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posted on 09 December 2016

The New Art Of Utility Investing

by Richard Stavros

Investing Daily Article of the Week

In the face of macroeconomic and sector-specific challenges, income investors should consider a strategy that focuses on a new type of high-growth utility.

These forward-thinking utilities are pursuing a new business model that could deliver superior earnings and dividend growth, even in a rising-rate environment.

Of course, higher rates aren't the only challenge for the sector. The industry is undergoing a dramatic transformation due to the spread of renewables and the shift toward natural gas.

Meanwhile, anemic economic growth has kept a lid on electricity demand. That's caused utilities to scramble for other sources of growth, whether via mergers and acquisitions or upgrades to infrastructure.

The one thing that's becoming increasingly clear is that customarily cautious utilities will have to become more entrepreneurial to adapt to this rapidly changing environment. And these new, high-growth utilities seem well positioned to do just that.

In the December issue of Investing Daily's Utility Forecaster, we share exclusive insights from the Edison Electric Institute's annual financial conference, where bankers, analysts and utility executives meet to discuss the future of the industry.

At this year's show, some of the characteristics of this new type of growth utility were apparent, and we detail them below.

Power on Demand

For years, investors believed that growth in a utility's service territory was singularly beholden to population and economic growth. If a service territory was lacking in either, then there wasn't much the utility could do about it.

But technology is starting to change all that. With the rise of renewables and new technologies such as distributed generation, an entrepreneurially minded utility can now go where the growth is.

How? Utilities that have shrewdly pushed into renewables can design and manage a power system for large industrial or commercial customers wherever they're located.

Of course, such customer-poaching could still happen the old-fashioned way, by persuading customers to move to another service territory for a better deal.

To that end, utilities that have the best smart-grid technology will likely be the most successful in wooing businesses.

The Drive for Growth

Entrepreneurial utilities have another big growth opportunity thanks to the advent of the electric car.

Indeed, the Edison Electric Institute, the association representing investor-owned utilities, has called the electrification of the transportation sector essential to the long-term health of the industry.

Some studies have estimated that if all light-duty vehicles were electrified, power sales would rise by about 25%, increasing utility revenue by $100 billion per year.

Though it will be a while before that happens, a recent Bloomberg report estimates that electric vehicles will account for 35% of new vehicle sales by 2040.

And Moody's Investors Service estimates electrics could account for two-thirds of the industry's sales growth by 2030.

Regardless of what happens at the federal level, states are making serious efforts to promote electric cars. Last year, for instance, eight states announced an ambitious goal of making all car sales in their states zero-emission vehicles by 2050.

In studying these different state programs, we found that those utilities with a lead in grid technology have a big edge when it comes to electric cars.

Eversource Energy (NYSE: ES), for example, is already devising different rate structures for electric cars.

Meanwhile, Southern Company (NYSE: SO) is developing a pilot program for electric cars and building charging infrastructure.

Of course, the California utilities are at the vanguard of such efforts, given the Golden State's aggressive push to reduce emissions.

While state cooperation and regulatory support will be critical to utilities' future growth plans, this support is emblematic not just of visionary politicians and regulators, but of a new generation of utility leaders who have been effective in coordinating this change.

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