In energy policy discussions, one topic almost never comes up — nuclear fuel shortages. But in a recent Scientific American blog post, Davide Biello points out that a wave of new nuclear plants will dramatically increase demand for uranium. Biello suggests that while reprocessing might become an important part of a weapons-reduction effort, it also might be necessary to expand fuel supply enough to attract investment in new reactors. He writes:
Reprocessing may reduce the demand for fresh uranium fuel. Although various estimates catalog known uranium reserves capable of fueling the existing global fleet of 440 reactors for at least 100 years, the growth in demand for new reactors in China, the U.S. and elsewhere might change that equation. “If we build 200 to 400 more reactors, then it’s definitely only 100 years of supply,” argues [Alan] Hanson, whose company [Areva] is the largest supplier of uranium fuel in the world. “Would you build a nuclear power plant with a 60-year lifetime with only 100 years of supply? I wouldn’t if I was an investor.”
Editor’s Note: Fortnightlyinterviewed Constellation Energy CEO Mayo Shattuck this summer. His comments were included in Fortnightly’sJune Frontlines column. The complete transcript of the interview follows, as part of an ongoing series of conversations about managing during a time of fundamental change.
FORTNIGHTLY: How does the changing U.S. utility landscape affect Constellation’s strategic direction? How have changing markets and government policies factored into Constellation’s decision to sell trading businesses and generating assets? SHATTUCK: A few macro trends are important to our strategy. The first, clearly, is that when the credit markets vaporized, certain businesses that we were in couldn’t be supported by the credit environment. It’s important for us to be an investment-grade company—particularly for a couple of the businesses we’re in, and less for another. Most utilities feel they should have an investment-grade rating because it leads to a lower cost of capital. Most state regulators would agree.
On the marketing side, marketing activity requires a daily posting of collateral. These numbers can move significantly with volatility in commodity prices. The change in the credit markets of last year and this year make it more difficult to support a commodities trading operation. To the extent you are focusing on marrying these two together, you’ll make sure you yield to an investment-grade company. But if you can’t make it in the market, you have to redirect your positions.
We took our non-core positions in commodity trading and gas trading and reduced the collateral associated with those by divesting them. That’s allowed us to get quickly to a place where we have three core businesses, and we have an investment-grade company and can march forward with a narrower scope—namely Baltimore Gas & Electric, our generation fleet, and our large-customer supply business, selling electricity and gas to large commercial and industrial customers. That’s the one that needs a significant amount of working capital, and therefore requires us to be investment grade and still have access to credit markets to support it. We’ve significantly reduced our exposure to trading operations.
The one business that doesn’t necessarily need to be investment-grade on its own is the merchant generation business. We are a merchant generator, but we’ve managed the balance sheet so we’re retaining an investment-grade rating.
The business of trading commodities and the depth of counterparties has changed. That’s another reason to pull back on exposures and markets. The liquidity and depth of these markets has changed. As a consequence, people participating in these markets have to reduce their exposure, or they could find themselves too big in some of these markets.
FORTNIGHTLY: How are you managing the regulatory changes happening in your service territory?
SHATTUCK: In Maryland, the issue that continues to be topical here is whether the deregulation of 1999 is working or not. We’ve been an advocate of competitive markets for some time, and are at the point of seeing the effect of falling prices on rates. That’s true in Maryland and Pennsylvania. Just at this moment the markets are beginning to respond to recessionary forces and also to other elements of competitive markets. We’re beginning to see falling prices, and the auctions taking place in PJM are yielding lower prices. So the debate about whether to re-regulate comes at an auspicious time, given how markets evolve under pure competitive forces. We’d like to see that continue, and see it across the United States.
Having said that, there is a certain degree of angst on the part of regulators and legislators about just how much time it takes for this whole process of deregulation to work. So there are advocates out there for certain kinds of re-regulation, developing a hybrid market. We have to engage in those discussions and consider whether there are certain elements of deregulation aren’t working well. That has been topical here in Maryland for a couple of years. We’ve been very willing to engage in that debate, even though we are advocates of competitive markets and are at the point where we should look to see what effects competition is having on rates in deregulated markets.
FORTNIGHTLY: As Constellation strengthens its alliance with EdF, how will the company be better positioned for success in the U.S. energy industry?
SHATTUCK: One of the reasons for the strategic alignment with EdF is to build up capacity for development of new nuclear. We’ve had a very effective partnership for three or three and a half years, and we keep pushing the ball down the road. They have an interest in having a greater footprint in the United States, so they have greater visibility to the markets, and understand where best to deploy their capital and their investment in UniStar with us.
We’re very pleased by this outcome, where they’ll own half of the existing nuclear fleet. It gives us a chance to have a significant partner to look for a variety of ways to ensure we can participate on the new nuclear side. All of us are respectively pretty small in the scheme of things to be building plants that can cost $10 to 13 billion. We have to think creatively about the alliances we need in order to do that—not just money, but skill and perseverance and links to other strategic partners.
We have a model that we believe allows us to participate in what we believe is an imperative to build a new nuclear capacity in the United States. We will stay in the game and lead the charge. We’ve been at it for four years. The DOE loan-guarantee program is going well, and we’re excited to be part of that process. Obviously we face challenges going forward, but we’re an example of a company that would be building a merchant plant and it will be exciting to see new nuclear happen as a merchant project.
FORTNIGHTLY: How does the trend toward green energy, conservation and distributed resources affect Constellation’s business plan?
SHATTUCK: We advocate for a realistic mix in generating capacity. This recent investment in the last 10 years in renewables has been fantastic, but we need to focus on the capacity of the grid to absorb and manage these intermittent resources. The model requires a balanced mix of all resources. Our attention to base load in the future is an equal imperative. We can’t lose sight of base load requirements.
It’s no surprise to anyone we have a balance of nuclear and fossil assets. We’ve tried to move the ball on efficiency and demand reduction and conservation. We have some innovative things happening in Maryland. We’re an advanced state, in the sense we’re already decoupled. We have incentives to help people reduce consumption—our Peak Rewards program. We’re moving down a path of the modern utility, where people are going to help the evolution of the grid by virtue of understanding their own use. We have the early starts of an AMI project, and we’re working on the early stages of things like smart grid and hybrid vehicles. All these things will make a huge difference in the long term, and every utility has to be looking at these things. I believe we are marching down a very progressive path on that front, and our state regulators are cooperative and interested in doing so.
On the competitive side of the house, where we’re selling power and services to large C&I customers, that business has grown to be quite large. We’re not only selling power and gas to these customers now, but offering other services associated with their participation in renewables. We’re installing solar panels, putting in distributed generation. That whole movement will be an important part of the future as companies like ours educate large C&I customers in how they can manage their energy use.
It’s part of our long-term business plan, balanced with strong low-cost base load power. That’s why we’re as involved as we are in the nuclear movement. But there is tremendous interest among customers in distributed generation, particularly for applications like peak-shaving, and improving their own environmental footprint. There are a lot of angles of attack that will drive distributed generation to play a more meaningful role, and hopefully that’s where technology and innovation also will play a significant role. My hope is that innovation leads to methods where we have much more capacity in much smaller sizes, hopefully in renewables technologies that will help society.
FORTNIGHTLY: From a management perspective, how are you managing the changes Constellation is going through? What are the most important issues that demand your attention, and how are you dealing with them?
SHATTUCK: The events of the last year clearly have been a distraction, but the operating units are doing just fine. There’s no reason for the operating units to be distracted. It’s the requirement of management to make sure they’re steadily focused on safety, reliability and their basic operations from a day-to-day basis. I think we’ve come through the stormy capital market period very well in that respect.
The areas of the company most affected were those being downsized as a result of the credit markets. The businesses themselves actually were doing reasonably well. It was the credit underpinning supporting them that dissolved. The difficulty is explaining to people that have performed well why they have a reduced amount of capital allocated to them, and they’ll have to go through a downsizing of employees.
As a result of the businesses we divested, most of those people ended up at Goldman Sachs, Macquarie Cook and EdF. Most of these people just transplanted themselves to their new owners, and that allowed us to devote capital to our new objectives. That was understood, and people felt good about how they were treated, but no question the specter of the credit and capital markets collapsing at the end of last year made everyone nervous. We had to change a lot of senior managers and put in place people that wanted to look out 10 to 20 years as opposed to thinking about what hedge fund they wanted to join. That all went very well. We made some management changes at the right time.
We’ve gone through the vast majority of the transition. In our last earnings call, we talked about a de-risking process, including divestiture. We’ll be proving ourselves in the next year as we downsize our participation in commodities markets.
FORTNIGHTLY: What aspects of the commodities business are you keeping?
SHATTUCK: We have a central service area to deal with the hedging requirements on the generation side and the customer supply business. We sell power around the country in places where we have no generation. That requires a sophisticated backbone of risk management. We have supporting operations for hedging of our generation fleet as well as megawatt hours that we sell to C&I customers. That’s the primary purpose of the operation now. It’s managing the remnants of what we now call the portfolio optimization book, which is really just the gradual reduction and elimination of the old commodities trading book. The market understands that.
FORTNIGHTLY: What have you learned from this transition at Constellation? What advice would you offer to a utility company CEO who is facing a similar set of challenges?
SHATTUCK: There were a lot of lessons learned in all of this. One of the main lessons is associated with the quality of our earnings mix. We tried to build a business based on this evolution of the competitive markets in the United States and internationally. At the end of the day, we weren’t successful at convincing people about the quality of earnings that fall into a bucket of trading earnings. They weren’t valued in the market place, so the additional risk associated with lower quality earnings wasn’t worth it. When the credit crisis came that problem got exacerbated, and we made the decision to move rapidly out of that.
The interesting lesson I find for myself and that may be applied to some others is that the utility industry does generate very high quality earnings. Whether from distribution, transmission or generation, they are high quality because they are repeatable, more annuity-like. To the extent you degrade your model with a lower quality earnings base, you potentially aren’t adding as much shareholder value as you might hope.
FORTNIGHTLY: The merchant power business carries some of the same kinds of risks, doesn’t it? How does that affect the quality of earnings?
SHATTUCK: On generation side it will be more cyclical, and of somewhat lesser quality, but still of high quality. It’s the trading revenues specifically that cast some doubt as to whether you’re really going to be rewarded for good performance. Trading earnings probably belong on bank balance sheets, and even they struggle a bit with how much value they get from trading revenue.
There are aspects of the marketing business, of which trading support is one, that can get a good value. A sales and marketing arm, as an example, where we’re providing risk management services to large customers, is shown to have high repeatability, high retention rates and good margins. That kind of business should be rewarded with a decent multiple.
All of our companies need access to the capital markets. We all borrow, but there are some aspects of the business that are really dependent on it. All utilities are dependent on access. The generation companies, obviously, to build these big projects must have access to capital markets. Those are the priorities when it comes to reliability of our system. We have to put capital there. In areas that we consider on the margin I think that great care has to be given to the quality of those earnings, so you’re really aiming toward achieving the highest shareholder value you can, and not putting a higher risk-reward expectation on lower-quality earnings that eventually could come back and hurt you.-Michael T. Burr