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Investing in Utilities

By February 6, 2017November 6th, 2021Energy Rant
Business Triangles

Most readers have likely seen the business triangle: cheap, fast, good [or accurate]; pick two. My first emotional reaction to the triangle was that it was something a lazy bum[1] would say. However, as a geezer, I think the law is valid for consulting. I will explain this in a future post.

For utilities, it would be something else; maybe cheap, constant, yes. Those are the price, time, and quality attributes of utility delivery. For utilities, the term “constant” represents reliability. The term “yes” represents quality or accuracy. In this case, 60 Hertz and the applicable constant voltage. I explained how and why electricity is cheap two weeks ago. Don’t miss it.

Business Triangles

Cost → Price

Utilities may be the only business line in existence that derives its product’s price directly from its cost to deliver. They are also the only business line that is 100% regulated, at least for the transmission and distribution parts. It is a remarkable success of private and public collaboration to deliver energy with very high reliability and low cost.

It seems as a regulated utility executive, I would plan for what I have to, or what I need to, based on customer desires.

  • I have to ensure reliability.
  • I need to keep up with customer desires, which can include more control and transparency of their energy use. This can include smart grid or advanced metering infrastructure (AMI).

AMI is a Great Investment

Referring to my fondest childhood memories the following may be a “no duh” statement to you, but it wasn’t to me: AMI saves ratepayers’ money and has a high return on investment. It saves money by driving down operational costs and minimizes some losses. The biggest operational savings comes from remote meter readings in lieu of expensive employees roaming backyards for meter reading. Puget Sound Energy provides the following breakdown of savings.

On the consultant side, we love AMI because it provides much more granular data on a 15 minute or hourly basis.

Personal Investing

*Caution* I am not giving investment advice. I am simply repackaging what I read on this subject.

In my younger years of foolishly trying to beat broad stock market returns, I was mainly interested in startup companies for one simple reason. It is much easier for an IPO[2] to double in size and value than it is for Exxon Mobile or Proctor and Gamble.

The thing about investing in stocks is the price is set at whatever the next fool is willing to pay for it. Period. It may have completely lost its mooring to earnings and other metrics. My conclusion: unless you have Warren Buffet time on your hands to find undervalued stocks, fuggedaboutit. Buy index funds.

Speaking of Warren Buffet, since the November elections, he has plowed $12 billion into the stock market. That is a lot, even for the $70 billion old man. He has also scooped up a lot of utilities in the last decade.

Investing in Utilities

Last August, Steve Huntoon from Public Utilities Fortnightly wrote, “Let’s admit one thing right off the bat. Rate of return is one of the most arcane subjects in utility regulation’s ocean of arcania.” He explains the sort of insights that would be invisible to the normal person, but visible to a genius like Buffet.

As I was taught in personal finance class in college, utilities are supposed to have a low return on investment, because there is very low risk. Huntoon explains this is not the case. He notes that

  • Regulated power generation companies outperform higher-risk competitive generation.
  • Lower beta (risk) stocks outperform higher risk stocks, in general.
  • Utilities outperformed the broader market over the past twelve years: 161% versus the Dow 30 at 133%.

Huntoon says utility stocks are the only stocks for which Wall Street analysts set the rate of return rather than forecast it. Regulators take their cues from these Wall Street analysts who declare that 10% return on equity is necessary. Whoa! That is a lot higher than the rest of the market.

Furthermore, Huntoon says utilities and their holding companies double leverage their equity returns. An example of operating companies and a parent includes ComEd, PECO, and Baltimore Gas and Electric rolling up to parent Exelon.

As an example, a utility may be capitalized with 50% debt (bonds) and 50% equity (stocks). For stock worth $100 million, 10% return, of course, is $10 million.

A parent company then does the same thing. For the same 50% split of debt and equity, the equity cost (interest) at 5% on $50 million is $2.5 million. This leaves $7.5 million on $50 million in equity, or 15% return on equity. Nice.

Watch Interest Rates!

I can say for sure that one reason utilities did well in the past 12 years is that real interest rates (interest minus inflation) were close to zero. Rising interest rates will hit utility stocks in two ways. First, you can see in the math above, the cost of debt service increases. Second, as importantly, bonds of all types become more attractive. Bonds compete with stocks for capital. When capital pours out of stocks for buying bonds, the stock price goes down.

[1] To my knowledge, bum is not yet on the list of faux pas of shunned politically incorrect terms.

[2] Initial public offering (of stock)

Jeff Ihnen

Author Jeff Ihnen

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