TOPIC #1
Utility Themes: Headwinds and Tailwinds
Amid increasing costs and macro uncertainty, utilities plot their courses for investment.
Turmoil, Turbulence, and Treasure
- Since early 2022, a span of less than 18 months, the energy and utilities sectors have faced a remarkable set of macroeconomic and geopolitical events that could have durable effects on the North American utilities industry.
- Russia’s invasion of Ukraine has caused significant human devastation, as well as knock-on effects on global gas and oil markets and the nuclear fuel supply chain that have reverberated to North America.
- The Federal Reserve is attempting to tamp inflation through monetary policy changes, removing liquidity from the market and steadily increasing the federal funds effective rate from .08% in early 2022 to 4.58% just 12 months later.
- Following the 2021 authorization of roughly $1.2 trillion for U.S. infrastructure improvements under the Infrastructure Investment and Jobs Act (IIJA), Congress authorized an estimated additional $370 billion toward a broad array of new and existing technologies across energy generation, transmission, and distribution segments and for electrification of transportation and other end-use applications via the Inflation Reduction Act (IRA).
KEY TAKEAWAYS
Utilities continue to put significant capex into the business, with more firms employing "back-to-basics" rate-of-return strategies.
Sector headwinds—inflation, rising interest rates, high natural gas prices, and affordability concerns—have been balanced by continued opportunities for utility investment and support from 2022’s Inflation Reduction Act.
It is unclear whether 2023 will match 2022’s sector financial performance or whether macro risks will outweigh growth opportunities.
Utilities continue to put significant capex into the business, with more firms employing "back-to-basics" rate-of-return strategies.
Sector headwinds—inflation, rising interest rates, high natural gas prices, and affordability concerns—have been balanced by continued opportunities for utility investment and support from 2022’s Inflation Reduction Act.
It is unclear whether 2023 will match 2022’s sector financial performance or whether macro risks will outweigh growth opportunities.
Turmoil, Turbulence, and Treasure (Cont.)
- Beneath this macro backdrop, energy and utility companies continue their efforts to reduce their greenhouse gas emissions footprints and, in many cases, pursue net-zero objectives.
- In their most recent annual commentaries, industry organizations American Gas Association and Edison Electric Institute highlighted opportunities for investment in their respective sectors. Key points raised by each are noted in Figure 1.1.
Figure 1.1: Energy Industry Organization Highlights
Energy and Utility Financial and Stock Market Performance
- Revenue growth across most industries is still positive, although it has ebbed in recent months. Concerns about a current or potential slowdown have weighed upon stock prices, which have tailed off from their highs in early 2022.
- Over the past 3 years—since the onset of COVID-19 in the United States in March 2020—both gas and electric utility stock indexes have generally trailed the broader S&P 500 index, as shown in Figures 1.2 and 1.3. The exception to this trend are independent power producers and renewables developers. Rising interest rates have contributed to stock declines through the second half of 2022.
- An exception to this general utility underperformance of the broader market has been the performance of independent power producers. Strong power market fundamentals have bolstered companies operating in markets such as PJM, and renewables, nuclear, and other lower-carbon emissions technology development is likely to accelerate as a result of the IRA.
Figure 1.2: Selected Utilities Aggregate and Electric Sector Index Values (Jan. 2, 2018-Mar. 10, 2023) (Index: Jan. 2, 2018 = 100)
Source: S&P Capital IQ Pro
Figure 1.3: Selected Utilities Aggregate and Gas Sector Index Values (Jan. 2, 2018-Mar. 10, 2023) (Index: Jan. 2, 2018 =100)
Source: S&P Capital IQ Pro
Energy and Utility Financial and Stock Market Performance (Cont.)
- Despite strong revenues, utilities have had negative EBITDA growth over the trailing four quarters (ended March 9), according to Standard & Poors. However, on a valuation basis, utilities have had a more attractive valuation over the past year, with utility market capitalization-to-earnings before taxes outpacing the same metric for the S&P 500 (see Figure 1.4). Some analysts attribute that to recession and geopolitical concerns and utilities’ traditional role as a relative safe haven.
Figure 1.4: Ratio of Market Capitalization to Earnings Before Taxes (Excluding Unusual Items) for Selected Indexes (Mar. 2013-Mar. 2023)
Source: S&P Capital IQ Pro
Significant Capital Investment Needs Over the Next Decade
- Utilities have almost uniformly been emphasizing significant investment needs over the near to medium term. As many are pursuing a “back-to-basics” rate-of-return model, capex is expected to grow across all segments in both power and gas businesses—from production/generation to transmission to distribution (see Figures 1.5, 1.6, and 1.7). Energy transition and lower GHG emissions resource investment remain powerful drivers of capital investment. S&P Global Ratings estimated 2022 capex in its North America regulated utilities coverage universe was at an all-time high of $190 billion.
- The IRA can accelerate capital spending by utilities through funding opportunities and favorable tax incentives. However, electric utility capex was already increasing at an accelerated pace, even before the IRA. Constraining this growth are persistent issues of supply chain bottlenecks and swollen interconnection queues.
Figure 1.5: Investor-Owned Electric Utilities Estimated Functional Capital Expenditures (2022) ($ Billions)
Source: Edison Electric Institute
Figure 1.6: Actual and Projected Capital Expenditures (2012–2024) for Investor-Owned Electric Utilities ($ Billions)
Source: Edison Electric Institute
Figure 1.7: Actual and Projected Capital Expenditures for Selected Electric, Gas, and Combination Utilities (2012–2025P)
Note: Values are for 46 investor-owned utility companies and holding companies from corporate investor presentations, annual reports, and other public sources. Based upon data available as of Mar. 14, 2023. 2022 figures are preliminary. P means projected.
Source: S&P Global Market Intelligence-Regulatory Research Associates
Rates and Ratings: Pressure on Utilities
- The combination of higher commodity costs (especially natural gas), higher general inflation rates, and investment needs is making its way into customer costs. Revenue per kWh for electricity in the United States ticked up significantly in 2021 and 2022 across all customer classes (see Figure 1.8).
- Given rising costs, utility rate case activity continued apace in 2022 (see Figure 1.9). Regulatory Research Associates estimates that U.S. investor-owned utilities (IOUs) requested rate increases totaling a combined $16.78 billion in 2022, up about 13% from a record-setting 2021.
- And while each jurisdiction has its own approach and considerations for establishing return on equity (ROE) that is utility specific, median ROE nationwide has been slowly declining since 2020. It appears, however, to have bottomed out or reversed in the past year or two (see Figure 1.9), although the range of ROEs remains wide. This may bode well for improved return on capital for the sector.
Figure 1.8: U.S. Revenue per Kilowatt-hour - Total and by Customer Class (2010-2022P) (Cents)
Note: P indicates that 2022 prices are preliminary.
Source: Energy Information Administration
Figure 1.9: Electric and Gas Rate Cases, Median Returns on Equity, and 30-Year Treasury Yields (1990-2022)
Note: Axes represent cases (left-hand side) and rates (right-hand side).
Source: S&P Global Market Intelligence-Regulatory Research Associates
Rates and Ratings: Pressure on Utilities (Cont.)
- Rating agencies have expressed some concern over pressure on financial measures. As noted by S&P:
“Over the past decade the industry’s financial measures have weakened from a combination of rising capital spending, regulatory lag, and lower authorized return on equity (ROE). The industry’s return on capital was about 6% a decade ago and today is closer to 4%. More recently, we have seen instances where not only the authorized ROE is lowered but also the equity ratio is lowered. These results have weakened the industry’s financial measures, pressuring credit quality. Under our base case of moderating inflationary risks during 2023, we expect the industry's credit measures to generally remain flat.”
- Interestingly, among IOUs, upgrades exceeded downgrades, reversing a trend from 2020-2021 (see Figure 1.10). However, there has been a significant move of electric IOUs from A- to BBB+ (see Figure 1.11).
Figure 1.10: U.S. Investor-Owned Electric Utilities (Parent and Subsidiaries) Ratings Actions and % Upgrades
Notes: Axes represent % upgrades (left-hand side) and actions (right-hand side). Actions reflect those of Fitch Ratings, Moody’s, and Standard & Poor’s.
Source: Edison Electric Institute
Figure 1.11: U.S. Investor-Owned Electric Utilities S&P Utility Credit Ratings Distribution (for Selected Years as of Dec. 31)
Source: Edison Electric Institute
In Their Own Words: Banks, Ratings Agencies, and Energy Companies
- We have reviewed and distilled comments by rating agencies and investment bank analysts on key issues faced by the energy and utilities sectors and their assessment of potential strengths and weaknesses of the sectors. Click the buttons below to view the associated comments.
IMPLICATIONS
The investment community has recently wavered between positive and negative sentiment for utilities. Some analysts highlight risks from potential recession and increased regulatory and political scrutiny as rates are expected to increase. Positive surprises on economic outlook, project progress, and commodity prices could change the outlook.
Utilities would be well served to continue to watch their financial metrics, monitor the pace of investment, and engage regulators as investments in energy transition, grid modernization, resilience, and electrification/decarbonization ramp up.
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