In 2023, the S&P Utility Index returned a negative -7.1% and materially underperformed the S&P 500 Composite, which returned 26.3%. (See Table 1). After outperformance in 2022, the sector buckled under the pressure of higher interest rates and ongoing economic strength. Over the past two years, the US Treasury yield curve rose dramatically as the Fed employed an aggressive eleven rate hikes to tame inflation and cool the economy (Exhibit 1). Short-term rates rose from zero to 5.5%, the Ten-Year Treasury yield from rose 1.5% to 3.9% (5.0% in mid-October 2023) and utility stocks seemed to fluctuate with the market’s outlook for a recession. Indeed, the SPSU fell 12.3% in the two-weeks following the September 20th FOMC meeting where the Fed emphasized a “higher-for-longer” interest rate outlook and raised concern that rates could go even higher than 5.0%. Alas, the SPSU hit a multi-year bottom (down -19% year-to-date) on October 4, 2023. In the fourth quarter, cooling inflation data and a softer economic outlook pulled the 10-Year Treasury yield down 110-basis points, which led to a modest 12% utility stock rebound.
Higher interest rates hurt utility stocks (and all investments) by raising the discount rate used to determine the present value of future cash flows. In addition, the higher interest rate/lower stock price environment make it more expensive for capital intensive utilities (and many companies) to fund growth and achieve historically high utility EPS targets (“5- 7%” and “6-8%” CAGR’s). Finally, 5%-plus short-term treasuries represent an attractive risk-averse return relative to the 3.7% current return on high quality utility stocks. All that said, the Fed appears likely to lower short-term rates in 2024-2025 and utility valuations now reflect some growth moderation.
The long-term fundamental prospects for utility stocks remain compelling. Utilities have substantial opportunity to invest in the infrastructure (rate base growth) needed to power a low-carbon economy. Electric demand could be on the verge of a structural acceleration driven by the intense power needs of a digitized and electrified world. Utilities with strong management teams and operating in constructive regulatory environments have the opportunity to deliver healthy EPS and dividend CAGR’s for years to come. Over the long-term, utilities are “winners” in the long-term energy transition and the 2022 Inflation Reduction Act (IRA) provides tax incentives for accelerated clean energy investment. In 2024, lower inflation and lower gas prices have eased affordability headwinds. Finally, the impact of the historic rate hike cycle could result in a lower yield curve.
The 2023/2022 Performance See-Saw
In 2023, the S&P Utility Index was the worst performing of the 11 S&P 500 Sector Indices with a negative -7.1% total return. (Table 2). In 2023, the better-performing S&P industry sectors were technology, communications, consumer discretionary and industrials (growth and economically cyclical sectors). Each of these sectors was among the worst performing sectors in 2022. On the other hand, defensive sectors (utilities, healthcare and consumer staples) were among the worst performing sectors in 2023, but better performers in 2022. The reversal of performance reflected the fluctuating economic outlook as fears for a recession faded.
With the rapid rise in the yield curve over the past two years, we present the sectors ranked by best-to-worst two-year total returns. The utility sector returned a negative -5.6% relative to the S&P 500 +3.4%. The S&P 500 Energy sector was the best two-year performer due to high oil and gas prices and recognition that fossil fuels will be important to global economies for some time. We also highlight the poor total returns of the clean energy ETF’s over each of the two years, with IShares Clean Energy ETF (ICLN) negative return of -24.7% and the Invesco Solar Index (TAN) negative return of -32.6%.
More on 2023: Higher Rates Explained Most, But Not All
Higher interest rates explained much of the under-performance, but utility stocks were also “shaken” by handful of other developments, including a NEP growth moderation, a tragic August 2023 Hawaii wildfire, a December 2023 punitive Illinois rate decision, and uneconomic offshore wind projects.
- Growth rates: On September 27, 2023, NextEra Energy Partners, (55%-owned by NextEra Energy (NEE), lowered its distribution CAGR to 5-8%, from 12-15%, due to the higher cost of capital. NEP is non-regulated and more vulnerable to higher rates than regulated utilities, but the action resonated throughout the sector and exacerbated concern that utility growth rates could moderate. Clean energy developers and utilities with clean energy segments do not have the ability to recover the higher cost of capital in rate cases. As a result, clean energy stocks fared much worse than regulated utilities, including AES (-30.1% return), NEP (-52.3%) and NEE (-25.3%). In 2024, the IShares Clean Energy ETF declined -25.7% and the Invesco Solar Index (TAN) declined -20.8%.
- Wildfire: On August 8, 2023, the Maui/Lahaina fire resulted in 98 deaths and significant property damage (<$6 billion). Hawaii is not subject to the inverse condemnation laws that impacted PG&E, but Hawaiian Electric (HE -64% return) was named as defendants in 64/65 lawsuits claiming losses/damages from the windstorms and wildfire. The severity of the wildfires and a surprisingly negative jury verdict (June 2023) against Berkshire Hathaway’s PacifiCorp utility regarding 2020 Oregon wildfires raised concerns regarding potential wildfire risk and liabilities for some utilities in the arid/dry/vegetative environments, including Xcel Energy (XEL/-8.7%), Portland General (POR/-7.6%), and Avista (AVA/-15.1%). Meanwhile, PG&E (PCG/+11.0%) and Edison International (EIX/+17.4%) saw wildfire multiple discounts diminish as investors grew more comfortable with CA wildfire legislation and company prevention efforts.
- Punitive Illinois rate decision: On December 14, 2023, the Illinois Commerce Commission issued surprisingly negative electric rate decisions for Ameren’s and Exelon’s electric utilities. The ICC’s authorized ROE was a historically low 8.72%/8.94%, which was substantially lower than previous ROE’s (9.9%) and Staff recommendations. The ICC also ordered the two companies to refile grid modernization plans without rate base recognition until approved. EXC and AEE shares declined 12% and 11%, respectively, following the order.
- Uneconomic Offshore wind: In mid-to-late 2023, several major offshore wind developers took large impairments and terminated purchased power contracts because higher costs of capital, inflation, supply chain issues and delays made projects “suddenly uneconomic.” While only two US utilities were impacted (Eversource -23% return and Avangrid -20% return), investors questioned the economics of aggressive US clean energy plans.
Finally, most of the nation experienced warm first and fourth quarter temperatures, which negatively impacted 2023 EPS.
Best and Worst Performers
In 2023, the top performing power stocks were not utility stocks, but non-regulated independent power producers (IPP’s), including NRG Energy (NRG/+67.4%), Vistra Energy (VST/+69.7%), and Constellation Energy (CEG/+36.9%). These three companies are the only US publicly-traded IPPs (with traditional generation nuclear/coal/gas) remaining after two decades of consolidation and bankruptcies. IPPs have lower capital budgets (ie, free cash flow) than utilities and are beneficiaries of higher power prices. As the nation’s only non-regulated nuclear generator, CEG benefitted from improved outlook for nuclear power as well as state and federal nuclear subsidies (IRA). On November 2, 2023, CEG acquired NRG Energy’s 44% ownership in the South Texas Nuclear Plant, while VST announced an agreement to buy Energy Harbor’s 4 GW nuclear portfolio in March of 2023. In May of 2023, activist Elliott disclosed a 13% position in NRG and a desire to replace management as well as restructure the company, which includes a rooftop solar/home services company (Vivent).
The best and worst utility stock performers are listed below and include small-cap takeover candidates, Otter Tail Power Corp (OTTR) and Unitil (UTL), gas utilities Atmos Energy (ATO) and Southwest Gas (spinning off non-regulated business) and rebounding California utilities, Edison International (EIX) and PG&E (PCG). See Table 3
Please see Table 4 for Utility Subgroup Metrics and appendix on pages 19-20 for more utility stock financials.
- Electric utility valuation multiples have declined from 23x forward earnings in early 2020 to less than 16x 2024 earnings estimates. Over the past twenty-five years, utility forward multiples have ranged between 10x and 23x earnings with a median of 17.1x.
- The gas utility performance reflects recovered investor sentiment offset by greater challenges to maintain earnings outlooks. Gas utilities currently trade at 15x 2024 and 14x 2025 earnings estimates despite significant consolidation activity at higher multiples over the past few years.
- The water utility under-performance reflects the impact of higher interest rates on higher multiple stocks. Water utilities trade at the highest multiples due to their scarcity, small size, takeover premium, ESG value, and long-term growth potential through consolidation and privatization.
- The six Canadian electric and gas utilities have outperformed in 2023, after underperforming in 2022. Given lower growth rates and higher current returns, interest rates have less of an impact on share prices. Canadian provincial regulatory environments are more challenging (lower allowed ROEs and equity ratios) than many US utility jurisdictions.
EPS Outlook
We expect EPS growth targets of 5-7% and 6-8% to moderate to mid-single digit growth (4-7%) as a higher cost-of-capital to fund rate base growth (and refinance existing fixed cost debt) pressures regulators to minimize rate increases. Utilities have significant rate base growth opportunities driven by de-carbonization, electrification and grid modernization. Gas and water utilities also have long pipe replacement-driven capex runways.
Investors have grown to expect consistent compounding of EPS and dividend growth. However, the days of feasting on low-coupon debt/high multiple stock issuances to fund growth have at least temporarily ended. Affordability issues pressure regulators to minimize bill increases, though moderating natural gas prices (40% of power generation) and inflation relieve some bill pressure. Strong management teams are important to execute the optimal balance of capital investment, funding, cost-controls, and rate increases, while constructive regulatory environments are important to getting investment recognized in rates. Following third quarter, managements of 17 utilities target “5-7%” EPS CAGR, 12 utilities target “6-8%”, and 2 utilities target 7-9%, one (PCG) targets 10% growth (Table 5). Recent growth target changes, include Evergy (4-6%, from 6-8%) and Northwestern Corp (4-6%, from 3-6%).
The August 2022 Inflation Reduction Act (IRA) offers “game-changing” financial incentives ($272 billion) for clean energy investment through the extension and expansion of investment (30-40% investment tax-credits) and production tax credits. The tax credits allow the utilities to lower the development, construction and operating costs of renewable energy generation, which means lower future customer bill increases. The increased rate base investment will help achieve ambitious carbon-reduction plans and aid earnings growth.
Capital Investment (Rate Base) Continues to Rise and Drive Healthy Earnings Growth
In 2023, EEI member electric utilities forecast capital investment of nearly $167.8 billion, which would mark the eleventh consecutive year of record investment. This compares to an estimated 2022 record investment of $150.8 billion ($136.6 billion in 2021) in utility infrastructure, including distribution ($51 billion, or 33%), generation ($37 billion, or 24%), transmission ($32 billion, or 20%), gas-related ($22 billion, or 14%) and other ($13 billion, or 8%). Over the next several years, we expect increasing utility capital needs for the following:
- Clean energy transformation (coal retirements, on/off-shore wind, solar, and storage).
- Electric transmission and distribution (grid modernization, hardening, undergrounding).
- Electrification, EV charging, efficiency, etc.
- Natural gas infrastructure (pipeline expansion and replacement, green hydrogen, and carbon capture).
Given the higher cost debt, utilities expect to issue more equity over the next several years. The record capital programs are manageable given strong balance sheets, reasonable payout ratios, healthy valuations over book value, and the industry’s high investment grade credit-rating (BBB+). The industry has maintained an S&P Credit rating of BBB+ average (25%: A- or higher; 70%: BBB-, BBB, or BBB+) since increasing from a BBB average in 2014. All three credit rating agencies (S&P, Moody’s and Fitch) have expressed concern regarding higher natural gas prices, inflation, interest rates, and increased capital spending but also note that regulatory relations have generally been constructive.
State Public Utility Commissions As Important As Ever For EPS Growth
State political and regulatory environments are as important as ever in determining the performance of individual utility stocks. Utility regulation generally remains supportive of investment, but some PUCs are more constructive than others. See Exhibit 3. Many jurisdictions have adopted changes to rate design, such as forward test years, rate mechanisms and adjustment clauses to allow timely recovery and return on costs associated with various capital investment programs (environmental, pipe replacement) and weather normalization. The allowed returns on equity (ROE) set by PUCs play a major role in utility earnings growth.
In the second half of 2023, a handful of disappointing rate cases, including Illinois electric and gas cases for Ameren (8.72%) and Exelon (8.94%), Evergy’s (KS silent on ROE) and XEL’s MN (9.25%) rate case, reminded investors of the uncertainty associated with politically-charged rate cases. On a positive note, several larger utilities saw jurisdictions raise allowed ROEs, including North Carolina (Duke Energy 10.1%, form 9.6%) and California. The three large California electric utilities (PG&E/10.7%, SCE/10.75%, SDG&E/10.65%) will see allowed ROE’s increase by 70 basis effective January 1, 2024. In addition, Georgia approved a rate settlement to recognize the over-budget Vogtle Nuclear Units, and several other cases were generally constructive.
Utility Rate Cases and ROE’s
In the first nine-months of 2023, the average authorized ROE for electric utilities (37 rate cases) rose modestly to 9.55% (37 cases), from 9.54% (53 cases) for the full year 2022. For gas utilities, the average ROE decided during the first nine months of 2023 was 9.66%, up from the 9.53% average for the full year 2022. In recent quarters, utility allowed ROEs have begun to rise (albeit modestly), after declining over the past 30-years. The average authorized gas ROE in recent fully litigated cases was 9.96% for cases decided during the first three quarters of 2023 and 9.87% for the 12 months ended September 30, 2023.
The spread between the allowed-ROE and the 10-year U.S. Treasury yield is currently 570-basis points, and it has ranged between 550-900 basis points over the past few years. During the 1990s, the utility sector averaged roughly 400-600 basis points spread. Given the dramatic rise in interest rates, we expect allowed ROEs to rise, but note that PUCs historically have taken a gradual and measured approach to changes in authorized ROE levels.
Inflation, interest rates and growing utility capital spending plans have led to an active regulatory calendar, including 54 electric and 41 gas rate cases pending in 34 states and the District of Columbia.
Trend Emerging-Electric Demand Growth
After a decade of flat growth, US electric demand appears on the verge a long-term structural acceleration. In 2022, US electric output rose 2.8% to 4.1 million GWhs, which is a record annual high. According to EIA, US electric demand grew a modest 5% over the past 10 years (2013-22 was 5.4%). Many utilities and the North American Electric Reliability Council (NERC) are raising previous forecasts and expect much stronger growth over the next decade driven by electrification, reshoring of manufacturing, data centers and growing use of power hungry technology (artificial intelligence) as well as bitcoin mining. Manufacturing reshoring is aided by incentives under the IRA and CHIPS Act.
A December 2023 report “The Era of Flat Power Demand is Over” by Grid Strategies, grid planners nearly doubled the 5-year load growth forecast over the past year. The nationwide forecast of electricity demand shot up from 2.6% to 4.7% growth over the next five years, as reflected in 2023 FERC filings.
Technology companies are rapidly installing data centers, which can require as much as 500 MWs (equivalent to 375,000 homes), with capacity factors of nearly 100% (runs non-stop all year). In November 2023, WEC Energy Group raised its 2024-26 electric demand growth forecast to 4.5-5.0%, from 0.7%, to reflect growing data center and technology demand. Microsoft plans a $1 billion data center outside of Milwaukee on the science/technology hub developed in collaboration with Foxcon. In Virginia, Dominion Energy, has connected 75 new data centers since 2019.
EEI forecasts electric vehicle (EV) adoption from 3 million EVs to 26 million by 2030 and the need for 140,000 EV fast charging ports, which would boost load by 1% annually. Forecasts for electric demand growth are an emerging trend and has not really showed up in data yet, but below are some notable comments from November/December utility presentations and conference calls:
- Southern Company (SO) “During 2023, we have continued to see an extraordinary level of economic development activity…We will update forecasts in February but want to highlight the magnitude of potential change in electricity sales growth. Recall our previous forecast assumed annual electricity sales growth of 0% to 1%. Factoring in the power needs of these new, highly data-centric businesses and manufacturing facilities, electricity sales are likely to have an annual growth rate closer to a mid-to-high single-digit range over the next 5 years.”
- Entergy (ETR) ETR forecasts 6-7% industrial sales growth 2022-2026 (16% cumulative) driven by Gulf Coast industries (petrochemicals, refining, industrial gases, chemicals) data centers, and IRA/clean energy transition. ETR projects industrial sales will increase by 16 TWh by 2022-26, a 30% increase to TWh. (an annual increase in overall electricity demand CAGR of ~3.5% during the period ’23-26).
- Portland General (POR) In the Northwest, Oregon is home to 15% of the US semiconductor manufacturing and POR has experienced 6.8% industrial load growth from 2017-2022 and highlights increased digital expansion and data centers. “Many large high-tech companies in our footprint have signaled upcoming growth projects concentrated among digital and high-tech customers.”
- IDACORP (IDA) In in its 2023 integrated resource plan, IDACORP raised its annual peak demand forecast to 3.7%, from 2.1% in 2021, and has experienced 2.4% annual customer growth.
- Edison International (EIX) The greater LA area is home to ~12.5% of all the EVs in the U.S. In 2023, EVs are expected to account for 3.2 TWh of load, or ~4% of total expected demand. By 2045, EIX estimates the demand from EVs alone could total 50+ TWh. (an increase to overall electricity CAGR of ~2%).
Growing electric demand leads to rate base growth and helps spread fixed costs over a larger base, which improves affordability.
Election Year Politics: Great Power Transformation Will March On
As we progress through 2024, we expect some sentiment shifts and angst regarding ambitious US clean energy plans and specifically rhetoric about a potential repeal of the Inflation Reduction Act (IRA). Should Republicans show polling strength (with anti-clean energy rhetoric), clean energy developers and suppliers could see weakness. However, we do not expect any material changes to the IRA or policies even under a “red-wave”. Many US states (29) have set renewable energy standards, including 22 with 100% clean energy targets. The more aggressive include Rhode Island (2030), D.C. (2032), Connecticut (2040), Minnesota (2040), New York (2040), Oregon (2040), California (2045), Hawaii (2045), New Mexico (2045), and Washington (2045). Republican “Red” states have benefitted from IRA tax incentives for major green-energy investments and the political and public support for clean energy is significant. Texas is home to more renewables than any state in the nation and Florida has ambitious solar power plans. Please see Exhibit 5.
The Great Power Transformation Marches On
EIA’s December 2023 Energy Outlook forecasts that the 2023 US power generation fuel mix will be 22% renewable energy (wind, solar, hydro, and battery storage) and 24% in 2024, while coal declines to 17% in 2023 and less than 15% in 2024. U.S. natural gas generation will average 42% in each 2023 and 2024. In 2023, wind, solar and battery storage account for 82% of the new, utility-scale generating capacity. (EIA June Update). EIA forecast includes 23 gigawatts of new solar generating online in 2023 (a 33% increase from 2022) and 37 GW in 2024 (up 39% from 2023). New solar generating capacity is accompanied by 9 GWs of new U.S. battery storage capacity in 2023, doubling the total amount compared with what was operating at the end of 2022.
In 2022, the US electric fuel mix was 40% gas, 20% coal, 18% nuclear, 20% renewable (10% wind, and 6% hydro) and 2% other, which means 60% fossil-fuel fired and 40% zero carbon. In the mid-1980s, US power generation was nearly 60% coal-fired. Given planned retirement schedules, coal’s rapid decline will continue. All new capacity will be renewable, battery-storage and/or natural gas-fired (excluding the 2.2 GWs Vogtle nuclear expansion scheduled for 2023- 24). Over the past decade, less-efficient nuclear (13 retirements since 2013) and gas power plants were retired and replaced with highly efficient natural gas plants and renewable generation.
In 2023, the US has ~1,200 GWs of power capacity, including 215 GWs of renewables (74 GWs of utility-scale solar and 141 GWs of wind capacity (12%). According to EEI (April 2023), developers plan to add 478 GWs of capacity over 2023-2027, including 228 GWs of solar, 104 GWs of wind, and 101 GWs of storage. Over the same period, EEI projects 102 GWs of capacity retirements (42 GWs of coal, 40 GWs of gas, and 16 GWs of oil).
Renewables Developers Have Huge Opportunities And Challenges
NextEra Energy Resources (wholly-owned by NextEra Energy) is the largest renewable owner, operator and developer in the US with the largest development pipeline. Other large owners, include Berkshire Energy, Brookfield, and Iberdrola/Avangrid. (See Exhibit 8 below) AES Corp, Invenergy (private), Apex (private) and Hecate (private) have ambitious renewable development plans. Regulated utilities Consolidated Edison, Eversource, Duke Energy and American Electric Power have strategically chosen to divest non-regulated renewable development businesses to focus on the regulated business. Renewable development challenges include higher interest costs, inflation, tariff and supply chain issues as well as integrating into the existing transmission system. Developers face clogged interconnection queues, permitting delays and a congested power grid. The transmission system was not designed to accommodate the massive renewable additions, particularly given wind/solar intermittency.
Interest Rates, Inflation Hamper Offshore Wind Goals The Northeast/New England states and politicians expect offshore wind to be a major piece of future energy consumption. However, the Northeastern Offshore Wind (OSW) target for 30 GW (enough to power 10 million homes) by 2030 is likely unachievable given the challenges from higher interest rates, inflation, supply chains and red-tape delays. The US currently has 42 MWs (0.042 GWs) of OSW in operation with two projects under construction. Europe and Asia have over 10 GWs in operation. In 2024, Vineyard Wind (800-MW’s/Martha’s Vineyard) and South Fork (122 MWs/Long Island) are expected to come on line.
In the second half of 2023, several large developers, including Orsted, BP, Shell, Equinor, took large impairments, requested contract repricings, and/or delayed projects. In late October, Ørsted, the world’s largest offshore wind developer, canceled two New Jersey projects (Ocean Wind 1 & 2). The states remain committed and plan to “rebid/reauction” for capacity. In late January 2024, MA. CT, and RI are holding a joint bidding process to reduce costs and risk for developers. The Biden Administration announced a memorandum of understanding between nine states (CT, MA, MD, ME, NC, NH, NJ, NY, and RI) and four federal agencies, pledging to coordinate efforts to identify and address domestic resources for steel, vessels, port infrastructure, and components for offshore wind resources.
We expect that offshore wind will become a significant part (though expensive) of the Northeast power capacity, but projects will not be owned by US utilities (except AGR). We expect Eversource to complete the sale of its three joint ventures in two phases (South Fork and Revolution in early 2024/Sunrise in the spring of 2024).
FERC-Regulated Transmission. Red Flag Alert: NERC Concerned About Reliability The North American Electric Reliability Corp. Annual Long-Term Reliability Assessment-December 2023 raised some concern that rising peak demand and the planned retirement of 83 GW of fossil fuel and nuclear generation over the next 10 years creates blackout risks for most of the US. The Northeast and Western half of the U.S. face an elevated risk of blackouts in extreme weather conditions and parts of the Midwest and central South areas could see power supply shortfalls during normal peak operations. To address the growing risk, NERC recommends new gas capacity and transmission investment.
In 2023, EEI member utilities invested $30.7 billion in electric transmission compared with $31.7 billion in 2022. Over the next few years, we expect FERC to solidify numerous policy directives and incentives, including ROE methodology, transmission planning and the interconnect process, as well as the need to alleviate the clean energy logjam, and gas pipelines. In mid-2022, the Midwest Independent System Operator (MISO) approved Tranche 1 of its $100 billion longterm planning projects, which included 18 transmission projects, totaling $10.3 billion and spanning IA, IL, IN, MI, MN, MO and WI. Winning bidders, included:
- Ameren (AEE) ($1.7-1.8 billion)
- Fortis (FTS )$1.0-1.5 billion
- WEC Energy Group ($800 million)
- XEL ($1-2 billion)
The projects are expected to be in-service in 2028 – 2030. LRTP projects are significant because they will help accommodate the influx of renewables needed to meet state and utility clean energy goals. We expect Tranche 2 to be awarded in 2024.
M&A Activity – Still Quiet Corporate Strategies Simplifying, Transforming, and “Greening”
Utility financial engineering (subsidiary acquisitions, spins, and/or divestments) remains active, but takeover activity of investor-owned utilities has slowed in recent years. Since 1995, the US electric utility sector has experienced over 145 acquisition announcements and over 120 completed deals. From 2016-2020, 23 deals were announced. Merger activity declined during the pandemic-impaired 2020-21 COVID-19 era. In 2022, five “whole” company mergers closed. In 2023, one deal closed and one agreement terminated. On February 1, 2023, Infrastructure Investment closed on the acquisition of South Jersey Industries (SJI) for an $8.1 billion in enterprise value, or $36.00 per share (53% premium and ~15X EV/EBITDA multiple). On April 17, 2023, AEP and Algonquin (AQN) mutually agreed to terminate the Kentucky Power transaction following FERC approval challenges.
Investor-owned utilities prefer organic rate base growth (pay 1x rate base) to the takeover of rate base at a multiple of rate base. Regulated utility acquisitions can lead to a lengthy regulatory approval process and require onerous concessions. For example, Avangrid’s acquisition (announced October 2020) of PNM Resources was terminated on January 2, 2024 after stuck in the approval process for over three years. In addition, a higher cost of capital hampers some buyer willingness to engage.
Over the past few years, many utilities have restructured, including sales of fossil generation assets, natural gas midstream operations, international operations, and non-utility subsidiaries, and the spin-off of competitive generation. Some have been the subject of activists including Jeff Ubben through Value Act and Inclusive Capital, Elliott Management (EVRG and NRG), Bluescape (EVRG), and Carl Icahn (First Energy and Southwest Gas). More recently, private infrastructure funds and investors, have taken advantage of the opportunity by buying gas utilities and gas infrastructure.
However, the sector remains ripe for consolidation as smaller companies face growing challenges to fund growth opportunities and need greater economies of scale. On December 11, 2023, media articles speculated that Allete (ALE) was exploring a sale. ALE is a Duluth, MN based utility with sizeable transmission growth opportunities. In 2023, several Mid/Large cap utilities sold gas utilities and other non-core assets primarily as a means to improve balance sheets and/or mitigate external equity needs.
Gas Utility Sales
- On December 1, 2023 (announced 9/26/23), Chesapeake Utilities (CPK) closed on the $923 Florida City Gas acquisition from NextEra Energy for $923.4 million in cash. Based on an approved average 2023 rate base of $487 million, the EV/rate base is nearly 2X. Based on $28 million of earnings power, the implied P/E is in the mid-20s.
- On September 5, 2023, Dominion Energy (D) agreed to sell three natural gas distribution utilities, the East Ohio Gas Company, Questar Gas/Wexpro Company (UT, WY, ID) and Public Service Company of North Carolina to Enbridge (ENB) for $14.0 billion ($9.4 billion cash and $4.6 billion assumed debt). The purchase price represents a consolidated 16.6x estimated 2023 operating earnings of $564 million (16.7x estimated 2024 operating earnings of $561 million) and ~1.3x Enterprise Value-to-2024 Estimated Rate Base (8% CAGR). The sales are expected to close by the end of 2024. Closing of each transaction is not conditioned upon each other.
- On October 30, 2023, Entergy agreed to sell its gas distribution business to Bernhard Capital Partners (private equity), for $484 million in cash, which represents 1.3-1.4x rate base.
Equity Stake Sales
- On June 20, 2023, NiSource (NI-27.38) reached agreement with Blackstone’s dedicated Infrastructure group to sell a 19.9% equity interest in NIPSCO for $2.150 billion. NIPSCO is Indiana’s largest vertically integrated electric and gas distribution company with 1.3 million customers. The transaction implies an equity value of $10.8 billion and enterprise value of $14.3 billion for 100% of NIPSCO. Other NI highlighted multiples: 32.5x LTM P/E and 1.85x rate base ($4.9 billion electric and $2.0 billion gas).
- On February 2, 2023, FirstEnergy Corp. (FE) agreed to sell an additional 30% equity stake in FirstEnergy Transmission, LLC (FET) to Brookfield Super-Core Infrastructure Partners for $3.5 billion. On May 31, 2022, FirstEnergy Corp. (FE) completed the sale of a 19.9% minority equity stake to Brookfield Super-Core Infrastructure Partners for $2.375 billion. FirstEnergy retains a 50.1% equity interest in FET.
Renewable Segment Sales
- On June 12, 2023, Duke reached an agreement to sell its renewables business (3,400 MWs) to Brookfield Renewable for $2.8 billion with net proceeds of $1.1 billion.
- On March 1, 2023, Consolidated Edison sold its Clean Energy Businesses (4 GWs of renewables) to RWE Renewables Americas for $6.8 billion.
- On February 22, 2023, American Electric Power (AEP) agreed to sell its 1,365 MW unregulated, portfolio to IRG Acquisition Holdings, a partnership owned by Invenergy, CDPQ and funds managed by Blackstone Infrastructure, at an enterprise value of $1.5 billion including project debt.
- On November 3, 2023, NRG sold its 44% stake in the 2,645 MW South Texas Project nuclear plant to CEG for $1.75 billion. The price implies 11.7x EV/EBITDA.
- On May 25, 2023, EverSource (ES) agreed to sell its offshore land lease and expects winning bids for its 50% interest in three offshore wind projects (South Fork Wind, Revolution Wind, and Sunrise Wind) totaling 1,758 MW by the end first quarter 2024.
- On March 6, 2023, Vistra Energy (VST) agreed to buy Energy Harbor’s nuclear (4.0 GWs, including Beaver Valley 1 and 2, Perry, and Davis Besse) and retail businesses for $3.4 billion and combine to form “Vistra Vision” (VV). Vistra will own a controlling 85% ownership interest in Vistra Vision; Nuveen and Avenue Capital will own the remaining 15%. VV will include 6.4 GW of nuclear generation, ~5 million retail customers, and ~2.4 GW of online and near-term pipeline of renewable and storage assets.
Activism
- On May 15, 2023, Elliott announced that it sent a letter and presentation to NRG’s Board outlining a path to shareholder value after meaningful under-performance. Elliott claims to own 13% of shares. Elliott seeks to: 1) add new independent board members; 2) push for $500M of cost reductions; and 3) conduct a strategic review of the home services strategy including Vivint.
- In August 2023, Southwest Gas (SWX) confidentially submitted draft Registration Form S-1 for a potential IPO of Centuri either through a shareholder spin (1Q 2024) or an IPO of 19.9% followed by sell-down of owned shares. Icahn owns 10.8 million shares and Corvex owns 4.1 million.
Electric and gas utilities will likely continue to explore assets sales to fund rate base growth. Utilities with ongoing strategic reviews or assets for sale, include: AGR (stakes in renewable assets), AQN (renewables), EMA-TSE (regulated & non-regulated assets), UGI Corp (UGI) selling propane and Southwest Gas (SWX). Utilities with non-regulated businesses, include ALE (renewables), Centerpoint Energy (CNP) (gas LDCs), DTE (non-regulated assets), Otter Tail Corp (OTTR).
Valuation
Over the past twenty years, electric utility multiples climbed from roughly 10x forward earnings to over 23x, driven by improving fundamentals and higher growth rates (Exhibit 12). Electric utilities trade at 15.0x consensus 2024 earnings estimates which is below the historical median. We consider the multiple attractive given higher utility earning growth rates and strong fundamentals.
Given that long-term interest rates (specifically the 10-year and 30-year Treasury yields) have risen dramatically to nearly 4.0% following a long-term secular decline since the late 1980’s, we measure the earnings yield (1/P/E) as a percent of the 10-Year T-Bond Yield to gauge interest rate adjusted valuations. As can be seen in Exhibit 10, the current ratio of 175% indicates the sector P/E is modestly higher than its historical median relationship with the 10-Year T-Bond Yield.
Interest Rates and the Fed
- While utility stocks are not bond proxies, and share prices are a function of earnings and dividend growth rates, higher (lower) rates negatively (positively) impact equities, given that future cash flows are impacted by the assumed discount rate.
- In addition, current utility dividend returns become less compelling when returns on other investments increase, including Treasury yields. The current 6-month Treasuries yield over 5.0% and US Treasuries hold even greater defensive appeal than utilities. The factors below mitigate the negative impact of higher rates.
- Annual dividend hikes: Utilities target annual dividend increases, which serve to mitigate the negative impact of higher rates. In 2023, electric utilities increased the annual dividend by a median of 5.0%.
- ROE is set based on interest rates: A utility’s cost-of-capital, including equity returns (ROEs), is set by state PUCs and increases (decreases) as interest rates rise (fall).
- Annual riders minimize inflation risk: State PUCs and FERC regulatory principles have improved to include more frequent rate adjustments, which mitigate inflation risk.
- Utility stocks pay higher dividends than other sectors: The present value of a higher near term dividend stream is less impacted by changes in interest rates than a lower near term dividend stream.
While utility dividend yields and 10-year U.S. Treasury yields are highly correlated and will likely remain so in the future, utility dividends have risen over time (most on annual basis) while the Treasury yield remains fixed. Utility stock prices, unlike Treasury bond prices, are likely to rise should earnings and dividends grow over time.
Conclusion
The utility sector offers a 3.7% current return and many utility managements target 4-7% annual earnings and dividend growth. The utility business model represents a safe-haven in the face of recession and/or inflation fears. In addition, the transformation of the utility sector from fossil fuel-fired to renewables provides the environment for strong annual earnings and dividend growth. We believe that the combination of strong utility fundamentals, and the potential for escalating geopolitical volatility and/or domestic economic slow-down bode well for the relative performance of utilities.
ONE CORPORATE CENTER RYE, NY 10580 Gabelli Funds TEL (914) 921-5100
