Asset AllocationApril 3, 2023

Building Out the Grid: Investing in Generation, Transmission

Investment opportunities in electric power are rising in popularity, but that does not mean they are simple paths to success.

Reported by Ed McCarthy

Art by David Plunkert

The U.S. electric grid has experienced some rough patches in recent years. According to grid regulator North American Electric Reliability Corp., the U.S. averaged slightly more than 9,600 power outages annually between 2015 and 2020, more than twice the average from the previous five years.

Some systems’ strains and outages made national headlines. As temperatures soared in August 2022, the California Independent System Operator asked residents and businesses to voluntarily reduce their electricity usage, including electric vehicle charging, from 4 p.m. to 9 p.m. in anticipation of high electricity demand.

Other areas around the country also have experienced weather-related grid problems. For example, an unusual cold spell in February 2021 disrupted power supplies in Texas and left more than an estimated 4 million electricity customers without power for days.

But extreme weather is not the only challenge. In February, PJM Interconnection, one of the largest U.S. grid operators, issued its electricity demand supply forecast for the years through 2030. Its analysis found that a combination of several trends was likely to create supply/demand imbalances, increasing the risk of blackouts and power shortages. Among the key findings:

The growth rate of electricity demand is likely to continue to increase as a result of electrification, coupled with the proliferation of high-demand data centers in PJM’s northeastern U.S. service .
Thermal generators (i.e., powered by oil, liquid natural gas and coal) are retiring at a rapid pace due to government and private sector policies, as well as economics.
Retirements are at risk of outpacing the construction of new resources, due to a combination of industry forces, including siting and supply chain, whose long-term impacts are not fully known.

A recently released survey by Nuveen found that global institutional investors with at least $500 million in assets are increasingly looking to infrastructure investments.

Infrastructure was the most commonly picked asset by investors in Nuveen’s third annual EQuilibrium Global Institutional Investor survey who plan to increase their alternatives allocations (chosen by 58% of investors). Those surveyed also indicated they are using infrastructure for a host of solutions. Private infrastructure was the most-selected for inflation-risk mitigation, and infrastructure debt was the top choice for allocations to alternative credit. In addition, infrastructure was picked most often as the asset class investors are prioritizing for their climate risk strategy.

When considering climate risk, “These considerations can result in actions such as investing in new green energy opportunities, reducing allocations to companies or industries with high carbon emissions, and actively engaging with management teams to advocate for more climate-aware policies,” said Amy O’Brien, Nuveen’s global head of responsible investing, in a statement about the survey.

Going Green

These trends create opportunities, according to Timothy Winter, senior vice president and portfolio manager with Gabelli Investor Funds in Rye, New York. “Compared to the rest of the world, we have very reliable electricity,” says Winter. “Yes, it does need to be upgraded, and it can be expanded, and lots of investment needs to be made. All of those dollars invested should be considered opportunities.”

Winter cites the same trends the PJM study identified. Society is moving from fossil fuels to clean energy and renewables, he explains. The growth in electric vehicles and improvements in battery storage are examples of that transformation, as are the uses of wind and solar energy for power generation. These are megatrends, and the shift to increased electrification is likely not reversible, says Winter, but it is not the potential increase in unit sales of electricity from increased demand that drives utilities’ profitability. Instead, it ’i the growth in infrastructure investment that the utilities must make to generate and deliver the electricity – and the companies’ ability to pass through those costs to ratepayers –that powers their profits.

Wind and solar power illustrate investment opportunities in the storage and transmission sectors. These power sources are weather-dependent, so their generation potential is intermittent; batteries allow these facilities to store power during peak production for later distribution when production is low or offline. Also, most people do not want to see wind turbines on the horizon or have a large solar farm in their backyard, so those power sources tend to be located away from population centers. But placing turbines offshore or building a solar farm in the middle of the desert means transmitting that power long distances to the grid for distribution, which can require large investments in transmission facilities.

The investment required for additional electrification infrastructure is good news for utilities, says Winter, because utilities get paid for infrastructure investment based on local regulators’ return on equity allowances. Winter’s “Utilities-U.S. Outlook 2023” report for Gabelli Funds noted that Edison Electric Institute-member utilities have forecast capital investments of almost $160 billion for 2023, versus an estimated $155 billion in 2022. The industry has increased its annual investment for 10 consecutive years, and Gabelli Funds expects the trend to continue based on utilities’ capital needs for:

Clean energy transformation (coal retirements, wind (on/off-shore), solar and storage);
Electric transmission and distribution (grid modernization, hardening and undergrounding);
Electrification, EV charging, efficiency, etc.; and
Natural gas infrastructure (pipeline expansion and replacement, green hydrogen and carbon capture).

“The more they invest, the more they earn,” Winter explains. “If you’re earning, say, a 9% or 10% return on equity and you’re investing more money, you’re going to grow earnings.”

Legislative Boosts

Recently enacted federal legislation has focused on building out the grid. The 2021 Infrastructure Investment and Jobs Act will not have a major impact on investor-owned public electric utilities, but it likely will spur investment in other areas, says Winter. He cites $9 billion allocated for hydrogen research and development, $6 billion for nuclear power plants, plus a subsidy credit program and a $5 billion grant program for municipal and co-op utilities.

However, Winter believes the Inflation Reduction Act of 2022 will drive significant investment in clean energy. His research report noted that the act “solidified, expanded and extended 30%-investment tax credits and 2.6 cent production tax credits for existing wind (on-shore and offshore) and solar generation and established new credits for nuclear, geothermal, storage, carbon capture, hydrogen as well as others. The ITCs can be increased to 40% based on domestic content and certain other conditions. The credits are in place for at least ten years and phase out in 2032 but only if electric sector emissions fall by 75% compared to 2022 levels..”

Most utilities believe the IRA provides “game-changing” incentives, and they plan to accelerate already ambitious infrastructure plans, the report added. The IRA provides multiple benefits: Tax credits allow the utilities to lower the development, construction and operating costs of renewable energy generation, which means lower future customer bill increases. At the same time, increased rate base investment through capital expenditures will help achieve ambitious carbon-reduction plans and aid earnings growth.

Buildout Obstacles

Despite the widespread agreement supporting the clean energy and electrification trends, implementing the policies faces hurdles. Many facilities’ proposals are likely to face objections from communities where the projects will be sited—the Not In My Backyard protest. Consequently, there is no guarantee that needed facilities will be built, at least not in the short term, says Anthony Crowdell, managing director with investment bankers and asset managers for Mizuho Financial Group Inc. in New York. “It’s very, very hard to build transmission and very hard to build generation,” Crowdell explains. “There’s just tremendous opposition to transmission lines.”

It’s relatively easy to construct transmission facilities over farmland in middle America, but that’s not where the load is or the customers live, says Crowdell. “If you need to put transmission, say, in Manhattan, the residents of Westchester or maybe lower Connecticut may not want to have a transmission line going over their heads. So the siting would be an issue, but the need is there for more transmission, particularly if we go to generation of renewable sources where they’re in areas where there’s currently no transmission.”

Winter cites the example of Eversource’s proposed $1.6 billion Northern Pass project. Originally proposed in 2011, it was offered as a shareholder-funded way to sell 1,090 megawatts of hydropower from Hydro-Québec into the New England grid. The proposal called for building a 192-mile transmission line across New Hampshire, but after Eversource spent more than $300 million on the project, vigorous local and state-level opposition led to its cancellation in 2019.

Some utilities are taking advantage of space available on their existing sites. Claud Davis, co-manager of the MFS Investment Management’s MFS Utilities Fund, cites Baltimore-based Constellation Energy Corp.’s decision to build the nation’s first 1-megawatt, demonstration-scale, nuclear-powered clean hydrogen production facility at the company’s Nine Mile Point Nuclear Station in Oswego, New York. According to a March 7 Constellation Energy press release, the project will “help set the stage for possible large-scale deployments at other clean energy centers in Constellation’s fleet that would couple clean hydrogen production with storage and other on-site uses.”

“They’re looking at potentially benefiting from the Inflation Reduction Act having credits for hydrogen development,” says Davis. “It makes sense because they’ve got the electricity interconnection and they already have the nuclear plant. When power prices are high, they can sell power into the grid, and when power prices are low, they can use it for an electrolyzer to generate hydrogen and get a tax credit for developing that hydrogen.”

A Good Investment?

All three sources agreed that the long-term outlook for electric utilities is positive, but Crowdell has a more bearish short-term outlook based on stock valuations. The utilities index outperformed the broad market indexes by a wide margin in 2022, and U.S. utilities’ prices going into 2023 were “rich” relative to historical valuations, he says.

Davis cites rising interest rates and the lag between incurring those expenses and recovering the higher costs from regulatory decisions as a headwind. On the flip side, though, utility stocks are sensitive to interest rates. Rising rates have made the relative valuations more attractive, and Davis says the fundamental outlook for utility investment opportunities is “probably about as good as it’s been in years.”

Winter is also bullish. His report concludes that “the utility sector offers a 3.4% current return and many utility managements target 5-7% annual earnings and dividend growth. The utility business model represents a safe-haven in the face of recession and/or inflation fears. In addition, the transformation of the utility sector from fossil fuel-fired to renewables provides the environment for strong annual earnings and dividend growth. We believe that the combination of strong utility fundamentals, and the potential for escalating geopolitical volatility and/or domestic economic slow-down bode well for the relative performance of utilities.”

In addition to publicly traded utilities, private infrastructure investments offer a range of riskprofiles for institutional investors, according to Di Tang, a senior investment director on Cambridge Associates’ sustainable and impact investing team. The intermittency of power generation by today’s dominant renewable energy sources such as solar and wind dictate the need for complementary and supplementary infrastructure such as battery storage, as well as demand response management solutions, says Tang.

“Today, a wealth of opportunities exist with both established and emerging infrastructure managers across North America developing utility- and sub-utility-scale sustainable infrastructure projects,” says Tang. “In addition, the maturation of the climate technology ecosystem has seen the influx of private equity and other alternative investment managers offering debt and equity investments in projects, as well as renewable energy developers and platforms.”

For example, the Ontario Teachers’ Pension Plan has made multiple recent investments in transmission companies, including Scottish Hydro Electric Transmission and Finnish power distributor Caruna. In October 2022, private investors Centerbridge Partners LP took a majority equity position in Fort Mill, South Carolina-based MacLean Power Systems, which provides pole-line hardware, insulators, arrestors, connectors and other related products.

In February, private equity investors United Utility Services acquired BHI Power Delivery in Weymouth, Massachusetts, from Westinghouse Electric Company. According to the press release from United Utility Service parent company Bernhard Capital Partners, BHI Power delivery supports “power infrastructure investment across all transmission, substation, distribution, and grid hardening projects, from engineering and construction to maintenance, live-line work and storm response.”