In 2022, the S&P Utility Index returned a modest 2% but outperformed the negative (18%) return from the S&P 500. In the face of dramatic increases in inflation, interest rates, and energy prices as well as recession fears, utility stocks benefited from their defensive appeal, earnings stability, and energy infrastructure growth opportunities. The negative earnings impact of higher costs was mitigated by utility customer bill adjustments and other measures. See Table 1.
Table 1 Utilities Over the Past Several Periods
Despite five consecutive rate hikes (current overnight target of 4.25-4.5%), the Fed believes inflation remains too strong. In addition, the US and Europe face an ongoing energy dilemma, including higher prices and supply shortages, driven by the transformation from fossil fuel dependency to clean energy. On the other hand, the US treasury yield curve is inverted (Exhibit 1) and indicates a developing recession, which would likely lead to lower inflation and lower interest rates. Under either a recessionary or strong growth economy, utilities would expect to deliver positive earnings and dividend growth. In addition, the August 2022 Inflation Reduction Act (IRA) provides significant incentives for accelerated clean energy investment for decades to come. That said, we believe investors are better served owning higher quality, financially strong utilities which can better absorb ongoing inflationary pressures.
Exhibit 1 US Treasury Yield Curve Rises and Inverts On Recession Fears
Source: US Department of Treasury
The “Top Ten Reasons to Consider Utility Stocks” are outlined below:
1) Defensive profile including fuel and inflation cost-recovery
2) Reasonable valuation of 18x 2023 P/E multiple, down from 23x (Table 3 & Appendix on page 22-23)
3) Competitive current return of 3.4% compared to the 10-year treasury yield of 3.8%.
4) Above historical average earnings and dividend growth potential
5) Electrification to enhance electric demand (Electric vehicle charging stations, heat pumps)
6) Renewable and net-zero carbon standards create long runway of rate-base investment
7) Improving ESG profiles (great power transformation)
8) Financial engineering, including ongoing consolidation and simplification
9) Possibility interest rates have peaked and US is in recessionary environment
10) Inflation Reduction Act to drive clean energy investment for decades
Table 2 S&P 500 Sector Performance
Source: Thomson One
Performance & Valuation
The S&P utility sector was one of the top performing sectors in 2022 only lagging the S&P 500 Energy sector, which benefitted from significantly increased oil and gas prices as well as investor sentiment. Other strong performers were the defensive Healthcare and Consumer staples sectors. In 2022, our universe of 45 electric utilities returned a median 4%, 14 gas utilities 3% and 9 water utilities -7%. Please see Table 3 for Utility Subgroup Metrics and appendix on pages 21-23 for more complete financial metrics of our utility universe.
· Electric utility valuation multiples have declined from 23x forward earnings in early 2020 to 18x forward earnings (2023) 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 partially offset by greater challenges to maintain earnings outlooks. Gas utilities currently trade at 18x 2023 earnings estimates. The median multiples had declined to as low as 15x forward earnings during the period from September 2019 through September 2021 when natural gas fell from favor given its carbon emissions.
· The water utility under-performance reflects the impact of higher interest rates on higher multiples 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 under-performed, including Algonquin (AQN-6.84-down 50%). The regulatory environments are more challenging than many US utility jurisdictions.
Table 3 Utility Subgroup Statistics
Source: Thomson, First Call, Gabelli Funds Estimates
Top Performers
In 2022, the top performing utility stocks were Constellation Energy (CEG), South Jersey Industries (SJI), PG&E (PCG), New Jersey Resources (NJR) and Sempra Energy(SRE). CEG, the sector’s only pure-play merchant nuclear generators, was opportunistically spun-off from Exelon amidst high power prices and demand for zero-carbon baseload generation. On February 24, 2022, SJI agreed to be acquired by an Infrastructure Fund for a 53% premium. PCG continues to rebuild its reputation and earnings power after emerging wildfire-related bankruptcy. As discussed earlier, energy companies benefitted from higher gas prices gas utilities, including
Sempra Energy, which is an electric and gas utility but also owns and develops LNG export facilities (Cameron in LA and Port Arthur in TX). See Table 4.
Table 4 Best and Worst Performers
Game-Changing Incentives Provide Tailwinds for the Next Decade
In August 2022, the Inflation Reduction Act (IRA) was signed into law and established significant financial incentives for clean energy. IRA solidified, expanded and extended 30%-investment tax credits (ITC’s) and 2.6 cent production tax credits (PTC’s) for existing wind (on-shore and offshore) and solar generation and established new credits for nuclear, geothermal, storage, carbon capture, hydrogen as well as others. The ITC’s can be increased to 40% based on domestic content and certain other conditions. The credits are in place for at least ten years and phase out in 2032 but only if electric sector emissions fall by 75% compared to 2022 levels. Further, the credits are marketable and can be bought and sold, which simplifies the previous complex tax equity structures.
Exhibit 2 Selected Benefits of the IRA
Source: S&P Global Market Intelligence
Most utilities consider IRA to offer “game-changing” incentives and plan to accelerate already ambitious infrastructure plans. 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.
Utilities Target Above-Historical Average Earnings Growth
Based on Thomson One consensus EPS estimates, our universe of 70 electric, gas and water utility stocks are forecast to grow 5.9% in 2022 (year-end earnings reports are expected in late January/February 2023) over 2021 and another 5.3% in 2023. The outlook follows 5.5% annual EPS growth over the past three years (2018-2021). Many utilities guide investors to targeted EPS growth ranges, which currently range between 4-8%, (median range is 5-7% and stronger utilities target 6-8%). Growth rates have increased over the past several years driven by growing investment in rate base. (Table 5).
Table 5 Carbon Targets and EPS Growth Rates For Selected Utilities
Source: Company documents, Thomson One, and Gabelli Funds.
We favor utilities with strong EPS growth potential based on the following characteristics: Constructive regulatory environment, affordable customer bills, economically healthy service area, customer growth, and clear path toward satisfying clean energy goals. As a guide, we provide state PUC rankings, electric rate rankings, EPS growth outlook and ESG goals.
How do higher debt costs, gas prices, and inflation impact utility earnings growth?
State public utility commissions (PUCs) have an obligation to keep utility rates affordable, but also allow a utility to recognize costs and earn a fair return on prudent infrastructure investment. All state PUCs authorize fuel adjustment mechanisms where fuel costs are immediately recovered and various adjustments for other items like property taxes, pension, healthcare, and bad debt expense. All prudent investment, costs and customer/sales changes are updated during general rate cases. The successful formula driving the strong earnings outlook remains the same: Investment Opportunities + Constructive Regulation = Earnings Growth.
• Interest Rates: Higher interest rates raise a utility’s cost of debt, which results in rate adjustments to recognize the utility’s cost-of-capital. Allowed ROEs increase (decrease) as interest rates rise (fall), while debt costs are fully recovered. For example, assume a utility is capitalized with 50% debt/50% equity, allowed ROEs are 10% and debt costs are 4.0%. The cost of capital would be 7.0%.
(50% * debt cost of 4.0%) + (50% * equity cost of 10%) = 7.0% cost of capital.
Should rates rise by 100-basis points
(50% * debt cost of 5.0%) + (50% * equity cost of 11%) = 8.0% cost of capital.
However, utility earnings are impacted in between rate cases due to the “regulatory lag” (higher costs between rates cases). In addition, holding company debt is not regulated and impacts earnings. Utilities generally finance with 10-30 year maturities, which also minimizes impacts. In addition, utilities carry a minimal amount of short-term or variable rate debt.
• Natural gas prices: Natural gas prices have risen from $3.00 MMBtu to well over $5.00/MMBtu and have been much higher in certain regions of the US. As regulated energy conduits, electric and gas utilities pass-through higher fuel costs through automatic adjustments on customer bills (margin neutral). On a positive note, high natural gas and power prices help make renewable power more economical on a relative basis.
• Economic slow-down: In 2022, US GDP was roughly flat through the first three quarters of 2022 and growth likely flat in fourth quarter. Most utilities have yet to see a decline in commercial or industrial sales and many jurisdictions have revenue decoupling mechanisms, which mitigates the negative impact of lower sales. Finally, the prospect of electric vehicle (EV) adoption represents the first potential secular spur to power demand since air conditioning. EEI projects that there will be nearly 22 million EVs on U.S. roads in 2030. Given growth in EVs, we estimate that more than 100,000 EV fast charging ports will be needed and could boost load by 1% annually over the next few decades
After Decade of Real Rate Declines, Rates Rise
We view rising customer bills as a concern to the utility investment thesis, but the fears are partially offset by political and public support of clean energy and reliability. In 2022, national electric and gas utility rates (customer bills) have risen significantly, including as much as 30-50% in some regions (data not yet available), and will likely rise further in 2023 given the various cost-pass-through mechanisms, including fuel costs. PUCs feel political and public pressure to keep rate increases to a minimum. Fuel clause and inflation-related increases reduce the “head-room” available for rate base and earnings growth.
Over the past decade, customers enjoyed the benefits of declining interest rates, low natural gas prices and benign inflation. These factors served to put downward pressure on rates and created customer bill headroom to recognize capital investment/rate base growth. As a result, utility infrastructure investment has been rewarded with constructive returns and higher earnings growth. In 2021, the average US retail price of electricity per kWh rose 5.1% on a nominal basis to $0.1144 per KWh, which is the highest nominal increase in over ten years. Inflation-adjusted electric prices rose 0.9% in 2021. Over the past 5 (2016-2021) and 10 years (2011-2021), real electric rates decreased -3.9% and -6.8%, respectively. See Exhibit 3 below:
Exhibit 3 Real Electric Utility Rates Declined Over Past 5- and 10-Years
We believe electric utilities with more affordable electric rates could face less regulatory challenges. Electricity prices paid by ultimate customers vary widely on a geographic basis, with customers in Hawaii paying the highest prices, at 30 cents/kWh in 2021. Customer bills are also relatively high in California and the Northeast, including New York, Connecticut and Massachusetts. The lowest prices at the state level were in Oklahoma, Texas, Louisiana, and Minnesota. Please find a list of the highest and lowest cost electric utilities below in Table 6. (Full list in appendix).
Table 6 Highest and Lowest Cost Electric Utilities (2021 Ultimate/Retail Rate)
Source: Public Data
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. 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. See Exhibit 4.
Exhibit 4 State PUC Regulatory Rankings
Source: Regulatory Research Associates (Part of S&P Global Market Intelligence SPGMI)
Selected Recent Constructive Rates Case Decisions
• Southern Company (SO): On December 20, 2022, the Georgia Public Service Commission (GPSC) approved annual rate increases $216 million in 2023, $377 million in 2024 and $403 million in 2025. Higher rates are based on an ROE baseline of 10.5% and 56% equity ratio. Should Georgia Power earn over an 11.9% ROE, a customer sharing mechanism is triggered.
• NextEra Energy (NEE): In mid-2022, Florida Power & Light’s mid-point allowed ROE was raised to 10.8%, from 10.6%, to reflect higher interest rates. FP&L’s new 4-year rate plan is based on a 10.6% allowed ROE (range of 9.7-11.7%) and called for a $692 million revenue increase on January 1, 2022, another $560 million on January 1, 2023, and $140 million in 2024 and 2025. The plan allows amortization of $1.45 billion of depreciation reserve surplus, a storm recovery framework, and an ROE adjustment.
• EverSource (ES): On November 30, 2022, the MA DPU authorized a $64.3 million for NSTAR’s electric distribution base rate increase in conjunction with the adoption of a five-year performance based rate (PBR) plan (1/1/2023-2027). The plan is based upon a 9.80% ROE (75%-sharing above 10.8%) and 53.21% equity ratio and allows up to 5% annual inflationary rate adjustments.
ROEs Constructive (Higher Equity Ratios) Relative to Interest Rates
Rate case activity for US investor-owned electric and gas utilities has been at elevated levels in recent years and but allowed ROEs authorized through the first nine-months of 2022 remain near all-time lows. According to RRA, the average allowed ROE was 9.37% for the first nine months of 2022, and 9.36% for the 12-month period ending on September 30, 2022.
Allowed ROEs appear to have flat-lined over the past few years, after declining over the past 30-years as U.S. Treasury yields declined. Importantly, the spread between the allowed-ROE and the 10-year U.S. Treasury yield is currently 600-basis points, and it has ranged between 600-900 basis points over the past few years. During the 1990s, the utility sector averaged a roughly 400-600 basis points spread. When combined with opportunities to invest and earn returns on a growing rate base, we consider the allowed-ROEs to be more than adequate to grow earnings. With interest rates on the rise, we expect allowed ROEs to rise slightly higher in 2023. Although, PUCs historically have taken a gradual and measured approach to changes in authorized ROE levels.
Exhibit 5
Capital Investment (Rate Base) Continues to Rise and Drive Earnings Growth
In 2023, EEI member electric utilities forecast capital investment of nearly $160 billion, which would mark the tenth consecutive year of record investment. This compares to an estimated 2022 record investment of $155 billion ($134 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%). We expect increasing utility capital needs for the following:
• Clean energy transformation (coal retirements, wind (on/off-shore), 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)
Exhibit 6 Record Capital Investment
The utility sector remains well-positioned to finance record capital programs 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 since increasing from a BBB average in 2014.
Political Support for Rate Base Growth
The global and US economy is in the early stages of a long-term power transformation. All of the US electric and gas utilities target ambitious carbon reductions and renewable energy standards, and publish sustainability reports.
Exhibit 7 30 With State Renewable Standards
Source: Berkeley Lab
Many call for carbon neutrality by 2050, and 100% renewable energy by 2035-2040. Many US states have set renewable energy standards, including 100% renewable energy in New York (by 2040), California (2045), Hawaii (2045), New Mexico (2045) and New Jersey (2045). Please see Exhibit 7 above. Further, many major investors, activists, lending institutions, political groups, and corporations are calling on all of society to make the environmental pledge.
The Great Power Transformation
In 2021, the US electric fuel mix was 38% gas, 22% coal, 19% nuclear, 14% renewable, and 7% hydro, which means 60% fossil-fuel fired and 40% zero carbon. In the mid-1980’s, US power generation was nearly 60% coal-fired. Over the past decade, coal and less-efficient nuclear and gas power plants have been shut-down and replaced with renewables and highly efficient natural gas plants. In the US, all new power generation under construction or in development is and will be renewable, renewable/battery-storage and/or natural gas-fired (excluding the 2.2 GWs Vogtle nuclear expansion scheduled for 2023-24). In 2021, the decade-long declining trend for coal generation (and carbon emissions) experienced a “hiccup” driven by high natural gas prices and renewable intermittency. (See Exhibit 8).
Exhibit 8 Fuel Mix Changes; Coal Drops to 20% in 2021, and Gas Rises to 38%
Source: EIA
EIA’s December 2022 Short-Term Energy Outlook forecasts that renewable energy (wind, solar, hydro, and battery storage) will provide 22% of U.S. generation in 2022 and 24% in 2023. Coal will decline to 20% in 2022 and to 19% in 2023. U.S. natural gas generation will average 39% in 2022 and 37% in 2023. Over the next 10-20 years, most expect dramatic changes in favor of net-zero generation.
De-carbonization of the US Economy Requires $4 Trillion of Capital Investment
To achieve the ambitious goals of 100% renewable power and a net-zero carbon economy requires massive investment and significant technological advancements. A Wood Mackenzie study estimated that the cost of transforming the U.S. to renewable energy in the next 10-20 years would be $4.5 trillion (translates to $300 billion annually over 15 years) given current technology. In addition, the 100% renewable target requires the building of 1,600 GW of new wind and solar generation and a nearly doubling of high voltage transmission (HVT). NextEra Energy forecasts that de-carbonization of US economy by 2050 would require $4 trillion of investment in clean energy infrastructure.
· According to NEE, de-carbonization of the US power sector requires the addition of 3,550 GW’s of wind, solar and storage at a cost of $2 trillion. The US currently has ~1,200 GWs of power capacity; including 200 GW’s of renewables.
· Over 2022-2025, NEE forecasts the demand for 160-GW’s of US renewables, which includes 30-50 GWs per year. Over 2026-2030, the US requires 70-100 GWs per annum and 100-140 GWs per annum over 2031-2035.
· Full de-carbonization of the US economy requires another $2 trillion investment including in the transportation, industrial and agricultural sectors through electrification and low-carbon fuels largely being powered by renewables.
· By 2042, SPGMI expects the US to be 79% carbon free. The consulting firm/data provider expects 117 GWs of retirements (70% coal and inefficient gas) and the addition of 354 GWs of solar and 325 GWs of wind. The forecast results in a 60% reduction in carbon emissions by 2042, which is short of the 75% IRA goal.
· According to EEI, the U.S. renewable pipeline totals more than 365 GWs of utility-scale wind and solar power capacity through 2026, including 191 GWs of solar and 97 GWs of wind.
· NextEra Energy (NEE) expects a more dramatic change in fuel mix, including nearly 60% renewable (75% zero carbon) by 2035. See Exhibit 9.
Exhibit 9 US Electric Fuel Mix Forecast to Be Over 50% Renewables By 2035
Source: NextEra Energy Presentation
NextEra Energy is the largest renewable developer in the US, followed by privately held Apex Clean Energy and privately-owned Invenergy. See Table 7 below:
Table 7 Largest US wind and Solar Developers (1,000 MW’s = 1 GW)
Source: SPMGI
The development of large utility scale projects has been challenged by higher interest costs, inflation, tariff and supply chain issues as well as integrating into the existing transmission system. At least one large offshore wind project has abandoned its output contract due to higher construction costs. Much of the transmission system was not designed for massive renewable additions needs to be upgraded and expanded to accommodate the intermittency of renewables,
Developers face clogged interconnection queues, permitting delays and a congested transmission system. Many regulated utilities have more recently opted to monetize non-regulated renewable businesses, including Consolidated Edison, Eversource, Duke Energy and American Electric Power (discussed later). Motives primarily relate to favorable demand and reinvesting in the regulated business. All regulated electric utilities with generation have plans to add significant renewable capacity, but often contract with developers to build and/or buy projects given the need for competitive resources planning process.
Renewable Development Costs Are Now Economical and Represent Rate Base Growth
Regardless of policy incentives, utilities benefit from adding renewable generation due to cost declines that have made new wind and solar generation more economical than older fossil-fired and nuclear generation. From 2010-2020, the leveled costs of wind and solar power have declined materially. While inflation has pressured development/construction costs recently (2022 data not yet available), the demand and economics for renewables becomes greater as natural gas prices rise.
Exhibit 10 Declining Renewable Costs Relative to Other Fuel Types
At its June 14, 2022 Analyst Day, NEE also outlined its estimate of the economics of power generation by fuel type. At $4.50/MMBtu gas, wind is the most economical at $25-32/MWh; followed by solar ($30-37/MWh), existing gas ($35-47 MWh), existing nuclear ($34-49/MWh), existing coal (443-74/MWh), and new gas combined cycle ($56-69 MWh). See Exhibit 11 below.
Exhibit 11 Renewables Competitive Relative to Other Fuel Types
Source: Nextera Energy Presentation
Exhibit 12 Declining Solar Costs
Source: American CleanPower Association
Offshore Wind Rapid Growth in US Wind Capacity to Accelerate With Offshore Development
Offshore wind is becoming an increasingly important form of renewable generation primarily due to geography and NIMBY limitations as well as improved economics. Offshore wind is a key element to many European and Asian nations clean energy strategies and expected to play a major role in the US Northeast. The US operates two small offshore wind farms totaling 42 MWs compared to over 25 GWs (25,000 MWs) operating across Europe.
The US has laid out plans to achieve 30 GWs of operating offshore wind capacity by 2030, and state targets total over 74 GWs by 2050. The states with the largest requirements are New York at 9 GWs by 2035, North Carolina at 8 GWs by 2040, and New Jersey at 7.5 GWs by 2035. Other states with requirements include Connecticut (2 GWs), Massachusetts (4 GWs), Maryland, and Virginia. The California Coast has deeper water and targets 3 GWs of floating offshore wind by 2030. As can be seen, on and offshore wind costs have declined significantly, but remain relatively expensive.
Exhibit 13 Wind Costs Decline, But Offshore Wind Remains High
Source: American CleanPower Association
There are currently 14 projects along the Northeast Coast in various stages of development, totaling 15.2 GWs. The largest is the 2.4-GW Beacon Offshore Wind Project (Equinor and BP PLC) off the coast of MA. There are two major projects (Vineyard Wind and South Fork) under construction. In September 2022, AGR and Copenhagen Infrastructure Partners (CIP) began construction of Vineyard Wind I (VW1; 800 MWs) with COD expected in 2024 (Table 11). However, AGR is attempting to restructure a contract with the state of Massachusetts for its 1,200-MW Commonwealth project given rising costs associated with inflation and interest rates.
In February 2022, BOEM’s offshore wind lease auction for the New York Bight’s 500,000 acres across six lease areas totaled $4.4 billion ($8,951/acre), while the May 2022 Carolina Long Bay auction for two lease areas covering 110,000 totaled $315 million ($2,861/acre). On December 7, 2022, the state of California awarded $787 million of lease areas covering over 370,000 acres ($2,028/acre) off the coasts of central and northern California to five companies. BOEM estimates the areas could generate some 4.6 GWs of offshore wind energy. The winning bids included RWE, Equinor, and Invenergy.
Table 7
Adding Wind and Solar is Not Enough; Battery Storage is the Key to Aggressive Renewable Goals.
· Carbon reduction targets will require not only significant investment, but technological breakthroughs in batteries, green hydrogen, carbon sequestration and fuel cells. We see the potential for the US natural gas industry to reinvent itself using green hydrogen, renewable natural gas, and carbon capture. Existing infrastructure can be upgraded to blend hydrogen and RNG with natural gas in increasingly higher levels.
· Battery Storage: According to EEI, 56 GWs of storage capacity is expected to come online from 2022-2026. As of December 2022, US utility-scale battery storage totaled just over 9 GWs compared to near-zero in 2019. Over the long-term, we expect widespread utility scale battery usage and growing efficiencies as larger batteries piggyback the auto industry. Developers have scheduled more than 23 large-scale battery projects, ranging from 250 MW to 650 MW, to be deployed by 2025. The IRA now offers stand-alone storage credits and existing wind and solar projects can be retrofitted to include new utility scale batteries.
Exhibit 14
· Renewable Natural Gas (RNG) is a pipeline quality gas captured from dairies, animal/food waste, wastewater treatment plants, and landfills. Most natural gas utilities are investing in RNG and requesting PUC permission to blend with existing natural gas supply to serve customers. In addition, many are investing in non-regulated RNG production. According to the American Gas Association (AGA), the US currently operates 189 RNG production facilities, and there are 146 under current construction, along with 96 planned for future construction. RNG can be compressed (CNG) for truck and bus vehicle fleets and for liquefied natural gas (LNG).
· Green Hydrogen: Hydrogen can be burned as a zero-carbon fuel in hydrogen-compatible turbines to produce electricity, power fuel cells to drive passenger vehicles, heavy-duty trucks, ships and even airplanes, and to heat and light buildings. Importantly, hydrogen can be blended with natural gas and transported through existing gas infrastructure. Hydrogen technology appears to be a promising pathway to enabling longer-term storage of renewable power and decarbonizing industry and transportation. The November 2021 Infrastructure Investment and Jobs Act allocates $8 billion over five years for the DOE to develop at least four clean hydrogen hubs, a network of regional suppliers and consumers, and the infrastructure necessary to connect them. IRA provides a $3/kg hydrogen credit and 2021 bill allocates $1 billion for a program to improve and reduce the costs of electrolysis.
· Carbon Capture Utilization and Storage (CCUS) directly reduces emissions and removes CO2. CCUS technologies will play an important role in meeting net zero targets, including natural gas pipelines, midstream and power generation, as well as heavy industry. Major oil companies like Exxon, Chevron, Marathon, Dow, and Phillips 66 among others are investing heavily, which could make technologies economically viable.
FERC-Regulated Transmission
In 2022, EEI member utilities invested $31.7 billion in electric transmission compared with $29.7 billion in 2021. 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. On July 25, 2022, the Midwest Independent System Operator (MISO) approved Tranche 1 of its $100 billion long-term 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), and
• XEL ($1-2 billion)
The projects are expected to be in-service in 2028-30’s. LRTP projects are significant because they will help accommodate the influx of renewables needed to meet state and utility clean energy goals.
Corporate Strategies Simplifying, Transforming, and “Greening”
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. M&A activity declined during the pandemic-impaired 2020-21 COVID-19 era to its slowest pace in two decades. On February 24th, 2022, South Jersey Industries (SJI) agreed to be acquired by Infrastructure Investment Fund (IFF) for $8.1 billion in enterprise value, or $36.00 per share. The price represented a 53% premium and a 21.7X P/E multiple on consensus 2022 earnings and ~15X EV/EBITDA multiple. The transaction is expected to close in early 2023 pending regulatory approvals including the NJ Board of Public Utilities. The electric and gas utility sector remains fragmented and we expect ongoing consolidation.
Table 12 Recent Utilities Transactions
Source: Public Data
Another ongoing theme is simplification and focus on the core business. 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), 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.
· On December 15, 2022, Southwest Gas (SWX) announced plans to sell 100% of its Mountainwest Pipeline (MW) to Williams (WMB) for $1.5 billion in total enterprise value (8x EV to $188 million 2023 EBITDA) and spin-off non-regulated Centuri to existing shareholders. Upon completion of both transactions, SWX would be a fully regulated gas utility operating in AZ, CA and NV. The transaction is expected to close in 2023. Icahn was influential in getting four (of 11) new board members and lobbying for the sale of MW.
· On December 15, 2022, FERC denied American Electric Power’s (AEP) sale of its Kentucky utility operations to Algonquin’s (AQN) Liberty Utilities. AEP agreed to reduce the sales price to Liberty Utilities by 7.5%, to $2.65 billion, from $2.85 billion, and delay the sale to January 2023.
· AEP also expects to close on the sale of 1,365 MWs of unregulated wind and solar assets early in the second quarter of 2023. The sale is part of an ongoing simplification program to focus on the regulated utilities.
· In November of 2022, Duke Energy (DUK) announced that it plans to sell its renewable energy business, which includes 3.4 GWs of wind and just under 1.7 GWs of solar, in early 2023.
· In October 2022, Consolidated Edison agreed to sell its Clean Energy Businesses (4 GWs of renewables) to RWE Renewables Americas for $6.8 billion. The sale is expected to close in the first half of 2023,
· ES expects to complete the strategic review (announced May 4, 2022) of its offshore wind program, which includes the potential sale of all or part of its 50% interest in JV with Orsted, by year-end 2022. The JV includes three contracted projects totaling 1,758 MWs, and 175,000 acres available for development. The projects are located on the same 250-square mile tract; 30-miles east of Long Island’s Montauk Point.
· On May 31, 2022, First Energy (FE) completed the sale of a 19.9% stake in its transmission businesses to Brookfield Asset Management Inc. for $2.4 billion.
· On May 25, 2022, PPL completed the $6.8 billion acquisition of The Narragansett Electric Company, Rhode Island’s primary electric and gas utility, from National Grid for $5.3 billion. The transaction represented roughly 1.9x the US rate base of $2.8 billion and 25x 2021 adjusted earnings. In June 2021, PPL completed the sale of its U.K. utility business, Western Power Distribution (WPD), to National Grid plc for £7.8 billion, £14.4 billion EV, or $10.6 billion and $19.4 billion, respectively. The transaction represented roughly 1.6x the UK regulatory asset value (RAV), or rate base, of $11.4 billion and 10.6x 2021 earnings.
In February 2022, Exelon (EXC) spun off its 32 GWs power generation business, Constellation Energy Group (CEG). CEG owns 20 GWs of nuclear (13 stations/21 reactors) in IL, MD, NY and PA and 6 GWs of natural gas and 3.6 GWs of hydro, wind, and solar plans.
· In February 2022, PSE&G (PEG) sold its 6.75 GW fossil generation portfolio (13 plants in NJ, CT, MD, and NY) to ArcLight for $1.9 billion. PEG retained the nuclear fleet.
· On January 10, 2022, CenterPoint Energy (CNP) sold its Arkansas and Oklahoma LDC’s to privately-owned Summit Utilities for $2.15 billion cash. Advertised multiples were 38x 2020 earnings and 2.5x rate base.
Oil Majors Forced to Invest in Clean Energy
The major oil companies and large midstream pipelines face growing political and investor pressure to develop emission reduction strategies and will likely be forced to reinvent themselves. BP, Shell, Total Energies, Chevron, and Equinor have all invested in offshore wind projects. From 2009 through today, Copenhagen, Denmark-based Orsted completely reinvented itself from Danish Oil and Gas. Orsted is currently the global leader in offshore wind and wind development with 90% of its business from clean energy and a 2025 net zero pledge.
Utility Valuations Reasonable Relative to Interest Rates Valuation Multiples
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 15). Electric utilities trade at 18.2x consensus 2023 earnings estimates which is modestly above the historical median. We consider the multiple reasonable considering higher utility earning growth rates and strong fundamentals.
Exhibit 15 Absolute P/E Multiple Range
Source: Thomson One, Company documents, Gabelli Funds estimates
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 16, the current ratio of 140% indicates the sector P/E is moderately expensive when compared with its historical relationship with the 10-Year T-Bond Yield.
Exhibit 16 Utility Earnings Yield as a Percent of 10-Year T-Bond Yield
Source: Thomson One, Company documents, Gabelli Funds estimates
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 and 12-month Treasuries yield over 4.5% and US Treasuries hold even greater defensive appeal than utilities. However, we highlight that utility stocks out-performed this past year despite the dramatic increases in short- and long-term interest rates. 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 2022, electric utilities increased the annual dividend by a median of 5.1%.
· 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 3.4% current return and many utility managements target 5-7% 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.
Table 13 Ranking of 2021 Average Price To Ultimate Customers (c/kWh)
Source: S&P Global Market Intelligence
Appendix 1: Large, Small/Mid Cap & Canadian Utilities Select Statistics
Source: Public data, Gabelli Funds estimates
Appendix 2: Clean, Independent Power, Gas & Water Selected Statistics
Source: Public data, Gabelli Funds estimates
IMPORTANT DISCLOSURES
This whitepaper was prepared by Timothy M. Winter, CFA. The examples cited herein are based on public information and we make no representations regarding their accuracy or usefulness as precedent. The Research Analysts’ views are subject to change at any time based on the market and other conditions. The information in this report represents the opinions of the individual Research Analysts’ as of the date hereof and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. The views expressed may differ from other Research Analysts or of the Firm as a whole.
As of September 30, 2022, affiliates of GAMCO Investors, Inc. beneficially owned 3.96% of National Fuel Gas, 3.67% of PNM Resources, 2.81% of Southwest Gas, 2.55% of Otter Tail, 1.60% of RGC Resources, 1.57% of York Water, 1.56% of SJW Group, 1.37% of Northwest Natural, 1.00% of Black Hills, 1.00% of Hawaiian Electric
One of our affiliates serves as an investment adviser to Hawaiian Electric or affiliated entities and has received compensation within the past 12 months for these non-investment banking securities-related services.
Funds investing in a single sector, such as utilities, may be subject to more volatility than funds that invest more broadly. The utilities industry can be significantly affected by government regulation, financing difficulties, supply or demand of services or fuel, and natural resources conservation. The value of utility stocks changes as long-term interest rates change.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Fund before investing. The prospectus, which contains more complete information about this and other matters, should be read carefully before investing. To obtain a prospectus, please call 800 GABELLI or visit www.gabelli.com
Returns represent past performance and do not guarantee future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so, upon redemption, shares may be worth more or less than their original cost. To obtain the most recent month-end performance information and a prospectus, please call 800-GABELLI or visit www.gabelli.com
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This whitepaper is not an offer to sell any security nor is it a solicitation of an offer to buy any security.
For more information, visit our website at: www.gabelli.com or call: 800-GABELLI
800-422-3554 • 914-921-5000 • Fax 914-921-5098 • info@gabelli.com
Gabelli Funds, LLC is a registered investment adviser with the Securities and Exchange Commission and is a wholly owned subsidiary of GAMCO Investors, Inc. (NYSE: GBL).
