JT Parker: We're seeing a lot of growth across the country in terms of infrastructure. There's a ton of momentum just given the sheer demand and need and energy transition and evolution. Our customers are grappling with making the right investment decisions because they have long-term implications and it's investment decisions you'll live with for a long period of time.
Teri Viswanath: That’s JT Parker, he leads the credit team for our power, energy and utility sector here are CoBank. And I’m Teri Viswanath, the energy economist at CoBank and your host of Power Plays.
As always, I am joined by my colleague and co-host Tamra Reynolds, a managing director at CoBank. Hello Tamra.
Tamra Reynolds: Hey Teri. To kick off the year at Power Plays, we wanted to talk about CoBank’s expectations for how 2024 might play out and more specifically, bring more awareness to the fact that CoBank works across multiple energy verticals.
While we specialize in cooperative banking. and hold a specific government charter to support rural community financing across lifeline businesses, our banking practice in other realms like project finance, utilities, midstream and gas distribution gives us a much more informed picture of the total energy landscape — which helps us support our core cooperative customers better.
Viswanath: For this conversation, we caught up with some of CoBank’s thought leaders: JT Parker, who you just heard from, who leads the credit team in our power, energy and utilities division; Matt Hale, a lead relationship manager within the bank’s electric distribution team; and Justin Merkowitz, who leads CoBank’s project finance group.
Here’s that conversation.
Parker: Just this week, I saw PJM, which is a regional market in the Northeast, tripling its annual load forecast for the next decade and increasing its peak load by more than 20%, which are pretty staggering numbers to think about.
Viswanath: From what I read, these future demand estimates are being driven by the growth of data centers, electric vehicle adoption and new manufacturing. But, first and foremost, it’s the data centers. JT, what does this mean for the electricity generation side of the house?
Parker: We heard Jim Matheson, the CEO of NRECA, talking about the data centers and how to support them and what resources to support them with. That's an interesting point, and really, you need an “all of the above,” in my opinion, strategy to support a stable, reliable, affordable grid, or in the absence of a new technology and with the technologies that we have today.
Reynolds: Let’s provide a little perspective here. Electricity consumption at U.S. data centers is expected to triple from the current levels by the end of the decade, rising from about 2.5% of total U.S. electricity demand to somewhere closer to 7% or 8%. But, what does “all of the above” actually mean in 2024?
Matt, as we were preparing for this discussion, you talked about customer meter data and how electric co-ops are getting creative with balancing new demand. Can you expand on this? Also, I think I heard you say that co-ops can’t manage what they can’t measure. What does that mean?
Matt Hale: Correct. I think another thing that co-ops are doing more and more — and I think they've had it at their fingertips but maybe not necessarily dug into it — is data coming from their members. There's a lot of data coming from their members, but their ability to fine-tune and mine that data hasn't readily been available or something that they've maybe paid attention to as much.
I think it's becoming more and more necessary for them to understand the data that's coming back from their meters, from their members, understanding their usage, and then trying to fine-tune that data to develop rate structures that are appropriate for all members. Because one of the things that we're seeing as part of that data conversation is customers and co-ops across the country, in both Colorado and Minnesota, in the places that I deal with, data centers becoming a bigger portion or growing portion of their load.
That requires a very fine-tuned rate structure in order to meet that because high demand's definitely a constant load for them, but there can be high shifts in regards to their power supply, and being able to fine-tune that demand to meet their needs through that data is something that's important to meet all of their customer segments that they deal with.
Viswanath: A Bloomberg headline caught my eye this week, “AI Needs so Much Power that Old Coal Plants are Sticking Around.” The authors of that article suggest that in order to cope with the surge in demand, and that’s demand coming from data centers, power companies are reconsidering plans to mothball plants that burn fossil fuels.
Parker: I heard a generation and transmission co-op CEO last year talking about this very fact, and that the fundamentals really over the next decade, could potentially weaken to a scary point. Recently in the news, I saw some announcements about previously announced plant retirements that have since been delayed due to reliability concerns, so I think there's recognition in the markets about this. I think you're seeing a lot of broad support and concern over reliability.
Reynolds: JT, this general recognition is playing out in utility capital spending programs, and ultimately, to the burden placed on electricity consumers.
The need to raise funds is in addition to the “once in a generation” infrastructure investment that the federal government is making in the form of grants and loans. In fact, the additional capital planning is in many ways a result of infrastructure grant programs that only cover a small fraction of total spend, and may lead to some financial deterioration in the short to intermediate term for electric utilities.
Matt, what do you make of this and how might this fundraising alter traditional capital planning?
Hale: Co-ops are becoming more and more focused on reliability and their ability to accelerate that reliability standard by integrating these grants, and hence, their overall capital structure is becoming very attractive for them. But, from a cost standpoint, is maybe accelerating something that they weren't exactly planning for. Something to be thinking about, something that they're keeping on the forefront of their mind, is that plan heading into 2024.
Viswanath: There is an historic amount of funding now available to fix the problem, so we can just move on. Right, JT?
Parker: I'd say some of the other generation challenges are just the challenges around building new infrastructure. Whether that's generation infrastructure or complementary infrastructure like transmission. Then you have all the permitting issues that are well documented and the lead times that go into new construction related to supply chain issues and inflationary challenges that we have to deal with. I think there's both a challenge with the existing generation fleet and how it's evolving, and also a challenge with new infrastructure and new generation.
Viswanath: The existing collection of federal, state and local siting and permitting regulations is a major obstacle that would seemingly stand in the way of progress. But, what about the equipment or warehouse procurement issues?
Reynolds: Supply chain challenges that began during COVID have continued to cause delays for co-ops. This problem is further complicated by record demand for electric grid components nationwide and a shortage of skilled workers to produce these components. So, Matt, no relief in sight for 2024, right?
Hale: I think costs are another thing from a supply chain standpoint that co-ops are going to continue to struggle with and have to plan for because, as we talk about this, co-ops' biggest expenses are their power supply, inventory, and then interest expense. Those are three big categories that co-ops have to manage to, and I think that's going to continue to be something that they have to look for, plan for, and appropriately manage in order to manage the overall cost to their member-owners.
Viswanath: Justin, you’ve been quiet so far, but I want you weigh in here. Your project finance team sees a significant amount of the new generation that will be developed in the next decade. Before joining the bank, I didn’t realize that CoBank’s project finance platform has been around since the mid-90s and has consistently been in the top 10 of the league tables, because we underwrite anywhere between a billion and a half to $2 billion of transactions each year. I think this is something you can weight in on. So, let’s talk about the current new build cycle, and what impact this massive federal investment is having on those projects.
Justin Merkowitz: 2023 was a very interesting year because it was on the heels of coming out of COVID, and we observed a lot of supply chain disruption, high inflationary environment, interest rates were very volatile. That very much impacted the project finance world because all in capital costs were significantly higher after we'd observed several years of declining costs for these various technologies.
Compared to 2022 where you saw a vast proliferation of projects that were a mix of either contracted profiles or relying on merchant cash flows — where the cash flows were not contracted — 2023, actually, that environment created an uplift in PPA prices to recover these higher capital costs. That actually worked very favorably for lenders, because it resulted in a lot more contracted opportunities, which is very much more of our sweet spot in terms of our credit appetite.
Viswanath: Ok, so rising costs: Are the federal subsidies offsetting these rising costs?
Merkowitz: The Inflation Reduction Act helped offset a lot of these higher capital costs because of the tax credits vis-à-vis the ITC and the PTC, making these projects more economic for the sponsors., But it did create a human capital constraint across all levels of the value chain that we've seen across lenders, even the sponsors, the market consultants, the attorneys, everyone across the board.
We saw sponsors wising up to that aspect of the market and they were looking to scale up their transactions and better pricing because ultimately, sponsors needed to attract lenders to their projects because there was so much competition in the market. We may see RFPs much more in advance than we did in prior years, which makes it increasingly difficult for trying to tee up your resources.
Viswanath: In my mind, I’m envisioning that these “mega RFPs” are like massive highway billboards that are signaling to the industry a huge buying spree ahead, and it’s already tough to source these grid components that Tamra talked about. But switching gears, are there other aspects of IRA financing surprises that we should talk about that are going to impact 2024?
Merkowitz: Probably the other big theme of the year I would say is transferability. So with the Inflation Reduction Act obviously opened up this swath of tax appetite vis a vis the transferability market.
Historically speaking, we have relied on traditional tax equity investors, which are large investment-grade financial institutions that would step into a tax equity partnership to monetize the tax credits. What the transferability market did was pretty much opened the door for any entity that has tax appetite in the market, and ultimately shifted to us getting comfortable with counterparty risk that we weren't accustomed to seeing.
We still are trying to get our heads wrapped around how liquid the market is and what the prevailing prices are for those tax credit transfers. We've heard a range of 90 to 92 cents of which the lenders will structure the tax equity bridge facility as an advance rate against the 92 cents to try to build in cushion. Nobody disputes that there'll be appetite for these tax credits. It's just a matter of us observing how the market unfolds and how the mechanics actually work.
Reynolds: Renewable energy is clearly the winner when it comes to these federal subsidies. But 2024, might also be the “year of the battery.” In fact, battery storage will probably make up 20% or more of the U.S. capacity additions, rising from around 17 and a half gigawatts to somewhere around 31 gigawatts by the end of the year. Matt, what’s driving co-op interest in this technology?
Hale: I've got a great customer that I work with, in regards to being proactive, has implemented batteries as part of their system. They're seeing this truly materialize in regards to cost savings because they're able to manage demand on a daily basis to where sometimes they've been able to — because of weather events and things of that nature — being able to materialize that into maybe a million dollars worth of savings on a daily basis.
Obviously, dealing with a cooperative that has some size, but I think truly hitting home in regards to doing what's in the best interest of their members to deliver reliable, affordable power day in and day out.
Viswanath: But from a market perspective, how have these investments fared so far? Justin, what are your thoughts here?
Merkowitz: It appears that the investment thesis out of the gate on value stacking hasn't materialized in a way that we first perceived. We've seen a lot more fully contracted opportunities for battery storage in the form of either long-term tolling agreements with investment-grade load serving entities, or 5, 10, 15-year resource adequacy contracts.
Viswanath: So the market has had to pivot, so that these projects will pencil. Got it. In that vein, what’s going on with offshore wind generation? There was a terrific MIT article that mentioned that 40% of the global population lives within 60 miles of the ocean, so offshore wind farms seemingly should play a critical role in ‘meeting the gap’ that JT discussed. But last year, a growing number of those projects were delayed or canceled as costs skyrocketed. Justin, what’s going for that segment?
Merkowitz: Even before all the disruption in the supply chain and inflation, offshore wind was already fairly expensive. And as you’ve probably seen in the news, with these inflated capital costs, they're just not penciling anymore for the developer. It's resulting in some pretty significant impairments.
We also recognize that there's a ton of RFPs in different markets around the country, and some of our most important relationships have development pipelines in offshore wind. It's going to be interesting to be seeing if the capital costs start to decline, and probably more importantly, if permitting becomes more seamless of an issue.
Reynolds: Justin, how about the other technologies that the federal government seeks to underwrite, hydrogen for example?
Merkowitz: The key challenges for hydrogen projects are significantly high production costs, and then uncertainty around the incentive and the mandate programs that exist, which really presents challenges from a financing perspective.
I don't think we're going to see a large utility-scale hydrogen facility in the market that's financeable in 2024. 2025, 2026 perhaps? But those deals seem to be getting funded mostly on balance sheet or with significant government subsidies. The other technologies that we've been hearing about, carbon sequestration and carbon capture, I think, again, probably in the very early stages, albeit we are hearing some whisperings from some of our customers that they've looked at these projects.
Obviously, with the USDA, DOE backing for some of these projects, they may become more attractive, but again, probably haven't been tested to scale that these are broadly financeable in the market.
Viswanath: Any others that we should talk about?
Merkowitz: The other technology I wanted to highlight is probably the fuel cell technology. While CoBank has not pursued a transaction in the fuel cell space, we recognize it's kind of a similar investment thesis to battery storage and the fact that they're actually smaller in terms of the size, very modular, they're typically for a C&I application, generally low operating risk, albeit probably in a more accelerated replenishment cycle. There's somewhere to the tune of $500 to $600 million of transactions that have floated for fuel cell technology. That's another area we're paying attention to.
Reynolds: JT, I think you wanted to chime in here?
Parker: Some technologies we've seen take steps forward recently, and there may be some important milestones in 2024, including with a key carbon capture project up in North Dakota, which is being led by a generation and transmission cooperative.
Reynolds: We haven’t really discussed massive changes in delivery. Will 2024 prove to be a breakout year for transmission? JT stressed the need, but are we seeing any movement here? Justin, is there anything here that we can get excited about?
Merkowitz: There was a major flagship transaction that closed that CoBank played a big part in, which was the SunZia financing, which was a massive $10 billion capital raise. We were proud to be the co-documentation agents there, massive amount of capital to be raised across the market. That's about 3.2 gigawatts of wind generation in New Mexico with the transmission line that begins in New Mexico, works its way up through Arizona and California. Very important project and setting the tone for other major projects of a similar nature that are expected to come to market in the next two years.
Viswanath: We are now in the midst of an economic period we have not seen since the 1970s and maybe early 1980s — structurally high interest rates and inflation, and those are the conversations we’ve had today. is this economic environment impacting capital decisions, or financing appetite? JT?
Parker: There was certainly a demand for shorter-dated and shorter tenor paper. Historically, where you'd seen the lower interest rate environment, maybe you'd see 30, 40-year debt in a high interest from the utility companies in that where you saw a significant shift to five years, maybe seven years.
You're seeing that brings its own challenges in terms of a refinance event down the road where who knows what the interest rate environment is. But you are seeing the lack of significant appetite for locking in the rates for significant periods of time that maybe you saw two or three years ago. That's been an interesting development that we've been able to follow.
Also, creative solutions around interest rate management. We've got a derivatives team that offers a lot of flexibility around how you want to manage your interest rate risk, that you can manage a portion of it, you can manage all of it. You can use swap options. You can use different types of instruments to manage that risk. I think there's just a lot more focus given the interest rate environment on how do we make the best decision on behalf of our customer owners and on behalf of our utility rate payers.
Hale: One of the things that I would speak to as we talk about the volatility, obviously, from a rates standpoint and the flexibility there is being able to take advantage of swings like we talked about on a daily basis. And locking those rates out maybe into the future. I think the other important piece of it all, as we talk about flexibility and previous conversations around technology, is, as technology becomes more and more part of the electric co-op system, it's not just your 30-year financing that you put in place and away you go, because the evolution of these assets, as we talk about technology, maybe they're 10, maybe they're 12, maybe they're 15-year assets.
It's thinking about the assets that you're putting in place and then the debt structure that's associated with it. Maybe you do a new AMI system. That's not something that you integrate as part of your 30-year work plan; it's something that you probably put out on 10, 12, 15 years, so you're matching the useful life of those assets with the financing that's associated with it. I think that's the evolution that we're starting to talk with customers about, that we're thinking about, and that we're trying to be partners with, in regards to our members, and structuring debt appropriately for the assets that they're putting in place.
Reynolds: There are financial strategies that our co-ops utilize to mitigate costs such as accelerating projects where it makes sense, utilizing technology, and managing customer rates. But, I want to understand how borrower and banker coordination might aid the financial agility equation.
Hale: Flexibility is key, more so now than it has been in times past. If we look historically, at times past, the rates were sub-3s, 3.5 maybe, and it was a set-it-and-forget-it mentality. You didn't really have to do a whole lot of planning.
You didn't have to do a whole lot of thinking in regards to maybe, 3.5%, maybe 3%. We set the rate at 30 years, and we move on. I think in this interest rate environment where we're seeing an elevated level of interest rates, we're also seeing very volatile swings on a daily basis. Sometimes on a daily basis, we'll see 25 to 30 basis points swings, and co-ops' ability to be flexible and working with CoBank allows them to take advantage of dips on a daily basis.
Our ability to be proactive with our customers, as we talked about a proactive nature in regards to electric systems, it's our proactive nature in regards to interest rate management with our customers. It’s those co-ops, financially planning more into the future now than they've had to in the past, is becoming key in regards to helping CoBank plan and be proactive in regards to their rate needs.
Being in this role and interacting with customers is what allows us to drive success for our members is that we get together, we talk about it, and that we facilitate great conversations that help them plan for the future.
Reynolds: I want to thank our CoBank guests, JT, Matt and Justin. It was really great to hear your insights on the new year. I hope all of you have found this conversation helpful. One of the really important themes for future investment is the growing electricity demand, especially for data centers. For next month’s discussion, we are going to catch up with experts who shed light on data technology, namely artificial intelligence, might be applied to the electric industry.
Viswanath: We are going to catch up with Dr. Jeremy Renshaw, who currently leads EPRI’s effort for artificial intelligence. Bye for now.
