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?
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%. 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. 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. 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.
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. 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.
Deregulation lowered the cost of wholesale electricity by about 60% in real terms 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.
This information presented contains EIP’s opinion which may change at any time and without notice. The information provided above is based on data obtained from third party publicly available sources that EIP believes to be reliable, but EIP has not independently verified and cannot warrant the accuracy of such information. In providing the information, EIP has made several assumptions that if changed, materially affect the information and conclusions provided.
 Weighting at the beginning of 3Q 2023.
 Bloomberg, Nexteraenergypartners.com ;“NextEra Energy Partners, LP revises growth expectations and limits equity needs” September 27, 2023.
 Bloomberg, “Biden’s Offshore Wind Hopes Sink after New York Ruling: BNEF” By Atin Jain, October 18, 2023.
 Avangrid paid $64mm in project termination fees in 3Q’23 to walk away from their Power Purchase Agreements (PPAs) on the Commonwealth Wind (0.8 GW, MA) and Park City Wind (1.2 GW, CT) offshore wind projects (source: company press release, Oct 25, 2023). Eversource Energy has taken a $392mm after-tax write-down related to its 50% interest in its joint ownership with Ørsted of the South Fork Wind, Revolution Wind and Sunrise Wind offshore projects (1.8 GW combined). Eversource is in a process of selling their interest in these three projects (source: company press release, Nov 6, 2023). Dominion Energy is in advanced stages of their process to assume a noncontrolling equity financing partner in the 2.6 GW Coastal Virginia Offshore Wind project as part of their Strategic Review process (source: company press release, Nov 3, 2023). On January 18, 2023, Public Service Enterprise Group (PEG) announced an agreement to sell its 25% equity interest in Ocean Wind 1 to Orsted at cost. Less than a month later (February 21, 2023) PEG announced it would not be investing in Skipjack, Ocean Wind 2, or any other offshore wind projects, and was evaluating options for its 50% interest in the NJ GSOE lease area.
 Lazard’s Levelized Cost of Energy Version 16.0, April 2023
 Wolfe Research Power Supply Outlook: Implications for Power, Rails, Natural Gas, Turbines September 15, 2023
 Source: EIA, Bloomberg. and EIP Estimates. EIP calculated as the change between the Average Price of Electricity to Industrial Customers in 1982 (US EIA October 2023 Monthly Energy Review, Table 9.8, adjusted to 2022 real dollars using the Consumer Price Index) and the average price of wholesale electricity over the past five years (US EIA weighted average wholesale electricity price data (ICE) as of November 2, 2023 after making an adjustment for estimated transmission costs.
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