China will reduce subsidies to its citizens for gasoline and diesel and is raising prices for food and electricity. That’s potentially big news for the commodities market.

The country’s moves are likely to slow, not kill off, growth in Chinese demand for energy, which has been running at 15.8 percent for gasoline and 17.8 percent for diesel fuel this year. Today’s growth comes in the aftermath of a 10 percent boost in Chinese fuel prices last November. And the oil market’s spill following the government’s late June announcement was quickly reversed the next day, as supply concerns again surfaced.

The action in China and reaction in the markets are clear signs of how volatile energy markets can be. All signs still point to a continuation of this bull market for several more years, until real demand destruction, development of alternative supplies and potential new finds can tilt the balance of energy market power back to the consumer. But there are going to be plenty of flips and turns in market psychology and, therefore, prices along the way.

The upshot—which should be clear to anyone who’s held them for any length of time—is oil and gas producer trusts aren’t one-way streets to profits. And although many are certainly still attractive even at these prices (see the CE Portfolio), it’s critical to balance their volatility with more steady fare.

On that score, nothing matches the handful of Canadian income trusts that generate electric power. As it is everywhere, electricity is an extremely steady business in Canada. Come what may for the economy, demand has steadily grown year in, year out—both with the inexorably increasing population and more recently from the accelerating electrification of all aspects of the North American economy. 



The steadily rising demand has translated into reliably rising sales for Canadian power companies. Coupled with abundant natural resources—particularly in hydroelectric power—that adds up to increasing cash flow and very healthy providers. And it means very high yields ranging from upper single digits to low teens for the income trusts that produce power.

A Rich Market

The fifth-largest electricity system in the world, Canada’s power industry is part regulated, part unregulated. Controlling virtually all transmission and distribution—as well as power production—are a handful of giant quasi-government entities that are almost all owned by the provincial authorities. In addition, there’s a handful of corporate utilities, which operate in pretty much the same way.

The wholesale power market, in contrast, is now unregulated in all but a few provinces in Atlantic Canada. Meanwhile, large industrial and commercial users have the right to shop for power in the two of the country’s three most important provinces, Alberta and Ontario, but few places elsewhere.

As in the US, the momentum for more deregulation has stalled in recent years. The last big pieces of power industry legislation have been in Ontario, most recently a bill passed in 2004 calling for integrated resource planning in the province. That’s hardly a major push toward deregulation, however.

As a result, Canada’s power market looks a lot like the US market now. There are some regions in which marketers, such as Portfolio pick Energy Savings Income Fund (TSX: SIF.UN, OTC: ESIUF), operate freely. Most provinces, however, are seemingly content to operate most of their systems basically as monopolies, though with unregulated power producers competing to provide generation capacity.

That’s where power trusts come in, as generators and sellers of output to the giants who rule the industry. The table “Canadian Power Players” lists the principal players in this group, as well as a high-yielding corporation we’re now tracking in the How They Rate Table, TransAlta Corp (NYSE: TAC, TSX: TA). We’ll be looking at more companies in this group in future issues.



Note that I’ve excluded the handful of Canadian limited partnerships (LP), such as Epcor, because they’re prohibited by charter from having out-of-country investors. It may be possible to buy these over the counter in the US, but it’s hardly worth the trouble.

For one thing, there are plenty of trusts available with even higher yields. Just as trusts, Canadian LPs will be subject to 2011 taxation. And if there’s a problem with dividends paid from an LP, it’s hard to see your recourse, given management’s hostility to US ownership.

I’ve also excluded infrastructure trust AltaGas Income Fund (TSX: ALA.UN, OTC: ATGUF), which remains a solid buy up to USD28. This first-rate operation has a thriving, rapidly growing power production business focused on renewable energy, particularly wind. The trust also has many of the same attractive characteristics power trusts do, including a very steady stream of cash flows. Its main business, however, is in infrastructure related to oil and gas production and distribution.

Sea of Calm

The ranks of power trusts have shrunk slightly since the Halloween 2006 announcement that they’ll be taxed like corporations beginning in 2011. First to go was Calpine Power Income Fund, whose well-run natural gas power plants were bought up when the trust’s parent, Calpine Corp, went Chapter 11. Countryside Power Income Fund was the next to go, as its mix of gas and biomass plants was purchased by a private capital entity at the height of the cheap money boom.

Finally, Macquarie Power & Infrastructure Income Fund (TSX: MPT.UN, OTC: MCQPF) won a bidding war with Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF) to buy Clean Power Income Fund. That added Clean’s huge base of wind plants, as well other carbon-neutral power, to Macquarie’s arsenal. And it increased the trust’s safe harbor under trust tax rules to issue more shares to fund growth.

For the most part, however, the power trust sector has been a sea of calm in the uncertainty on 2011 taxation. One reason is the nature of its business, which generates reliable, robust streams of cash flow and is, therefore, ideal for paying big distributions.



Another is the nature of any business based on recession-resistant demand and built-in price increases. There just aren’t that many unknowns with which to deal. Power trusts also have numerous noncash expenses that can be written off against income to shave taxes and preserve more money for dividends. And a number of the players in the sector also operate in the US, from which the income is exempt from the 2011 tax.

All that adds up to a considerably lower 2011 tax impact than any trust sector, save REITs and a handful of uniquely structured businesses. For example, within a few weeks of Finance Minister Flaherty’s tax announcement, Great Lakes Hydro Income Fund (TSX: GLH.UN, OTC: GLHIF) stated its projected tax impact was to cut cash flow available for dividends by roughly 14.4 percent.

The trust hasn’t updated that figure since. But with the government cutting the top tax rate for trust taxation to 28 percent and slashing the provincial rate, the prospective rate is definitely at a lower level now. Meanwhile, power trusts with greater exposure to the US, such as Algonquin, will see prospective tax rates lower still.

The question is what impact that will have on distributions and if the existing power trusts will elect to remain in their current form or convert to corporations for which other sectors appear to be preparing. To date, management of power trusts has been noticeably mum on the subject. In fact, outside of Great Lakes, most haven’t endeavored to provide a figure for a prospective future tax rate.

There are some inferences we can make here, however. First, power trust management is well aware that high dividend yields are their primary appeal. If they want to expand, they’ll have to maintain steady share prices; that means keeping distributions at high levels.

Second, although some power trusts such as Great Lakes Hydro and Northland Power Income Fund (TSX: NPI.UN, OTC: NPIFF) maintain very low payout ratios, the majority tends to pay out at fairly aggressive rates. Algonquin’s payout ratio, for example, is generally in the mid- to high 90 percent range. This may make it difficult for some to maintain current distribution rates when taxes kick in.  

On the other hand, prospective tax rates are well below the 28 to 31.5 percent that these trusts’ shares appear to be pricing in. All but Great Lakes Hydro sell at less than twice book value, and several actually trade at or below book. Half pay double-digit yields, and the rest pay at least a couple points above equivalent utilities.

There are still many bridges to cross on this issue, and much remains unresolved. It’s very likely that several of these trusts will be acquired in coming years, maybe even before today’s stretched credit market conditions improve.



Two are basically investment vehicles for powerful, expansion-minded parents. Great Lakes is majority owned by giant conglomerate Brookfield Asset Management, which has its hands in a wide range of areas including real estate and timber. Macquarie, meanwhile, is conjoined with the Australian bank of that name, which plans some $8 billion in Canadian investment over the next several years.

Either of these giants could basically absorb the affiliated power trust as an inhale. They may elect to keep them independent, and they could pump a lot more money into them. The bad news is we won’t know until it happens. The good news is either option would be great for investors.

A third trust, Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF), is still roughly a quarter owned by its former parent Boralex. The income fund basically has no real employees but rather represents a royalty interest on a portfolio of hydroelectric, biomass (woodwaste) and natural gas power plants operated by the parent.

Last year, the income fund unsuccessfully attempted to shop itself, kicking off a rapid decline in its share prices. The coup de grace was a dividend cut earlier this year, as management decided the existing assets wouldn’t reliably generate that level of payout. That left the shares in their current trading range.

Since then, we’ve seen insider buying of the income fund. The parent remains in the pink of health and continues to expand. There’s been little movement on the ultimate fate of the income fund. But the current level of payout does appear sustainable while we wait.

All these internal uncertainties aside, however, 2011 taxation looks like pretty much a nonissue for power trusts. That’s one reason I own a healthy chunk of them in the CE Portfolio. And the rest of those tracked in the How They Rate Table are good candidates for purchase as well.

Surprising Growth

Unlike oil and gas trusts, power trusts aren’t generally known for their growth potential. As the column in the table marked “Revenue Growth” shows, however, this group has actually grown quite rapidly over the past several years.

Moreover, despite facing the same restrictions on issuing shares as other trusts, most of the trusts in the table have continued to grow over the past couple years. Atlantic Power Corp (TSX: ATP.UN, OTC: ATPWF), for example, boosted cash flow substantially this year by buying an additional stake in the Pasco plant in Florida. Innergex Power (TSX: IEF.UN, OTC: INRGF) boosted its share of several hydro facilities by buying out former partners, as did Algonquin.

Because they’re small, trusts don’t need huge projects to meaningfully lift cash flow and dividends, as Innergex did after completing its deal. Trusts still contribute only a tiny sliver of the country’s overall power production, meaning they’re also not a threat to the core business of larger companies. And their projects are heavily focused on renewable energy, giving them dramatically enhanced opportunities to sell with the approach of carbon regulation.

How big is their opportunity? The Canadian Electricity Association (CEA)—the primary lobbying organization for the country’s power industry—projects CAD190 billion in new investment will be needed to upgrade the country’s power grid through 2030. That includes powerful new interconnections with the US, where a substantial share of the country’s output is currently exported.



Quebec is currently the leader in this regard, with major sales contracts south of the border to sell its almost entirely hydro output. Manitoba is now moving to do the same with its bounty of wind facilities.

As for power itself, demand is expected to grow between 1.5 and 2 percent a year over the next couple decades. That’s a total increase of around 40 percent in total demand over that time, requiring considerably more building even if conservation goals from transmission and distribution (T&D) investment are met.

New construction will also have to compensate for the estimated 20 percent of the current power plant fleet that will be retired by 2020. All told, CEA projects a total of 60,000 megawatts of new capacity will have to be added over the next 15 years or so.

At present, Canada derives about 60 percent of its power from hydroelectricity. Most is owned by large government-owned utilities such as Hydro-Quebec. But with most of the larger project opportunities already capitalized on, a rising portion of new hydro now is coming from smaller projects, with a large chunk developed by power trusts.

Though on the run in many areas of the world—because of its environmental impacts—hydro is king in Canada. Volumes depend heavily on factors outside producers’ control, such as rainfall and snowfall. But it remains cheap and will be increasingly competitive as carbon regulation becomes reality in North America next year.

Greenhouse gas legislation is also a plus for wind power, and investment has begun flowing there as well. But much of the grid currently runs on nuclear energy (15.8 percent of output in 2006) and fossil fuels such as gas and coal (roughly 23 percent). As is the case in the US, the nukes are large facilities and mostly run by government utilities, though energy infrastructure giant TransCanada Pipelines has become a player in nuclear with its purchase of the largely dormant Bruce Plant facility.

In contrast to nuclear, however, most renewable energy projects are small. That matches them ideally with power trusts. The largest trust, Great Lakes Hydro, has a market capitalization of less than CAD1billion, compared to a market cap of several billion dollars for a somewhat small US utility or CAD22 billion for TransCanada.

The arrangement works like this: A giant government entity like Hydro-Quebec solicits bids for new capacity. Entities like power trusts submit bids to build and operate the facilities. Hydro-Quebec picks the winners based on considerations such as the soundness of the project, financing, projected costs, environmental impact, fuels used and so on.

The winning bidder then secures the financing—mostly from bank lines of credit but increasingly from innovative means and partnering—and builds the project. When it’s completed, the power is sold to Hydro-Quebec (or other government entity) at the agreed-upon price, though typically with a step-up clause that builds in rate increases over time. Renewable energy is particularly favored in this way.

For power trusts, the challenge is to build or buy as many cash cow projects as possible and to operate them as effectively as possible. Performance has varied from trust to trust. Some of the projects haven’t measured up to expectations, as the drop in Boralex’s dividend this year confirms. But by and large, the record has been solid.

Favorites

My favorite power trusts are still the trio in the Conservative Portfolio. That’s Algonquin Power Income Fund, Atlantic Power Corp and Macquarie Power & Infrastructure Income Fund.

All three are on the more aggressive side when it comes to distributions. Algonquin’s payout ratio has averaged in the high 90 percent range the past few quarters. Macquarie’s was actually well more than 100 percent following its acquisition of Clean Power, though it came back to around 80 percent in the first quarter. Macquarie also boosted its distribution this year by about 3 percent, even with its payout ratio at a high level.



Atlantic Power, meanwhile, is organized as an income participating security (IPS), with its distribution roughly 40 percent equity dividend and 60 percent debt interest. As I’ve reported here, as well as in High Yield of the Month, it plans to wind up the bond portion at the first available date in November 2009, though the imputed value of the equity portion at Atlantic’s current price would still produce a yield of nearly 20 percent. It’s increased its dividend twice since inception in November 2004, though none since October 2006 as the fund has focused on growing cash flow and preparing to cash out the bond portion of the IPS.

Of the three, Atlantic has no 2011 risk because it’s technically a high-yielding stock and not a trust. Algonquin, meanwhile, is strongly protected against 2011 taxation, with two-thirds of its income coming from the US. That portion is actually somewhat depressed currently because of the recent weakness in the US dollar.

Macquarie’s ability to dodge 2011 taxation is somewhat questionable, making it more likely to be taken over by its parent bank beforehand. But its focus on growing assets should also increase cash flows and the ability to support a high dividend. The investment in LeisureWorld also features some tax advantages, though these have yet to be quantified by management.

As for operations, the trio has run its plants effectively. First quarter earnings were solid for all three. Algonquin posted higher cash available for distributions per share despite weakness in the US dollar, which hurt revenue from US operations.

Atlantic Power’s net was spurred by the additional interest in the Pasco plant, acquired in late 2007. And it continued to run the Path 15 power line well. Project earnings before interest, taxes, depreciation and amortization—essentially operating cash flow for the company’s portfolio of power project interests—rose a robust 22 percent.

Macquarie enjoyed a 50.7 percent increase in revenue, thanks to last year’s successful acquisition of Clean Power. Cash available for distributions per share slipped as the trust added shares to close to deal. But the payout ratio was still moderate at 80 percent of cash available for distributions, and management affirmed it’s comfortable with the recently raised distribution.

We’ll know more about how these trusts are faring when second quarter results are announced. That should happen in the early part of August. The steady nature of these businesses, however, argues strongly that there will be few surprises, even if energy prices do take a breather from their recent torrid run. That, plus very high yields, is a great reason to buy Algonquin Power Income Fund up to USD9 and Atlantic Power Corp and Macquarie Power & Infrastructure Income Fund below USD12.

As for the rest of the list, I continue to hold Boralex Power Income Fund as a comeback play, as well as for its very high yield. The market still hasn’t forgiven the trust for the recent distribution cut, and Bay Street is skeptical. But the new level appears sustainable, even with the tougher conditions for the woodwaste unit and the end of favorable hedges that have protected US revenue. And parent Boralex continues to report strong growth by adding profitable projects to its mix. The trust also trades at a discount to book value.



This isn’t one on which to bet the farm, and there are still risks. That’s why I moved it to the Aggressive Holdings Portfolio several months ago. But downside risk looks limited from here, and those who already own it should hang on. Those who don’t and are willing to take the risks with a still-challenged trust can buy Boralex Power Income Fund up to USD6.

Great Lakes Hydro, Innergex and Northland Power yield somewhat less than the Portfolio power trusts. That’s the price of generating somewhat more consistent cash flow over the past couple years. Great Lakes’ affiliation with Brookfield is another reason for its higher valuation than its peers.

All three, however, are quite suitable holdings for conservative investors. Of the three, Innergex has been the most aggressive about increasing distributions, lifting its payout 3.2 percent in February after adding some alternative energy to its almost entirely hydro power portfolio. Northlands has the added appeal of a presence in Germany, while Great Lakes has the largest presence of the three in the US. Northlands is the most diversified by power mix, with renewables and gas leavening out its hydro holdings.

They’re not going to the moon, but they’re also exceptionally steady. Buy Great Lakes Hydro Income Fund up to USD20 and Innergex Power Income Fund and Northland Power Income Fund to USD14 for income and modest growth.

Like Atlantic Power, Primary Energy Recycling (TSX: PRI.UN, OTC: PYGYF) is an IPS that derives substantially all of its income from power plants in the US. Unlike Atlantic, the company actively manages the projects, which basically recycle energy from four major industrial projects.

The trust ran into trouble last year, as one of the projects was shuttered for a time and another ran into contract problems. The good news is that’s now behind the company and it’s again covering distributions with cash available for distributions. Operating and maintenance costs fell 55.8 percent in the first quarter.

Management is now undergoing a strategic review of operations, which could end in either dissolution of the IPS or a sale of the company. Until its intentions are clear, Primary Energy Recycling rates a hold. But as long as operations stay on the right track, downside risk is low.

Last but not least is TransAlta Corp, a producer operating primarily in energy-hungry Alberta and a new entry for How They Rate coverage. The company has enjoyed strong growth in recent quarters, as its focused operations on energy patch demand and exited most foreign holdings.

Like all corporations, the dividend is less than it is for trusts. But it’s well covered by a rising earnings stream and a good candidate for a share price-lifting boost. Buy TransAlta Corp up to USD40.