Many think of utilities stocks as a staid investment: they present relatively low risk, offer stable dividend payments, and are often viewed as a bond proxy for conservative money. But recently, the utilities sector has begun a rapid transformation that could change this perception.
The convergence of two powerful trends is driving this transformation. The first is the widespread transition of energy companies into pure-play regulated utilities. This business model allows a utility to get a premium valuation as investors reward the certainty and stability of earnings. The second is the accelerating adoption of renewable energy sources such as solar and wind which is being driven by advances in technology, regulatory changes and the emerging power of environmental, social and governance (ESG) investors.
These trends are giving the utilities sector a new tailwind: Pure-play utilities are choosing renewables for their capital expenditures. This green-power push, in turn, is attracting the attention of both utility and ESG investors who are willing to pay higher multiples for energy stocks with a strong renewables portfolio.
Incentivizing renewable energy investments
In 2020, we’ve seen major companies such as Dominion Energy (D), Public Service Enterprises Group (PEG), and DTE Energy (DTE) announce plans to transform themselves into pure-play regulated utilities by spinning off assets such as gas pipelines and storage facilities. To put these into context and to illustrate why investors like the change, it helps to understand how the regulated utility model can reward companies for capital expenditures.
State regulators allow utilities to earn a set rate of return, known as the rate base, on the value of their operating infrastructure. New infrastructure investments are added to the utility’s rate base and leads to increases in the company’s revenues. Naturally, utilities are going to prioritize investments that regulators are likely to approve.
Coal is out. Even natural gas, which was popular a few years ago as a “bridge fuel” to renewables is facing regulatory uncertainty in some warm-weather jurisdictions. In 2019, Berkeley, California banned natural gas hook-ups in new homes. Regulators in many states are pushing renewable energy, and in turn, utilities are responding by adding renewables to their infrastructure plans — and investor money is following.
The ESG premium
Trillions of ESG dollars are estimated to be looking for stocks that fit their criteria. In the energy sector, utilities with plans to add solar, wind, and other renewables offer the classic profile of stable returns, along with an environmental story. As a result, investors are rewarding these stocks with a low-carbon rate base with higher multiples than utilities still dominated by fossil-fuel infrastructure. Utility stocks which previously traded at a 18x earnings multiple are being revalued upwards at 20x (or greater) multiple if that utility invests in renewable energy and is viewed as an ESG investment.
A change that’s here to stay
I think of the trends reshaping the energy sector as a revolution, not as a fad. It’s not just investors who favor the regulated utility model—credit rating agencies do, too. They look favorably on the stable, predicable cash flow coming from the company’s base, and view it as a low-risk business model with associated higher credit ratings. We are seeing companies such as NextEra Energy (NEE) making deals to balance out its earnings with more regulated assets and I expect the positive impact on credit ratings to continue driving M&A activity in the sector.
Even without the push from regulators and ESG investors, renewable energy makes more sense for utility companies than it did just a few years ago. Solar and wind are becoming more efficient, while costs are coming down to be nearly on par with fossil fuel power generation. When a utility adds a new wind facility, it can expect a lifespan of some 30 years of that investment.
The result is that the utilities have the ability to keep growing earnings through the huge runway of potential renewable investments and grid infrastructure upgrades — and those investments should continue to attract ESG money into the sector. If you’re still holding on to the old image of utility sector as stodgy, it may be time to take a fresh look.