Electric utility reactions to the American Jobs Plan, which proposes a federal clean electricity standard (CES), have so far been mixed. Some have balked at the timelines implied by President Biden’s 100% clean electricity goal, while others have embraced a strong interim goal of 80% emissions reductions by 2030.
But what explains this split? A close look at some of the utilities publicly supporting a federal CES, which would require utilities to increase their share of carbon-free energy over time, reveals utilities like Exelon or PSEG heavy on nuclear and renewables were first to support the plan. Conventional wisdom suggests they have the most to gain, or least to lose from federal clean energy policy. But conventional wisdom is wrong.
New analysis from Morgan Stanley indicates it’s coal-heavy utilities and their shareholders who have everything to gain from a federal clean electricity standard. Utility managers, as fiduciaries to their shareholders (and beneficiaries of lucrative stock options), may even have a duty to support federal clean electricity mandates, if it means higher returns.
Monopoly – it’s not just a board game
To understand why Morgan Stanley reached this conclusion, let’s take a step back and examine how monopoly utilities make and grow their profits, and by translation, support continued stock price growth. Unlike a traditional business which increases its value selling the best product possible at the lowest cost possible, monopolies are allowed revenue and profits as a matter of regulator oversight.
Simply put, utilities recover the actual costs incurred to serve customers through electricity prices set by regulators. These prices include fixed profit margins for company shareholders earned on infrastructure investments like poles, wires, power plants, substations, and even the smart meter in your house. These returns make investors eager to put up capital for these investments, so that utilities can build what they need to build.
The catch is that these costs must be “prudent,” a standard that precludes recovery of egregious misuses of public funds like fraud, excessive cost overruns, certain legal liabilities, or engineering errors.
In short, investing in new capital is good for business, so long as regulators are on board.
Morgan Stanley’s Analysis
Morgan Stanley’s Power & Utilities Equity Research team conducts independent analysis to advise institutional investors on utility stocks. When it comes to monopoly utilities, choosing wise investment opportunities means seeing around the corner to determine which ones are well positioned to propose and have approved capital investments.
According to Stephen Byrd, Head of North American Equity Research, Power/Utilities for Morgan Stanley and lead author of the report, many electric utilities “have an opportunity to achieve a triple benefit from shutting down coal-fired power plants and building renewables: faster earnings growth, lack of upward pressure on customer bills from this shift, and lower carbon dioxide emissions.”
Morgan Stanley has noted in the past that “the fastest-growing U.S. utilities are those that are moving most aggressively toward clean energy…[while there is a large] re-rating opportunity for utilities with relatively high carbon-intensive power fleets” if they ditch coal to invest in renewables. The reason? Renewables are capital-intensive investments. By contrast, old coal assets have mostly depreciated, meaning monopoly utilities can earn high returns by putting new steel in the ground.
The Morgan Stanley team further noted a consistent relationship: utilities leading on the renewables transition, like Xcel Energy and NextEra, are valued higher than their peers, while coal-heavy utilities like First Energy and PPL were trading at a discount to their peers. But their insight on this was key – these same coal-heavy utilities with risky, costly, dirty power plants on the books could also increase investor returns if they accelerated the switch from coal to clean.
Now, in their most recent analysis, Morgan Stanley scored 74 utilities focusing on four factors:
- near-term growth projections (measured by capital investment growth)
- capital investment opportunities from coal shutdowns
- cost performance, and
- state-level regulatory environment
The analysis reaffirmed their earlier findings – that coal-heavy utilities currently trading at a discount to peers have major potential to grow their stock prices by embracing the renewable energy transition. Byrd noted via email that this is a “large and growing opportunity for utilities, driven by the rapid cost reductions for solar, wind, and energy storage.” Building new wind and solar is cheaper than running coal in most parts of the U.S. and can even reduce costs in many cases, which keeps regulators happy, and more likely to defer to utility investment plans.
Consider the case of American Electric Power (AEP), whose assets in Kentucky, Ohio, and West Virginia span Appalachian coal country. Once the largest U.S. coal utility, AEP recently announced a plan to reduce its carbon emissions 80% below 2005 levels by 2030 (in line with the American Jobs Plan 2035 goal). AEP is not projecting major rate increases will be necessary to meet these goals.
This is laudable, but far from altruistic. AEP intends to invest in 16,600 megawatts (MW) of renewable energy projects by 2030 and retire 8,000 MW of fossil resources. Morgan Stanley estimates the opportunity to invest in renewables to replace existing coal is $13.8 billion, a number only surpassed by Duke Energy, a significantly larger holding company. To raise the capital needed, AEP plans to sell Kentucky Power, a coal-intensive subsidiary struggling to achieve consistent returns. That shift translates into consistent earnings growth while reducing the risks of continuing to operate uneconomic coal.
What does this have to do with the American Jobs Plan?
The American Jobs Plan includes a clean electricity standard, requiring utilities to rapidly and consistently invest in new renewables and reduce fossil generation. According to University of California, Berkeley and Energy Innovation analysis, this would require $1.5 trillion in new investment in wind, solar, and storage by 2030 with virtually every electric utility sharing a piece of this pie.
Additional measures to support capital investment and renewable economics include transmission tax incentives, and a new Grid Development Authority to facilitate siting and permitting for renewables and transmission projects to aid the renewable energy transition.
Still, hesitant utilities may be less worried about growth and more worried about implementation. And there will be challenges – these same utilities simply have not built the in-house capacity to have confidence in the reliability of a high-renewables grid. But they will learn, just as grid operators like Southwest Power Pool, a 14-state regional electricity grid that spans the windy Central Plains. SPP has seen wind generation triple in the last five years and overtake coal as the region’s largest generation source in 2020 without decreasing reliability.
Morgan Stanley has identified a major opportunity to increase stock prices through more rapid grid decarbonization and grow investor earnings. A national clean electricity standard would make this happen, providing a boon for struggling coal-heavy utilities who can successfully execute on this strategy, much like AEP hopes to do.
All this is to say – what are regulated utilities waiting for? With budget reconciliation and a bipartisan infrastructure bill hanging in the balance, investor-owned electric utilities would be wise to jump into the game.