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posted on 09 December 2015

Utilities See Green By Going Green

by Richard Stavros

Investing Daily Article of the Week

There was a time when global climate talks, such as the ones being held in Paris this week, were thought to be critical in spurring adoption of renewable energy. But that's not the case anymore.

U.S. utilities already see the money to be made in green energy, and their planned investments in generating cleaner power will rise dramatically in the years to come, helping drive future earnings growth.

Indeed, the U.S. Energy Information Administration projects that gas-fired generation will grow by 40% through 2040.

Furthermore, the government predicts that renewables will account for more than half of the generating capacity added through 2022, as utilities take advantage of tax credits while helping their states meet renewable mandates.

But utilities' main incentive is to grow their earnings by adding greener infrastructure to their regulated rate base.

That's why even with the politically contentious Clean Power Plan, the majority of the industry has chosen to move toward compliance.

In fact, that was one of the big surprises of last year's Edison Electric Institute Financial Conference. Utility executives argued that new rules were coming so quickly that their firms didn't have the luxury of waiting to see which way the political winds would blow.

In anticipation of more stringent environmental regulations, many utilities have already developed multi-year plans to shutter coal-fired plants and build gas-fired replacements.

But even without the Clean Power Plan, the industry would have continued to move toward cleaner gas-fired plants simply because the prolific shale plays have made natural gas cheap and plentiful.

To be sure, my colleague Robert Rapier, who helms our sister publication, The Energy Strategist, argues that investors should care what policies arise from the climate conference in Paris, as they can have "big impacts on money flows in the energy sector."

Rapier notes that carbon-emissions regulations have been a big factor in investors' avoidance of coal stocks in recent years. And government policy explains the "explosive growth of the wind and solar power sectors," he wrote.

He also warned that government edicts can make or break new companies. That's why even if the world's governments were able to reach an agreement on climate change in Paris this week, we would carefully evaluate new entrants to the sector.

In fact, a recent report on the Paris talks by Berkeley Research Group concluded that governments will likely pursue one or more of the following three approaches toward reducing carbon emissions: 1) implement energy efficiency and conservation programs; 2) create subsidized investment into non-carbon technology; and 3) "last resort" carbon capture and sequestration/storage.

The report concludes that most of the 183 nations that have filed plans so far are taking the first two approaches.

Of course, the Clean Power Plan is significantly ahead of many other countries' initiatives, since these rules have been vetted, debated and discussed for many years at this point.

And the conclusion by Wall Street investment banks and ratings agencies is that the Clean Power Plan will be a positive for a number of our favorite utilities. The two biggest factors are the size of their coal fleet and whether they operate in states known for having constructive regulatory environments.

Utilities with big coal fleets have opportunities for earnings growth by retiring aging coal plants and building new gas-fired plants. And constructive relationships with regulators help ensure that such spending is quickly recovered by passing the costs along to ratepayers.

Analysts with Morgan Stanley believe that fully regulated utilities in the Southeast with sizable carbon footprints could be the biggest beneficiaries of the Clean Power Plan. They project as much as $50 billion in spending will be needed to decarbonize the region. A number of our portfolio holdings stand to gain from this regulatory windfall.

Ratings agency Fitch conducted its own analysis by ranking the states most likely to be affected by the Clean Power Plan, as well as those that have demonstrated above-average timeliness of cost recovery.

The states that ranked most highly in both categories were Illinois, Indiana, Maryland, Ohio and New Jersey.

We've long argued that as the U.S. moves toward renewable energy, there will be winners and losers as the utilities sector is held to a new, higher standard.

As we've seen already in the great gas-utility grab, this new regulatory environment will redefine strategies, mergers and acquisitions, and ultimately valuations. We just hope to profit by following the money.

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