The Edison Electric Institute’s 2024 Wall Street Briefing was held on February 20, 2024. The meeting came after the electric utility sector’s disappointing performance in 2023. The EEI Index, a composite total return measure for all 39 EEI member companies, declined 8.7% in 2023, much worse than the total returns of 26.3% for the S&P 500 and 16.4% for the S&P Mid-Cap 400. Utilities was the best performing S&P 500 sector in 2022 (even though it posted a low-single digit loss); but it was the worst performing by far in 2023.
This relative underperformance has continued so far in 2024. I do not have 2024 performance figures for the EEI Index, but the S&P 500 Utility Index, all of whose constituents are EEI members except for CEG, ATO and AWK, is down 1.7% (on price), compared with the broader index’s 7.6% gain. While much of the market’s strong performance is attributable to the Magnificent Seven and especially NVIDIA (NVDA), it is still up overall for the year excluding the Mag 7 (as evidenced by the S&P 500 Equal Weighted Index’s 3.9% gain).
According to its mission statement, EEI is an association that represents all U.S. investor-owned electric companies. Its members serve 250 million Americans, about 75% of the population, and employ seven million people. They account for 5% of U.S. GDP and 4.3% of total employment. The Institute lobbies government in support of public policy issues affecting the industry and its customers. It provides strategic business intelligence to its members and hosts conferences and forums to facilitate communications between its members and their stakeholders, including the Wall Street investment community.
The Briefing kicked off with introductory remarks from Dan Brouillette, who became EEI’s president on January 1 with the retirement of Tom Kuhn, who held the position for more than three decades. Prior to joining EEI, Mr. Brouillette was president of Sempra Infrastructure, a subsidiary of Sempra Energy (SE). Before that, he was the 15th Secretary of the Dept. of Energy in the Trump administration. While in that role, Mr. Brouillette was a member of the President’s National Security Council and the Vice President’s National Space Council.
After reminding the audience of the importance of electricity to the economy – Electricity accounts for the “first” 5% of GDP because most economic activity cannot take place without it. – Mr. Brouillette said that this is both an exciting and pivotal time for the industry as it (1) struggles to keep up with the growth in electricity demand brought on by the increasing use of electric vehicles and data centers; (2) seeks to maintain the system’s resilience in the face of challenges posed by the energy transition and cybersecurity, strains caused by growing peak workloads, and other potential disruptions, such as severe storms and wildfires; and (3) strives to ensure that nearly all customers can continue to afford to pay their bills.
The Briefing then turned to a panel discussion of EEI executives that included Richard McMahon, SVP, Energy Supply and Finance; Brian Wolff, Chief Strategy Officer & EVP, Public Policy and External Affairs; Philip Moeller, EVP, Business Operations Group and Regulatory Affairs; and Emily Fisher, EVP, Clean Energy and General Counsel & Corporate Secretary.
Discussion and Analysis
Although higher interest rates and disappointing stock price performance were troublesome for EEI member companies in 2023, the industry still managed to put to work an estimated $167.8 billion in capital expenditures in 2023, up 11.3% from 2022. Over the past 10 years, EEI members’ capital spending has increased at a 6.4% compounded annual rate. Current projections, compiled by the EEI Finance Dept., indicate that capital spending will level off at around the 2023 level over the next two years.
Despite the increase in capital spending over the past decade, which has exceeded the rate of inflation, 38 of 39 EEI member companies continue to pay dividends on their capital stock. Many have increased their dividend rates steadily over that period. 87% increased their dividends in 2023. The current average dividend yield of member companies is now 3.9%
Even with the high level of capital spending and generous dividend payouts, the average credit rating among EEI member companies is now BBB+, having increased from BBB over the past decade. Rating agencies have positive or stable credit rating outlooks for 84% of EEI members. Nearly all utilities view maintaining high credit quality as a top priority, so with capital spending likely to remain elevated, more will likely rebalance their capital structures by issuing equity in 2024, subject to market conditions.
Since the pandemic, affordability has emerged as a key consideration and will likely become increasingly important over time. Regulators have been supportive of a variety of spending programs intended to replace aging infrastructure, harden their transmission and distribution systems to withstand severe storms and promote energy efficiency as long as monthly customer bills have remained affordable. This has allowed utilities to earn acceptable returns on their infrastructure spending.
With the onset of the pandemic and the initial sharp decline in employment that ensued, more customers fell behind on their bills. Many states responded by passing legislation that put a moratorium on utility shut offs, but allowed utilities to accrue the unpaid bills as a regulatory asset which would be paid over time. With the passing of the pandemic, those moratoriums have since been lifted. In anticipation of this, many utilities have developed programs to allow customers with arrearages to catch up by taking advantage of the federal Low Income Home Energy Assistance Program (LIHEAP), offering discounts on unpaid bills directly to customers or (with the approval of state regulators) raising rates to cover amounts written off.
In 2023, more than seven million households (equal to about 5% of total households) received payment assistance from LIHEAP. Yet, four out of five households that are eligible to receive assistance under the program did not receive it. EEI is advocating for full funding of LIHEAP.
Customer affordability is a key concern of state regulatory commissions and therefore a major consideration in their support of the elevated capital spending plans of utilities. While expenditures are targeted to maintain and improve the quality of service, and promote energy efficiency and conservation, those objectives must be balanced against the ability of customers to pay for those upgrades over time. If the monthly bills are not affordable, some of these programs may be stretched out, delayed, scaled back or even dropped. So far, I am not aware of any instances where state regulators have limited any proposed spending programs due to affordability concerns, but the issue remains top of mind. For example, some states are considering not reimbursing their utilities for certain non-operating costs.[1]
Low energy commodity prices, especially for natural gas, have kept total customer bills low, even as the distribution charge portion of their bills has increased. This has provided the industry with sufficient cover to pursue their capital spending programs. In the absence of an expansion of the LIHEAP program, there may be increasing pressure to restrain the rate of increase in customer bills, especially for low income consumers. Thus, besides advocating for full funding of LIHEAP, EEI and its members are exploring alternative payment methodologies that offer tailored support and direct assistance to customers in need, but it is unclear at this time whether such efforts will be able to provide sufficient relief.
Resource adequacy is another concern, especially as demand continues to grow. Several years ago, strained capacity factors became a concern in portions of the Midwest and West, but with increasing demand from industrialization, data centers, and transportation electrification as well as the challenges presented by intermittency of power generated from renewable resources, concerns about resource adequacy have become more widespread. EEI says that there is no single solution to this problem. Each one must be crafted region-by-region or state-by-state.
EEI expects that the EPA will finalize its Clean Air Act Section 111 Rules governing greenhouse gases emissions for new and existing power plants soon. The Institute is supportive of the regulation, but it is lobbying for the EPS to be flexible in the schedules for plant retirements adopted voluntarily by many utilities. Some electric utilities may need to delay such retirements by a year or two (or more) in order to ensure resource adequacy.
Wildfires are another potential risk to electric system reliability. There should be a common understanding about the range of mitigation measures that electric utilities can undertake prudently in the regions that they serve. Utilities are not the only source of wildfire risk, so all stakeholders must be part of the effort to mitigate them. States and local communities must recognize the importance of maintaining the financial health of their electric utilities to promote their own economic security. Financial risk mitigation tools, such as insurance, may also assist in managing the consequences of wildfire risk.
This week, the SEC added its proposed Climate Related Disclosure Standard to its agenda at its upcoming meeting on March 6. EEI has advocated for a scaling back of the original proposal to eliminate the disclosure requirements for scope 3 emissions, which it asserts are inherently inaccurate. There has been speculation that the Commission will make the entire CRDS optional and drop scope 3 reporting. Most EEI member companies already disclose their scope 1 and scope 2 emissions under a template crafted by EEI several years ago.
The Inflation Reduction Act provides for tax credits available to producers of hydrogen, which creates no CO2 when burned. The U.S. Treasury Dept. is currently crafting rules for granting those tax credits. A provision of the Act specifies that hydrogen producers must match the carbon emitted by the electricity consumed in the production of hydrogen to the carbon saved from using the hydrogen as a fuel. Otherwise, there is a risk that more CO2 may be consumed in the creation of hydrogen than saved from incorporating hydrogen into the fuel mix.
Previous rules allowed such matching to take place on annual basis, but the proposed rules call for an hourly match. EEI and its members believe that this is unrealistic and will likely be a barrier to increasing the production of hydrogen. They are therefore lobbying Treasury to incorporate greater flexibility in its rules. The European Union recently adopted a policy of monthly matching through 2030. EEI also suggests that CO2 emissions reduced by optimizing existing resources should count toward complying with the matching rule.
Regardless of who wins the White House in November, EEI does not anticipate any major changes to the infrastructure provisions of the Inflation Reduction Act (IRA). The law is beneficial to most states both in promoting economic activity and issuing tax rebates that directly and indirectly benefit customers in red and blue states. That broad base of support should ensure the continuation of the law after the election, but there may be changes at the margin to certain of its provisions.
Investment in transmission is essential to allow greater use of intermittent resources, such as solar and wind power, accommodate the construction of new power plants and move electricity to areas that are capacity constrained. The industry invested an estimated $30 billion in transmission in 2023 and that annual investment is expected to grow at a mid-teens annualized rate for at least the next couple of years, but its efforts to deploy new transmission are being hindered by state and local siting and permitting challenges. EEI is hopeful that some progress on siting and permitting can be achieved in the lame duck session after the November elections. FERC rules regarding transmission planning and cost allocation (i.e. that costs allocations must be at least roughly commensurate with benefits) have been on hold for two years now.
FERC may lose its quorum, if Commissioner Allison Clements, who is not seeking a second term, leaves before the end of the year. Without a quorum, its ability to get anything done is hamstrung. Last week, President Biden nominated three people, two Democrats and a Republican, to fill the vacant seats and eliminate the quorum risk. Political handicappers say that all three should be approved because they are well qualified. However, election year politics could delay confirmation until after the November election.
As Mr. Brouillette highlighted in his opening remarks, this is a pivotal time for the industry, which by definition usually precipitate change. Whether any such change favors the electric utility industry and its investors will be determined by events, including the course of the economy in 2024 and beyond.
Utility stocks have been rangebound since 2020. They underperformed the broader market in 2020 and 2021 in the lead up to the pandemic, but then outperformed through most of 2022 as the broader market corrected. In recent years, they have been a relative safe haven during market downtrends.
Much of the underperformance in 2023 can be attributed to rise in interest rates. Higher interest rates were undoubtedly a contributing factor in the compression of the sector’s average earnings valuation multiples in 2023. Some investors and analysts who see utility stocks as a fixed income alternative determine relative attractiveness by comparing their average dividend yield to the 10-year U.S. Treasury yield, which is a proxy for the “risk-free” alternative rate. By that measure, the S&P 500 Utility index’s current dividend yield of 3.64% is about 55 basis points below the 4.19% yield on the 10-year Treasury. In recent months, that yield spread peaked at 120 bp in October and fell to 33 bp in January.
But utility stocks are more than just yield. Current consensus estimates anticipate earnings growth of about 7.5% in 2024. Earnings multiples for utility stocks compressed in 2023 as interest rates rose significantly as the Fed tightened monetary policy. However, if the impact of the industry’s pivotal moment is gradual or delayed (which seems likely at this juncture), companies achieve their earnings targets and interest rates go no higher from here (so there is no further multiple compression), the sector can deliver a total return of 11% in 2024, equal to the current average dividend yield of 3.6% plus the projected average earnings growth of 7.5%. They could therefore outperform again, with the help of sector rotation, if the market becomes rangebound or enters a correction.
[1] https://chicago.suntimes.com/editorials/2024/02/16/illinois-utility-bills-customers-ratepayers-add-on-fees-legislation-comed-peoples-gas-editorial
March 4, 2024
Stephen P. Percoco
Lark Research
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