2008 Utility Market Outlook
FMI Corp.'s Top Consultants Survey the Electric, Gas, Water and Other Utility Markets
By Mark Bridgers, Mike Chase & Dan Tracey

Looking ahead to 2008, the utility construction industry can again expect growth rates in every segment that will exceed both gross domestic product (GDP) and inflation. Despite the decidedly positive outlook, financing remains a constraint on utilities’ capital spending as debt markets tighten and the global economy slows its growth. The problem of an aging workforce in utility contracting will remain critical in 2008, as will the movement toward “green” and renewable technologies. According to a recent survey completed by Harris Poll, one-third of Americans would prefer to work for a company that encourages socially responsible and environmentally friendly practices. How many electric, gas, water/sewer and telecommunications firms — or the contractors that serve them — can meet this expectation? Very few. Employment experts agree that this issue is a rallying point among Generation X (born between 1966 and 1982) and Y (born between 1983 and 2000). Utilities and contractors that want to attract and retain these staff should focus on presenting an environmentally friendly image. They will have a distinct recruiting advantage over those that ignore this trend. Demand for capital spending in all utility segments is quite strong due to service needs created by aging infrastructure, the increasingly complex regulatory environment and continued population growth. However, as in 2007, we expect capital spending on infrastructure to fall short of identified needs despite the strains placed on existing systems. Water/wastewater and sewer infrastructure are among the oldest and most in need of upgrade and pose the highest risk of failure.

The recent steam pipe explosion in New York City dramatically illustrates the need for additional funding. Mounting pressure for government funding and the use of public-private partnerships as an alternative financing mechanism will also contribute to a changing landscape during 2008. Construction demand in the telecommunications sector remains high as sweeping technological enhancements outpace construction activity.

Power Generation Forecast

FMI forecasts robust growth at almost twice the general economy for electric and gas utilities during 2008, although not quite as strong as the 10 percent advance in 2007. Tempering FMI’s 2008 forecast are climate change and public pressure for renewable energy sources that will demand innovative solutions by utilities and contractors.

Pending legislation will continue to place limits on utility’s sulfur, nitrogen and carbon emissions; the questions now are when and how the reductions will be mandated (carbon tax, incentive program, cap and trade, etc.). Although the upcoming presidential election makes any significant political action during 2008 unlikely, many contractors are already seeing an increase in retrofit work as forward-looking utilities prepare for the more stringent emission standards.

Power Transmission & Distribution

A depressed domestic housing market and rising construction costs lead FMI to reduce the growth forecast for Transmission and Distribution (T&D) spending in 2008 as compared to last year’s forecast. On Aug. 15, 2007, the National Association of Home Builders (NAHB) reported that the NAHB/Wells Fargo Housing Market Index had reached its lowest level since January, 1991, which was a recessionary time period. The index gauges builder perceptions of current single-family home sales and sales expectations for the next six months. Thus, capital spending on T&D is forecast to see just a modest rise from 2007.

“Our priorities are to upgrade our energy delivery network and invest in transmission projects that will strengthen the grid within our adjoining footprint…and to continue to improve our existing facilities” — Michael G. Morris, CEO of AEP

Despite the slowdown in T&D spending growth since 2004, the cost of work in this sector continues to rise. According to the Handy-Whitman Index of Public Utility Construction Costs, transmission and distribution costs have increased an average of 4.8 and 5.4 percent per year, respectively, since 2003. Factors that will continue to drive construction costs upward in 2008 include increased competition for crucial resources such as steel, aluminum and labor from Asian markets and limited refining capacity in North America affecting plastics.

Utilities are taking advantage of both new funding and technological advancements as they continue to update their aging infrastructure. The super efficient high temperature superconductor (HTS) wire will make its debut in an urban environment during 2008 when Consolidated Edison, the U.S. Department of Homeland Security and American Superconductor team install HTS in New York City’s grid. The $40 million project is scheduled for a system demonstration by the end of 2008 since new cables can be placed into the existing underground tunnels and ductwork.

Ameren announced last year that it would commit $1 billion (over and above the $500 million budgeted) toward reliability and environmental performance through 2008.

Water

While water supply spending is expected to increase 7 percent in 2007, growth now and over the next four years is forecasted at the lowest levels since 2004. FMI sees water supply construction growth as limited by residential construction setbacks, the need for updated processing facilities to increase delivery capabilities and a lack of funding. Since 2005, water construction spending has been trending up, but the bottoming-out of the housing market and the lack of funding have curbed FMI’s outlook for both water supply and wastewater construction spending.

Facing significant capital shortfalls as it is, the slowed growth of water supply spending does not bode well for the continued need for infrastructure maintenance and new infrastructure construction. According to a report released by the Water Infrastructure Network, the United States spends upwards of $15 billion to $20 billion on new water and wastewater construction annually. An additional $23 billion a year is needed to replace aging infrastructure and comply with federal water regulations; it is this replacement funding that is largely absent.

One solution to the dearth of funds is privatization and it has been gaining ground. Currently, 40 percent of cities have at least some form of outsourcing or public/private partnership for water services, and an additional 14 percent are considering the option of a partnering agreement. Of those 40 percent that do utilize the private sector, most cities buy design and construction services while other services are utilized much less frequently. The use however of these outsourced services is trending up.

Three main criteria drive the movement to accept privatization:

1. Lack of Funding: Plans exist for much of the necessary capital infrastructure upgrades and expansion, but a financing shortfall prevents spending.
2. Environmental Regulation: Compliance with federal, state and municipal regulation will also act as a driver toward the use of privatization as an alternative to tax increases to fund infrastructure. Consent decrees are utilized with greater frequency in order to force municipalities to address inappropriate discharges.
3. Perspective Shift: The driver with the most potential to influence privatization is the change in the ideology of our leaders. Recognition that the way we have handled our water problems to date cannot resolve the problems we continue to make. New ideas must be the solution to our old problems.

The utilization of alternative financing solutions is one part of the answer to our deteriorating water infrastructure, but success ultimately hinges on the emergence of sustainable thinking in the construction industry. Many of the “green” products currently used by the water industry focus on conservation, such as waterless urinals in corporate skyscrapers and rainwater reclamation systems for irrigation. In order for significant gains in efficiency (and in turn capacity) to be made, the water supply sector will need to see technological advances that focus on material composition as well as conservation.

Sewer

The sewage and waste disposal sector faces many of the same issues as water supply. Both markets demand considerable amounts of capital funding to care for their aged and overcapacity systems. Specifically, water plants and pump station construction should see capital expenditure growth between 7 to 10 percent over the next five years. Although the water infrastructure is rapidly deteriorating, new or replacement pipeline construction has a conservative tempered growth forecast of 4 to 6 percent through 2011.

The financing gap is large and many organizations have tried to estimate the size of it over the next 20 years:

• The Environmental Protection Agency (EPA) — $76 to $534 billion
• The Congressional Budget Office (CBO) — $292 to $822 billion
• The U.S. Government Accountability Office (GAO) — $300 billion to $1 trillion
• The Water Infrastructure Network (WIN) — $1 trillion

On a local level, the continued increases in federal regulations and mandates, coupled with a decreased allotment of federal funding to wastewater infrastructure, have placed huge strains on local governments to meet these new guidelines on their own. Currently, each state’s clean water revolving loans account for less than 10 percent of wastewater infrastructure projects.

Public pressure is mounting to address aging infrastructure and while the likelihood of a catastrophic failure is low in this construction type, the “slow bleeding” of minor failures is accumulating. Rate increases and operating efficiencies, such as economies of scale and asset management, will not alone provide the needed funds for the current backlog of capital improvement projects. Novel approaches and new funding streams must be recognized and successfully implemented to stabilize our wastewater infrastructure.

Telecomm

During 2006 spending on communications-related construction experienced its largest increase since the dot-com era, reaching more than $15 billion. The cyclical nature of communication spending indicates we will again reach 2001’s record levels in 2009. Spending growth is expected to level off after 2007’s strong 12 percent rise to a more modest 5 to 8 percent annual rate through 2011.

The following factors will drive the communication sector’s capital construction in 2008 and beyond: increasing usage, access and storage capacity; security requirements; and infrastructure upgrade demands. Spending growth will be focused primarily on enhancing our existing infrastructure, in addition to providing scalable solutions to the advancing communications network. Communication service providers have invested more than $110 billion in network upgrades over the last decade. Experts agree that this investment will increase over the next decade as technologies become more complex and services require more sophisticated equipment to operate.

Wireless infrastructure continues to absorb a majority of new communications construction spending. Estimates put worldwide mobile phone users at 3 billion by year-end. The recent bandwidth-intensive trend to bundle voice and data transmissions will fuel the demand for infrastructure growth. According to In-Stat, the number of cellular base stations installed in the United States jumped 15 percent in 2007, after several years of single digit growth. Every major wireless service provider is enhancing networks to provide faster service and higher-performance connection speeds, as demand for 4G services takes precedence over 3G.

Government regulation looms as one check on the sector’s capital spending. Many providers are opting to rely on existing infrastructure as more stringent regulatory standards require expensive disaster protection and security upgrades that eat up their capital spending. IDC, a telecommunications industry research company, estimates that businesses worldwide spent $70 billion on communication, security and business continuity technology systems in 2003, and they predict that number will increase to more than $120 billion by 2010.

Conclusions & Implications

Utility contractors can be confident that their services will continue to be in high demand through 2008. Many of our clients report record backlogs and FMI’s 2008 forecast indicates that capital spending by utilities will continue to outpace virtually all other industries. FMI expects an increasing number of utilities to look to outside service providers to fill the talent void and to support the growing demand for capital construction spending.

The variable regulatory climate will favor those contractors that can stay abreast of legislation on both a federal and state level (where the pace of change is much faster). Contractors that embrace renewable and “green” technologies will find a wider scope of work and people resources available to them as renewable energy sources move to the mainstream. As a wise, amphibious Muppet once said, “It isn’t easy being green.” B ut it will be profitable.

Mark Bridgers, Mike Chase and Dan Tracey are consultants with FMI Corp., which provides management consulting, training, and investment banking services to the worldwide construction industry. They can be reached at (919) 785-9351 or MBridgers@fminet.com. For more information on FMI, visit www.fminet.com.