Our portfolio consists of companies that hold natural and legal monopolies of energy infrastructure assets such as pipelines, power transmission lines, terminals and storage facilities—or, as we refer to them, “poles and wires” and “pipes and tanks”. Most of these assets were built from the 1940s through the 1970s, and while ownership of these assets has in some instances changed hands numerous times through mergers, acquisitions, bankruptcies and near-bankruptcies, the original and subsequent owners of these assets are primarily regulated pipeline and power utility companies and the major oil companies. While these assets have nearly always enjoyed steady returns in the high single and low double digits, managements are often tempted by higher potential returns from businesses with more risk.
Non-Cyclical Energy Infrastructure
The term “energy infrastructure” is a broad term that includes the “poles and wires” that transmit and distribute electricity and the “pipes and tanks” that transport, store, and distribute natural gas and petroleum. We believe the value of our portfolio companies’ assets lies in their rights-of-way and incumbency of their natural or legal monopolies that support stable cash flows. It is these sources of value, with an emphasis on performance rather than “bucketing” companies by category, that we use to define our investment universe. While terms like “midstream” or “energy infrastructure” may be descriptive of our universe, they do not independently imply the performance distinction we seek. “Midstream,” for instance, is a broad term that includes every part of the petroleum industry between the “upstream” (oil and gas production at the wellhead) and downstream (refining and marketing), yet conveys nothing about the stability of earnings or barriers to entry. Indeed, many of the business segments that are covered under the “midstream” designation or that are assigned to the “energy infrastructure” space are cyclical, supply-facing merchant businesses with variable margins. We exclude holding these businesses in our portfolio where possible, but they are commonly included in the energy infrastructure sector or MLP indices. This is because we believe it is important to distinguish between the asset class or tax structure on the one hand (i.e. MLPs, C-Corps, etc.) and the business sector on the other (i.e. regulated pipelines, storage, processing, shipping, etc.). The investment challenge is that companies often have a mix of assets, including both non-cyclical monopoly-like businesses and cyclical non-regulated businesses. Our goal in selecting stocks and constructing a portfolio is to maximize allocation to stable monopoly businesses while minimizing exposure to cyclical merchant activities.
Regulatory Asset Base
While selecting for companies whose blend of assets favors stable, non-cyclical monopoly-like businesses over cyclical merchant businesses, we also seek what are called Regulatory Asset Base businesses (“RAB”). Returns on investment with most cyclical merchant businesses depend upon a range of variable factors such as sales volume, pricing, expense control and capital investment discipline, and investors are obliged to anticipate how the economy, commodity prices and labor costs will all affect profitability.
RAB businesses, by comparison, are essentially legal monopolies that receive an “allowed” rate of return on their invested capital instead of a margin on sales. A company that owns a RAB business earns a profit based on an allowed rate of return multiplied by the capital invested, and its revenue is equal to this allowed profit plus the cost of operating the business – the inverse of a traditional business as illustrated in the graphic to the right. The amount the customer pays is equal to this revenue divided by the units sold which is why regulatory asset base businesses are also referred to as “cost of service” or “cost-plus” arrangements, and why these businesses are not subject to the vagaries of the economy, labor costs or commodity prices.
The graphic compares the revenue and return structure of a RAB business with a typical, non-financial, operating business.
Price per unit
× Units Sold
= Total Revenue
= Return on Investment
Return on Investment(Allowed)
÷ Units Sold
= Price Per Unit
In North America, RAB businesses primarily include electricity transmission and distribution (i.e. poles and wires) in addition to petroleum and natural gas transmission, storage and distribution (i.e. pipes and tanks). In some states power generation remains a cost of service or RAB business but is an unregulated merchant business in most other states.
Cost and Regulation
The vast majority of our portfolio is made up of natural gas pipeline and power utility companies that either are regulated monopolies earning an allowed rate return on their invested capital (i.e. RAB businesses), or companies that operate unregulated monopoly-like assets and sell their services under long-term contracts mimicking this approach. The tariff structures may differ, but these arrangements are all based on the concept of cost-of-service recovery, with the tariffs effectively or directly reimbursing the business owner for operating costs plus a fair return on capital.
The importance of cost to these business arrangements cannot be overstated. For example, a utility must justify all of its expenditures to state-appointed regulators who must balance those against the interests of the consumer and business advocates demanding the lowest cost energy. The meaning of “cost” extends beyond what the customer pays to encompass externalities such as unreliable service, high environmental impact and poor safety. In our experience, shareholders suffer when a business is poorly run and cannot control its costs, even when that business is a regulated monopoly with cost-plus pricing. In addition, as the cost of renewables continue to decline, we see more opportunities for renewable developers as well as direct investment in wind, solar, and related technologies by our portfolio utilities. In our view, the formula for success for an energy infrastructure business and its investors can be rendered as “the low cost way of shipping and delivering the lowest cost energy.” Increasingly, this has come to mean investing in safe, reliable energy at a low cost to the consumer and with the least impact on the environment.
Carbon Impact Investing
The energy system in the United States is moving away from the reliance on carbon-heavy fuels such as coal in favor of renewable/cleaner resources like solar and wind. These changes have ushered in one of the best environments for investing in certain well-managed, forward-looking monopoly-like gas and electric utilities in decades. However, successful investing in this transition requires an historical perspective and an in-depth understanding of how the many parts of the energy chain fit together – from supply to consumption. We use our expertise to invest in companies that are profiting by taking a critical role in driving the changes in the energy system, and in 2018 we introduced a Carbon Impact Strategy that seeks to capitalize on this transition. Please reach out to us to find out more about the products that we manage in this Carbon Impact strategy.
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