Low-carbon strategies are yielding rewards for shareholders.
Michael Rutkowski, service group leader, financial and strategic advisory, Jeffrey W. Miller, director, and Jason K. D’Souza, senior consultant, are with Navigant Consulting’s Energy Practice. Email Rutkowski at email@example.com, Miller at firstname.lastname@example.org, D’Souza at jd’email@example.com.
2007 proved to be a strong year for utility stocks, with the Dow Jones Utility Index outpacing the Dow Jones Industrial Average by 10 percent (16 percent vs. 6 percent). This is a reversal from 2006—the first year the Industrials beat the Utility Index since 2003.
There is a story behind every company’s individual performance; however, compared to previous years, which were characterized by such broad industry strategies as back-to-basics and attempted mega-mergers, 2007 cannot be characterized by any one dominant strategy or direction by investor-owned utilities. In 2007, two IOU acquisitions by private equity groups were announced: TXU by KKR, TPG and others (closed in October), and PSE by a Macquarie-led investor consortium (still pending). The year also saw the acquisition of Energy East by a major foreign player, the Spanish utility giant Iberdrola, S.A. (still pending). However, only one traditional M&A transaction went forward, and a relatively small one at that: Aquila by Great Plains Energy (still pending).
But 2007 might be remembered as the year we started to see shades of green impacting total shareholder return (TSR). This phenomenon is demonstrated in the one- and three-year TSR—dividends plus change in stock price—of 77 utility companies.1 An analysis of the TSR of these companies by their traditional industry sub-segments (energy delivery, gas distribution, integrated gas, power generation, integrated electric and gas) showed a correlation between high TSR and apparent “green” business strategies. In particular, for generation-owning companies, those with the highest relative percentage of non-carbon and nuclear generation capacity have achieved higher TSRs.
A sector review reveals continued leadership from the power generation and integrated gas segments, with three-year TSRs of 86 percent and 98 percent and one-year TSRs of 34 percent and 25 percent, respectively (see Figure 1). Generally, these companies have been able to take advantage of continued high energy prices, selling power or gas into the market. For the broad group of 77 investor-owned utilities, the total one-year TSR was 23 percent, with the average one-year TSR for all companies in the analysis at 13 percent.
While 2007 was a strong year for utilities compared to broader market indices, the group of companies analyzed did not fare as well as they did in 2006. In 2007, to be in the top quartile of companies in the group, a utility needed a one-year TSR of 21 percent or better, versus almost a 30 percent one-year TSR in 2006. Even more compelling was the increase in poor-performing utilities, as 18 of 77 companies had negative one-year TSRs in 2007, compared to only three utilities in 2006.
As expected, in the list of top ten utilities in 2007, the power generation and integrated gas segments were strongly represented (see Figure 2). Additionally, six integrated electric and gas companies have top-ten 2007 TSRs; interestingly, five of these companies have strong nuclear generating capabilities (PSE&G, Constellation, PPL, Exelon, and Entergy), indicative of how the market rewards companies with these power-plant assets. The other integrated electric and gas company in the top ten—Allegheny—represents a continuation of a recovery story.
Among the bottom ten utilities in 2007 (see Figure 3) were seven of the 47 integrated electric and gas companies, with PNM at the bottom of the list, having missed earnings expectations in the first three quarters of 2007. Interestingly, three of the utilities on this list—Pinnacle West, Unisource, and Southwest Gas—have significant operations in Arizona, a state with both an unfavorable regulatory environment and slowing customer growth.
Eight companies—PSE&G, NRG, Constellation, PPL, Williams, Energen, Exelon, and Allegheny—have achieved top-ten TSRs both in 2007 and from 2005-2007. Further, the two “new” companies in the top-ten utility list in 2007—Reliant and Entergy—both were ranked as top-quartile performers over the three-year period.
On a three-year TSR basis, strong similarities are evident among the losers in the IOU portfolio. The four companies with the lowest three-year TSRs—Aquila, PNM, Hawaiian Electric, and NiSource—appear on both lists. These companies have underperformed for a variety of reasons, from continued missed earnings estimates (PNM) to general financial concerns (NiSource). Additionally, two of the seven energy delivery companies (Energy East and Central Hudson) are on the list of bottom-ten utilities based on three-year TSRs, while a third (United Illuminating) is just outside the bottom ten for one-year TSR, potentially indicating the market’s perception that growth prospects are limited by these utilities’ lack of generating assets.
Carbon & Shareholder Return
Given 2007’s heightened attention to carbon emissions and the overall green position of utilities, the one-year and three-year TSRs merit an analysis from a green perspective. Specifically, companies’ generation portfolios are compared in terms of carbon exposure (annual tons of CO2 emitted/total installed MW) and their relative non-carbon position (nuclear and renewable capacity) to answer the following questions:
• Does a company’s non-carbon generation position (i.e., nuclear, renewables) have an impact on TSR?
• How does the carbon exposure of a company’s generation portfolio impact TSR?
These findings proved very interesting.2, 3 Generally, 2007 TSR correlates to overall green position (see Figure 4), although there is some significant variation in performance.
In short, companies with the highest relative amount (in percentage terms) of non-carbon generation capacity have higher TSRs.
Five of the top seven companies with the highest amount of non-carbon generating capacity, had returns of over 20 percent in 2007. Additionally, the top quartile of companies based on this metric averaged returns of 26 percent, compared to an average of 10 percent for the remaining companies in the portfolio. These percentages are even more compelling when taking into consideration that companies with significant hydropower assets are weighing down returns—i.e., the five companies whose assets are over 15 percent hydro (Avista, Idacorp, PG&E, Portland General, and CMS) had an average return of -0.4 percent. Generally, these companies all had to purchase high-cost power at market prices, due to poor hydro conditions.
Similarly, the review of companies with nuclear assets is consistent with the view of companies with high relative amounts of non-carbon generating capacity, as the average TSRs for these companies are substantially higher than the remaining portfolio of companies. Specifically, for the utilities where nuclear assets comprises over 20 percent of their installed capacity, the average one-year TSR is 29 percent, compared to 11 percent for the remaining companies in the portfolio; the results from this analysis are consistent with results from reviewing average three-year TSRs, as the three-year TSRs for these nuclear-intensive companies is 99 percent, compared to 59 percent for the remaining companies in the portfolio.
Conversely, companies with the highest relative carbon exposure (annual tons of CO2 emitted per total installed MW) are substantially lower than the remaining portfolio of companies. Specifically, for the fourteen utilities with over 4,000 annual tons CO2 emitted per installed MW, the average one-year TSR is 6 percent, compared to 17 percent for the remaining companies in the portfolio. Also, this trend is consistent when reviewing average three-year TSRs, although to a lesser extent; for the companies described above with high carbon exposure, the average three-year TSR is 54 percent, compared to 69 percent for the remaining companies in the portfolio. In effect, the market may be pricing into these stocks the uncertainty of potential carbon regimes.
Breaking With History
TSR results in 2007 for the 77 company utility portfolio revealed that the strategic distinctions of past years’ winners and losers (e.g., back to basics, traditionalists, etc.) have all but disappeared. And most of the post-Enron recovery stories of past years’ winners are now ancient history.
Further, 2007 revealed that the companies with the largest amounts of non-carbon generation capacity and the highest relative percentages of nuclear capacity were high performers in terms of both 1-year and 3-year TSR. This is explained by the significantly higher margin opportunities afforded to nuclear generation in competitive wholesale markets—a dynamic that will only increase when a market mechanism for carbon control is introduced.
Companies with the highest relative carbon exposure tended to be low performers in terms of one-year and three-year TSRs. One possible explanation is the uncertainty surrounding any future carbon regime; depending on carbon allocation (or taxation) mechanisms and the relative position of their generating units in the resource stack, these companies could turn out to be winners or losers. We could, in fact, be seeing the beginning of the market discounting shares of these companies with the most uncertainty regarding future earnings due to carbon exposure.
In the end, companies with CO2-emitting generation resources (and their investors) will need to consider future scenarios related to potential market mechanisms for carbon control, and initiate strategic actions that will result in “no-regrets” outcomes. Many companies are well positioned based on past years’ bets (e.g., the acquisition of nuclear assets by Entergy and Exelon). Others are now diversifying their generation portfolios to include more non- carbon-emitting generation (e.g., Edison International), while many others with both coal and nuclear capacity are in a relatively neutral, or physically hedged position with respect to carbon exposure.
As the mechanisms for carbon control become clearer over the course of 2008, more winners and losers will emerge—in terms of total shareholder return—based heavily on both carbon and green impacts.
1. Companies in this analysis were traded publicly during the period 1/1/2005 to 12/31/2007 and in one of the five industry sub-segments listed. Excluded were companies with less than $700 million in market capitalization, companies in the midst of bankruptcy proceedings, companies now owned by private investor groups, and foreign-owned companies.
2. The carbon analysis is based on a subset of the 77 utilities and contains only power generation and integrated electric and gas companies, a total of 51 companies.
3. Data Sources: EPA CEMS; Nuclear Regulatory Commission, EIA, NERC ES&D, CFE, StatsCanada, CEMS, U.S. Federal and State Agencies, ISOs, Unit Owner and/or Operator Websites, Global Energy Primary Research; current generation capacity by type as of Dec. 13, 2007; July 2006 - June 2007 for tons CO2 emitted.