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Equity Perspectives

How investors assess utilities that use coal, carbon emission-free nuclear power, low-cost natural gas, and renewable sources, such as wind and solar to produce electricity.

 

In Brief:

  • Electric utilities have long been popular among dividend investors because they have very stable businesses, allowing their stocks to offer higher-than-average dividend yields.
  • As energy markets in the United States contend with a maze of regulatory cross-currents, state and federal subsidies, and renewable mandates, a deep understanding of each company’s capital structure is required. As such, regular collaboration among equity and fixed-income analysts is critical.
  • Many utilities have switched from coal to cheaper natural gas and renewables, while nuclear plants have been plagued by construction delays and cost overruns.
  • Coal-powered electricity continues to decline, while natural gas’s share of the “energy stack” has steadily increased.
  • Improved technology and subsidies have made renewables more attractive to utilities, but renewables are still a small portion of the overall electricity market.
  • With higher interest rates driving down utility stocks of late, developing “variant perceptions” through diligent research remains crucial for delivering alpha.

 

On one level, the saga of an energy conglomerate we’ll call “WattsUp” reflects the profound changes in the economics of generating and delivering electricity in both the regulated and unregulated sectors. Confronted with state mandates and federal tax credits for renewable generation, its aging coal and nuclear plants have become less competitive, while natural gas and renewables are ascendant.

At the same time, WattsUp’s situation has focused a particular spotlight on financial engineering that has transformed overleveraged companies, adding and subtracting value across the capital spectrum.

Enter Lord Abbett research analysts Glenn McIsaac, Mitchell Moss, and Wells Chen. McIsaac covers equities in the utilities sector. Moss covers fixed-income securities, including distressed opportunities that arise in that universe. And Chen covers municipal bonds, some of which are tax-exempt securities issued to cover the capital spending to install emission control equipment on power plants.  

In the process of evaluating WattsUp, these analysts encountered a form of “ring fencing,” which involves shielding the credit risk of the parent issuer from the troubles (including bankruptcy) of a subsidiary issuer within the corporate structure. With a ring-fence, if a nonregulated subsidiary defaults on its debt and files for bankruptcy, the parent, theoretically, would be able to obtain or maintain a “standalone” credit rating substantially higher than its ailing affiliate. However, the subsidiary’s restructuring trouble could cloud the parent’s equity valuation for years, as restructuring drags on and claims against the parent grow.

Power Play
Ring-fencing of utilities is often done to “judgment-proof” part of the company from the bankruptcy court. The tactic also may help on the regulatory front, said Utah utility analysts Charles Petersen and Elizabeth Brereton in a 2005 paper. “Regulators are concerned that the fall-out of the bankruptcy of a utility’s parent or affiliates will negatively affect the utility’s costs and access to the credit markets, or, worse, drag the otherwise healthy utility itself into the bankruptcy, to the detriment of ratepayers and the regulator’s own authority,” they added. 1

WattsUp is one of the nation's largest investor-owned electric systems, based on the number of customers served. It also has extensive transmission operations and a well-diversified generation fleet that drew on carbon emission-free nuclear, scrubbed coal, natural gas, hydro, and other renewables, including a substantial wind power operation under long-term contracts.

Where WattsUp ran into trouble can be traced to its heavily indebted unregulated merchant-generating subsidiary (“WattsDown”), whose assets include older coal and nuclear plants, which are getting squeezed by new and more efficient energy suppliers, helped by the abundance of cheap shale gas from the giant Marcellus Formation in Appalachia and the plummeting cost of renewables.

A well-known activist investor with prior restructuring experience (and several investors, including a private equity group led by a former energy CEO) injected $2.5 billion in equity into WattsUp, but as WattsDown’s finances worsened, that subsidiary filed for bankruptcy and sought policy changes from the federal government that would require electricity customers to pay slightly more in order to preserve the fuel diversity and reliability benefits of coal and nuclear plants.  

As the CEO of WattsUp recently warned, unless something is done to change markets that have been administrated in a way to disadvantage coal and nuclear plants, and unless the states step in to provide support, there may be no coal or nuclear plants left in the unregulated power markets.

Coal and Nuclear Subsidies Face Substantial Headwinds
While the Trump administration pushes for U.S. energy dominance and encourages greater use of coal and nuclear energy, cheap natural gas has become an increasingly popular fuel for electricity generation.  (See Chart 1.) Renewables such as solar and wind power also have grown more attractive, thanks to subsidies and improving economics. According to the Federal Energy Regulatory Commission (FERC), proposed net installed capacity additions by utility-scale wind and solar in the United States could effectively double by December 2020. Still, renewables remain a small portion of domestic energy generation. 

 

Chart 1.  Natural Gas and Renewables Continue to Eat Up Coal's Market Share 
Sources of U.S. electricity generation—2007 and 2017

Source: U.S. Energy Information Administration.

 

According to the U.S. Department of Energy, 531 coal-powered plants were retired between 2002 and 2016, while plans to retire eight nuclear reactors have been announced since 2016.

Despite calls for a coal revival, the pace of coal-plant retirements continues. According to an E&E News review of federal figures, U.S. power companies plan to cut nearly 12 gigawatts of coal-fired capacity this year, or about 4% of the American coal fleet.2

State and federal deregulation may help coal plants to a certain extent, but coal still faces a challenging future. “With natural gas futures prices remaining stubbornly below $3.00/MMBtu [million Btu], and a 70% decline in the cost of wind and solar renewables since 2010, no developer is going to build a new coal plant in the United States,” said McIsaac, “and coal-plant retirements will continue.”

Even so, some existing coal-plant operators have proven to be worthy credits, according to Moss.  “For deregulated coal plans I cover, I expect their ultimate retirements will occur well beyond their debt maturities, ” he said. “Good coal operators have done a great job at cutting operating costs and improving reliability to produce as many megawatts as they can to cover fixed costs. Changes in regulations and continued declines in generating costs for gas-fired and renewable capacity are key areas I watch to determine the on-going competitiveness of coal plants.”

Non-carbon-emitting regulated nuclear plants have helped keep electricity rates low due to low operating costs, Moss added, but utilities are having a hard time justifying large investments in plant maintenance and in new nuclear-generating capacity. The recent cancellation of two units being built in South Carolina following regulatory disputes and numerous construction problems is a recent example. Although the units featured advanced reactor design, costs of the project soared to an estimated $20 billion, from an initial estimate of $12 billion. An existing gas-fired plant and new solar generation in the state is planned to replace the cancelled nuclear project.  

While federal environmental rules have been relaxed, McIsaac noted that the FERC in January rejected Energy Secretary Rick Perry’s proposal to help coal and nuclear power plants to ensure reliable, resilient, and affordable electricity, particularly in times of weather-related stress. “The FERC recognizes the importance of a diverse fuel mix and a resilient grid, but they were unwilling to effectively re-regulate coal plants operating in competitive markets,” McIsaac explained. “The FERC opened a new docket to further explore grid resiliency, but that will take time, and doesn’t do much now to help struggling coal plants.”

The renewables industry praised the FERC decision, confident that market intervention ultimately may not help keep coal plants open or improve grid reliability.3 But six Republican members of the United States House of Representatives from coal-intensive states have since introduced a bill that would create a new tax credit that subsidizes virtually all the coal plants across the nation. In addition, WattsDown has requested that the Energy Department order the nation's largest grid operator to enter power supply contracts with WattsDown's coal and nuclear plants to ensure the plants received sufficient revenues to remain open.  

As for nuclear subsidies, Southern Company is over budget and behind schedule on two new units at the Vogtle plant in Georgia that are receiving federal subsidies in the form of Department of Energy loan guarantees, which lowers the utility’s borrowing costs for plant construction, and federal tax credits tied to the new units’ generation. State regulators continue to support Vogtle’s construction schedule and cost estimates. These costs will ultimately be passed on to customers of Georgia Power and the plant’s co-owners.

Meanwhile, McIsaac and Moss are following state efforts to help aging nuclear facilities stay afloat.  In New York, a three-judge federal appeals court is weighing arguments for continued state subsidies of three western New York nuclear plants, which could amount to billions of dollars. The case stems from a challenge to New York’s zero-emissions credit program for struggling nuclear plants. That program is part of New York’s Clean Energy Standard, which requires half of New York's power to come from renewable sources by 2030.4 (Illinois has a similar lawsuit working its way through federal courts.)

Some observers believe the outcome of that case will be binding in future federal court cases within the region, which includes New York, Connecticut, and Vermont.  In any case, Ohio, Connecticut, Pennsylvania, and New Jersey are also wrestling with ways to rescue their nuclear industry.  In New Jersey, with the legislative and executive branches controlled by Democrats, some Democrats support a stand-alone nuclear subsidies bill. Other Democrats prefer a broader renewables package, including giving at least as much help to the state’s solar industry and even reviving a controversial offshore wind project—with all these subsidies adding to customer’s electricity bills.4  

Coal Comfort Fades
Having researched the creditworthiness of many coal-burning power plants, Moss recalls the times when a number of companies and governments around the world were investigating technologies that might capture and store the carbon dioxide emitted from coal at a reasonable cost.

Earlier this century, for example, one technology that attracted considerable investment involved the conversion of coal into synthetic petroleum products or natural gas.  Unlike conventional coal-burning plants that ignite the coal and sent pollutants into the air, “synfuels” were supposed to create a synthetic natural gas. Plants using syngas are known as integrated gasification combined cycle (IGCC) facilities and generally have emissions comparable to burning regular natural gas. But building the plants at commercial scale has proven very difficult and there have been massive cost overruns, as Mississippi Power discovered when it attempted to build an IGCC plant.

“Initial plans called for a 600–700 megawatt facility at cost of $2–2.5 billion,” Moss recalled.  “After multiyear delays and $4 billion of cost overruns, it wound up costing about $6.5 billion, so the company pulled the plug on the synfuel production and just ran the plant as a combined cycle using natural gas.  The rationale was that even if they could get the IGCC technology to work perfectly, the cost of using coal (locally mined lignite) and the fuel conversion process would only be economical if gas prices are above $5 per thousand- cubic feet [Mcf].” Natural gas prices have been under $4.50/Mcf for quite a while.

In coal-rich Montana, there also was considerable interest in storing billions of tons of carbon dioxide from coal-burning plants in old coal mines, abandoned oil and gas fields, and in various other geologic formations—a process known as “sequestration.”  But so far, that hasn’t worked out either.

“Is sequestration a worthwhile endeavor? Perhaps,” Moss said. “But private industry, and not the federal government, would be the more likely funding source for any R&D to prove its worth, and that only happens if there is an economic incentive to try to sequester the carbon. As a result, even Montana is realizing it should move away from coal-fired generation and focus on gas-fired plants and wind farms.”

Current Outlooks
As WattsUp braced for the bankruptcy of a key subsidiary, both its shares and bonds were trading at substantial discounts (as of March 2, 2018). Enticing as that may have been to some investors, one big question was whether WattsUp will be held responsible for some of WattsDown’s debt, and to what extent.

Against that backdrop, other investors were drawn to well-managed companies that either converted much of their systems to modern gas-fired plants, which helped them boost rate base and earnings, or that have steadily increased dividend over the last 10 years.

Then there’s a company that is building a liquefied natural gas (LNG) export terminal that is scheduled to come online in 2019.  “The world LNG market has softened a bit since the company started construction; but the positive financial impact of the project is unchanged, because the company has locked in long-term contracts with counterparties,” said McIsaac. ”The company will be paid for its terminal—a benefit that hasn’t been fully reflected in the company’s stock price.”

The bottom line is that while utility companies may be defensive stocks, diligent research and active management remain crucial to the investment process.

Reported by Steve Govoni, Senior Financial Writer

 

1 According to the Institute for Energy Research, renewable electricity mandates are laws that require utilities to sell or produce a certain percentage of electricity from renewable sources. Usually the required percentage of renewable electricity increases over time until reaching a target percentage, such as 20 or 25 percent, at a target year, such as 2020 or 2025.
2 Benjamin Storrow, “GOP Is Trying to Prop Up Coal, but Plants Keep Closing,” E&E News, March 15, 2018.
3 “Oral Arguments Heard in New York ZEC Case, State Subsidies in Spotlight,” Platts.com, March 12, 2018.
4 “Our view: NJ Leaves Ratepayers out of Nuclear Subsidy Deal,” The Press (of Atlantic City), March 21, 2018.

IMPORTANT INFORMATION
Keep in mind that all investments carry a certain amount of risk including possible loss of the principal amount invested.  

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
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The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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