Utility stocks and bonds have long been beloved by pension funds and other conservative investors for their safe income generation.
But dramatic falls in the cost of solar and wind energy pose a threat to that safe profile, potentially leaving utilities with large and increasingly uneconomic sunk costs in older generating technologies.
Average whole life project costs for large wind and solar generation in the United States are now less than for coal or nuclear and about the same as natural gas, according to a study of tax subsidy-neutral prices from investment bank Lazard.
“Numerous key markets recently reached an inflection point where renewables have become the cheapest form of new power generation, a dynamic we see spreading to nearly every country we cover by 2020,” Morgan Stanley analysts said in a report released in July. “We project large reductions in carbon intensity in the global power sector, driven by the seismic shift in renewables.”
To be sure, cheaper and cleaner energy is a good problem to have. Morgan Stanley predicts that President Donald Trump’s announced withdrawal aside, the United States will meet its 2025 Paris Agreement target of a 26 percent to 28 percent reduction in 2005 carbon emissions.
The pace of change has been breathtaking. Morgan Stanley says the cost of solar panels has fallen by 50 percent in less than two years. At the same time, engineering improvements are allowing for larger wind turbine blades, fueling exponential improvements in wind economics.
That’s great news, but not if you are or own a utility representing a big embedded bet on other technologies that are being put at a disadvantage by the fall in solar and wind generating costs.
Southern Co. on June 28 announced it was suspending work on a plan to use coal gasification at a plant in Mississippi and faces significant challenges at a planned nuclear facility under construction.
And on July 31, South Carolina state-owned Santee Cooper and publicly traded SCANA Corp. announced they were abandoning construction of two nuclear power plants after cost overruns, equipment problems and the bankruptcy of contractor Westinghouse Electric.
Solar and wind also tend to suppress power pricing in markets with competition because, as their power is essentially free once upfront build-out costs are out the door, they not only displace higher-cost existing technologies that usually meet peak marginal demand, but lower the entire pricing structure.
Politics meets economics
The revolution in the utility power-generating model will create winners as well as losers, with some incumbents who are already exposed to more competition and who’ve taken steps to adjust ahead of the game.
Regardless of how the chips fall, the stark truth is that there will be far more chips up in the air in the world of utilities than in any identifiable earlier period. This implies more volatility, both in earnings and in the trading of utilities securities, which benefit from a long-term shareholder base featuring heavy exposure from pension funds and insurers.
As earnings and trading volatility rise, it is reasonable to expect investors to require better prospective returns to compensate them for the risks. The Dow Jones Utilities index’s components continue to trade at a higher price/earnings multiple than the broader index, but at far less of a premium than only a year ago.
That fall in multiples may have further to run. Much depends on regulation, and it is certain that utilities, which are well embedded in the political processes of their home districts, will exert powerful influence to protect their margins where possible.
Green power may also face political backlash from Trump’s administration, either in the form of tariffs on solar panels, many of which are made in China, or in other forms intended to protect the coal industry.
But it is also true that politicians and their voters both have good reason not to want their utilities to face dire consequences.
While governments may fear instability in power generation and seek to shield incumbents, industry and jobs will generally follow cheap power, a point forcefully illustrated by the history of the Tennessee Valley Authority. At some point, if the economics of solar and wind continue to improve, the politics of suppressing that will become untenable.