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Utilities Banking on Shift to Clean Sources for Future Growth

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The utility sector is currently undergoing a transition as the primary fuel source, coal, is being replaced by natural gas, and we could notice increased usage of clean energy to produce electricity. The new U.S. administration’s coal-friendly moves will definitely lead to some of the coal-based utility plants running for a longer time period than expected.

We advocate that there needs to be a balance between emission control and clean energy generation. A constructive utility rate environment, increase in electricity production from natural gas and renewables, and supporting clean coal-powered projects will enable utilities to efficiently serve a larger customer base.

In the segment below, we discuss the basic strengths of the utility sector.

Transition Toward Cleaner Source

Utility operators are gradually changing the source of electricity production. Abundant cheap natural gas and declining installation costs of renewable sources like solar and wind are acting as tailwinds for the sector. The regulated utilities are also getting ample support from the administration to shut down old and less profitable fossil fuel plants and replace them with more technologically sound new generation units.

The U.S. Energy Information Administration’s (“EIA”) report indicates that the share of U.S. total utility-scale electricity generation from renewable sources will increase from less than 17% in 2017 to 17% in 2018 and increase to 18% in 2019. EIA expects natural gas to generate nearly 34% of U.S. electricity in 2018 and 2019, up from 32% in 2017, while coal is expected to contribute 29% in 2018 and 2019, down from 27% from 2017. The above prediction from EIA indicates the preference to or against the legislation supporting the usage of coal.

Increase in Infrastructure Resilience

Due to its geographical location, the United States is battered by tropical storms, cyclones, extreme cold weather and hurricanes. Natural disaster disturbs normal day to day life including utility services.

Utilities are investing steadily to upgrade and strengthen their existing transmission and distribution lines. Usage of technology for the maintenance of wide-spread electric lines helps to lower the possibility of power outages. Strengthening infrastructure will help utilities serve their expanding customer base efficiently and effectively.

Extensive 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 introduced new smart meters and strengthened their transmission and distribution lines, which helped in the efficient usage of energy.

Utility operators are also benefiting from the ongoing research in the solar photovoltaic 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 moves 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 companies. We will see more utility scale solar and wind projects coming up, which will boost green power generation.

Thanks to the backing from government, EIA expects wind-generation capacity to increase to 735,000 megawatt hours per day (MWh/d) by the end of 2018 and 779,000 MWh/d by the end of 2019 from 697,000 MWh/d in 2017. EIA expects solar-generation capacity to increase to 1705,000 megawatt hours per day (MWh/d) by the end of 2018 and 198,000 MWh/d by the end of 2019 from 145,000 MWh/d in 2017.

NextEra Energy (NEE - Free Report) a Zacks Rank #3 (Hold) stock has plans to make long-term investment in clean energy assets. NextEra Energy’s current renewal energy development program aims at nearly 10,100-16,500 MW of new renewable projects (including wind repowering) online over the 2017-2020 time frame.You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Acquisitions & Merger

Utility sector operators don’t shy away from merger and acquisition (M&A) activities to supplement 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 company, the more access it has to funds essential for vital infrastructure upgrades.

We believe that in a mature energy market like the United States, M&As 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 lowers operating costs through the usage of common back office space.

At the beginning of this year, SCANA Corp. (SCG - Free Report) entered into a merger agreement with Dominion Energy (D - Free Report) . Per the accord, each stock holder of SCANA will likely get 0.669 shares of Dominion. Considering the assumption of $6.7 billion debt of SCANA by Dominion, the transaction is worth roughly $14.6 billion.

We are noticing major deals in the water utility space. American Water Works Company (AWK - Free Report) entered into a few deals during the first quarter of 2018 and is in talks to acquire a few more this year. While Connecticut Water Service has decided to merge with SJW Group (SJW - Free Report) , citing that the union will be accretive to earnings of each company, and that there will be ample financial flexibility to expand operation and compete with water utility operators in the fragmented industry.

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. 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 uninterruptedly.

To Sum Up

We notice a transition in the utility sector with more focus on clean energy generation. Stable operations, highly visible revenues and cash flows, combined with the sector’s income/yield attributes are some of its key defining features.

There is increasing focus on electricity storage facilities that will provide more support to the grid during a peak demand period. Already more than 700 MW of storage facility has been installed in the United States and we expect more storage facility across the country. We also expect more battery storage facility to be added to the system as utilities produce more from renewable sources and continue to let go traditional fossil fuel sources.

Although price appreciation is low compared to the S&P 500 peers, these regular dividend payers can be a safe investment choice.

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