Utilities: Regulatory Environment, COVID-19, And Taxes - Location Matters

Jun. 04, 2020 12:20 PM ETBRK.B, D, EMRAF, NEE, NFG, SO, WEC, DUK, EMA:CA55 Comments

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Summary

For several decades, the S&P has offered a rating of how supportive state regulators are to the utilities in their jurisdiction.
Nine states are rated as “More Constructive.” Eight states are rated as “Least Constructive” with the balance rated as "Average”.
With decreasing utility demand, decreasing accounts receivable collections, and with higher corporate income taxes potentially on the horizon, utilities will be greatly impacted by their state regulators.

Never has the geographic location of an investor’s utility selection been more important. The changes taking place will greatly impact utility shareholder performance over the next several years. Regulatory oversight will be critical in how utilities deal with the financial impacts of the COVID-19 outbreak and the ramifications on utilities of a substantial decline in consumption, a delay in accounts receivable collections, and the impact of future tax increases.

Demand Destruction, Cash Flow Issues

The coronavirus pandemic has triggered a macroeconomic shock that is unparalleled in peacetime. In a report issued by the International Energy Agency, IEA, found on average for the 30 countries representing 30% of global electricity consumption, for each month of lock-own, electricity demand declines by 20%. The IEA expects global demand to decline by 5% in 2020, the largest decline since the 1920s and eight times the electricity demand destruction of the global financial crisis in 2008-2009.

The following chart is from the June 2020 issue of Power Magazine and outlines changes in global energy demand for the past 120 years. As they say, a picture is worth a thousand words, and this graphic certainly tells a strong tale.

In the US, different state’s lockdown restrictions impact electricity demand differently. For example, according to the same Power Magazine issue, New York ISO reported NYC has experienced an 8% decline in peak power demand and up to a 20% decline at other times. Texas ERCOT has reported only a small peak power demand reduction with overall electricity demand down about 2% to 5%. In the Southwest Power Pool, demand is down 7% to 9% from like-degree days of last year. According to the Brattle Group, national electricity demand was down 6.5% in April, as reported by the seven ISO regional overseers. In a nutshell, the collapse in commercial and industrial demand for electricity is not offset by the increased residential demand caused by stay-at-home orders.

With the summer months upon us, electricity demand historically spikes higher as cooling energy consumption replaces heating energy consumption. The former relies heavily on electricity while the latter is a mix of electricity, natural gas, and fuel oil. However, this summer’s demand is an unknown entity. The industry publication Utility Dive reports utilities face new challenges created by the shifting commercial and industrial loads vs. residential loads. Demand from residential air conditioning is already strong and electricity bills could go extraordinarily high in the heat of the summer, June, July, and August. In the same article, Scott Hinson, chief technology officer at consumer energy data specialist Pecan Street outlined the demand/supply problems for Texas as:

“Because residential customers' usage is atypically high, local utilities could face higher transmission charges and ERCOT could face reliability challenges. Texas operates on a fairly thin reserve margin and has data center and manufacturing loads that are not flexible, which means an increased air conditioning load could test those margins."

In addition, most utilities conduct scheduled power plant maintenance on each side of peak summer demand, but many spring projects have been disrupted by the COVID-19 lockdown. For example, the Southwest Power Pool reported a 30% decline in power plants going offline for maintenance in April and May of 2020 vs. 2019. Delayed maintenance could result in a higher degree of power outages during the summer and delayed maintenance could become a bigger issue during peak demand.

Utility accounts receivables are about to be hit with an old-fashioned and dreaded Muhammad Ali One-Two combination. Like two quick jabs to the head and body, utilities are dealing with customer’s temporary layoffs and their inability to make monthly utility payments. This will be quickly followed by a minimum of a doubling of the January unemployment rate even after the economy “recovers.” Both of these are being aggravated by a moratorium on utility shutoffs. Utility finances are being shell-shocked by a dramatic cut in short-term cash flows, some of which will return as the country reopens, while some will not.

Utility investors are anticipating some type of federal bailout to offset the short-term cash shortfalls caused by the disconnect moratorium and the delay in accounts receivables. However, the bigger question will be how the individual state regulators deal with longer-term utility losses created by COVID-19. Several state regulators have already suggested utilities keep track of AR past due amounts for possible future relief.

Corporate Taxes

Congress reduced corporate income taxes through the passage of the Tax Cuts and Jobs Act of 2017. As a regulated industry with state-specific maximum profits allowed, utilities developed various means to reduce their profits which were provisionally increased through a lower tax liability. Some accomplished this by reducing utility rates and others by maintaining user rates and investing the lower tax offset in utility infrastructure without inclusion into the regulated rate base. The programs to reflect lower operating costs associated with a reduction in tax liabilities were developed and approved by the individual state public utility commissions.

With the massive amount of COVID-19-associated fiscal stimulus, and with the potential for more to come, the federal budget deficit and our national debt is expected to balloon. Regardless of who wins which branches of government in the elections of 2020 and 2024, investors should brace themselves for a repeal of the 2017 corporate tax cuts, or at least a partial repeal as a minimum. While other tax levies could be on the table, such as a new national value-added tax and a repeal of the individual tax cuts, corporate income tax hikes would seem to be almost a certainty if the Democrats win a majority in Congress and the White House. Even under a Republican administration, minor tax hikes could be needed to offset the mushrooming and COVID-19-fed federal deficit.

In the not too distant future, investors should begin taking into consideration a realistic possibility of corporate tax hikes, and the processes utilities need in order to recoup these higher costs through higher PUC-approved rates.

Utility Regulators

Utilities live or “die” based on their regulatory oversight, and not all state regulatory environments are the same across the country. As credit ratings are based on a utility’s ability to pay the interest and to eventually pay off their debts, and understanding the out-sized impact regulations have on utility profits, Standard and Poor’s for years have offered their assessment on each state’s regulatory environment. While there have been a few variations on the presentation of S&P’s assessment of regulatory environments since I discovered the service in 2006, and is currently offered by S&P’s Regulatory Research Associates RRA, the current listing separates states into various financial “support” categories. These fall into “Above Average or Most Constructive Support,” “Average Constructive Support,” and “Below Average or Least Constructive Support” of the utilities under their jurisdiction. Each of these categories are separated again as 1, 2, or 3, with 1 being highest in the category, 2 being average, and 3 being below average for the category.

Below is an interesting map of these ratings by state, as of May 2017.

From this map, it is easy to determine which utilities service these states. Below is a list of publicly traded utilities which service the Most Constructive/Above Average states:

More Constructive/Above Average #2

Alabama: Alabama Power - Southern Co. (SO); Spire Inc. (SR)

Virginia: Dominion Virginia Power, Virginia Power and Electric - Dominion Energy (D), Allegheny Power - FirstEnergy (FE), Appalachian Power - American Electric Power (AEP), Atmos Energy (ATO), Columbia Gas of Virginia - NiSource (NI).

Wisconsin: We Energies - WEC Energy (WEC), Wisconsin Public Service Corporation - WEC Energy, Xcel Energy (XEL), Wisconsin Power & Light - Alliant Energy (LNT), MGE Energy (MGEE).

More Constructive/Above Average #3

Florida: Florida Power & Light - NextEra Energy (NEE), TECO - Emera (OTCPK:EMRAF), Progress Energy Florida - Duke (DUK), Florida Public Utility - Chesapeake Utilities (CPK).

Georgia: Georgia Power - Southern Company

Iowa: MidAmerican Energy - Berkshire Hathaway (BRK.B), Alliant Energy, Black Hills Energy (BKH).

Indiana: Duke Energy, Cinergy Corporation - Duke Energy, Indianapolis Power & Light - AES Corp. (AES), Northern Indiana Public Service - NiSource, American Electric Power.

Mississippi: Entergy (ETR), Mississippi Power Company - Southern Co., Atmos Energy.

Pennsylvania: Northeast Utilities - Eversource (ES), FirstEnergy, PECO - Exelon (EXC), Allegheny Power - FirstEnergy, PPL (PPL), National Fuel Gas (NFG), Exelon.

With a combination of the financial stress on utilities caused by the COVID-19 pandemic through both a decrease in demand and the inability of customers to pay their bills, utilities will be more reliant on support from their overseers to minimize the negative impacts of the current crisis. Add to this COVID-19 dependence the prospect for higher corporate taxes increasing utility’s cost of doing business. These issues will pressure regulators in every state to implement added/different means of utility financial support, with some states excelling in their support of the utilities under their jurisdiction.

How effectively individual state regulators deal with these two critical issues will greatly impact the future performance of an investor’s utility selections. For my investment dollars, I look at those companies whose business falls into states with better regulatory environments. Why invest in companies whose overseers are rated as below average for financial support when the same investment dollars can be placed with companies with far better constructive regulatory support?

Personally, I own stock in the following: American Electric Power Convertible Preferred Series B (AEP.PrB), Berkshire Hathaway B, Dominion Energy, Duke Energy, Emera, Emera Reset Preferred Series C (OTC:ERRAF), Interstate Power Preferred/Alliant Energy (IPLDP), National Fuel Gas, NextEra Energy, NextEra Energy Convertible Preferred Series O, (NEE.PrO), Southern Company, and WEC Energy (WEC). While I also own a few other utility names, these twelve stocks make up the bulk of my utility sector portfolio. These are all listed above as doing business in states with the most supportive regulatory environments.

Note: Please review the disclosures found on my profile page.

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