The Utility sector is presently at a crossroads after the release of the new emission standards by the U.S. Environmental Protection Agency (EPA). The finalized Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels.
To meet the new emission standards, the industry needs more investments going forward. In this context, the near-zero interest rate is of a great help but a hike in rates could adversely impact the utilities, though rate hikes aren't imminent following the weak September non-farm payroll report that showed the U.S. economy losing its growth momentum during the summer months.
As would be expected, larger utilities will have more financial strength and better access to capital to achieve regulatory compliance. This is also likely to trigger more consolidation in the utility landscape, with a definite focus on generating electricity from natural gas and renewable sources. Consequently, we expect to see higher solar installations across the U.S., more so in 2016 due to the expiry of the higher solar tax credit at year end.
The combination of steady electricity price gains and stable-to-improving demand will drive the utility sector. A decline in the unemployment rate, increase in hourly earnings of average workers and higher demand in residential and other customer classes are tailwinds for the utilities.
Rising up to the environmental challenge, utility companies are steadily improving their operations by investing in more environment-friendly power generation facilities. Per a recent release from the U.S. government's Energy Information Administration (EIA), the electricity industry retired nearly 9,800 megawatts (MW) of conventional steam coal-fired generating capacity during the first six months of this year.
These retirements represented 3.3% of the amount of operating steam coal capacity at the end of 2014. The industry plans to retire an additional 3,133 MW of coal capacity this year and nearly 6,000 MW during 2016.
Apart from the Clean Power Plan, the current spate of coal-fired plant retirements has largely been influenced by the need to comply with the Mercury and Air Toxics Standards. Low natural gas prices have also been a stimulus.
We believe a constructive utility rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will definitely enable the utilities to efficiently serve a larger customer base.
In the segments below, we discuss the basic strengths of the utility sector.
Regular Dividend & Share Buybacks
Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008-2009 when utilities continued to pay dividends without fail.
Stable & Growing Demand
The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for their services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.
Focused on R&D
In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, transmission and distribution lines, and gas pipelines into operation to meet the rising demand for power without compromising on energy efficiency.
Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.
Barriers to Entry
Utility businesses are by their very nature monopolistic. In fact, that's the primary reason why they are so heavily regulated in the first place. But on the other hand, the benefit of this heavy regulation is that they don't have to worry about new entrants in their area of operations as companies in other industries have to. The need for greater capital investments also creates a big hurdle for new operators in the space.
Mergers and Acquisitions
Utility sector operators don't shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access have they to funds essential for vital infrastructure upgrades.
We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way to enhance market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and also lowers operating costs through the usage of common back office space to control the expanded operation.
In Jun 2015, Wisconsin Energy Corporation completed the acquisition of Integrys Energy, forming WEC Energy Group ( WEC ). The enlarged company provides electricity and natural gas to nearly 4.4 million customers across four states. However, the merger between Exelon Corp. ( EXC ) and Pepco Holdings ( POM ) has yet to clear the final regulatory hurdle with the Public Service Commission of the District of Columbia and the two companies in discussion to find a solution to their differences.
In Dec 2014, NextEra Energy Inc. ( NEE ) announced that it has entered into a definitive agreement to acquire the utility wing of Hawaiian Electric Industries, Inc. ( HE ) for a total consideration of $4.3 billion. The merger process is currently on course and is awaiting some regulatory approvals.
To Sum Up
We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water does not have any viable substitute. This is perhaps the most vital driving factor for the industry.
Stable operations, highly visible revenues and cash flows, combined with the sector's income/yield attributes are some of its key defining features.
Moreover, the mature capital intensive U.S.-based utilities have hitherto benefited from lose monetary policies. Volatility in the markets has also driven investors to seek protection in the utility space. These regular dividend payers are often regarded as a "bond substitute." So long rates remain the same, utilities will continue to have an advantage over low-yielding Treasury bonds.