From Hagen Ernst, Deputy Head of Research & Portfolio Management at DJE Kapital AG
Constantly charged up
In boom times many investors often think of utilities as "boring". But in times of a crisis utilities are among the top performers on the stock markets. The sector is experiencing a continuing trend towards electrification and is able to shine with relatively stable profits despite a decline in demand.
In view of the uncertainty regarding the intensity of the global recession utilities with their relatively stable profits are suitable both as equity investments as well as a bond substitute in the current difficult market situation. In principle, the sector as a whole should benefit from the trend towards electrification: Despite the rise of energy efficiency measures worldwide demand for electricity will remain stable or even rise slightly. This is due to three reasons: the increasing spread of electric cars, the switch from heating systems to environmentally friendly electric-powered heat pumps and the expansion of data center capacities. In the coming months, however, demand for electricity is likely to fall for the time being, as industry as a consumer of electricity takes a back seat.
Regulated utilities with guaranteed profits even in the crisis
If the consequences of the corona pandemic are underestimated, specially regulated suppliers might be of interest. Regulated utilities receive a fixed remuneration on their capital such as electricity or gas grids or power plants. The advantage: profits are thus 100 percent guaranteed. However, profits can only increase by expanding the regulated capital base in the form of growth investments. Profit growth is therefore limited since profits can only increase through investments in the expansion or renewal of grids and power plants. In addition, the permitted remuneration on capital is based on the risk-free interest rate. All parameters are set for a fixed regulatory period - which is usually five years - adjustments are made afterwards. Due to the low interest rate situation worldwide the permitted returns are therefore usually adjusted downwards after the regulatory period.
Hong Kong and USA offer attractive investment opportunities
Hong Kong (HK) has the most secure regulatory environment in the world. In addition, HK utility shares sometimes show dividend yields of over four percent. For example, the local utility HK Electric is fully regulated. A regulation period of 15 years (current remaining term: 14 years) means a high degree of planning security. Moreover, HK Electric is only represented in Hong Kong and has no foreign business. The current investment plan implies an annual profit growth of three percent.
Regulated utilities from the USA generally have the advantage that they still have the highest growth rate worldwide. There has been little investment in the existing networks for years, so there is a high need for investment here. But they are comparatively expensive. In addition, the regulatory environment in individual states is uncertain or risky, for example in California, where high compensation payments must be expected due to the recurrent heavy forest fires. The regulatory environment in Wisconsin is considered very safe. The utility WEC is based there.
British water utilities are regarded as particularly crisis-resistant
Even in a recession water consumption is stable while demand for electricity weakens as industrial customers generally demand less. Since the lockdown, for example, demand for electricity has fallen by 43 percent in Italy, 18 percent in Spain and France, and 11 percent in the United Kingdom. In Germany, more than 80 percent of E.ON's operating profit comes from regulated power and gas networks. In view of planned synergy effects of EUR740 million from the merger with Innogy, E.ON anticipates annual EBIT growth of 7 to 9 percent for the period 2020 to 2022.
Current drop in demand only temporary
Because of the looming recession, wholesale prices for electricity dropped, in some cases sharply. In Germany, the wholesale price for base load collapsed from €50/MWh to €35/MWh, in Scandinavia from €35/MWh to €20/MWh. Although a temporary drop in electricity demand is to be expected due to the production stop in power-intensive industries such as the automotive sector or energy-intensive basic industries such as steel, chemicals and cement, the price of electricity is expected to fall temporarily. However, increasing electrification should ensure stable or slightly rising demand in the long term. In addition, the phasing out of coal and nuclear energy in Germany will lead to the closure of a large number of reliable power plants. The current low level of electricity prices is therefore unlikely to be sustainable.
Hydropower plants are particularly valuable. The operating risks and downtimes are comparatively low. The useful life is practically unlimited. In addition, cash costs are generally not higher than € 10/MWh, so that positive margins can still be generated even at the current low electricity price level. The three suppliers Verbund, Fortum and Uniper have a particularly large share of electricity from hydropower. Verbund has an electricity share from hydropower of almost 100 percent and also has a regulated grid business. Fortum has a hydropower share of almost 50 percent, the other 50 percent are generated from "CO2-neutral" nuclear power. Uniper generates 12TWh of electricity annually from hydroelectric power plants in Sweden. All three power generators have fallen sharply due to lower electricity prices: Fortum by -40% since the beginning of the year, Verbund -27% and Uniper -22%.
Renewable energies lead the way worldwide
Although the expansion of renewable energies may falter slightly as a result of the worldwide increase in national debt, this share of the electricity mix will continue to rise in the future. Even in China, a rethink is taking place. In view of the poor air quality, China also wants to become less dependent on coal-fired power, whose share has so far been more than 50 percent. Accordingly, China is pushing the expansion of renewable energies. However, the market is reserved for domestic suppliers like Goldwind. Goldwind is the leading supplier of wind turbines in China, which also operates wind farms itself. Besides China, however, the USA is also a growth market. Last year, several major auctions took place here, a number were won by Orsted, the leading operator of offshore wind turbines from Denmark, among others. The markets in South East Asia are also interesting. Orsted won lucrative projects in Taiwan here as well. Major auctions are also planned in South Korea and Japan. In Europe, on the other hand, the expansion of renewable energies is comparatively well advanced. Tenders for new wind farms are currently focusing on offshore wind projects in the North and Baltic Seas. In Germany, distance regulations to houses are currently slowing down growth of onshore projects. However, it remains to be seen to what extent a pragmatic solution can be found here. Onshore projects are much cheaper and are needed to replace old coal-fired power plants.
In addition, wind power plants usually have long-term supply contracts with fixed electricity prices and are therefore practically regulated. At RWE, for example, 70 percent of the wind farms are operated with fixed remuneration. However, it remains to be seen to what extent the expansion of renewables will slow down worldwide due to the Corona crisis. In the Netherlands and Germany, for example, the first auctions were held without subsidies due to higher electricity prices. However, this is no longer the case in view of the sharp drop in electricity prices. Although the generation costs of wind farms are falling as a result of ever larger turbines, the leading supplier Vestas, for example, already has turbines over 5 MW. But the production costs are still considerably over €50/MWh.
Expansion of renewable energies requires further high subsidies
In view of the increasing public debt worldwide this could become a problem. In addition, operators have been able to sell completed projects at high prices to institutional investors or insurance companies in the past, as they have accepted ever lower interest rates in the search for returns in a low-interest environment. In the future, however, they will demand higher returns again. There are a number of suppliers in Europe. Through the acquisition of E.ON Renewable, power generation based on wind and solar power is part of the core business. After Enel and Iberdrola, RWE is now the third-largest supplier, with an installed capacity of 8.7 gigawatts (GW). By 2022, capacity is expected to increase to 13 GW. The market leader in the field of offshore wind farms is Orsted. At present, the Danish operator has the most offshore capacity with 6.7 GW. By 2022, the capacity is to be expanded to 9.8 GW. In the future, the company also wants to grow more strongly in onshore wind power plants. By 2025, the company plans to build 5 GW of onshore capacity, primarily in the USA.
Summary: Utilities have an upside potential
In general, utilities are considered as a safe haven in difficult market phases due to their relatively stable profits. Despite the current decline in demand, the sector offers interesting investment opportunities for investors - both as an equity investment and as a bond substitute. In the medium to long term, the sector as a whole should benefit from the trend towards electrification.
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