Electric power generation in the United States is a highly regulated industry, and has been since the 1920s and 1930s. The primary Federal entity regulating the production and transmission of electricity is FERC, the Federal Energy Regulatory Commission, but FERC’s regulation is high-level. The nitty gritty of pricing regulation that affects both the revenues of public utility companies and the prices paid for electricity by end users falls under the purview of state public utility commissions.
These high regulatory burdens put the stock of public utilities in a special category for investors. Their earnings growth is largely constrained by their regulators. Conservative, income-focused investors often buy them for their consistent and reliable dividend yield, which historically has moved with interest rates. These are the archetypal “widow and orphan” stocks, bought for income and not principally for appreciation.
However, we read comments in a recent issue of Barron’s that pointed out some current trends that might make utilities of more interest to growth-oriented investors. T. Rowe Price portfolio manager David Giroux noted:
“Disruption is a situation where new regulation or technology will significantly impact the trajectory of a company’s earnings growth… [Public utilities are] a case where disruption is helping an industry. I’m going to close down the coal plant and put up a wind farm, or solar farm with some storage, and maybe do some grid modernization. All of that is allowing a lot of utilities to actually grow their rate base at a 5%, 6%, 7% rate — 8% in some cases. And it’s not impacting customer bills, because half of a utility bill is the coal, or natural gas. As you close down gas and coal plants, that portion of the bill goes down. So, high-quality utilities are growing earnings 5–7%, and customer bills are only going up 2%. That’s a dramatic change from 20 years ago.”
His observations are interesting, but we have some caveats before growth investors jump on the public utility bandwagon.
The disruption being caused by the growth of renewables in the energy mix is one that for now, is still largely being driven by regulators, not by pure market forces. Those regulatory forces are not all visible at the level of FERC and state utility commissions, although the latter can include rate surcharges that are used to subsidize renewable infrastructure. The Environmental Protection Agency (EPA) and the Department of Energy (DoE) have a big influence. By setting clean air standards, or making other regulatory changes, they can make or break the economic assumptions that underlie utilities’ integrated resource plans (IRPs) — the long-term decisions they make about generation and transmission infrastructure.
At the end of 2017, the DOE under Trump appointee Rick Perry moved to make a new rule that would counter some of the regulatory tilt towards renewables, by mandating that coal and nuclear generated power be given credit for those energy sources’ “reliability and resiliency” attributes. The proposed rule was shot down. Whether you believe that the proposed rule was politically motivated, or that its opponents were politically motivated (both are likely true), one thing is sure — the issue of electricity pricing is a political football being tossed around in a highly partisan environment.
Given that reality, we are a little wary of long-term analysis like that recently produced by NIPSCO — Indiana’s third-largest public utility. NIPSCO’s IRP came to the conclusion that it made the most economic sense to shutter two coal generation plants and replace the capacity with renewables. Environmentalists noted that Indiana is a Republican-leaning state without state-level renewable energy mandates, and praised the supposedly “economic” nature of the proposal. The decisive factor, though, was the incorporation of the cost of EPA-mandated retrofitting so that the coal plants would comply with Federal clean air regulations. Critics of NIPSCO’s plan focused on those regulations — and the fact that changes to the regulatory framework would change the plan’s economics profoundly.
Investment implications: Energy generation and delivery is being disrupted by technological change. That technological change, though, is still reliant on regulatory support to be competitive with legacy energy sources. Investors who believe that such regulation will move forward without political turmoil could bet on public utilities being able to grow earnings more rapidly than in the past, as they phase out legacy generation capacity and shed the regulatory compliance costs associated with maintaining it. Those less sure about the political future of renewable-friendly regulation might continue to view utilities as low-growth, “widow and orphan” stocks.
