The fires that have unfortunately occurred in California have put the state’s utility companies in the spotlight, which may have overshadowed the narrative from a stock investment perspective. Mizuho Senior Utilities Analyst Paul Fremont helps us cut through the noise to understand where the sector might be headed in the next year. 

Big Spenders

Paul and the Utilities research team predict an 8 percent total return for the UTY (an index comprising a geographically diverse set of public utility stocks), which is below the total expected return of the S&P 500. This is in part due to the current high 2021 P/E ratio for electric utilities versus that for the S&P as a whole.

In 2020, Paul is thus recommending pure-play regulated utilities with little to no regulatory exposure over the next couple of years and trading at a discount, which he expects to outperform the UTY in 2020.

Underpinning growth in electric utility earnings is a long runway of capital-spending opportunities driving above-average rate base growth. (Under the regulatory formula used to set customer rates for electricity, a company’s net income is partly a function of rate base.) In the 1980’s and 1990’s, rate-base growth was barely two to four percent, but today it’s typically north of five percent.

Capital spending has increased due to a number of factors, of which ESG considerations are at the forefront. Companies with ageing coal plants are retiring them and replacing them with cleaner, more efficient sources of generation such as gas and renewables. Additionally, new transmission infrastructure has been required to link renewable plants, typically located in sparsely populated areas, to load centers, which are often major cities.

Offsetting the Costs to Consumers

Growing regulatory pushback to higher customer rates may pose the greatest threat to earnings growth. However, this has been mitigated by the recent decline in the commodity price of fuel, particularly natural gas. The Mizuho team posits that cost cutting will replace fuel savings going forward as the principal offset to higher rate-base spending.

Ultimately, reduction in operating and maintenance costs may represent the “final frontier,” Paul says, for keeping customer bills low while still providing the necessary investment in the future.