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Utilities Face Wall Street Whiplash from Interest Rates, Trump

Markets & Finance

As low natural gas prices drive down competitive market-based revenues to power generation owners, many vertically integrated (i.e. companies that own generation, transmission, and distribution assets) electricity companies have chosen to sell their generation assets and move towards a purely regulated transmission and distribution business model. 

For example, First Energy is planning to exit from the competitive power generation business, by selling generation assets and/or appealing to policymakers to re-regulate the units (bankruptcy of the company’s generation business is also on the table). First Energy recently inked deals to sell 1.6 GW of generation capacity. Moody’s generally saw FE’s plans to refocus on the regulated side of the business as a positive move.

In 2015, American Electric Power (AEP) announced plans to divest from its 7.9 GW merchant generation fleet. In 2014, PPL spun off its generation assets to focus on the regulated side of the business.  PPL and Riverstone created a new company, Talen Energy, to manage the competitive generation business, and now Riverstone is taking over total ownership of Talen. In 2014, Duke Energy sold much of its merchant generation fleet in the mid-west, noting returns have been too volatile.

And of course, Exelon has been pursuing state subsidies to keep its merchant nuclear generation afloat, threatening to shut down plants that aren’t made whole by the government or ratepayers.

Investors generally saw these moves as positive, because regulated utilities get a guaranteed rate of return that is stable and comforting (though opportunities for growth may be limited).

So, investor-owned utilities are refocusing on the regulated side of the business to offer more stable, positive returns to shareholders. Conservative investor are generally draw to utilities (including gas, water and electric) for safety, stability, and dividend income. Therefore, in these uncertain times, CEOs and Boards may believe it is more appropriate to leaving the volatility of the markets to independent power producers and private equity investors that have greater appetites for risk.

All was looking good, until recently when interest rates started to climb and the Trump Administration began touting the idea of corporate tax reform.

First, for risk-averse investors that were drawn to low-risk (i.e. people always need gas, electricity and water) utility equity when interest rates on bonds were at rock bottom, may eventually find their way back to the bond market. By reducing demand, the price of utility stocks could be driven down.

Second, utilities have to borrow money to finance capital expenditures, and these costs are eventually paid back by ratepayers. Increased interest rates mean higher borrowing costs. Basically, everything becomes more expensive, creating more headwinds from regulators against spending.

Third, the Trump administration has expressed plans to reduce the corporate tax rate from 35% to 15%. For corporations with high tax rates, this plan sounds awesome. But utilities benefit from many tax breaks, deductions, and deferrals, making their effective tax rate very low. This means utilities do not stand to benefit much from the corporate tax breaks. Morgan Stanley argues reducing the corporate tax rate can actually hurt utilities by decreasing earnings.

Morgan Stanley also believes unregulated businesses will be back in favor in 2017 (subscription), noting corporate tax cuts, higher borrowing costs (from increased interest rates) for new plant construction, and rising gas prices will benefit existing generation assets.

In what may seem like the blink of an eye, Wall Street analysts are turning a cold shoulder to regulated utilities, believing the sector is overvalued and has more downside risk than upside potential.

Of course, Trump’s plans on tax reform are just plans at the moment, and a big push for infrastructure could create opportunities for regulated utilities.  But for now, the ache of whiplash is setting in.

Christina Simeone

Kleinman Center Senior Fellow

Christina Simeone is a senior fellow at the Kleinman Center for Energy Policy and a doctoral student in advanced energy systems at the Colorado School of Mines and the National Renewable Energy Laboratory, a joint program.