Many equity analysts seem bullish about former Vice President Joe Biden’s plans to remake the American power industry if he is elected president. Biden has proposed a plan for the country to generate 100% of its power from carbon-free sources (solar, wind, nuclear, etc.) by 2035. These analysts have assumed that as utilities invest more in new sources of power, the increased spending would trigger a virtuous circle: the rate base would increase, which would drive earnings growth and potentially push share prices higher. These equity analysts are likely correct. But as credit analysts, we are looking at these clean energy investment opportunities through a different lens.
A credit perspective
We view the Biden proposals as potentially negative for credit in the intermediate term. The word ``potentially’’ is critical here because the proposed Biden plan is short on details and raises many questions for us. Who will foot the bill for the sizable investment required to transform the power sector? How much help will the federal government provide, and in what capacity? And finally, is the proposed 2035 deadline a mandate or a goal? If this proposed transition to a carbon-free system takes longer (most utilities are using 2050 as their target for transitioning to carbon neutrality) we anticipate the financial burden on regulated utilities and customers would be lighter. We would view that scenario as credit neutral.
Evaluating the Biden plan
One thing is evident: the two presidential candidates’ policies on energy are far apart. If Trump wins, we would expect more of the same in the power sector. Coal generation would likely be phased out and renewable generation, coupled with battery storage, would likely become a growing share of the generation mix over time. However, Trump has indicated that he would let state regulators and utilities determine how quickly that transition would materialize. We believe a Biden presidency would bring disruption. More importantly, his proposals would require a substantial amount of new capital spending to transform the country’s generation fleet. The US currently gets only about one-third of its power from carbon-free sources, a mix of nuclear and renewables. While no one can say exactly what it would cost to reach the 100% target, we believe the ultimate price tag would likely be trillions higher than the $2 trillion federal investment Biden has proposed.
Traditionally ratepayers pick up the tab for new investments made by regulated utilities. In this case, we believe regulators would be reluctant to make customers bear the weight of any added costs. This could be especially true in service territories where incomes are relatively low. In jurisdictions where regulators don’t allow utilities to add construction costs to the rate base as they are incurred (otherwise known as construction work in progress), or if the regulator forces the utility to depreciate the asset over a time period that exceeds the useful life of the asset, annual free cash flow deficits at the utilities could nearly double. We note that the vast majority of regulated utility companies have already been producing large negative cash flow deficits that require external funding. We would also expect credit metrics to deteriorate as a result of incremental debt potentially accelerating faster than cash flow.
Unregulated generating companies, which cannot pass on costs to ratepayers, would likely face pressure under Biden’s proposed plan. Forcing these power companies to invest in renewable projects, absent some significant federal support, means the initiatives would likely be funded through a mix of internally generated cash flow and debt, at the expense of shareholder distributions/repurchases and deteriorating credit quality. Contracted renewable assets are currently earning mid-single-digit internal rates of return, below the cost of capital of the unregulated generating companies. If these companies were required to invest in renewable assets, without some form of incremental compensation, it could be destructive to enterprise value.
None of these scenarios is a given. We believe more generous federal subsidies or favorable regulatory treatment at the state level could help ease the financial impact on utilities. What we have laid out here are possibilities, not predictions, of what might come.
Is the plan doable?
In the course of our research, we spoke to a variety of people in the power industry to get a read on their thinking about Biden’s proposals. Nearly all felt the proposed plans were unrealistic and that getting to 100% clean power by 2035 was not achievable. They cited two main reasons: the costs to consumers would be too high and the technology barriers too great. Battery technology, as an example, has not advanced far enough to handle the demands of a carbon-free electric system in our view. Most of those we spoke to regard the proposed 2035 date as a tool to spur green energy development rather than a hard and fast deadline.
Again, from our credit perspective, a slower transition to a carbon-free power system would be more manageable for the industry and less harmful to corporate fundamentals.
Navigating the path forward
The future is always hard to see, and in the case of the power sector, the outlook is especially murky. None of us can know for sure how politicians, state regulators, businesspeople and scientists might navigate the path to a cleaner energy future. Our goal as credit analysts is simpler: helping investors think about some of the issues that may arise as we move from here to there.
Click here to read more of Loomis Sayles’ 2020 Election coverage.
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