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Electric Utilities: Is the Yield Worth the Risk?

Volume 75, No.1

Electric utilities, historically viewed by investors as a “safe” and reliable” choice for conservative investments, is an industry undergoing massive change. In the past, utilities operated under strict government regulation and acted as geographic monopoly franchises but changes in technology and deregulation are forcing the industry to evolve and expand into new businesses and reduce price controls. This fosters competition, which is good for the economy, but how do these changes affect the risk profile of utility investments?

Characteristics of the Utility Industry

Companies in the electric utility industry exhibit many commoditylike characteristics including slow unit growth, declining prices and capital intensity. Investment Counsel has typically avoided industries exhibiting these characteristics, opting instead for growing businesses that consistently earn cash returns above their cost of capital, have management teams that allocate capital in a way that maximizes share holder value, and are available at prices below their intrinsic value. The state commission regulatory environment that governs the electric utility industry has always been the one factor that differentiates the utility companies from other commodities. As a result of this regulation, utility companies have been able to consistently earn returns in excess of their cost of capital. This has made utility companies safe havens for conservative investors seeking low risk investments with modest yet stable earnings growth and consistent dividend payments.

Changes in the Utility Investing Environment

Changes in power generation technology and the cost of resources used to produce electricity have led economists and law makers to question the traditional regulation model governed by state commissions. More recently, lawmakers have issued state orders to deregulate certain components of the electricity industry in order to foster competition amongst firms. Although change has been slow due to certain failures over the past few years, including those experienced in California, a certain level of deregulation is inevitable. This has and will continue to change the way electric utilities conduct business in the future and more importantly, will continue to change the utility risk profile for investors.

Regulation of the Electric Utility Industry

The utility industry is fairly complex and in order to determine how deregulation will affect the industry, it is important to understand how the industry has been regulated in the past. Early utilities found it difficult to maintain investor confidence and attract new capital given the capital intensity of the industry and the breadth of competing firms. With the help of “Progressive” politicians, industry executives were able to convince government agencies that utilities were "natural monopolies" or businesses that exhibited such tremendous economies of scale and huge capital investment that one company would serve the market more effectively and economically than two or more firms.

The Effects of State Commissions on the Risk Profile of Public Utilities

State commissions greatly reduced the risk profile of utilities because they were responsible for setting rates charged to customers and for overseeing utility financials. The rate setting process was favorable for utility investors because rates were set so that the utility was able to recover operating costs and “prudently incurred” capital costs, and in addition, earn a “reasonable” rate of return. State regulation instituted a guaranteed return on investment for utility companies which enabled them to raise money more easily. Because of the regulation, utility companies could pay lower interest rates than typical corporations. Regulators enhanced the financial integrity of companies, meaning that utility bonds paid interest at regular intervals, and that utility stocks paid healthy dividends to attract investment in the most capital-intensive industry in the United States. They were considered “safe havens” for these reasons and very attractive to conservative investors.

The Beginnings of Deregulation

The electric utility industry is in the process of moving from a regulated market to a more deregulated environment. State regulation worked in favor of utilities until the early 1970s. Then electricity generation productivity gains slowed, input costs increased (owing to fossil-fuel price shocks), environmental regulation intensified, and nominal interest rates increased the cost of capital and further raised construction costs. In response to cost issues in the 1970’s, Congress passed The Public Utility Regulatory Policies Act (PURPA) in 1978. Although aimed at energy conservation, the law increased competition at the electricity generation component of the industry, which ultimately challenged the natural monopolistic nature of electric utilities and the need for state commission regulation. With the success of PURPA and additional legislation passed in 1992, the Federal Energy Regulation Commission (FERC) issued new orders in 1996 that greatly increased competition in the industry and gave consumers a choice in who provided their electricity. This led to much of the deregulation that occurred in the late 1990’s and ultimately to the difficulties observed in California.

Investment Counsel Study

The industry has been slow in the deregulation process (due much to California’s experience,) but many economists continue to argue that consumers would be better served by an industry with some level of deregulation. Regardless, uncertainty exists and much learning needs to occur before the electric utility industry can confidently move to a competitive market. It is this uncertainty as well as recent failures that give us concern. Consequently, we conducted a study to help us better understand the effects that the above mentioned changes have had on the industry. We identified 42 electric and multi-line publicly traded utility companies exhibiting 20 years of financial data. Using this list of companies, we analyzed how certain financial statistics have changed since the 1996 FERC’s orders. To simplify the study, we compared ten year medians prior to 1996 to ten year medians subsequent to 1996. The following is a list of our findings.

Dividends

The most attractive aspect of investing in utilities has always been their relatively high dividend yields and consistent growth. We found that dividend yields have declined significantly since the FERC issued orders in 1996. Median dividend yields in the ten years prior were 6.7% compared to 4.8% in the ten years following the orders. Median dividend yields this year fell to 4.1%. Some of the reduction is attributable to the stellar performance of the utility sector over the past few years, but a significant portion is due to a slowdown in the growth of dividend payments. Dividend payment increases have been flat over the past ten years while payments prior to 1996 grew at a median rate of 2.6%. We do not expect dividend payments to increase substantially over the next few years as companies reduce their payout ratios in an attempt to increase flexibility and to lower debt and strengthen balance sheets. This may allow utilities to weather any difficulties experienced in a more competitive environment and improve credit ratings in order to raise capital if required. With short-term Treasuries yielding more than 5%, utilities look less attractive. For conservative investors who require income, we recommend short term interest paying Treasuries or certain money market instruments.

Returns on Investment

Historically, utilities investors were virtually guaranteed a dividend and modest appreciation of their capital invested in the stock. In a deregulated competitive market, this will no longer be the case. Utilities will be forced to compete against one another based on price. There will be winners and there will be losers. Investors who pick the winners will do well and investors who pick the losers will do poorly. Some utilities, once considered safe dividend paying investments, will not be able to compete and will be forced out of business (or be acquired by a stronger firm). The risk profile for electric utility companies will increase dramatically. Our study indicates that returns on investment in the industry have remained relatively constant at 5%. More interesting however, is the dispersion of returns on capital. Companies with strong wholesale operations, like Duke Energy and TXU Corp., increased returns on capital substantially while returns for traditional utilities fell. This makes it evident that utility investing will require thorough analysis to identify companies that possess the characteristics needed to compete more effectively in a deregulated environment.

Capital Expenditures

Economists argue that the greatest potential gains from electricity restructuring will stem from improvements in the capital allocation process. In a deregulated environment, utilities will no longer be guaranteed a pre-set rate of return on investments. In order to ensure future investment dollars, they will have to streamline their investment decision processes and become more selective in terms of projects they undertake. We fear, however, that because utility managers have always relied on state commissions to assist in this decision making process, they have not built a strong competence in capital allocation.

Conclusion

For many years we felt that electric utility investments were appropriate for conservative income seeking investors and purchased these companies for clients matching this profile. As the industry continues down the path of deregulation, the future for the industry is less transparent making individual companies “riskier” investments. Based on findings from our study and industry research, we have been forced to rethink our investment strategy in the electric utility industry. For conservative clients, we are not allocating new monies to the utility industry and we will likely reduce exposure in accounts that are significantly overweighted versus the S&P 500 sector weight, when taxes permit. We feel differently for clients with the ability and willingness to take on a higher level of risk. As deregulation takes form and the industry evolves, there will be opportunity for clients exhibiting higher risk profiles. Investment success will not come in the form of dividends, but via capital appreciation from companies that are able to build large scale wholesaling operations with access to cheaper capital. At present, however, many of these companies are trading at prices that exceed their intrinsic values. We are finding better values in industries with more clarity of earnings growth and less regulatory risks than the electric utility industry exhibits. We will continue to monitor changes and deregulation in this industry.