Financial analysts say 2017 will likely be a challenging year for the power sector even as some companies do well since the financial and regulatory themes that play out over the next couple of years will not affect all equally.
The sector’s prospects, not surprisingly, will depend heavily on what happens in Washington where tax and regulatory reform is high on the agenda of both the Trump administration and the Republican-led Congress.
President Donald Trump has promised to roll back the Obama administration’s Clean Power Plan, which is designed to limit greenhouse gas emissions from existing power plants, but has been under a stay from the Supreme Court for about a year. But the most tangible risk for the sector, say analysts, is tax reform, which is moving ahead on a clearer path and with more momentum.
The sector’s prospects, not surprisingly, will depend heavily on what happens in Washington where tax and regulatory reform is high on the agenda of both the Trump administration and the Republican-led Congress.
While Trump has said he intends to dismantle the CPP—and his appointees to the Department of Energy and the U.S. Environmental Protection Agency point in that direction—the path forward on that effort is less clear. The Supreme Court’s 2007 endangerment finding requires the EPA to act on greenhouse gas emissions, so the battle will most likely come down to the timing and stringency of any eventual replacement.
As Julien Dumoulin-Smith at UBS has noted, Republicans have argued that the EPA over stepped the bounds of the Clean Air Act with the CPP by requiring plant operators to engage in remediation efforts outside the premises of their plants, such as participation in a regional carbon trading scheme. If successful in that line of attack, they could “effectively de-fang the CPP,” for instance, by requiring plant owners to merely implement efficiency improvements at their plants.
The most likely outcome, Dumoulin-Smith said, is not just the delay of the CPP program, but “structural impediments” that could permanently impair implementation of the CPP or its replacement even in future administrations, and that could have implications for the long-term growth prospects of the power sector.
The prospect of CPP compliance provided a focus that prompted power companies to invest in generation assets, such as gas, solar and wind projects, to replace the expected closure of coal plants and in transmission lines to move renewable energy from source to load.
Without that focus, Dumoulin-Smith sees “an emerging bifurcation returning between those regions with meaningful state-led growth prospects relative to those with more of a focus on completing more competitive bills”
Growth could cluster on states with more “green” agendas that could increase their renewable portfolio standards, such as Connecticut, Maryland—which just overrode a veto by its Republican governor to raise its RPS—and Washington, as well as states across the Northeast and California and Texas where renewables have been strong for years.
The absence of the CPP may also push utilities “further outside of their norms for growth,” and prompt them to pursue natural gas investment opportunities, such as gas pipelines and gathering systems, said Dumoulin-Smith.
Daniel Ford at Barclays also sees the dismantling of the CPP slowing the growth of replacement plants to make up for closing coal plants, instead, he said, companies could shift capex toward grid modernization efforts, but that is not likely to kick in until 2019. Without the CPP or grid modernization, he said, utility growth rates could decay by 1% to 2% a year after 2019.
Without the Clean Power Plan or grid modernization, utility growth rates could decay by 1% to 2% a year after 2019.
Daniel Ford
Analyst at Barclays
“Gridmod” has significant growth potential for utilities, but Ford notes that it will have to withstand state-by-state cost planning tests. He also sees a bifurcating landscape in terms of states’ environmental goals with policy-driven states like California, Hawaii, New York and New Mexico separating from market-driven states such as Alabama, Louisiana, North Carolina, Texas and West Virginia.
On the other side of the environmental agenda is the prospect of a loosening of regulations for domestic oil and gas, such as the streamlining of pipeline permitting. The beneficiaries of those actions would be regulated utilities with exposure to natural gas pipelines or midstream gas assets. Among the potential beneficiaries, Ford lists Consolidated Edison, Dominion Resources, DTE Energy, Duke Energy, Eversource Energy, National Grid, NextEra Energy, Southern Co., and Sempra Energy.
Dumoulin-Smith also see the absence of a CPP stimulus pushing some companies “outside their norms for growth” to pursue even more gas opportunities. He sees DTE in particular emphasizing its gas opportunities and looking for acquisitions beyond its recent gas gathering acquisitions.
Dumoulin-Smith also sees the consolidation trend continuing outside of natural gas acquisitions as larger utilities look to shore up growth prospects. But he notes that some U.S. companies could be reluctant to pull the trigger, given the uncertainty around the prospects for tax reform and the fact that many have already incurred debt in past acquisitions. Instead, acquisitions could be fueled by international companies, such as Iberdrola of Spain or Hydro One or Algonquin of Canada, that are eager to employ their cheap cost of capital in leveraged transactions.
In the U.S., power companies are more likely to be looking to de-leverage in 2017, said Neel Mitra at Tudor Pickering Holt. “Reducing leverage is the most important driver across all sectors from fully regulated utilities to fully deregulated IPPs,” he said.
IPPs, such as NRG Energy, already have a head start in deleveraging and were rewarded by the market with an aggregate uptick in share price last year, but utilities have begun the year by underperforming, which is no surprise, said Mitra. “The macro backdrop is providing more headwinds than tailwinds for 2017,” he said, citing rising interest rates, low load growth, and potential tax reform. That tilts his preference toward utilities, such as Sempra and Exelon, that have a “robust growth pipeline” over “yield-based utilities.”
Income vs. growth
The stocks of regulated utilities have traditionally been favored by investors keen on reaping income from dividends and steady earnings growth. But with the prospect that the fiscal stimulus of tax reform and infrastructure spending could lead to rising inflation, income stocks may not fare well. Those policies would “appear to benefit other sectors over” regulated utilities, said Ford at Barclays.
At least for the first half of 2017 Ford sees uncertainty around income oriented utility stocks. The Trump administration’s success with those policies will determine if the group rebounds in the second half of the year, but he notes that regulated utilities as a group are working against a larger trend in the market.
Stock funds focused on income have seen net outflows since October. Until momentum returns to the sector, Mitra said his bias is toward selling income oriented utilities stocks on rallies.
In this environment, Mitra prefers integrated utilities that have meaningful income from merchant generation operations and “emerging infrastructure companies” that combine regulated utility operations with natural gas or renewable energy subsidiaries, such as Exelon, Dominion, DTE, NextEra and Sempra.
The underlying theme here is the tax reform efforts under way in Washington. Those reforms could have the largest and most immediate effect on utilities. They are also among the most complicated of the changes affecting the sector.
“Utilities don’t really care about tax cuts...The real issue is the effect it has on rate base."
Hugh Wynne
Researcher at SSR LLC
Usually a tax cut is good for industry. That is not necessarily the case for utilities. A tax cut could be good for utility customers. Ford estimates they could see a 2% to 3% cut in rates. But, overall, utilities would likely see little change in income levels or cash flow, which Ford said would put them at a disadvantage to a typical S&P 500 company, which could see as much as a 10% gain in earnings.
On a more granular level, the effects are more varied. Utilities with significant unregulated income would stand to benefit while those with significant parent company leverage could have to adjust their earnings downward.
Ford puts Exelon, Public Service Enterprise Group and CenterPoint Energy in the first group and AES Corp., Entergy and FirstEnergy in the second.
UBS’ Dumoulin-Smith estimates that the aggregate impact of tax reforms on utilities will likely be negative with the potential for downward earnings revisions. Those views underscore the complications of utility accounting.
In utility accounting, funds put aside to pay taxes, deferred tax liabilities, are expensed but not paid in cash. Because deferred tax liability does not represent an outlay of capital, regulated utilities are not allowed to earn a return on investments funded by their deferred tax liability.
The essence of the matter is that taxes for utilities are a pass-through to ratepayers. “Utilities don’t really care about tax cuts,” said Hugh Wynne, co-head of utilities and renewable energy research at SSR LLC. “The real issue is the effect it has on rate base.”
Cuts in corporate tax rates do not benefit the earnings of regulated utilities; they ultimately give them back to customers. Only power companies with large, profitable competitive businesses such as Dominion Resources, Exelon, NextEra or PSEG, should see a permanent improvement in after-tax earnings, Wynne and his fellow analyst, Eric Selmon, wrote in a Nov. 29 report.
The tale of two taxes
There are two tax-cut proposals on the table right now. The House-Republican plan would cut corporate tax rates from 35% to 20%. The Trump plan would cut rates by 15%. For utilities, there is another significant difference between the two proposals beside the difference in the level of cuts.
The House plan includes a provision that calls for the expensing capital expenditures, resulting in the loss of the interest rate deduction that capex now enjoys. Utilities would not be required to expense capex under the Trump plan.
The net effect of House Republican and Trump tax cut proposals would be the same. They would result in a net increase in rate base for regulated utilities and an expectation of growth in utilities' regulated earnings.
The net effect of both plans would be the same. They would result in a net increase in rate base for regulated utilities and an expectation of growth in utilities’ regulated earnings.
Lower tax rates reduce the value of tax deductions, which would slow utilities’ accumulation of deferred tax liabilities, which are an offset in the calculation of rate base. Thus, lower taxes would accelerate rate base growth.
Under the House plan, the positive impact of lower taxes would be offset by the expensing of capex. However, utilities would still capitalize and depreciate their investments in plants and equipment so their provisioning for income taxes would remain unchanged. In SSR’s analysis, the expensing of capex for tax purposes would increase utilities’ deferred tax liabilities, slowing rate base growth.
Under the Trump plan, companies would not be required to expense capex, and most would not opt to do so, said Wynne, because it would slow rate base growth—the key component in the growth of stock prices for regulated utilities—and result in higher rates for customers. For utilities that do not chose not to expense capex, the 15% tax rate in the Trump plan would materially reduce deferred taxes and accelerate rate base growth.
In SSR’s analysis, if the corporate tax rate were cut to 15%, as proposed in the Trump plan, growth in aggregate rate base between 2015 and 2020 would accelerate from 6.6% annually under the current tax code to 7.5%, but the loss in value of utilities’ tax deductions would cause cumulative cash flow to fall by 4.4% of current market capitalization between 2017 and 2020.
Under the proposal from House Republicans, tax rates would drop to 20%, but capex would have to be expensed, resulting in a slowing of aggregate rate base between 2015 and 2020 to 6.3% annually from 6.6%, but cumulative cash flow would rise by 1.5% of current market capitalization between 2017 and 2020.
In SSR’s analysis, the utilities that would benefit the most from a reduction in tax rates are those whose capital expenditures are largest relative to rate base. But because transmission and distribution repair costs are more easily deducted under Internal Revenue Service rules than generation repair costs, T&D utilities would tend to enjoy more of a benefit from a tax cut than would vertically integrated utilities with generation assets.
The companies that would stand to benefit the most from a tax cut in Wynne and Selmon’s estimates are Alliant, Avangrid, Edison International (parent of Southern California Edison), Entergy, Exelon, Pacific Gas and Electric and PSEG. Those that would benefit the least are Allete, El Paso Electric, Great Plains Energy, Idacorp, OGE Energy, Portland General Electric, and Westar Energy.
But because the proposed tax cuts also would affect the tax treatment of capex and the deductibility of interest, those changes would also have an impact on utilities’ after-tax cash flow and on their capital needs. This means that the impact of a tax cut on utility cash flow is often negative. But if utilities are allowed to expense capex in full, there could be a cash flow benefit.
Under the Trump plan, a company could elect to expense capex, but they would lose the deductibility of interest expense. The House-Republican plan does not offer that option; it would require the immediate expensing of capex and would eliminate the deductibility of interest expense.
Wynne and Selmon estimate that the companies whose cash flow would benefit the most under the House-Republican plan are Ameren, El Paso Electric, Entergy, Great Plains, Pinnacle West Capital, SCANA, and Southern Co. Those that would benefit the least are Avangrid, CenterPoint, Con Edison, Eversource, Exelon, OGE and PSEG.
The cash flow beneficiaries under the Trump plan would be DTE, El Paso, Great Plains, Idacorp, Northwestern, SCANA and Southern. Those that would benefit the least are Alliant, American Electric Power, Edison International, Entergy, Eversource, Exelon, and FirstEnergy.
Right now in Washington, the House-Republican plan seems to have more momentum, says Wynne. With Trump’s executive order on immigration and other issues, “I don’t get the impression the administration is taking the lead on tax reform.”
Of course, what will happen in the coming months is anybody’s guess. It seems safe to say, though, that the outlook for the power sector will be complicated.
Not only to utilities have to deal with the prospect of higher interest rates and inflation, there are regulator and fiscal changes under way in Washington. It would appear that the companies likely to do the best in this environment are those with robust capex plans, especially those in states and regions where grid modernization and distribution improvements and the expansion of renewables and natural gas infrastructure are priorities.
