Heads Up, Arizona, Part 3: The Cost of Energy Infrastructure to 2032

June 18, 2008

This is the third of five stories on Arizona's infrastructure needs over the next 25 years, based on a recently-released report, "Infrastructure Needs and Funding Alternatives for Arizona: 2008 to 2032," which was commissioned by the Arizona Investment Council (AIC) and prepared by the L. William Seidman Research Institute at the W. P. Carey School of Business.

Building the infrastructure necessary to meet Arizonans' rising demand for energy will cost between $74 and $87 billion (allowing for inflation) over the next 25 years. But how to pay those costs -- and exactly what type of infrastructure to build -- is up for debate. It's a debate that the energy section of the AIC report aims to initiate. "Arizona faces important and difficult decisions about how to meet rapidly growing demands for energy," the report's authors write.

The time to begin that debate is now, the authors suggest. "With construction lead times of eight years or more, now is the time to plan for new facilities and to think of new ways to finance infrastructure in a capital-intensive sector."

Rising energy demand

Over the next 25 years, Arizonans' demand for electricity will increase by about 85 percent; demand for natural gas and petroleum products will nearly double.

Much of that demand increase is due to a rapidly growing population -- set to increase by 65 percent to nearly 11 million people by 2032. Some of the demand increases are due to increasing per-capita energy use.

As technologies advance, air conditioners and other appliances have become more energy efficient, said Kent Hill, Seidman research economist and principal author of the report's electricity section. "But those efficiency gains have been more than offset by larger homes and more energy-intensive consumer products, such as computers and digital TVs," Hill said.

How to meet that rising demand for energy was a focus of the energy section of the AIC report. The kind of rapidly increasing demand for energy the report forecasts makes for an environment in which capacity additions -- new infrastructure -- are critical.

"Given the expected 85 percent rise in electricity demand, the state is probably -- and we're being a bit generous here -- already at capacity. From this point onward we need to add the capacity to match the increases in demand," said Tim James, Seidman's director of research and consulting.

Some have suggested that simply expanding the electricity generation capacity of Palo Verde Nuclear Generating Station could supply all of Arizona's future demand. But Hill said that an expanded Palo Verde still wouldn't be enough, although it would certainly go a long way toward meeting our electricity needs.

In the past, the state managed increases in demand by building new gas-fired power plants -- "enough to quadruple gas-fired capacity in the state," Hill said.

But that approach may not work in the future, for a number of reasons, Hill suggests. "For one, natural gas has become much more expensive since the 1990s, when relatively low natural gas prices drove a surge in natural gas plant construction. Secondly, as environmental concerns escalate, both natural gas and coal generation methods are likely to be discouraged (without major technological breakthroughs, at least)."

Given the difficulty of predicting what future gas prices and environmental policy will be, the researchers considered three different scenarios for generation investment -- predominantly coal, predominantly natural gas, and expanded nuclear.

"Those generation mixes give us different estimates of the amount of infrastructure that we will need to build and the cost of that infrastructure," said James.

The total 25-year capital cost of generation infrastructure under the natural gas scenario is $36 billion. The cost rises to $45 billion for coal and $49 billion for nuclear.

The most financially efficient generation method is the one that minimizes the total cost of generating electricity, including fuel and operations expenses as well as capital costs. Even though it's much more expensive than coal generation and, depending on the level of gas prices, somewhat more expensive than gas generation, an increasing reliance on nuclear generation may be preferred if the country is serious about reducing carbon emissions.

Adding the generation costs to the costs of electricity transmission and distribution infrastructure, the total 25-year electricity infrastructure bill is between $65 and $77 billion. That investment, James said, will create a network of electricity infrastructure that is "fit for purpose to provide the coming population and the existing population with sufficient electricity generation, transmission, and distribution to cope with what's going to happen to us if all those people arrive as expected."

In the natural gas, petroleum, and other fuels sector, new refineries, new transmission and distribution pipelines, and new storage capacity will be necessary to cope with the estimated 100 percent increase in demand for liquid fuels. Especially important is a natural gas storage facility, said Dennis Hoffman, Seidman's director and principal author of the AIC report's pipelines and fuels section.

"We have virtually enough natural gas traversing the state today to cover all of our future needs," Hoffman said. "Yet consumers don't have claims to all of that natural gas. We need a way to store -- at a minimum -- 2-3 days' supply. That storage will help us guarantee the security of our supply of natural gas." A new storage facility -- Arizona currently has none -- would cost between $200 and $300 million, Hoffman estimates.

Overall, the costs to secure enough capacity to meet rising demand for natural gas and petroleum products are around $9 billion over the next 25 years.

Financing the bill

Yet it's not the bill, per se, that's at issue: it's the state's ability to pay it. In the electricity sector, adding operations and maintenance costs to the capital bill, the report finds a $109 billion gap between the state's current ability to fund electricity infrastructure and the infrastructure costs.

In the natural gas, petroleum, and other fuels sector, the general conclusion is that "demand will be met by the private sector, which has historically demonstrated an ability to quickly satisfy consumer demand," said Hoffman.

Yet it's not really possible to disentangle the fuels sector -- where capacity will be funded by the private sector -- from the electricity sector, which will struggle with a $109 billion funding gap. "If there isn't sufficient revenue power on the part of the electricity generators to sign long-term agreements with the pipeline transmission organizations," James said, "those organizations won't have sufficient funds to be able to build the pipelines we need."

So bridging the gap between funds and costs in the electricity sector is critical to the overall ability of the state to meet its growing demand for energy.

Arizona's ability to do that, though, may be limited, according to the report. "Arizona is in the precarious position of having major utilities with poor bond ratings and, at the same time, a sluggish regulatory process that results in periodic (typically large) rate changes rather than smaller, more frequent ones. When market investors doubt the ability of a utility to recover costs in a timely fashion, ratepayers must absorb higher interest costs for the utility's debt financing," write the report's authors.

That's certainly been an issue for Arizona's largest provider of electricity, APS, which went to the Arizona Corporation Commission again this year for a rate increase (a rate increase was granted by the ACC in 2007). The Commission has not yet ruled on this year's increase request.

Bridging the gap, then, calls for innovative financing mechanisms. The report offered several, including:

  • Changes in the way that the Arizona Corporation Commission sets rates, for example, "establishing a process that allows for more frequent but smaller rate increases to minimize the effects of regulatory lag and reduce the impact of rate shock on Arizona businesses and consumers;"
  • Establishment of capital recovery mechanisms, such as hook-up fees, to "facilitate more timely recovery of required distribution, transmission and generation investment;" and/or
  • The creation of a transmission infrastructure authority, akin to the Water Infrastructure Financing Authority, to provide power providers with low-cost loans in order to finance infrastructure construction.

A good financing mechanism, according to the report, is one that "smoothes out the pattern of expected price increases, improves the timeliness and predictability of capital investment recovery, and balances the cost of growth with who pays for it."

Even with the introduction of innovative new financing mechanisms, the report concluded, electricity prices will have to rise. "The era of declining electricity prices is over," write the report's authors. "Retail prices will have to rise to allow producers to recover the higher cost of fuels and more expensive methods of generation that are necessary if the industry is to support environmental initiatives."

Now is the time to plan

The bottom line, according to the report's authors, is that decisions about the kind of energy infrastructure the state will pursue -- and how the state will finance it -- have to be made now. "The decision must be made within the next few years if the plants are going to be ready to meet the needs of Arizonans a decade from now."

Bottom Line:

  • Over the next 25 years, electricity demand will increase by about 85 percent; natural gas demand and demand for petroleum products will nearly double.
  • The capital cost of adding energy capacity -- new infrastructure -- to meet rising demand is between $74 and $87 billion.
  • In pipelines and fuels, there is no gap between funding and costs. In the electricity sector, the story is very different. Over the next 25 years, there is a cumulative funding gap of $109 billion.
  • Arizona's ability to bridge the $109 billion funding gap in the electricity sector may be "limited" due to the state's major utility's poor bond rating and a "sluggish" regulatory process.
  • Bridging the funding gap will require innovate financing mechanisms that "smooth out the pattern of expected price increases, improve the timeliness and predictability of capital investment recovery, and balance the cost of growth with who pays for it."
  • The time to act -- to plan construction of the energy infrastructure that will meet Arizonans' growing demand -- is now.