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Paris Is Burning

One of our favorite things about utilities is that the regulatory compact allows them to make money from situations that would be ruinous for other industries.

Take, for example, the sweeping environmental regulations promulgated during the Obama era. These mandates helped put coal producers on the ropes (though competition from cheap natural gas was arguably a much bigger factor).

Similarly, you might assume that regulated utilities with significant coal-fired generation would also face headwinds from such rules. But while some small utilities were certainly feeling the pinch of compliance, their larger, better-capitalized peers were shrewdly using Obama’s Clean Power Plan (CPP) as an opportunity for earnings growth.

Since it was up to the states to meet the federal government’s mandates, state regulators felt compelled to approve utility plans to shutter coal plants and build cleaner-burning gas-fired generation as well as renewables. Because utilities are allowed to earn a fair return on these investments, the industry had a powerful incentive to go green, especially given weak electricity demand.

However, the CPP was also highly controversial. Even before last year’s election, legal challenges had effectively sidelined the rule, though it might have been revived if the election had turned out otherwise.

Then last week, the Trump administration announced its intent to withdraw from the Paris Agreement, a climate accord in which most of the countries in the world pledged to reduce emissions from carbon dioxide.

So does this latest development put the final nail in the coffin for utilities’ earnings opportunity from cleaner power? Probably not.

Even the staunchest supporters of the Paris Agreement concede that the accord is more of a framework for negotiating future agreements than something designed to deliver truly meaningful results. The targets are entirely voluntary, and there is no punishment for failing to meet them.

Interestingly, however, the process for withdrawing from the agreement has a pretty long time table. At the earliest, the U.S. would complete its withdrawal from the accord shortly before the next U.S. presidential election.

Federalism Is Suddenly Back in Fashion

While remaining a party to the Paris Agreement would have kept the possibility of regulatory momentum alive at the federal level (though obviously it would be dormant for the next several years), the feds are hardly the only rule makers.

As far as environmental regulations go, state-level mandates are back at the fore. Even in the absence of the CPP, 37 U.S. states have either formal or voluntary goals for renewables. And some states are pursuing far more ambitious targets than the federal plan had sought.

In fact, certain states are proposing even more aggressive standards than they had previously in order to counter the federal government’s recent actions.

For instance, California and New York, which collectively accounted for about 11% of the country’s total electricity demand in 2015 (in terms of megawatt hours), are looking to have 50% of their power generated by renewables by 2030. And a number of other states are targeting renewable generation of 20% to 30% by the mid-2020s.

Additionally, a dozen states, including California and New York, have formed the U.S. Climate Alliance, with the intent of fulfilling their role in upholding the Paris Agreement despite the U.S. withdrawal.

Meanwhile, the private sector is also going green. More than half of the companies in the Fortune 500 have voluntarily imposed their own clean-energy targets. This could allow forward-thinking utilities to pitch renewables projects to big customers who operate far afield of their traditional service territories.

Indeed, shrewd players such as Florida-based utility giant NextEra Energy Inc. (NYSE: NEE) are pioneering a new utility business model that uses competitive renewables to drive earnings growth. Other utilities are taking note of its success and are starting to develop similar businesses of their own.

Lastly, utilities take an ultra-long-term perspective toward their investment cycle, with outlooks that typically span decades. Despite the shorter-term political cycle, the long arc of federal policymaking bends toward mandates for renewables and carbon emissions. Utilities are certainly mindful of this.

Beyond that, with regard to existing infrastructure projects, utilities can’t turn on a dime. If at least some work has already started and regulators remain supportive, then it will continue.

From an investment standpoint, the nice thing about the Clean Power Plan was that it provided a highly visible long-term runway for future earnings growth. And the Paris Agreement would have provided additional support. Now there’s more uncertainty.

At the same time, the CPP had forced some utilities to consolidate because the cost of compliance meant they could no longer go it alone.

In general, we would prefer that our companies have greater flexibility to decide how to adapt to changing market dynamics. Cheap and abundant natural gas and increasingly economic renewables are one example of shifting market forces. Revolutionary new technology is another.

Given these challenges, we don’t mind that some of the heavier coal burners might have a few more years to strategize about how best to adapt to this new operating environment.


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