History May Not Predict Future
Mark Beyer is chief economist of the New Jersey Board of Public Utilities. This article expresses his views and not necessarily those of the New Jersey BPU, its commissioners, or its staff.
History May Not Predict Future
Utility investors currently favor the earnings stability associated with regulated markets rather than the higher risk and return associated with competitive markets. However, history and economics suggest that maximizing exposure to regulated assets may not be an optimal long-term investment strategy, despite its present popularity.
The factors considered below include lower allowed returns on equity, the law of diminishing returns, declining demand for the product, price increases, and a possible death spiral.
Investor Preferences: Now and Then
Recent acquisitions of regulated assets include Southern Company's purchase of AGL Resources, Mid-America Holdings' purchase of NV Energy and NextEra Energy's pending purchase of Oncor Electric Delivery Company.
American Electric Power selling its merchant generation and PPL Corporation spinning off its merchant generation indicate an investor preference for regulated assets. And a preference for pure play securities, either regulated or merchant.
The actions of Exelon Corporation indicate how corporate strategies can change over time. In 2016, Exelon completed the purchase of Pepco Holdings, a multi-state utility holding company comprised of regulated distribution companies.
Its press release stated that the merger "Increases Exelon's utility-derived earnings and cash flows, providing a solid base for the dividend."
Exelon's Pepco strategy contrasts sharply with its 2005 attempted purchase of Public Service Enterprise Group, Inc., which owns nuclear assets together with a well-regarded distribution company. Investors at the time were attracted to the profitability of merchant generation assets where earnings were not limited to returns allowed by regulators.
Its press release stated, "The combined company will create the nation's largest power generation platform."
The purpose of these examples is to show the dramatic change that has occurred in investor preferences for various asset classes, rather than to suggest that regulated assets or merchant generation are a better investment. Either approach may have been an optimal strategy at the time.
One investment strategy that appears unlikely to reappear is diversification into unrelated businesses that have not created much shareholder value, given their history of producing substandard returns.
Why the Trend to Regulated Assets?
Utilities are attractive in a slow-growth, low-interest rate environment characterized by an oversupply of capital. That's because of their ability to grow rate base and cash flows. Those make above-average dividends possible.
Regulatory commissions in the various states determine the prices electric utilities can charge and their earnings. That is due to the monopoly nature of providing electricity to consumers. In addition to being able to recover prudently incurred costs for operating expenses, depreciation and taxes, utility investors are allowed to earn a return on rate base.
Regulated returns coupled with such rate recovery mechanisms as contemporaneous recovery of the return on and of capital shows why investors are so attracted to regulated assets. In addition, FERC-regulated assets generally have higher regulated returns, formula rates and recovery of abandonment costs, making such assets even more attractive to investors.