Priced Out of the Market

Regulated? Diversified? Or merchant?

If you’re not familiar with these terms, they describe different types of electric utilities that have varying levels of investment risk.

And we’ve found new support from an unlikely quarter that merchants, or independent power producers (IPP), should be avoided by income investors at all costs.

IPPs are merchant generators that sell electricity in competitive power markets, which have seen prices plummet in recent years due to cheap natural gas and competition from renewables.

NRG Energy Inc.’s (NYSE: NRG) CEO Mauricio Gutierrez recently made a stark appraisal of the merchant-power business, telling Wall Street analysts that he believes “the IPP model is now obsolete and unable to create value over the long term.”

That’s a stunning admission from a man who runs one of the country’s largest IPPs, with more than 47,000 megawatts of generation. Indeed, we had to scrape our jaws off the desk after we read it.

Though we were shocked that the head of a merchant-power giant would concede that he’s soured on his company’s business model, we’ve been steering clear of IPPs for some time.

Subscribers to Investing Daily’s Utility Forecaster are already familiar with the laundry list of problems plaguing the merchant-power industry.

Naturally, Gutierrez has his own laundry list. The CEO noted that “changes in fuel mix, consumer preference, technological innovation, and increased distributed generation have put pressure on the traditional IPP model, particularly as commodity markets continue to weaken.” Got all that?

Of course, these market dynamics are affecting the utility space as a whole, not just IPPs. Indeed, we’ve covered these trends extensively in recent years.

And our view has long been that regulated utilities are superior to merchants in this environment because the stability afforded by regulation has given the sector time to respond to these changes.

To be sure, we had high hopes that NRG’s previous CEO, David Crane, might reinvent the merchant-power business by investing in new technologies such as rooftop solar and electric cars. But his efforts came too late and simply piled on more debt to a company operating in an incredibly challenging industry.

In fact, a little more than a year ago, Moody’s Investors Service revised its industry outlook for competitive power producers to negative, citing declining prices for power and natural gas.

At the same time, Moody’s announced a stable industry outlook for U.S. regulated utilities, underpinned by a continued expectation of a supportive regulatory environment.

Where IPPs Go, YieldCos Follow

Meanwhile, the so-called YieldCos that have attempted to put the IPP model on steroids have had mixed results since their debut a few years ago.

We’re still not yet convinced that YieldCos can deliver long-term value, though we’re warming up to NextEra Energy Partners LP (NYSE: NEE), which is backed by a utility super-giant.

But memories are still fresh of the previous NRG CEO’s own surprise admission that the YieldCo business model was “completely broken.” Yep, at the very least, NRG’s CEOs will be remembered for their candor.

Instead, we continue to believe that the most risk-averse income investors are served best by focusing on utilities with 100% regulated operations.

Those who are comfortable with a bit more risk could enjoy both growth and income from diversified utilities, particularly those using stable regulated operations to support their push into renewables.

We believe this hybrid business model will prove best at adapting to the rising-rate era. In fact, two such companies turned up on our list of the 10 utilities that are ready for higher rates.

Given Fed Chief Janet Yellen’s latest jawboning, you should probably check out our list before it’s too late.