Utility companies a key source of transition alpha
POWER utilities attract controversy for their outsized impact on climate change.
Not only is the sector responsible for a third of global carbon emissions, but it has also recently drawn criticism after several energy companies restarted coal-fired plants as a consequence of the war in Ukraine.
Presented with this, climate-conscious investors might be tempted to remove power utilities from their portfolios. But doing so would be counter-productive. Depriving such companies of capital endangers the net-zero transition.
In eliminating their own emissions, utility companies can play a crucial role in the decarbonisation of other energy-intensive industries. If power companies can reduce their carbon footprints, their customers in the transport, manufacturing and construction industries will follow suit.
We realise that not every utility is fully committed to the green transition. Yet, we see an increasing number taking this responsibility seriously. Some of the most progressive companies are going to great lengths to decarbonise their own operations. Many are also ramping up investments in renewables and electricity grids.
But these changes don’t just benefit the environment. The shift to a low-carbon business model can be a profitable one, too.
Utilities that fully embrace decarbonisation can benefit from a boost to earnings as renewables’ growth prospects improve. Moreover, companies that phase out traditional thermal power plants also avoid the possibility of having to write down the value of fossil-fuel assets that become obsolete.
All of this means utilities stocks could become a rich source of “transition alpha” in the years ahead.
Green journey
The world has a lot riding on the decarbonisation of the global power system, which has the potential to halve global greenhouse-gas emissions when combined with the electrification of road transport and buildings.
The sector’s Scope 1 emissions – or those that stem from their operations and the resources they own or control, such as carbon dioxide produced by a coal power plant – represent Scope 2 emissions for other industries, or those that result from purchased energy.
For example, when a car manufacturer purchases electricity from a power utility, its Scope 2 emissions come out of the utility’s Scope 1 emissions. This means that if utilities can lower their Scope 1 emissions by transitioning away from fossil fuels, they effectively clean up Scope 2 emissions for other sectors at the same time.
We find that, in many cases, power utilities are meeting, or sometimes exceeding, expectations on their transition plans.
In Europe, for instance, one utility company increased its share of renewables in 2023 to 80 per cent of its installed net capacity, or 32 GW, compared with 42 per cent in 2016. It also plans to phase down coal and nuclear activities in the coming years. By 2030, all of its earnings are expected to come from non-fossil sources.
A US-based utility giant, meanwhile, has more than tripled its generation capacity of renewables such as wind and solar in the five years to 2022.
It has a weighted average of 93 per cent of planned growth (as opposed to operational) capital spending, or US$78 billion, committed to green projects in the four years to 2025, which also include battery and hydrogen storage.
Moreover, the company plans to eliminate all Scope 1 and 2 carbon emissions across its operations by 2045 at no incremental cost to customers, as it aims to benefit from the decarbonisation of the US economy, which it said represents a US$4 trillion market opportunity.
Another European utility company has closed 17 coal and oil thermal power stations since 2001, and reduced its emissions per unit of power produced by over two-thirds since 2007.
It plans to spend 36 billion euros (S$52.6 billion) in organic investments in the energy transition between 2023 and 2025. In the next two years, it expects its earnings before interest, taxes, depreciation and amortisation, as well as its net profit, to grow 8 per cent to 9 per cent on a compounded annual basis.
These three companies are not isolated examples.
Improving economics and increased focus on sustainability from consumers and investors are pushing utilities towards shifting power generation away from fossil-fuel sources.
The number of utilities and independent power producers committed to the Science Based Targets initiative (SBTi) – which validates corporate net-zero targets – is now seven times what it was three years ago.
‘Cleaner’ business
The changing dynamics of the utilities industry have important implications for investors.
As their business becomes “cleaner”, companies will be able to profit from higher growth and reduce transition risks, which can lead to outperformance.
A recent study showed that utilities that generated less carbon power and spent more on low-carbon investments outperformed an equal-weighted portfolio of US sector peer stocks by 32 per cent over the past five years.
The widening divergence in performance within the sector also highlights the rapidly changing nature of utility stocks.
A highly regulated sector with long-term contracts, utilities have traditionally been associated with stable, defensive and bond-like returns. But they are now increasingly offering an element of growth, driven by the acceleration in renewables and grid investments.
Furthermore, their strategies are often in line with government priorities, allowing them to tap into additional financing incentives and invest even more in the long term.
In other words, certain utilities allow investors to capitalise on the growth of the renewable energy sector while securing stable cash flows and long-term visibility on earnings. As their business becomes “cleaner”, power utilities will be able to profit from higher growth and reduce transition risks, which can lead to outperformance.
Investors, too, can help accelerate utilities’ decarbonisation efforts. For instance, our investment managers ask the companies to have their decarbonisation targets validated by the SBTi or similar third-party verifiers, which develops guidance on transition best practices.
We also encourage companies to incorporate mid- and long-term emission-reduction targets in the remuneration of management with penalties or incentives. We further engage with companies to target an orderly shift in the generation mix, for example by retraining workers in the fossil fuel industry towards clean energy skills, and avoiding simple disposals of dirty assets.
Utilities are powerful contributors to a shift towards a decarbonised economy. Leaders of decarbonisation should reap rewards from their investment to phase out fossil-fuel sources and also offer investors attractive long-term opportunities.
The writer is client portfolio manager of thematic equities at Pictet Asset Management
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