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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Lockdown Strikes Utilities As Electricity Demand Plunges

Electric utilities around the world, like other industries, are not immune to the unpleasant financial effects stemming from the covid19 pandemic. While electricity customers “shelter in place,” sales to commercial and industrial customers have dropped off substantially. Utility companies serving highly industrialized regions should see the biggest negative impacts at least on a near to intermediate term basis.

Stores close. Factories close. People are out of work. Sales volume drops. Customers will not or cannot pay their bills. What do utilities do?

A few weeks ago, a medium-sized gas company, Chesapeake Utilities, announced that it would suspend service disconnections through May 1. In the past these actions were principally designed to target elderly and low income customers often with some regulatory nudges. This time we are not even sure the company waited for regulators before acting. Even more radically, Brazilian water utility SABESP announced it was suspending billing to customers in poor neighborhoods. The rationale was that as a public utility, or a public service institution, water related hygiene was a crucial necessity in the present fight against COVID-19.

US utilities have a long-standing tradition, often dictated by regulators, not to disconnect residential service in the dead of winter for non payment. But this looks different. Electricity is a relatively small portion of a typical household’s expenses. And given its importance to modern life a bill that most customers pay if able. For a utility to pre-emptively recognize potential for widespread non payment speaks to a far broader concern.

And it is at this point we need to remind readers that the industry is regulated. In countries which permit private ownership of power generation and distribution, the bulk of industry profits derive from a return on assets dedicated to public service, not from actual kilowatt hour volumes sold. In the near term we expect kilowatt hour sales volumes will decline and regulated utilities will experience some loss of revenue and profits. The biggest losers, though, will be the unregulated power generators, gas producers and gas and electric retailers. Those already beleaguered businesses will take the hit, so to speak. They only generate revenues (and hopefully profits) based on the actual volumes of electricity or gas sold, not on the total amount of investment deployed to produce a highly desired commodity.

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Regulated utilities are in a different position. They have public service obligations. We have no doubt utilities will not not suspend service. whether prompted by regulators or by voluntary action. At the end of the day regulated utilities get fully compensated for their “generosity” with respect to customers via their state public service commissions.

The real question is whether the regulators socialize these revenue losses among all classes of customers and investors alike. When the going gets tough, the providers of capital are often asked to take a “haircut” on their expected return. Apart from scope and scale, this issue isn’t new for utilities or regulators. Under utility accounting conventions, unpaid bills simply become deferred assets where they will eventually be recovered through rates paid by all electricity users, typically over a few years.

In brief, it is good to be a regulated utility in perilous economic times. The vitality of the business itself is of critical importance to public welfare. And no matter how severe an economic disturbance, almost everyone derives benefit from well functioning electric companies. As a result, the ability of regulators to impose severe financial hardship—perhaps in the name of shared sacrifice—is limited. In fact the few times in recent memory we actually do see utility bankruptcies is when a liability is so large that it cannot be allocated for recovery according to existing regulatory principles.

Looking to the future, we expect that if the present steep sales decline is short-lived, regulators will tell the utilities to absorb the the loss like everyone. else If the pandemic’s economic consequences prove longer-lived, regulators might reluctantly permit price increases to elevate earnings to previously allowed levels. But here’s the problem. Fuel and labor, both key inputs, must be paid on a timely basis or the utility rapidly ceases to function. Conceivable the providers of capital can wait. Or take less than they expected.

Furthermore, regulators can take an elastic view of proper compensation to capital. The appropriate return on utility shareholders equity is a social as much as economic construct. It is a “spread” concept. The goal is to compensate equity investors for the business risk they assume in a specific utility. Typically this calculation can be understood as a spread over the risk free rate of return. The latter is typically understood as the yield on ten year US treasury bonds. Currently authorized returns on equity are say 9%, minus the risk free rate of 0.8%, equates to a spread of 8.2% or 820 basis points. This is rather wide from a historical perspective. As a result it represents from a regulatory perspective a sort of low hanging fruit. If cost savings are needed to keep rate levels manageable in a difficult period, cutting shareholder returns generates very little voter hostility as we enter an election season.

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In the end, regulated utilities will step up their public service role and forego revenues from customers willing, but for myriad reasons, unable to pay. If we’re all lucky, utility investors will eventually be made whole albeit perhaps on a delayed basis. Unregulated companies whose finances are driven by volumetric demand will suffer.

As in nature, tectonic moves like those recently seen in the equity and credit markets expose rifts. Right now, investors are being paid quite handsomely to invest in electric utility equity versus the return on supposedly risk free bonds. If regulators suddenly need to cut the fat so to speak this is likely to be the first place they’ll look. If so this may also on a worst case basis cause some companies to revise their dividend policies downward. Paradoxically this seemingly negative move, widespread dividend reductions—the absolute worst for an income investor—could signal the onset of a new bull market for utility equities.

With the addition of transportation and new residential/commercial uses, electricity suppliers are poised for enormous growth in demand longer term. We are not accustomed to thinking about utilities as growth businesses. But if the growth we anticipate materializes, the value to investors is likely to be via stock appreciation as opposed to current income. This will be disappointing to income investors but this is the change we believe is coming. Like other things, no one is ever ready.

By Leonard Hyman and William Tilles for Oilprice.com

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