This is Part 4 in a four-part series of mini-blogs concerning Long Term Service Agreements in the power industry.
By Bill Ray and Craig Nicholson
Stable natural gas prices — coupled with ever-increasing gas turbine efficiency and favorable cost scale associated with the latest technologies — continue to make gas turbines the logical, base load power plant solution. However, with the influx of renewable solar and wind technologies, gas plants are challenged to improve flexibility and operate differently from original design or intent. It is estimated a 25% penetration of renewables in a geographical market creates the “duck curve” effect in fossil generation. The duck curve describes two intraday peaks early and late in the day with an intraday decline forming the duck’s back. Conversely, renewables rise during the day replacing the intraday decline in fossil generation. This phenomenon highlights the necessary load shifting required on any given day to balance supply and demand. Central to this characteristic is the timing imbalance between supply of renewable energy sources and electricity demand. This requires greater flexibility from traditional technologies to balance load, support the grid and provide rapid response to upsets in the renewable supply while presenting significant challenges on how gas plants operate in such markets.
This trend in renewables is set to continue and grow. Rapid renewable growth targets are in place in many states, led by California with commitments of 50% renewable by 2020 and 100% by 2032. Other states such as New York are committing to becoming carbon neutral by 2040. Cities are also committing, such as Washington, D.C, which is planning to reach 100% renewables by 2032, up from a prior goal of 50%. Utilities are getting on board too, as reported in the Wall Street Journal, last month Xcel Energy — serving parts of Colorado, Minnesota and six other states — announced it plans to shift to 100% carbon-free generation by 2050, the first major U.S. utility to make such a pledge. Xcel’s CEO claimed improvements in technology have enabled purchase of wind and solar technologies at a fraction of the prices it paid a decade ago. In 2017 coal accounted for more than 30 percent of Xcel Energy’s power generation.
Future technological disruptors have the potential to create further structural shifts in the way the electrical grid and subsequent markets operate. Key technologies such as Electrical Vehicle (EV) adoption and use, battery storage, offshore wind, machine learning and Artificial Intelligence (AI) will drive more change. Battery technology innovation continues to drive down costs, and proven offshore wind technology adopted in Europe and China will likely proliferate on the U.S. eastern shore. Machine learning and AI is still developing but will likely see big strides in the coming years. Developments in AI in a connected world brings the potential of future productivity gains and new business models based on additional insights gleaned from data. Connectivity coupled with IT infrastructure entering power plant control rooms brings new risks associated with securing assets from cyber-attacks. Such opportunities and risks were not apparent a decade ago but must now be considered.
“Rapid renewable growth targets are in place in many states“
Operation of the electrical grid in the traditional sense continues to be challenged as we move away from centralized, vertically integrated utilities operating thermal technologies to a more distributed, fragmented and innovative grid. This poses new challenges and new opportunities. Gas plants fall on both sides in terms of anticipating challenges and realizing opportunities.
According to the Energy Information Administration’s Annual Energy Outlook 2018, in the reference case, electricity demand will slowly rise through 2050 at an annual growth rate of 0.9%. Average electricity prices are projected to remain flat and natural gas prices to stay relatively low, putting pressure on coal-fired generators. A combination of a rise in renewables, cost pressure from natural gas, environmental concerns and the necessity for extensive capital investment will contribute to continued coal electric generation retirements through 2025. To put this structural shift in perspective, within the PJM interconnection — which is the largest wholesale energy market in the U.S., spanning 13 states from Virginia to Illinois – coal-fired electricity generation fell 5.2% in the first nine months of 2018, while natural gas-fired generation rose 19%. Nationwide, by 2050, energy derived from renewables is expected to double, with the balance of growth coming primarily from natural gas fired generation. A steady 20% decline in nuclear electric generating capacity is projected, with no new plant additions beyond 2020.
With the abundance of natural gas, subsequent low gas prices and relative operating flexibility of gas plants versus their peer thermal technologies, gas turbines are well positioned to continue to contribute to the electricity generation mix. The future will bring more renewable energy, continued pressure on carbon-based energy and disruptive technology innovation such as improved batteries and machine learning, with some of these changes occurring during the term of a current LTSA agreement. As gas plant owners consider their long-term maintenance strategies, they will need to consider these dynamics, ensuring that maintenance agreements are constructed to withstand the vicissitudes of future market dynamics and the rising amount of renewable energy.
Fundamentally there are two approaches to negotiating a maintenance plan. First is a status quo approach, that is a maintenance plan in the future based on lessons learned from the past. Such LTSAs will have minimal flexibility for future developments and will focus primarily on fixing past commercial and technical issues so they won’t be repeated going forward. Such agreements may incorporate known major events such as rotors, exhaust cylinders, generator maintenance, controls retrofits or major upgrades. Nevertheless, such agreements crystallize assumptions at the onset and don’t typically have the flexibility to adjust without a potentially costly renegotiation.
An alternate approach, as previously discussed in this blog series, is to consider the LTSA more like an employee or team member. The structure of the deal would be such that over-performance is incentivized and under-performance penalized. Just like an employee’s performance goals, the LTSA performance objectives are set forth on a regular basis and the LTSA provider makes necessary adjustments within the LTSA framework. Non-performing LTSAs would ultimately be terminated, whereas over-performing LTSAs would be rewarded. Assessment of LTSA efficacy to given metrics should yield desired outcomes.
In addition to the market landscapes and challenges, the asset owner must evaluate the current competitive landscape and vendor capabilities. Traditionally OEMs have dominated LTSA offerings; however, with the emergence of independent service providers (ISPs), there is opportunity to consider alternatives to the OEM through an ISP or consortium of ISPs, self-performance or a combination of self-performance and partnership with a service provider. Alternatives to the current provider are both viable solutions and serve as a point of leverage in any negotiation. It is important that any alternative option is acceptable in the event of cessation of talks with a favored vendor. Tradeoffs among OEMs and ISPs or self-performance typically come down to evaluating the OEM price premium against the risk associated with the capability to perform services in house or through a third party.
Once the asset owner determines whether an LTSA is to be renegotiated or put out for bid, it is prudent to implement a structured framework that addresses the full value chain. The framework should address current and future market and commercial needs, owner capabilities, best practices as well as technical aspects of the plant addressing obsolescence and upgrades.
The bid process should incorporate a dedicated timeline based on the current contractual and operational realities of the plant and work to produce a Request For Proposal (RFP) package designed to clearly stipulate the intended scope and rules of engagement. This should include a method for communicating with bidders and opportunities for vendors to access the plant and clarify questions to enable accuracy in their bids. Additionally, a well-designed RFP will aid and assist fair evaluation of potential bids, optimize the negotiation with selected vendors, maximize the clarity in vendor bids and improve the outcome of the negotiated LTSA.
It is our opinion, given the benefits and opportunities associated with long term maintenance agreements, that LTSAs will continue to play a key role in the maintenance of gas-fired plants. However the market landscape of agreements signed today will change, driven by increased adoption of renewable energy and technology before the end of the term. The agreements should be adaptable to remain relevant over the term of the agreement. A well-crafted long-term service agreement that best positions an asset owner over the agreement term is an attainable goal provided the proper level of planning, forethought and preparation is put into the process and draws from the insights discussed in this blog.