- The September sell-off in utilities was due to concerns about profitability of renewable development, not interest rates.
- Renewable developers (not utilities) are facing cost pressures from supply chain, labor and financing costs. Offshore wind has been hit hardest and the East Coast projects have cost increases of 50% leading to write-offs and cancellations.
- Onshore wind and solar have rising costs too but remain the low-cost source of new power generation in areas with high wind and sunshine. The problem there is NextEra (the parent of both Florida Power & Light and the largest renewable developer in the U.S.) and their renewable financing vehicle NextEra Partners which used a complex financing vehicle that is backfiring on them.
- Most utility parent companies do not have a renewable developer subsidiary but the average PM doesn’t know the difference and sold the whole sector.
- The regulated utility subsidiaries are sound, have good growth prospects and can pass through all cost increases including higher interest rates because they are regulated monopolies. In fact, higher interest rates, with all else equal, will lead to higher allowed returns on equity.
It’s not interest rates.
No matter the direction of utility stock prices, ask most people on Wall Street and they will say it’s all about interest rates. Our rigorous analysis of history says otherwise, and besides, how could the roughly 14% drop in the PHLX Utility Sector Index (UTY) over a two-week period in September and early October be tied to the most telegraphed series of interest rate increases that mostly happened last year and which haven’t increased since July?[1]
The answer lies in the business of developing utility-scale wind and solar projects which is facing supply chain related and financial cost pressures. Most renewable projects are built by so-called renewable developers, not by the regulated utilities that are monopolies earning a regulated return on all investment. A renewable developer buys the solar panels or wind turbines, secures the land or offshore acreage, contracts for installation and seeks to make a profit selling the electricity to the utilities under 20 to 25-year fixed price contracts. But it just so happens that a few utility parent companies also engage in renewable development as a separate business, and it’s that connection that we believe scared investors in late September.
It doesn’t help that the largest renewable developer in the U.S., NextEra Energy, Inc. (NEE), is also the largest member of the UTY, weighing in at nearly 19%[2]. Even worse is that NEE has been financing the bulk of its renewable projects with a publicly-traded sponsored vehicle named NextEra Partners (NEP). NEP buys completed projects from the parent (NEE) and has been financing those purchases with a convertible preferred equity instrument sold to institutional investors. This year, along with other renewable developers, NEP’s share price had declined about 35% versus its average price last year. That means the number of shares that would be issued to the holders of those convertible preferreds went up by about 50%. More share issuance means less accretion from buying projects from the parent company, so NEP had to lower its growth guidance from about 12% annually to about 6% annually.[3] Ouch.
Now, investors start wondering whether other utilities could have similar problems using a similar financing tool. They don’t. It was a NextEra invention that you can bet will not be copied. But a few have different problems related to offshore wind development which has seen cost increases of over 50% since they signed long-term contracts at prices that are no longer economic.[4] Again, this is a side business that a few utility parent companies have decided to engage in. And as it happens, four offshore wind developers are subsidiaries of utility parent companies located in the Northeast. All of them have faced cost increases and some of them are seeking to reduce their exposure to the offshore renewable development business by either walking away from uneconomic projects or through selling down their ownership in offshore wind projects.[5]
Let’s be honest, a large portion of investment funds are run by portfolio managers who simply don’t have the bandwidth to know all the details of the industries and companies they invest in. So, when they learned that some utilities have this exposure to problematic renewable energy, they sold first and asked questions later.
What Happens Next?
So, what happens next? Higher prices for these 20-25 year electricity purchase contracts sufficient to allow developers to make a competitive return on the invested capital.
Why? Because ONSHORE wind and solar are still the cheapest form of new capacity, (where it’s windy and sunny) even without subsidies, in part because the cost of other forms of power generation have also risen.[6] With subsidies under the Inflation Reduction Act, they are even cheaper.
Yes, renewables are intermittent, and you can’t base the entire power system on them, but intermittency is not the concern of renewable developers. When we deregulated the power markets in the late 1980s/early 1990s, they began operating like all other free markets. A power generator has no more obligation to provide power 24/7/365 than an aluminum or copper producer must provide their product to the London Metal Exchange 24/7/365.
These two reasons are why over 100% of net new capacity under construction and planned over the next 5 years is wind and solar. Wait, over 100%? Yes, because coal plants are closing. Natural gas fired power generation is growing as well, but nearly 90% of gross capacity additions is wind and solar.[7]
Deregulation lowered the cost of wholesale electricity by about 60% in real terms[8] but it removed a regulatory policy tool that could have been used to ensure reliability. It is, in fact, the regulated utilities that have to maintain system reliability. As legal monopolies, they have what is known as “an obligation to serve”, so some are investing in natural gas-fired power plants and batteries to back up wind and solar– and that investment will help grow their earnings.
You know what else helps regulated utility earnings? Higher interest rates that lead to higher allowed returns on equity (ROE). That’s right business school graduates, the allowed ROEs are based on the Capital Asset Pricing Model where the returns on equity represent an equity risk premium on top of the “risk free rate” of interest. It’s another reason why the simple narratives about utilities and interest rates aren’t true.