As the world shifts toward a low-carbon economy to stem the effects of climate change, decarbonizing the global energy sector will be critical. While much of the investment focus is on renewables, we believe an underappreciated opportunity can be found in electric utilities.
- Over the next 20 years, trillions of dollars in capital will be spent modernizing the global electric grid to accommodate increased electrification and the rising share of renewable energy sources.
- We believe regulated electric utilities are an underappreciated way to invest in the energy transition and are attractive investments owing to their high growth potential and stable return profile.
- With relative valuations at 15-year lows, we believe electric utility stocks are particularly attractive versus the broader equity market.
As the world shifts toward a low-carbon economy to stem the effects of climate change, decarbonizing the global energy sector will be critical. The clean energy, clean transport, and electricity sectors will likely experience unprecedented growth as demand for conventional, hydrocarbon-based energy wanes. While renewables such as wind and solar have so far attracted the most attention from investors seeking to capitalize on this secular trend, we believe electric utilities are a less obvious, underappreciated opportunity that merits closer inspection.
As distributors of power, electric utilities are essential for enabling the energy transition. In the coming decades, trillions of dollars in investment capital are expected to be spent modernizing the grid to incorporate the increasing share of renewables. And critically, because they’re regulated entities, electric network utilities may offer investors the potential to earn attractive, stable returns for years to come. While renewables and utilities are both energy-transition plays, here’s how, in our view, the two industries stack up from an investment perspective:
|Electric network utilities
|Strong expected long-term growth potential||✓||✓|
|Supportive policy and government support||✓||✓|
|Stable potential returns and few competitors||✓||𐄂|
Source: Wellington Management, February 2021.
The shifting global energy mix
The world’s energy consumption is changing, with electricity poised to gain significant share of the energy mix over the next two decades, mostly at the expense of less efficient, carbon-intensive fossil fuels such as coal and oil. As electric vehicles siphon demand from internal combustion engines, as electric heat pumps replace oil and gas heating, and as electric appliances overtake gas-powered appliances, demand for electricity will likely increase.
Electricity consumption expected to increase
Global final consumption of energy by source
Source: World Energy Outlook 2020, Sustainable development scenario, International Energy Agency. No forecasts are guaranteed.
While the electrification of energy demand helps advance a lower-carbon future, to fully decarbonize the sector, the carbon intensity of electricity production must also fall. Carbon-free forms of power such as wind, solar, and other renewables are expected to take share of the electricity-production mix over the same period, with the proportion of solar-powered electricity rising tenfold, wind power quadrupling, and coal-generated electricity shrinking by over 80%.
Renewables expected to become major sources of electricity
Global electricity generation by source
Source: World Energy Outlook 2020, Sustainable development scenario, International Energy Agency. No forecasts are guaranteed.
Favorable renewable economics creating a tailwind for utilities
Over the past decade, the break-even costs of solar- and wind-power generation have declined by 90% and 70%, respectively.1 While renewables were heavily dependent on government subsidies for many years, they’re now economical on a stand-alone, free-market basis. According to NextEra Energy, the largest renewables operator in the United States, wind and solar are already less expensive than other forms of power generation—without subsidies. In fact, the operator estimates that by 2025, it’ll be cheaper to build and operate a brand-new onshore wind or solar farm than to operate an existing coal plant, even accounting for the added costs of storage required for round-the-clock supply.2
Because renewable power generation has no ongoing fuel costs (wind and sunshine are free) and few operating expenses, utilities essentially exchange the lifetime costs of fossil fuels for up-front construction capex—which is then amortized over several decades. As those costs continue to fall, companies can increasingly retire and replace fossil fuels with renewables at potentially lower prices for consumers. While a period of very low fossil fuel prices, inflationary cost pressures in new renewable capacity, or regulatory pushback, could disrupt this trend; these are highly unlikely, in our view.
Attractive economics for renewables generation
Estimated costs per MWh by 2025
Adapted from NextEra Energy presentation at the Edison Electric Institute Conference, November 2020. Represents projected cost per megawatt-hour (MWh) for new-build wind, solar, and natural gas installations after 2024; excludes production tax credits for wind and assumes a 10% investment tax credit for solar; projected per MWh operating cost, including fuel for existing nuclear and coal. Based on NextEra Energy estimates.
Enticed by these falling costs, investors have flocked to pure play wind and solar equities, driving prices up. These stocks now appear to be very expensive, trading at historically high valuations relative to the broader market.
Capital investment at scale will be required
The global electric grid will need to be upgraded and expanded to integrate renewable power sources and ensure a constant supply of electricity. The International Energy Agency estimates that over the next 20 years, electric networks will require US$623 billion of annual global investment, a 112% increase over the past five-year period.1 This estimated yearly spend for electric networks exceeds that for renewables and represents potentially greater growth.
Investment in the grid expected to surpass renewables
Global annual investment (US$ billions)
Source: World Energy Outlook 2020, Sustainable Development Scenario from International Energy Agency; Wellington Management. No forecasts are guaranteed.
Policy tailwinds in place
In addition to increasingly favorable market-based economics, policies aimed at furthering a low-carbon future are in place or in development around the world:
United States: Solar and wind tax credits were extended in December 2020. President Joe Biden’s climate plan, which includes a net-zero emissions goal by 2050, features policy shifts and aggressive near-term infrastructure spending goals across clean energy, cleantech, and low-carbon transport.
Europe: The European Green Deal targets carbon neutrality by 2050. In late 2019, each country submitted a unique national energy and climate plan, with a primary focus on decarbonization.
United Kingdom: The Climate Change Act of 2008 committed the country to reducing carbon emissions from 1990 levels by 80% by 2050. The new Clean Growth Strategy aims to accelerate the pace of decarbonization over the coming decade.
China: In September 2020, President Xi Jinping pledged to target carbon neutrality by 2060, a monumental task, given that China is the world’s largest carbon emitter, responsible for twice as many emissions as the next-highest emitter, the United States.3
Japan: In October 2020, Prime Minister Yoshihide Suga pledged to reach carbon neutrality by 2050.4
Consensus seems to have grown among political leaders that decarbonization is essential for combating climate change. While pockets of political resistance remain, more constituents appear to view the transition as inevitable and positive for economic growth. Public support also seems to be rising as electric vehicles and appliances are viewed as more efficient than gas-powered alternatives. And governments may be starting to realize that policy support for decarbonization may create millions of private sector jobs.
Regulated utilities offer stable return streams
As monopolies that earn a regulated return on their invested capital, electric utilities can provide attractive risk-adjusted return potential. While allowed return levels vary, the average nominal return on equity has been approximately 10% in developed markets and 12% in emerging markets, higher than the cost of capital and competitive relative to the broader equity market.5
Unlike utilities, renewables development is typically contracted for a finite number of years, rendering investment returns less predictable, and amid increasing competition and the commoditization of clean power, we believe renewables companies face downward pressure on returns. Finally, utilities may act as inflation hedges, passing through interest-rate increases in the United States and inflation plus real interest rates in most of Europe.
Utilities’ valuations are attractive
Finally, we believe utilities present a clear valuation advantage over renewables. Pure play renewables stocks currently trade at rich valuations. In contrast, we find the valuation of electric utilities more appealing. At year-end 2020, global electric utilities traded at a price-to-earnings ratio of 0.87 times relative to the MSCI All Country World Index, close to a 15-year low.6
As the equity market rebounded in the second half of 2020, utility stocks underperformed. The market may have overly discounted fundamental risks to electricity demand or returns on equity amid the COVID-19 pandemic. The market may also be less focused on utilities, given additional expected broad market recovery in 2021. Whatever the reasons, sector valuations are dislocated from what we believe are attractive business fundamentals and solid underlying return drivers. In light of the potential for significant capital investment, more favorable government policies, and stable returns over time, we find these valuations particularly compelling.
Electric utility stocks may be a bargain relative to history
P/E of MSCI All Country World Electric Utilities Index relative to MSCI All Country World Index
Source: FactSet, as of December 31, 2020. Indicates relative forward two-year price-to-earnings ratios (P/E). For illustrative purposes only.
Assessing investment opportunities
Like any sector, electric utility investments vary, and some stocks are more attractive than others. As active managers, characteristics we include in our research mosaic include:
Attractive absolute and peer-relative valuation. One measure we apply is “intrinsic return,” or the sum of free cash flows before growth capital expenditure, the net present value of future growth, and the future growth from inflation-linked regulation. This framework allows us to compare the valuation of all infrastructure equities on an apples-to-apples basis.
On their way to being green: In our view, utilities that have plans in place and are transitioning to low-carbon infrastructure and renewable power production have more upside potential than companies that are already 100% there.
Potential for asset-base growth: On a related note, companies in transition may experience greater asset-base growth from increasing power demand or the need to modernize legacy infrastructure.
Perceived social value: If local consumers, regulators, and other government entities collectively support increased electric grid investment to facilitate the low-carbon transition, a utility should find it easier to get capex plans approved.
Ability to keep prices low: Utilities that can keep customer bills low tend to enjoy more local support. Today, renewables are cheap enough to enable most companies to keep prices down, so this is becoming less of an issue.
Management alignment: We look for evidence that management teams are on board with the energy transition. Companies that articulate net-zero emissions targets, for example, or other carbon-related milestones are preferred over those that don’t.
Constructive regulatory jurisdiction: Utilities that enjoy high allowed return levels and other forms of regulatory support are more attractive than those that operate under contentious regulatory or unregulated environments.
We’re in the early stages of the global transition to a low-carbon economy. As the energy sector decarbonizes, investors will be able to tap an expanding opportunity set that includes electric infrastructure. While renewables have been viewed as investment darlings for several years, we believe electric network utilities have greater upside potential today. Trillions of dollars of investment capital are required to modernize the grid in support of renewable power supply, storage, and reliability. We believe this massive growth potential may be captured profitably by investments in the electric utility sector, and that this opportunity is currently underappreciated by the market.
1 “World Energy Outlook 2020, Sustainable Development Scenario,” International Energy Agency, October 2020. 2 "Environmental, Social and Governance 2020 Report," NextEra Energy, December 2020. 3 The Guardian, September 22, 2020. 4 Reuters, October 26, 2020. 5 Wellington Management, country-specific utility regulators, as of December 31, 2020. Data reflects the regulated return on equity for the companies within the global utilities’ primary universe. Markets are categorized as follows: developed nominal includes the United States, Canada, and Hong Kong; developed inflation-linked includes the United Kingdom, Italy, and Australia; emerging nominal includes India, China, South Korea, and Malaysia; emerging inflation-linked includes Brazil, Chile, the Philippines, Peru, and Colombia. For illustrative purposes only. Not representative of an actual investment. 6 FactSet, December 31, 2020.