April 26, 2023
A Decarbonization Playbook for the New Inflation Era
Managing Director, Regulatory Reporting
Utilities are facing investment headwinds from high interest rates caused by inflation that could derail decarbonization efforts. But there is a path forward to realize net-zero goals while keeping a steady flow of funding sources to finance the transition to renewable energy.
Dramatic Increase in Interest Rates
The Federal Reserve has hiked interest rates from near zero in March 2022 to between 4.75% and 5% over the course of just 12 months. Not since the dramatic rise in interest rates in the late 1970s have we seen such a rapid increase. The culprit is inflation. Though declining slowly, it remains stubbornly high at 5.6% (Core CPI April 2023), which is well above the 2% long-term target set by the U.S. Federal Reserve Bank.
High interest rates increase the cost of both equity and debt financing for regulated utilities. Debt financing is more expensive as investment grade bonds require a premium over risk-free government treasuries at today’s higher yields. Likewise, equity financing is more expensive due to lower stock valuations, suggesting alternative forms of financing may be warranted.
Utilities should look to accelerate capital spending by deploying three key strategies:
- Prosumer incentives
- Robust computing platforms for both front- and back-office operations
First, divestiture of low carbon assets carries significant value. Divesting these assets early in their lifecycle will generate cash proceeds that can be earmarked for decarbonization projects while reducing the burden on more expensive debt and equity sources due to higher interest rates. Just like a homeowner who sells an existing house to raise funds and then rents while building a new home to free up cash, utilities can execute a similar strategy, divesting plants now to fund capital projects while using purchased power as a temporary bridge to secure energy needs during construction of renewables. By divesting attractive generating fleets running on cleaner-burning natural gas, utilities free up cash for heightened spending on new decarbonization projects.
2. Cultivating Prosumers
Still, even with divestitures, utilities will need investment help from the end-consumer of electricity. This brings us to the second strategy: cultivating prosumers by engaging energy consumers and transforming them through rate tariff incentives. Investments in renewable energy must involve residential and business customers to make zero-carbon investments such as rooftop solar and electric vehicles. Utilities can serve as the enabler (together with state regulators) to promote and reward the prosumer with financial incentives. To execute this strategy effectively, utilities need more robust CIS engines with highly granular billing and usage categories closely linked with AMI data sources to provide targeted time-of-use (ToU) rate tariff incentives. Coupled with attractive net metering programs and innovative virtual power plants (VPPs) that offer credit premiums for sourcing power at peak times, prosumer adoption can be accelerated.
3. Robust Computing Platforms for Both Front- and Back-Office Operations
To pave the way for both the growth of the prosumer era and increased investment in renewables, utilities will need to employ the “third leg” in the strategy: to develop front- and back-office digital solutions that incentivize prosumer behavior while providing ERP and CIS computation engines that maximize cash flow from operations. A modern CIS and ERP can be the enabler for utilities to operate more efficiently in a high interest rate environment while aligning with government and consumer goals to achieve net-zero by 2050.
The Need for a Plan-to-Recovery Model
For both meter-to-cash and build-to-retire business processes, modern computing platforms should be positioned to deliver a full Plan-to-Recovery model. A successful execution is one that keeps all CIS and ERP data resident in a single data repository longer, for more timely and accurate computations of customer bills and rate case filings. From granular ToU rate offerings for prosumers in the front-office CIS to the more accurate calculations for depreciation and rate base in the back-office ERP, utilities need to be mindful of the adverse effects of inflation and high interest rates by seeking to mitigate the high costs of capital through CIS and ERP modernization projects that maximize cash flow and profitability.
The silver lining of prolonged high interest rates is the prospect of higher return on equity (ROE) percentages and higher allowance for funds used during construction (AFUDC) credits for clean energy construction which drives more return-based spend in the revenue requirement and less zero-return fuel costs. Exchanging non-return fuel costs for capital spend will also keep energy costs from rising above the rate of inflation as near-term capital spending as construction work in progress (CWIP) has no immediate impact on rate tariffs until constructed assets are moved into the rate base. But computing systems must be modernized to efficiently move construction costs into unitized assets to optimize accurate and timely recovery of depreciation in the revenue requirement. Only modern ERP and CIS systems can shorten the plan-to-recovery cycle for the build-to-retire and meter-to-cash business processes.
Now more than ever, the time has arrived for utilities to redouble their efforts to move swiftly into decarbonization in a way that maximizes value for all stakeholders – consumers, investors, government and suppliers – for a modern utility of the future.
At Utegration we understand the urgency to act now. Between our industry experts and our innovative solutions, we can help you deliver on the promise of a low-carbon future. With Utegration as your partner, you can execute well by deploying SAP technologies and our energy-specific add-ons designed to ensure your utility moves into the future and thrives even during inflationary times.