4 Utilities Positioned Well for Biden's Infrastructure Overhaul
Here's how regulation can dictate their growth and valuation.
As the Biden administration pushes its $2.3 trillion American Jobs Plan and clean energy agenda, utilities will be cast in a leading role. This means investors must keep a close eye on each utility’s regulatory outlook. Utilities in constructive regulatory environments with timely cost recovery and attractive returns on investment have a big growth opportunity under President Joe Biden’s ambitious plans. For utilities in less constructive regulatory environments, more investment could constrain cash flow and become a liability.
Most regulators understand that long periods of poor rate regulation and shareholder value destruction are detrimental to a utility’s ability to raise capital and maintain system reliability. However, regulators also face direct or indirect political pressure from ratepayers in the jurisdiction they serve. This conflict makes it essential for investors to understand the regulatory dynamics for each utility.
We assess each company’s regulatory environment on four primary factors:
The focus on environmental, social, and governance issues by regulators, politicians, and investors increases utilities’ regulatory risk. We think this is particularly important as the Biden administration proposes significant investment in transmission, distribution, and clean energy infrastructure to spur jobs and reach net-zero carbon emissions by 2035.
While we think the Biden administration’s net-zero goal is overly aggressive absent major technological advancement, regulators will nonetheless need to support the transition away from fossil fuels, notably coal-fired generation. This will require ratemaking that allows utilities to invest in wind and solar along with the transmission and distribution infrastructure to support clean energy. Transitioning away from fossil fuel generation before the associated assets have reached the end of their economic lives creates the risk of stranded assets that shareholders would have to finance.
Ratemaking regulation is even more important for utilities with high Sustainalytics ESG Risk Ratings that are trying to improve their environmental, social, and governance profile. The ESG Risk Rating measures the degree to which a company’s economic value is at risk driven by ESG factors or, more technically speaking, the magnitude of a company’s unmanaged ESG risks. A company’s ESG Risk Rating comprises a quantitative score and a risk category. The quantitative score represents units of unmanaged ESG risk, with lower scores representing less unmanaged risk. Unmanaged risk is measured on an open-ended scale starting at zero (no risk) and, for 95% of cases, a maximum score below 50.
An issue is material within the ESG Risk Rating if its presence or absence in financial reporting is likely to influence the decisions made by a reasonable investor. To be considered relevant in the ESG Risk Rating, an issue must have a potentially substantial impact on the economic value of a company and, hence, its financial risk and return profile from an investment perspective. An underlying premise of the ESG Risk Ratings is that the world is transitioning to a more sustainable economy. Therefore, effective management of ESG risks should be associated with superior long-term investment returns. Some issues are considered material from an ESG perspective even if the financial consequences are not fully measurable today.
For fully regulated utilities, service territory monopolies and efficient scale advantages are the primary sources of economic moats. State and federal regulators typically grant regulated utilities monopoly rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital invested to build, operate, and maintain their electric, gas, or water distribution networks. In exchange for regulated utilities’ service territory monopolies, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.
Utilities regulation typically allows investors a fair return on capital. The regulatory process begins with a utility’s regulatory asset base, which grows annually through investments less depreciation and deferred taxes. This rate base, the utility’s capital structure, and operating costs determine net revenue. Usage-based customer rates are calculated using forecast demand. Regulators set allowed operating expenses, and management can achieve lower costs to shareholders’ benefit.
This implicit contract between regulators and capital providers, on balance, gives us confidence that most regulated utilities will outearn their costs of capital in the long run and that the threat of material value destruction is low, usually supporting narrow economic moats.
However, the regulatory environment and management’s ability to operate within its specific regulatory construct are critical to assessing whether a utility’s excess normalized returns are more likely than not to be positive 10 years from now. For regulated utilities with no moats, we typically identify situations in the regulatory environment that lead us to believe there is a chance of a multiyear period of value destruction during the next decade. We’ve seen certain utilities perpetually struggle to earn their regulatory allowed returns and often underearn their cost of capital for many years. We incorporate this as a key factor into our regulated utilities moat analysis.
Regulated utilities operating in a standard regulatory structure typically demonstrate a cyclical return on invested capital pattern based on operating costs, capital costs, and investment needs relative to the timing of customer rate changes. As required operating and capital costs rise and rates remain fixed, ROICs will fall below costs of capital. Regulators true up these costs and capital investments during rate reviews, typically leading to ROICs that exceed costs of capital. On average, a utility’s ROIC should be slightly higher than its cost of capital over many cycles to encourage investment in the network.
If things go wrong, utilities might never capture those positive economic returns immediately following a rate adjustment. Higher-quality regulatory jurisdictions aim to implement forward rates and riders to reduce this earnings lag.
Regulatory issues that could erode a regulated utility’s ability to earn its cost of capital include:
NextEra Energy (NEE), WEC Energy Group (WEC), Edison International (EIX), and Atmos Energy (ATO) are the clear winners in our regulatory analysis. These utilities have leading constructive regulatory environments, giving us confidence that regulators will support customer rates that allow these utilities to consistently earn returns on invested capital greater than their costs of capital. This is important because all of them have large capital investment plans that will produce sector-leading earnings and dividend growth only if they are allowed to recover returns on and returns of their investments on a timely basis.
Florida regulation and management execution give NextEra our highest regulatory ranking.
Florida provides an excellent regulatory framework for utilities. NextEra subsidiary Florida Power & Light has proved adept at operating within this framework while providing customers with the lowest electricity bills in the state. The midpoint of FPL’s allowed return on equity range is 10.6% and the high end is 11.6%, one of the highest in the country. Through its operating prowess, management consistently earns near the upper end of its allowed return range. Automatic base rate adjustments for the company’s new generation effectively eliminate regulatory lag on investments. Usage-based rates prevent NextEra from attaining the highest ranking for nonfuel rate-adjustment mechanisms. We expect another constructive outcome in its January 2021 regulatory filing, effective 2022.
Florida’s strong economy and population growth support our forecast for over 7% rate base growth through 2025. FPL’s goal to build 10 gigawatts of solar by 2030 will increase solar to 20% of its energy mix. Investors will earn an immediate return on those investments under automatic customer rate adjustments. Management aims to pair battery storage with its solar installations. Recent Florida legislation also supports ongoing storm hardening investments. Transmission and gas generation round out the unit’s regulated growth opportunities.
FPL is one of the best-managed utilities in our coverage universe. It consistently has electric bills that are the lowest in Florida and 30% below the national average, a key consideration, given the unit’s large capital investment program. Regulators have rewarded management by supporting 10% annual increases in regulatory capital employed over the past decade. Management also increased its goodwill with Florida regulators by acquiring Gulf Power, where customer rates had increased over 30% since 2008 while FPL had kept its customer rates flat. Management has been able to reduce Gulf Power’s higher operating costs, increase service reliability, and enhance customer satisfaction.
The highly contracted competitive energy business, NextEra Energy Resources, is well positioned to benefit from the renewable energy transition and the Biden administration’s clean energy focus. NextEra has proved to be a best-in-class renewable energy operator and developer. Management enters into long-term power sales contracts, which reduce cash flow volatility and exposure to volatile commodity prices. Management took early advantage of federal renewable energy tax credits, producing higher returns than regulated utilities. NextEra is the largest U.S. renewable energy developer, and management has positioned the company well for the next phase of renewable energy growth in solar and battery storage.
Management’s continued execution on its Energy Resources development program leaves us confident that NextEra will deliver at the high end of its four-year, 23-30 GW development target range in 2021-24. Management has said it expects the market for solar to grow 18-20 GW per year through 2030.
Our near-term profit outlook accounts for forecast rate increases at FPL and investments through 2025, additional wind and solar generation investments at NEER, normal weather, and continued strong demand and economic growth in Florida. We expect continued constructive regulatory treatment in the utility’s upcoming rate case. We forecast management will top its 6%-8% annual earnings growth target in 2021-23. At FPL, we assume an 11.5% long-term allowed return on equity, give management’s ability to consistently achieve the high end of its allowed range. We estimate the company will invest roughly $14 billion annually on average through 2025.
Stable Wisconsin regulation provides WEC with a foundation for steady growth.
Wisconsin is the company’s most important regulatory jurisdiction, representing 64% of consolidated rate base. What investors should appreciate the most about Wisconsin regulation is the stability it has provided WEC Energy. For the past two decades, the regulatory environment has been consistently constructive. Wisconsin regulators were among the first to support and encourage low-emission generation. In the early 2000s, WEC Energy’s Power the Future investments were awarded a 12.7% allowed return on equity, one of the highest at the time. Further, these investments were guaranteed this return for the life of the lease terms, ranging from 25 to 30 years. In Wisconsin, WEC Energy enjoys rates based on two-year forward test years and an earnings-sharing mechanism over its allowed ROE. Its allowed return on equity has consistently been above the peer average and currently averages over 10.0% at the company’s subsidiaries in the state.
WEC Energy faces long-term risk related to its natural gas distribution utilities. We think natural gas will remain the primary source for heating in the Midwest for the foreseeable future, but there is risk that policymakers expedite the shift away from retail natural gas use. If policymakers expedite the transition, we have high confidence that Wisconsin regulators would allow WEC Energy to recover any undepreciated gas infrastructure costs, reducing concerns that the company would face stranded assets. We think investors can be similarly comforted that regulators will support the company’s transition away from coal generation.
The regulatory environment in Illinois, which represents approximately 16% of the company’s rate base, has also improved meaningfully over the past decade. Allowed ROEs are adjusted annually to track U.S. Treasury yields, which has led to below-average allowed returns on equity as interest rates have fallen. However, the formulaic approach reduces regulatory uncertainty if interest rates were to rise sharply. Numerous rider mechanisms significantly reduce regulatory lag. The investment capital tax rider spurred investment in the state, and the gas pipeline replacement rider at WEC Energy’s Chicago subsidiary will support 20 years of capital investment in the area. Like its Wisconsin subsidiaries, the Illinois utility enjoys forward-looking test years. Unlike in Wisconsin, the unit benefits from revenue decoupling, supporting returns regardless of volume fluctuations due to weather.
The company’s $16.1 billion of planned capital investment, which includes its investment in American Transmission Co., supports our earnings and dividend growth forecast at the high end of management’s 5%-7% target. We assume WEC Energy completes its Illinois modernization projects and renewable energy expansions. We forecast rate base growth in line with our long-term earnings forecast.
Renewable energy will be a focus. The company plans 800 megawatts of new solar, 600 MW of new battery storage, and 100 MW of new wind generation in its five-year plan. It plans to retire 1,400 MW of coal generation and 400 MW of older, less efficient natural gas generation. The company has also allocated $2.2 billion for unregulated renewable energy infrastructure investments through 2025. We think these are good investments for shareholders since they come with higher returns than WEC Energy’s regulated business but have regulated-like risks.
California has proved to be a strong partner for Edison International.
California will always present political, regulatory, and operating risk for utilities like Edison International. But California has set aggressive clean energy goals, and policymakers know that implementation will require the state’s electric utilities to remain financially healthy while creating more growth opportunities than most other U.S. utilities. While PG&E (PCG) received much of the regulatory and political pushback from recent fires across the region, California has proved to be a strong partner for Edison International and peer utility Sempra Energy (SRE).
At its core, we think California is a highly constructive regulatory environment. Regulators recognize the important role that utilities play in achieving the state’s environmental and energy policies. Edison’s infrastructure investments to support these policies result in limited pushback from regulators, helping to support earned returns on capital.
To encourage these investments, Edison International’s subsidiary, Southern California Edison, enjoys favorable ratemaking structures such as usage-decoupled revenue, accounts that track costs for future recovery, higher-than-average allowed returns on equity, and a rate-adjustment scheme to address sharp moves in interest rates.
In mid-2019, Edison received approval for nearly all its core capital investment covering 2018-20. This is in line with 92% of its proposed investments that regulators supported in 2015-17 and 89% in 2012-14. This is a high success rate, suggesting that Edison’s investment strategy is well aligned with expectations from regulators and customers. Edison also has received regulatory support for grid modernization, system hardening, and reliability investments that are incremental to its base plan.
Growth opportunities at Southern California Edison address grid safety, renewable energy, and next-generation energy services such as electric vehicles, distributed generation, and energy storage. Investments to address wildfire concerns alone could top $4 billion during the next four years. We think Edison’s plans for $5 billion of annual capital investment, where regulators have a history of approving nearly all of Edison’s proposed investments, support 6% rate base growth.
Investments in electric vehicles look particularly attractive. Late last year, the company was granted approval for a scaled-down version of its initial Charge Ready 2 plan that allows for $437 million in investments to support California’s 2030 goal of 5 million zero-emission vehicles. It’s clear that regulators want Edison to lead the way, and the company has received approval to invest nearly $1 billion in EV infrastructure. We expect that investment to triple in the coming years to support a projected 2 million EVs in Edison’s service territory by 2030.
Edison’s usage-decoupled revenue, approved allowed returns through 2023, and cost-tracking accounts help insulate it from regulatory uncertainties. Good regulatory support should generate 7% annual earnings growth in 2021-24. But this growth trajectory could be lumpy as regulatory delays, wildfire issues, and California energy policy changes lead to shifts in spending and cost recovery.
New equity issuances in 2019 and 2020--in part to fund Edison’s $2.4 billion contribution to the state wildfire insurance fund and a higher allowed equity structure in rates--weighed on earnings the last two years. But Edison now has all its financing in place to execute its large growth plan, which ultimately will drive earnings and dividend growth. Uncertainties in 2021 include a decision in its 2021-23 general rate case, resolution of some $6 billion of 2017-18 wildfire liabilities, and determination of any 2020 fire liabilities. We continue to forecast constructive regulatory treatment from California regulators.
We expect Edison to retain a small share of unregulated earnings, but those are more likely to come from low-risk customer-facing or next-generation energy management businesses wrapped into Edison Energy.
Constructive Texas regulation supports Atmos’ high regulatory ranking.
With a weighted average 9.8% allowed return on equity for its natural gas distribution utilities (two thirds of earnings) and an 11.5% allowed ROE for its Texas intrastate pipeline and storage (one third of earnings), Atmos consistently has been able to earn returns on invested capital well above our estimated weighted average cost of capital.
Atmos’ investments in infrastructure replacement are for the most part covered by favorable regulatory frameworks that include formula rate mechanisms with rate trackers. The result is that about 90% of capital investments begin to earn a cash return within six months of the expenditure. With the program to replace deficient pipe lasting another 20 years and the urgency recognized by the regulators, we believe these constructive regulatory frameworks that allow for shareholder value creation will continue well beyond this decade.
Replacing natural gas infrastructure that has become unsafe due in large part to age provides value-accretive investment opportunities for Atmos. This follows several incidents, notably the 2010 explosion in San Bruno, California, that killed five people. More recent gas-related incidents involved Atmos’ distribution system in northwest Dallas (February 2018) and an explosion at NiSource’s (NI) Columbia Gas of Massachusetts, which resulted in one fatality and 25 injuries in communities north of Boston (September 2018). These incidents have placed a priority on safety for natural gas distribution utilities like Atmos.
Favorable regulatory frameworks and large infrastructure investment opportunities have driven strong earnings growth and steady dividend increases for Atmos Energy. We expect $12.3 billion of capital expenditures during the next five years, above the top end of management’s $11 billion-$12 billion target. We expect this level of investment to receive regulatory support and continue well beyond this decade.
Over 85% of Atmos’ plan is focused on safety and reliability, specifically replacing cast iron, bare steel, and vintage plastic pipe that the industry has identified as susceptible to catastrophic failure. Atmos, with the approval of regulators, has accelerated the replacement of pipes made of these materials and is currently replacing about 1,000-1,200 miles per year of distribution pipeline and transmission lines. Atmos has over 72,000 miles of pipe, about one third installed over 50 years ago before gas pipelines had established standards. We estimate that the program to replace at-risk pipe will last at least another 20 years.
The regulatory decisions in the jurisdictions where Atmos’ utilities operate have for the most part been constructive for investors, providing returns on equity at or above industry averages. Almost 40% of operating earnings are from natural gas distribution businesses in Texas under a long-standing and unique regulatory framework that allows municipalities to set rates. However, the Railroad Commission of Texas, or RRC, has oversight and becomes involved if a distribution utility appeals a rate case decision by a municipality or in unincorporated areas. Approximately one third of Atmos’ operating earnings are from its pipeline and storage businesses in Texas, all regulated by the RRC.
Pipeline and storage rates and natural gas distribution rates in Texas have had ROEs above industry averages and favorable regulatory frameworks that have provided consistent returns on invested capital above the cost of capital for many years. The role of the RRC is reviewed every 12 years. The current natural gas regulatory framework with RRC oversight goes through September 2029. We believe the regulatory framework for natural gas utilities in Texas will last well beyond the next decade. In total, approximately 72% of Atmos’ rate base is in Texas.
The remaining operating earnings are from distribution utilities in seven other states that have constructive regulatory frameworks and ROEs at or above industry averages. These jurisdictions have provided returns on invested capital consistently above Atmos’ cost of capital, and we have a high level of confidence that the solid spreads will continue through the next decade and beyond.
Most of Atmos’ regulatory jurisdictions have formula rate-adjustment mechanisms that allow the company to recover returns of and returns on 90% of its infrastructure investments within six months and nearly all of its investments within one year. This allows Atmos to minimize regulatory lag and consistently earn near its allowed return, which is well above our estimate of its cost of capital. Given the urgency of replacing deficient pipelines for safety reasons, we think regulators are unlikely to undo these investor-friendly regulatory frameworks, supporting our stable moat trend rating.
Despite Atmos’ aggressive capital investment plan, we expect average customer bills to remain affordable. The average customer bill in 2020 is lower than it was in 2008, though bills will increase over the next five years because of the company’s large capital plan.
Travis Miller and Charles Fishman, CFA, contributed to this article.
Andrew Bischof does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.