"The hook." That's the label EEI's website has placed on the advertising section the electricty utility trade association created during the summer of 2005 in conjunction with Forbes Magazine. Produced by Nuala Byrne of Forbes Special Sections, the advertorial appeared in the September 1, 2005, issue of Forbers and the September issue of Edison Electric Institute's Perspectives. Click here for a look at the special advertising section as it appeared in Perspectives. Below, just the words written by Jim Brumm.
Finding New Growth for Electric Utilities
“The hook.”
That is one analyst’s description of Warren Buffett’s mid-May move to expand his utility investments to the West Coast through Des Moines, Iowa-based MidAmerican Energy’s agreement to purchase PacifiCorp for $5.1 billion.
At the time, the legendary investor said he hoped to buy more energy assets over the next decade, adding, “We’ll never be a seller but we’re always a buyer.”
“Buffett got people excited,” former analyst, Julie Cannell, explains, citing the value investors attracted to electric utilities for the first time since the bad taste left by Enron and Enron wannabes pushed these stocks sharply lower in 2002.
With Buffett’s move, she added, a 30 month rise in utility stock values “seemed real” to investors who finally took a serious look at the industry’s growth potential then being enhanced by the expectation that Congress was finally bringing industry regulation into the 21st century.
By early August, shortly after Congress passed the Energy Policy Act of 2005, these investors had bid utility stock prices, as measured by the S&P Utilities Index, to the highest levels in five years. This pushed the Utility Index over 165, more than double its mid-October 2002 low of 82.
Calling the new law “the most significant” changes in federal utility regulation in 70 years, Federal Energy Regulatory Commission Chairman Joseph Kelliher said it is “a very good law” that reflects Congressional desires for a stronger energy infrastructure.
In addition to regulatory changes, the new law “is chock-filled with tax incentives to support new utility infrastructure investment,” wrote Merrill Lynch utility analyst Steve Fleishman. He summarized the key ones as:
• Accelerated tax depreciation for electric transmission and gas distribution (15 years compared to 20 previously);
• Accelerated depreciation of pollution control equipment (7 years compared years compared to 20);
• Two-year extension of the production tax credit for renewables (valued at 1.8 cents per kilowatt hour);
• Nuclear incentives, including a production tax credit for new nuclear plants and better tax treatment of decommissioning funds;
• Tax deferral on gains from selling transmission assets to an independent transmission organization; and
• A 20 percent tax credit for clean-coal facilities.
Fleishman’s comment also pointed out “the pollution control incentive has not been well advertised and could help those with large environmental (capital expenditure) mandates.”
The tax changes enhance the “dramatic opportunities” for investment being created “as the U.S. economy becomes more and more dependant on more and more reliable electric energy,” says Edison Electric Institute Chairman Michael Morris.
Also the Chief Executive Officer of American Electric Power, he sees this reflected in the profit growth potential for coal and nuclear power plants, explaining for a decade now the need for additional generation has been satisfied by building natural gas fueled power plants and pressing aging plants into service.
While these plants got the industry through the heat waves sweeping across the nation this summer “in real good shape,” delivering record supplies of electricity, the rising cost of gas made this an expensive effort, Morris explained.
Added to this summer’s heat stress have been the demands of a growing economy that the U.S. Energy Information Agency projects will increase 2002’s demand nearly 50 percent – to 5.47 trillion kilowatt hours in 2025.
The agency expects the growth to be particularly strong in the commercial sector, averaging 2.4 percent per year as rapid additions to commercial floor space, the continuing penetration of new telecommunications technologies and medical imaging equipment, and increased use of office equipment overwhelm the expected efficiency gains for electric equipment in the sector.
The EIA sees more moderate growth in the industrial and residential sectors, projecting averages of 1.3 percent per year and 1.6 percent per year, respectively, as they too reflect the greater use of computers, printers, scanners and the chargers need to fuel the cell phones that have overwhelmed society across the nation.
The needs for electric utility investments triggered by this growth – which some have estimated at $12.7 billion by 2030 – has also been recognized by state regulators, according to Cannell.
An analyst following utility stocks for two decades, she is now a consultant specializing in electric utilities who often testifies in state utility regulatory proceedings.
Describing “most recent rate decisions (by these bodies) as constructive,” Cannell explained the regulators have a “growing awareness of the need to have financially viable” utility companies.
While the returns allowed have been reduced as interest rates declined in recent years, the amounts are “still solid,” she said.
These returns reflect the profit potential of investments in regulated activities – a utility’s rate base. As the commissions clear spending on new power plants or environmental controls for older plants, transmission upgrades and the other efforts needed to meet growing demand, the approved spending becomes an investment that expands the utility’s rate base.
With a larger base, the company has an opportunity to show the earnings growth, which Cannell describes as the “valuation investors really look at” in their search for new investments.
Also commenting on the value of rate base expansion was Harris Nesbitt electric utilities analyst Michael Worms. In a research comment written after Congress completed work on the new law, he cited “its reliability mandates and production incentives” stating “we look for even greater infrastructure expansion” than the electric power industry has been discussing in recently described growth aspirations.
Beyond the potential for profit growth, the new energy law also dangles the possibility of higher stock values as non-utility companies – from private equity funds, to large manufacturing companies, to investment banks -- get the chance to buy electric and gas companies. Such purchases have been blocked since the depression by the Public Utilities Holding Company Act, commonly called PUCHA, which was repealed by the new energy law.
However, such investments will not be automatic, Worms pointed out, explaining the state and federal regulatory process “remains intact, which could be viewed as a considerable hurdle” to mergers and acquisitions.
Merrill Lynch’s Fleishman also cites the obstacles of state regulation and the enhanced merger oversight granted the Federal Energy Regulatory Commission by the new energy law while saying he believes the “PUCHA repeal combined with consolidation trends in the non-regulated power business could spur additional utility M&A activity.”
With the old law out of the way, Fleishman explained it will “be easier for nontraditional players or diversified utilities to buy other utilities. Moreover, it would allow for more flexibility for geographically dispersed M&A activity.”
“Nevertheless, this is not exactly repeal of Glass Steagall,” he said referring to the change in depression-era banking laws that spurred consolidation in the financial industry a few years ago. “Remaining FERC and state regulatory obstacles still make utility M&A difficult process,” the analyst explained.
It is the nontraditional players that have attracted the attention of Ken Hurwitz, a partner in Haynes and Boone’s energy practice, who sees “financial institutions coming into the (utility) sector.”
His views were echoed by FERC’s Kelliher who told reporters utilities “might see more financial industry” interest, adding “I think (this) is a good thing, especially for a capital intensive industry” like utilities.
The commission is “optimistic that PUHCA repeal will bring sorely needed new avenues of capital investment into the U.S. electricity sector, particularly for the transmission grid where investment has been lagging growth for years,” the chairman’s prepared remarks explained.
Hurwitz expects the nontraditional interest to come from someone who has already developed a skill set related to utilities. As an example, he cited the investments GE has already made in the gas industry.
Beyond the new investments, he expects the U.S. to “wind up with a smaller number of utilities” as a result of the “consolidation (the new law) encourages.”
Noting there are “now a hundred or more” investor owned electric utilities in the U.S., Hurwitz said “I would go so far as to say that within the next five to 10 years, the current number … could shrink to 10.”
EEI’s Morris believes PUCHA’s repeal “will add to the asset acquisition game” by lowering “the barriers to non-utilities or international companies.”
As a result, he expects others “who think like Buffett” will be making utility investments, which means “capital will flow into this business – as it needs to.”