Investors typically view utilities as a defensive sector, and for good reason. Monopolistic industry structures and the necessity of utility companies’ services have translated into durable earnings and dividend growth, even during recessions.
But investing in the sector isn’t as simple as it seems. State regulators have a say in how much utility companies can grow, and the regulatory backdrop is dramatically different for each state. In our view, the regulatory variability between states has widened in recent years, making it essential to understand each state’s regulatory landscape to get the most from the sector.
Raising Rates: A Partnership, or a Public Battle?
We see a high degree of variance in how states allow utility companies to raise rates. As we explained in a previous blog post, regulators must approve rate increases that ultimately determine how much money a utility can make to invest. In some states, the case for raising rates is an annual, public battle, an environment much less conducive to growing earnings.
In other states, such as Wisconsin and Michigan, utility companies have worked closely with regulators to lay out a plan to replace aging infrastructure and use more clean energy sources. These investments are lowering customer bills and making the energy grid greener, and the constructive relationship with regulators makes us less concerned about their ability to raise rates in the future.
In another example of regulatory variability, we see different responses to the COVID-19 pandemic. Some state regulators have been forward thinking, and were quick to realize that the souring economy would increase utility companies’ bad debt expenses if some customers can’t pay bills. These regulators have put mechanisms in place that allow the companies to recover those costs in the future. Utility companies operating in these states have been allowed to take those costs off the income statement and keep earnings intact.
Utilities in other states have received no guidance or clarity on the issue and have assumed there will be little to no support from state regulators.
Each State’s Regulatory Backdrop Is Also Subject to Change
Every election cycle can introduce changes in the regulatory body overseeing utilities, which investors must continually monitor. For example, in Arizona, three of the five seats of its commission overseeing utilities are up for grabs in November. The outcome of those elections could have a dramatic impact on the ability to recover expenses.
Other regulatory minutiae also varies on a state-by-state basis. For example, states differ in how they estimate future costs for a utility company, which plays a role in their ability to earn a fair return.
Each of these regulatory issues can affect a utility company’s ability to grow its earnings and dividend over time. Navigating that regulatory complexity is a crucial, but overlooked, aspect to investing in the sector.