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The utility sector is at the crossroads after the release of the new emission standards by the U.S. Environmental Protection Agency (EPA) last August. The finalized version of the Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels. An EPA report also indicates that nearly $600 billion will be required to be invested in the water sector over the next two decades to get uninterrupted water and wastewater services of high quality.
Evidently, larger utilities with more financial strength and better access to capital are favorably placed to achieve regulatory compliance. This is also likely to trigger more consolidation in the utility landscape, be it the water or the electric utilities. For the latter, the focus is definitely on generating electricity from natural gas and renewable sources. As a result, we expect to see higher solar installations across the U.S. The extension of investment tax credits and production tax credits will further support solar and wind installations in the next few years.
The combination of steady electricity price gains and stable-to-improving demand will drive the utility sector. A decline in the unemployment rate, increase in hourly earnings of average workers and higher demand in residential and other customer classes are tailwinds for the utilities.
Rising up to the environmental challenge, utility companies are steadily improving their operations by investing in more environment-friendly power generation facilities. A recent release from the U.S. government’s Energy Information Administration (EIA) projects renewables used in the electric power sector to increase by 11.3% in 2016 and by 4.4% in 2017.
The report also forecast hydropower generation in the electric power sector to increase by 9.1% in 2016 and then decline by 0.6% in 2017. Generation from renewables other than hydropower is forecast to grow by 13.3% in 2016 and by 8.6% in 2017.
The report indicates U.S. coal consumption in electric generation will decline by 58 million short tons (MMst) or 8% year over year in 2016. The decline will largely be due to higher demand for clean burning, low-priced natural gas and unseasonably warm temperatures during winter that reduced overall electricity generation.
We believe a constructive utility rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will enable the utilities to efficiently serve a larger customer base.
In the segment below, we discuss the basic strengths of the utility sector.
Regular Dividend & Share Buybacks
Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008–2009 when utilities continued to pay dividends without fail.
We have a long list of companies who are sharing profits consistently with their shareholders. Notable among them are companies like CenterPoint Energy (CNP - Free Report) , Connecticut Water Service Inc. and Duke Energy (DUK - Free Report) who have raised dividend rates annually for more than 10 years now.
In Jan 2016, CenterPoint Energy and Duke Energy increased their quarterly dividend rates by 4% and 3.8% to 25.75 cents and 82.5 cents, respectively, while in Jan 2016, Connecticut Water Service raised its payout by 5.6% to 28.25 cents.
Stable & Growing Demand
The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for their services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.
Due to the planned reduction in coal-powered units, the EIA forecasts total U.S. electricity generation in 2016 to average 11.2 terawatt hours per day, marginally below 2015 generation. The EIA expects total electricity generation to grow by 1.6% in 2017.
Focused on R&D & Extension of ITC/PTC
In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, and transmission and distribution lines, into operation without compromising on energy efficiency.
Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.
In addition, the utility friendly move of the U.S. administration through the extension of the validity period of Solar Energy Investment Tax Credit (ITC) and Wind Energy Production Tax Credit (PTC) will help the utilities. We will see more utility scale solar and wind projects coming up, which will boost green power generation.
Mergers and Acquisitions
Utility sector operators don’t shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.
We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and also lowers operating costs through the usage of common back office space.
In Mar 2016, Exelon Corporation (EXC - Free Report) completed the much-awaited acquisition of Pepco Holdings and has plans to invest $23 billion in regulated assets during the 2016–2018 time frame, which will help in earnings growth of 7% to 9%.
In May 2016, Great Plains Energy Inc. (GXP - Free Report) announced that it has entered into an agreement to acquire Westar Energy Inc. .The transaction has an estimated value of $12.2 billion, including $3.6 billion of Westar Energy.
On Feb 1, 2016, Dominion Resources Inc. (D - Free Report) announced that it has entered into a definitive agreement to acquire Questar Corp. (STR - Free Report) . Dominion will require to shell out nearly $4.4 billion and assume Questar's outstanding debt. The transaction is expected to close by the end of 2016 subject to regulatory approvals.
We are also likely to see major acquisition activities in the water utility space. During the first quarter of 2016, American Water Works Company (AWK - Free Report) closed seven acquisitions adding 6,868 customers to its existing customer base. The seven pending acquisitions will add another 33,752 customers. Another player in the water utility space, Aqua America Inc. has also completed several acquisitions in its service territories, adding 5,250 customers (as of May 3, 2016) to its existing customer base.
To Sum Up
We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water and wastewater services do not have any viable substitute. This is perhaps the most vital driving factor for the industry.
Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features.
Without a doubt, the increase in interest rates in Dec 2015 has raised the borrowing costs for the utilities. With all eyes set to the next move of the Fed, it appears that the Fed chair has abandoned all plans of a rate hike in June citing weakness in international markets and lower-than-excepted job additions in May. Though Fed officials are seriously considering a hike in July or September, low interest rates for now will definitely benefit the utilities.
Volatility in the markets has also driven investors to seek protection in the utility space. These regular dividend payers are often regarded as a “bond substitute“ and consistent performing utilities continue to be a safe investment option for jittery investors.
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Seeking a Stable Portfolio? Utilities Are a Must
The utility sector is at the crossroads after the release of the new emission standards by the U.S. Environmental Protection Agency (EPA) last August. The finalized version of the Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030, from 2005 levels. An EPA report also indicates that nearly $600 billion will be required to be invested in the water sector over the next two decades to get uninterrupted water and wastewater services of high quality.
Evidently, larger utilities with more financial strength and better access to capital are favorably placed to achieve regulatory compliance. This is also likely to trigger more consolidation in the utility landscape, be it the water or the electric utilities. For the latter, the focus is definitely on generating electricity from natural gas and renewable sources. As a result, we expect to see higher solar installations across the U.S. The extension of investment tax credits and production tax credits will further support solar and wind installations in the next few years.
The combination of steady electricity price gains and stable-to-improving demand will drive the utility sector. A decline in the unemployment rate, increase in hourly earnings of average workers and higher demand in residential and other customer classes are tailwinds for the utilities.
Rising up to the environmental challenge, utility companies are steadily improving their operations by investing in more environment-friendly power generation facilities. A recent release from the U.S. government’s Energy Information Administration (EIA) projects renewables used in the electric power sector to increase by 11.3% in 2016 and by 4.4% in 2017.
The report also forecast hydropower generation in the electric power sector to increase by 9.1% in 2016 and then decline by 0.6% in 2017. Generation from renewables other than hydropower is forecast to grow by 13.3% in 2016 and by 8.6% in 2017.
The report indicates U.S. coal consumption in electric generation will decline by 58 million short tons (MMst) or 8% year over year in 2016. The decline will largely be due to higher demand for clean burning, low-priced natural gas and unseasonably warm temperatures during winter that reduced overall electricity generation.
We believe a constructive utility rate environment, increase in electricity production from natural gas and renewables and investments in infrastructure upgrade projects will enable the utilities to efficiently serve a larger customer base.
In the segment below, we discuss the basic strengths of the utility sector.
Regular Dividend & Share Buybacks
Utility operators generate more or less stable earnings unless there are severe factors disrupting their operations. The regulated nature of operations provides stability and removes volatility from future earnings. These operators in turn reward their shareholders through the payment of sustainable dividends and share buybacks. This was evident during the economic crisis of 2008–2009 when utilities continued to pay dividends without fail.
We have a long list of companies who are sharing profits consistently with their shareholders. Notable among them are companies like CenterPoint Energy (CNP - Free Report) , Connecticut Water Service Inc. and Duke Energy (DUK - Free Report) who have raised dividend rates annually for more than 10 years now.
In Jan 2016, CenterPoint Energy and Duke Energy increased their quarterly dividend rates by 4% and 3.8% to 25.75 cents and 82.5 cents, respectively, while in Jan 2016, Connecticut Water Service raised its payout by 5.6% to 28.25 cents.
Stable & Growing Demand
The biggest positive as well as the most fundamental strength of the utility sector is that there is basically no viable substitute for their services. The endless need for electricity and utility services is a prime driver. This gives revenues and cash flows a high level of certainty and visibility.
Due to the planned reduction in coal-powered units, the EIA forecasts total U.S. electricity generation in 2016 to average 11.2 terawatt hours per day, marginally below 2015 generation. The EIA expects total electricity generation to grow by 1.6% in 2017.
Focused on R&D & Extension of ITC/PTC
In their pursuit of improving the standard of services, utility operators have steadily invested in research and development (R&D). They have brought new smart meters, and transmission and distribution lines, into operation without compromising on energy efficiency.
Utility operators are also benefiting from ongoing research in the solar photovoltaic (PV) sector. Solar energy is a growing alternate energy source and the new solar cells with higher conversion rates allow operators to generate more power from fewer solar panels. This enables the operators to lower the cost of generating power from alternate sources as these are generally more expensive than fossil fuel sources.
In addition, the utility friendly move of the U.S. administration through the extension of the validity period of Solar Energy Investment Tax Credit (ITC) and Wind Energy Production Tax Credit (PTC) will help the utilities. We will see more utility scale solar and wind projects coming up, which will boost green power generation.
Mergers and Acquisitions
Utility sector operators don’t shy away from M&A activities to supplement their organic growth. In addition to giving their operations greater scale and scope, such measures also lead to cost synergies and better utilization of resources. The larger the companies, the more access they have to funds essential for vital infrastructure upgrades.
We believe that in a mature energy market like the U.S., mergers and acquisitions represent a sure way of enhancing market share. This expands market reach through the usage of transmission and distribution lines, diversifies the generation portfolio and also lowers operating costs through the usage of common back office space.
In Mar 2016, Exelon Corporation (EXC - Free Report) completed the much-awaited acquisition of Pepco Holdings and has plans to invest $23 billion in regulated assets during the 2016–2018 time frame, which will help in earnings growth of 7% to 9%.
In May 2016, Great Plains Energy Inc. (GXP - Free Report) announced that it has entered into an agreement to acquire Westar Energy Inc. .The transaction has an estimated value of $12.2 billion, including $3.6 billion of Westar Energy.
On Feb 1, 2016, Dominion Resources Inc. (D - Free Report) announced that it has entered into a definitive agreement to acquire Questar Corp. (STR - Free Report) . Dominion will require to shell out nearly $4.4 billion and assume Questar's outstanding debt. The transaction is expected to close by the end of 2016 subject to regulatory approvals.
We are also likely to see major acquisition activities in the water utility space. During the first quarter of 2016, American Water Works Company (AWK - Free Report) closed seven acquisitions adding 6,868 customers to its existing customer base. The seven pending acquisitions will add another 33,752 customers. Another player in the water utility space, Aqua America Inc. has also completed several acquisitions in its service territories, adding 5,250 customers (as of May 3, 2016) to its existing customer base.
To Sum Up
We can have different fuel types like coal, oil, natural gas, nuclear power and renewable sources to produce electricity, but we do not have any alternative to electricity. Similarly, clean water and wastewater services do not have any viable substitute. This is perhaps the most vital driving factor for the industry.
Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features.
Without a doubt, the increase in interest rates in Dec 2015 has raised the borrowing costs for the utilities. With all eyes set to the next move of the Fed, it appears that the Fed chair has abandoned all plans of a rate hike in June citing weakness in international markets and lower-than-excepted job additions in May. Though Fed officials are seriously considering a hike in July or September, low interest rates for now will definitely benefit the utilities.
Volatility in the markets has also driven investors to seek protection in the utility space. These regular dividend payers are often regarded as a “bond substitute“ and consistent performing utilities continue to be a safe investment option for jittery investors.