozen—that will bring the unit cost down. Similarly, wind energy is extremely attractive: once built, it’s completely removed from the vicious cycles of oil and gas prices. But the capital cost per unit will be much lower if obtained from large wind farms.

To get these economies of scale, the legislation envisions a more efficient procurement mechanism. Initially, the state relied on single electric utilities, each of which would contract for a small amount of wind energy. The larger the scale, however, the harder it is for utilities to be the agents of procurement, because in Massachusetts—as in other states where the traditional electricity oligarchies have been reformed—utilities no longer have all the customers. The new law provides a better way: it has utilities pool their RPS demand to allow for larger scale procurement. In addition, the law established a process under which the Commonwealth will determine a mechanism to pool state-wide demand through procurement of renewables into a single “customer.”

With that, the costs of renewable energy and energy efficiency must be allocated to all the consumers equally in the electric sector so that one electricity customer—including traditional utility and competitive retail supplier customers—doesn’t pay more than another to satisfy a state-wide public policy goal. Before 2012, these costs were allocated only to those who happened to be the customers of the utilities who had contracts for renewables and efficiency technology. That wasn’t fair. Sustainability and environmental quality are common goods, and all residents benefited. Under the new law, investments through long-term commitments to purchase wind and solar energy will be shared by all who want to buy electricity off the grid.

Finally and perhaps most critically for the present argument, the right to build the transmission infrastructure needed to bring these renewables to market should be subject to a competitive process. In the spirit of FERC Order 1000, these kinds of transmission projects, secured by commitments from electric ratepayers via regulatory mechanisms, shouldn’t necessarily go to incumbent utilities. Independent companies, or utilities from other jurisdictions, often can do it cheaper, better, smarter. Competition will push the process to get the best equipment vendors, the best developers, and the most efficient investors to come to the opportunity. In essence, in transmission, competition ultimately will be a better system than oligarchy, and has a much better chance to bring down the price of renewable energy.

The Massachusetts legislation, in other words, will put FERC Order 1000 into practice; a large scale and efficient procurement, coupled with a competitive process for selecting the best transmission project, will assure that the state remains the best in class in the development of a vibrant and competitive renewable energy sector.

Enter the Pension Funds

FERC Order 1000 and progressive, pro-competitive legislation such as that emerging in Massachusetts provide the basis for a different financing model for transmission, a model that can drive the cost of transmission and renewables down. In this evolving landscape, pension funds, insurance companies, and other institutional investors will become direct owners of a greater portion of America’s infrastructure. With that change, transmission is transformed from the extractive industry it is today, to an inclusive and competitive industry.

But why should direct investment by institutional investors, especially pension funds and insurance companies, be seen as a good thing? Because they have the capital to invest, they need long-term, predictable returns to pay their pension and insurance benefits, and with their investment the breadth of stakeholders in our electric infrastructure will be greater than ever.

In recent years, America’s institutional investors have shown signs they are gearing up for leaner years ahead. Endowments, foundations, and pension, insurance, and sovereign wealth funds appreciate more than ever that—for many of them—the days of consistent double-digit returns in conventional investment classes are over. While many investment managers have come of age believing the asset bubbles of the 2000s were the norm, slightly older veterans know that we can have a decade or more of low returns in conventional equity markets. Indeed, looking ahead, turmoil in the sovereign and municipal bond markets suggests that even capital preservation might be a non-trivial task. In this environment, assured 7.5 percent returns—a frequently cited target number—will be very challenging indeed.

This is why investments in infrastructure—especially of the kind that has a credit-worthy contract behind it—are deemed so valuable. In the past 10 years, almost $100 billion has been invested in U.S. electric transmission development. Most has been financed by utilities, providing them with a safe 10 to 12 percent rate of return. Some is now project-financed; independent transmission companies compete in RFPs, and bid market-based tariffs that are designed to win a competitive procurement. In this emerging, competitive transmission sector, developers have to design project returns that are low enough so that capital costs keep the bids competitive, but high enough to satisfy the investment thresholds of the financiers and developers.

The beauty of transmission infrastructure assets is that they last for decades and, properly designed, can provide annuity-like returns for investors who would happily have some stable returns amidst the cocktail of up-and-downside risk, volatility, and potential loss of principal found in the typical equity investment these days. Indeed, the recent portfolio descriptions of a lot of institutional investors commonly complain that “infrastructure” and “hard assets” are under-represented and notoriously difficult to find.

The fit between infrastructure projects that need investors, and investors who need infrastructure-type investments, should be obvious. In the coming decades, there will continue to be an urgent need for infrastructure investment in the United States and abroad. Electricity infrastructure assets, thus far, are mostly in the hands of utilities. Thus, an institutional investor seeking infrastructure exposure in that industry could, until recently, only buy utility stock. The problem with that is utility management might, or might not, be content to be an infrastructure play. Utilities in search of growth buy or merge with others. Investors and regulators have become increasingly skeptical about the benefits to the public from these ventures, and they are making M&A more difficult to execute.2

This is why recent developments in electric infrastructure finance are so intriguing. Slowly but surely, a transmission asset class is emerging that institutional investors can buy directly, with little or no danger of utility management surprises. Four major independent transmission projects have been developed, and one transmission company has been set up as a real estate investment trust (REIT). The independent transmission projects are: Neptune Regional Transmission System (New Jersey to Long Island); the Hudson Transmission Project (New Jersey to Manhattan); the Trans Bay Cable (Pittsburg, Calif., to San Francisco); and the Cross Sound Cable (Connecticut to Long Island). Interestingly, they are all direct current (DC) projects, and all are subsea. Collectively, they total almost $3 billion of capital invested. The equity has come from pioneering private equity firms, while the debt has been eagerly subscribed by institutional investors—notably, public and private institutions, and Taft-Hartley pension plans and insurance companies.

In all these cases, the initial development was carried out by a new breed of developers, some of them from the oil and gas business, others from the power plant development boom of the 1990s. After the first few projects paved the way, early development capital began to flow from U.S.-based private equity firms into projects, in large part because the private equity (PE) firms saw how attractive the electric power transmission asset class was to their limited partners. In exchange for the capital for early development, the PE firms obtained the right to buy equity and influence the placement of debt in the projects.

The Force of Financial Gravity 

That brings us to the current period, 2013 through 2020. Looking ahead to the next $100 billion of infrastructure opportunities in the U.S. electric transmission sector, the question is: who will command the opportunities? The utilities, of course, will get their share, even though federal and some state regulators are trying to bring some competition into the sector. Assuming $50 billion or so is available to the competitive, project-finance market, who will get to invest the $15 billion or so of equity, and the $35 billion or so of debt, in the next Neptune and Hudson-like projects? A similar set of questions applies to the rest of the world, where the investment potential is multiples of the U.S. opportunity.

For transmission developers, the investment terrain is promising. There are mountains of capital wanting to be deployed by institutional investors. There should be competition between transmission developers, and those that can directly access investor capital at competitive rates will thrive, because their lower capital cost allows the developer to base bids in the competitive arena at a lower cost of money.3 Moreover, companies representing institutional investors willing to buy and hold will have an advantage over those who need to flip the asset a few years into projects’ commercial operation. Cross Sound Cable and Neptune interests have already been sold in secondary markets, and the buyers were firms that had comparatively low cost of capital. For institutional investors, transmission projects are prized assets; they’re long lasting, low maintenance, and critical to their customers, and they typically have a material residual value at the end of the initial financing period.

Moreover, transmission projects can be liquid assets. In the long run, after the transmission projects are built, many of them will wind up in REITs. In a private letter ruling issued in 2007, the U.S. Internal Revenue Service ruled that electric power transmission assets qualify as “real property” and can therefore be held in REITs.4 Just as master limited partnerships are good institutional homes for oil and gas pipelines, REITs are good homes for electric transmission lines.

The biggest challenge for institutional investors is financing project development risk. At the moment, the mosaic of state transmission rules make investment in new transmission a risky proposition. FERC Order 1000 will do a lot to diminish that risk, which in turn should give new transmission projects access to low-cost capital. Since the demand for new, competitively developed transmission projects will increase, and there’s abundant capital wanting to be deployed in this asset class, institutional investors will simply have to become accustomed to investing some early development capital. In the competition to be awarded new transmission projects over the next 10 years, the cost of capital will matter, and institutional investors will have to shift their focus from allocating transmission capital from traditional fund vehicles toward more direct and larger infrastructure development vehicles.

It seems inevitable that the force of financial gravity—institutional investors seeking infrastructure’s long-term stable returns and infrastructure’s seeking stable, long-term investors—ultimately will exert itself. But it isn’t easy to replace an oligarchical system as deeply embedded as we have in transmission. FERC’s Order 1000, the intensity of the desire of state governments to control their own electric energy destinies (in the absence of federal leadership), and financial gravity are going to change the enormous machines called the transmission grid of the United States—and enable natural gas and renewables to step in where coal and nuclear power are stepping out.

Endnotes:

1. Originally formulated by Robert Michels, a German-Italian sociologist (1876-1936), as cited in Daron Acemoglu and James A. Robinson in Why Nations Fail. The Origins of Power, Prosperity, and Poverty, New York: Crown, 2012.

2. For example, see “S&P Cuts Duke Energy, Citing Abrupt Leadership Changes,” Wall Street Journal, July 25, 2012. “The ratings firm said as a result of the sudden leadership shift, the company may not be able to realize regulatory goals in two of its biggest jurisdictions.”

3. Most recently, Calpers, the Califoria retirement fund, acquired a majority interest in the Neptune project in 2013.

4. Sharyland Utilities, L.P. was the party requesting the private letter ruling. Subsequently, Sharyland created a REIT that includes as participants Hunt Transmission (a Sharyland affiliate), along with John Hancock, TIAA-CREF, Marubeni, and the Canadian Op-Trust.