Utilities are undergoing a massive spending cycle to make the energy grid greener – and the projects should be applauded by more than environmentalists. We believe investors are also poised to benefit. While it may sound counterintuitive, higher capital expenditures tend to increase earnings power for utilities companies. To understand why, it helps to have a quick primer on how utilities earn money.
Higher capital expenditures are typically positive for utilities companies. That’s not always the case for many other industries, particularly in the industrial sector, where a big jump in capital expenditures can depress cash flow for considerable time. For utilities companies, however, increasing invested capital provides a direct opportunity to drive earnings power.
Utilities are allowed to earn a set rate on the amount of invested capital they employ. That rate is determined by working with state regulators. When a utility company embarks on a large capital project, they can ask regulators to increase rates, which ultimately generates more money for the company. But politics and operational efficiency play a role here: The regulators are much more likely to approve those increases if the utility is keeping services reliable, customer costs low, and scoring political victories for the agency. As we like to say, utilities have to earn their right to grow.
This is what makes clean energy investments so powerful. The declining cost of wind and solar energy means using these sources could ultimately lower customer bills. Politicians and their constituents also value making the energy grid greener. Hence, regulators are likely to view requests for rate increases favorably. The key for investors, however, will be to select well-managed utilities that have constructive relationships with their regulators.
We believe the development of renewable energy is a growth opportunity for investors that could drive earnings and dividend growth for at least the next decade.