Utilities primer
– GLI101
Utilities & ESG
Watch: Ralph Izzo, PSEG talk about the climate change challenge
“Climate Change challenges us to think and act in new ways regarding how we use and provide energy … an unmatched opportunity to grow the economy, promote innovation and create new jobs while protecting the planet for future generations.”
Ralph Izzo
Forbes – September 2007
Overview
The global urgency of tackling climate change means how we generate, transmit, distribute and use energy will change dramatically over the next 30 years. By 2050 renewable energy will become the leading source of primary energy consumption.
Renewables and natural gas will grow from a 40% to 70% share of net electricity generation in the world over this period. The global listed utilities companies will key players in how this energy trans-formation will evolve and subsequently offer fantastic opportunities to invest in the future.
According to the International Energy Agency (IEA), if we continue our current path, global energy demand will grow by 50% by 20501, with increasing electrification transforming traditional ways of meeting demand. The graphic maps the consumption of energy sources over the coming 30 years. It is forecasted that much of this growth will be met by clean energy technologies and renewables. Another key development is the growth in natural gas.
Evolution
Energy Intelligence’s (EI) annual ranking of the world’s top 100 ‘green’ companies represent approximately 50% of the world’s power generating capacity across five continents. EI evaluate each power producer’s ‘greenness’ according to car-bon dioxide emissions per megawatt hour of electricity produced, volume of renewable energy capacity and proportion of renewables to total capacity.
On average, the 100 companies in the ranking emitted less than 500 kilograms of carbon dioxide per megawatt hour generated in 2018 – at 440 kg/MWh, down from 569 kg/MWh in 2011. This continued decline in emissions is due to the progressive switch of large utilities’ installed capacity to carbon-free technologies, including renewables and nuclear energy. Since the first ranking in 2012, non-hydro renewables tripled from 4% to 10% of total capacity.
Carbon-free power accounted for 80% of new generation capacity in 2018. From the GLIO Index, in Europe, Iberdrola (4), Orsted (7)3, Enel (11), SSE (20) and Engie (26) all rank highly according to EI’s ranking. While perhaps less radical than in Europe in the past, the switch from fossil fuels to renewables among the largest North American utilities has still been re-markable and gathering pace. NextEra Energy (5), PG&E (32), Dominion Energy (35), PSEG (41), Southern Co (46), Duke Energy (47) all make the top 50. In the next 50, Entergy, Pinnacle West, Xcel, AEP, FirstEnergy, Trans-Alta, Emera, Alliant, DTE and WEC are all included.
In Asia, China Resources and CLP rank in the top 100. Between these 24 companies in the GLIO Index, they have the capacity to produce 620GW, or enough to power approximately 200 million homes. The companies included in the GLIO Index are focused on regulated utilities which generate, transmit/trans-port and distribute electricity and gas.
According to the American Society of Civil Engineers (ASCE), much of the US energy system predates the turn of the 21st century and they estimate that $177bn of new investment is required in the next ten years. In Europe, the EU estimates that nearly €300bn capital expenditure is required over the same period, around 65% of that in electricity transmission. An outlook to 2050 based on external studies in Europe shows that a full decarbonization of the power sector in coming decades will require continuing grid developments to facilitate this energy transition.
Much of this essential generation and grid investment will rest in the hands of the listed utilities, as they own much of the transmission and distribution system. In its updated July 2019 report, the Edison Electric Institute (EEI) estimated that the capital expenditure would total $124.3bn in 2018, $113.8bn in 2019 and $103.8bn in 2020 among its US members. The major US listed utilities have completed a large portion of the critical network investment over the past decades and they have multiple billions of dollars earmarked for future investment.
Developments
Dominion Energy is aggressively pursuing a clean-energy future anchored by a commitment to reduce carbon emissions by 55% and 80% by 2030 and 2050 respectively. To accomplish this goal, the company is investing heavily in solar and offshore wind energy as well as extending the life of its zero-carbon nuclear power fleet. In fact, the company recently announced the largest offshore wind installation in the US with a capacity of over 2.6GW.
The project, which is expected to be completed in 2026, represents an investment of nearly $8bn and is a fitting complement to the company’s 12MW test project, which is the first fully-permit-ted offshore wind project in federal waters and is expected to enter service by the end of this year. The company is also pursuing investments in battery storage, pumped hydroelectric storage and other resources that can support the intermittent nature of renewable resources.
Southern Company has stated it is committed to providing clean, safe, reliable and affordable energy, while transitioning to low- to zero-carbon operations by 2050. The company has made significant progress in its approach to electric generation resource diversity, which includes investment in renewable energy, natural gas and nuclear, coupled with modernizing its grid. Since 2007, without any regulatory mandates, Southern claim to have reduced CO2 emissions by 36%. American Electric Power (AEP) has developed next-generation sustainability goals to guide the company into a cleaner energy future.
These include, reducing carbon emissions by 70% by 2030 and by at least 80% by 2050 (with an aspirational goal of zero emissions), investing $2.3bn in renewables through 2024 and adding more than 7,700MW of regulated wind and solar through 2030. The company continues to invest in a smarter, more modern grid.
The story is similar across the Atlantic. Large caps Enel, Iberdrola and Engie have initiatives to accelerate the decarbonization of their energy mix. For example, Enel, Europe’s largest listed utility company, announced a €28.7bn strategic plan for 2020-2022 in November last year. It earmarked over €14bn to deploy new renewable capacity and progressively replace coal. The Group is expected to develop 14.1 GW of new renewable capacity by 2022 and to reduce coal capacity and production by 61% and 74%, respectively, from 2018 levels. Renewables are expected to represent 60% of total capacity by the end of 2022. Enel’s investment in the efficiency of grids and digitalization will reach approximately €12bn. Over a similar period, Iberdrola plans to invest €13bn in its renewable energy business by 2022 and reduce emis-sions by 50% by 2030.
Through a series of medium-term plans, all three of the large cap European utilities state they will be carbon neutral by 2050. Peter Bisztyga and Harry Wyburd, European utilities & renewables analysts at Bank of America, explain the shift in Europe. “2019 could well be remembered as the year when the world fully realized the urgency of climate change, with numerous governments pledging to adopt ‘net zero’ carbon targets. As we look ahead to the new decade, we anticipate that the journey to net zero will require a significant acceleration in growth of renewables, electrification and energy efficiency. “We expect the substantial investment requirements to be met with ever increasing flows of capital into sustainable asset classes,” they say. “We believe that many of the pan-European utilities are entering the next decade in a strong position to benefit from these secular trends, having spent the last decade restructuring their business models.”
Investment case
Global utilities play a major role in the infrastructure allocation mix. Looking at the GLIO Index, regulated electric and gas network utilities make up approximately 50% of total market capitalization. It is difficult to over-play the importance of utilities to the functioning of the global economy and our day-to-day lives.
Given the dominance of listed utilities in the global energy space, a diversified mix of companies provides excellent exposure to future energy needs. The critical need for change in energy generation and grid modernization provides otherwise lower-growth utilities with strong expansion prospects. This need for investment somewhat ensures that regulators are incentivized to reward capital investments. This provides good growth and a strong defensiveness.
Regulated utilities tend to have three to five-year rate agreements with regulators. As mentioned, regulated utilities are increasingly looking to add wind and solar generation assets to their rate base due to improving economics. Utilities can develop renewables and make them regulated-like by contracting them through power purchase agreements, typically for 15-20 years. Inflation impacts on allowed returns often occur through rate base and cost of capital calculations. Utilities offer investors stable earnings, plus attractive cash flow and dividends. While industrial and commercial energy demand is primarily a function of economic conditions, residential demand historically is steady over the long run and weather-driven in the short term. Even in the event of an economic down-turn, customers still have the need for the majority of the services that utilities provide. Subsequently, they offer attractive total returns, on average 4% dividend yield over the longer-term backed by consistent annual dividend growth.
The US utilities will normally target a 60-75% payout ratio and normally look to grow dividends in-line with earnings according to Wolfe Research. GLIO Electric & Gas Utilities have significantly outperformed global equities over short, medium and long-term investment horizons, and Sharpe ratios beat global equities over nearly all holding periods. The numbers are similar in Europe. Utilities offer investors naturally defensive characteristics. These characteristics prove very attractive in a low-rate or more cautious investment climate. The final graph examines the upside and downside capture of global electric utilities (bars) and the broader GLIO Index (lines) over eight separate historic investment horizons. The results are remarkable.
During the short, medium and long-term investment horizons, both the GLIO Index and GLIO Electric Utilities consistently capture at least 80% of the upside when compared to global equities. When global equities fall, the GLIO Index only captures approximately 60% of that fall, therefore protecting investors 40%. Even more impressively, GLIO Electric Utilities register better defensive qualities again dropping less than the GLIO Index in all cases. Over the investment horizon range of three-to-ten years, the downside protection of the sector is particularly significant.
Tim Humphreys, Portfolio Manager, Ausbil, ex-plains the importance of utilities in his infrastructure portfolio. “In addition to exhibiting lower volatility, lower betas and higher yields than broader global equities, the defensiveness of the sector offers our clients significant downside protection in times of stress, while capturing most of the upside when markets are rising. Utilities are a critical part of any infrastructure portfolio because they sit at the center of many key issues facing all of us in the early-21st Century.”
Reliable mix
The world needs a diverse energy mix to ensure a reliable supply of energy. To serve customers effectively and efficiently, energy must be generated when, where and how it is needed. Ensuring reliability under all circumstances, including weather extremes and emergencies, requires utility companies to use a mix of energy sources.
These energy sources are key to com-panies’ ability to serve all customers, in-cluding businesses and industries whose energy usage differs from that of most residential customers. As energy transfor-mation develops over the next 30 years, the generation mix will continue to skew towards renewables and natural gas. As those sectors grow, storage capacity will evolve, smart grid technology will become the norm, and energy intensity will fall. The global listed utilities that rise to these challenges will be fundamental to fueling that development, creating a cleaner future and will continue to com-prise a key component of any investor’s portfolio.
