Utilities Offer Robust Growth, High Yields, Low Betas and Compelling Risk-Adjusted Returns; Rate Base Growth Accelerates on Surge in Planned Capex and Tax Reform

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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September 21, 2018

Utilities Offer Robust Growth, High Yields, Low Betas and Compelling Risk-Adjusted Returns;

Rate Base Growth Accelerates on Surge in Planned Capex and Tax Reform

In this research report, we present our updated forecast of rate base growth for each of the publicly traded utilities, and roll forward our forecasts to include 2022. We expect the regulated utility sector to realize 7.5% average annual growth in electric plant rate base over the next five years (2017-2022), up from 6.5% p.a. over the last five years and consistent with ~5.0% to 5.5% annual growth in earnings per share (Exhibits 2 & 3). Given the sector’s 3.5% dividend yield, regulated utilities offer the prospect of ~8.5 to 9.0% average annual returns, competitive with prospective returns on the S&P 500. Given the sector’s three-year beta of 0.25x (Exhibit 5), adding regulated utility stocks to equity portfolios can reduce volatility without sacrificing expected returns. The primary risk faced by utility investors is that of further rises in long-term interest rates, eroding the relative PE of the sector.

Within the sector, the prices of ETR, FE and PCG fail to capitalize fully their attractive five-year growth rates, while ALE, IDA and POR appear over-valued given their more limited prospects for rate base growth (Exhibit 7). More broadly, we favor those utilities whose existing rate base and future rate base growth are weighted toward transmission and distribution assets (Exhibit 12). We estimate the growth in transmission and distribution rate base at 10.8% and 8.7% respectively over the next five years, vs. only 5.8% for generation. Given the age of the U.S. generation fleet, however, we see the composition of utility capex changing over time; we estimate that a fifth of the generation capacity operating in the U.S. today could be retired by 2030, over a third by 2035, and over half by 2040 (Exhibits 15 through 17). We therefore expect generation capex to gain momentum; by the mid-2020s, generation rate base could be growing much more rapidly, benefiting the vertically integrated utilities.

  • We are reiterating our recommendation to overweight the regulated electric utility sector in light of our updated and extended forecasts of electric plant rate base growth. Regulated utilities combine (i) prospective returns competitive with our expectations for the broader equity market with (ii) a very low beta and a track record of significant outperformance during major market downturns.
  • We forecast ~7.5% compound annual growth over 2017-2022 in the industry’s aggregate electric plant rate base, including construction work in progress (CWIP), up from 6.5% p.a. over the last five years (2012-2017) (Exhibits 2 and 3). Taking into account non-plant rate base, and allowing for historical rates of equity issuance during prior periods of comparable rate base growth, we expect 7.5% annual growth in rate base to drive ~5.0% to 5.5% growth in earnings per share.
    • Our revised growth forecast represents an increase of 90 basis points relative to our pre-tax reform estimate of October 2017 and an increase of 30 basis points p.a. relative to our post-tax reform forecast of January 2018. The increase over the last year is thus driven by a surge in utilities’ planned capex as well as by the beneficial impact of tax reform.
  • Given the 3.5% dividend yield of the sector, we see regulated electric utilities offering the potential for ~8.5% to 9.0% compound annual returns, absent a significant change in sector PE. We believe these returns compare favorably with long run expected returns for the S&P 500. The forward earnings yield of the S&P 500, based on 2019 consensus eps, is currently 6.1%. Inflation expectations are ~2.1%, based on the difference between the yield on 10-year U.S. Treasury notes and 10-year TIPS, suggesting that investors expect long run nominal returns of ~8.2% on U.S. equities.
  • While regulated electric utilities appear poised to offer returns competitive with the S&P 500, the three-year beta of the sector is only 0.25 (Exhibit 5). Adding regulated utility stocks to a diversified equity portfolio can thus reduce portfolio volatility without sacrificing returns.
  • The relative PE of the regulated utility sector would very likely fall were long term interest rates to continue to rise. Given the current macroeconomic context of strong economic growth, low unemployment, rising inflation, a significant increase in this year’s federal budget deficit, and the Federal Reserve’s intention to continue to raise the Fed Funds rate while reducing its holding of Treasury bonds, we see this as the primary risk facing investors in the sector.
  • To assist investors in identifying attractively valued stocks that are well positioned for earnings growth, we have screened for regulated utilities whose valuations are at odds with their prospects for medium term rate base growth (Exhibit 7). (Our preferences among the regulated utilities, set out in Exhibit 1, reflect this assessment, but are based on a broader set of quantitative and qualitative factors.)
  • Exhibit 7 presents our rate base growth forecasts for each of the U.S. regulated utilities. We have highlighted in green three utilities, ETR, FE and PCG, whose 2020 PE multiples appear attractive relative to our forecasts of these companies’ rate base growth over 2019-2022.
  • By contrast, ALE, IDA, and POR trade at valuation premiums that contrast unfavorably with their low prospective rate base growth.
  • More broadly, utilities whose current rate base and future rate base growth are weighted toward transmission and distribution assets should grow more rapidly over the next few yearsUtilities’ announced capex plans through 2022 point to far more rapid growth in transmission and distribution rate base (estimated at 10.8% and 8.7% p.a. respectively over 2017-2022) than in generation (estimated at 5.8% p.a.) (Exhibits 9 and 12).
  • While generation rate base has grown rapidly over the last 15 years, the drivers of this growth – the need to augment the reserve margin of the bulk power system in the early years of this century, followed by a decade of environmental upgrades to the coal fired fleet – are now behind us.
  • By contrast, capex on the grid will benefit from the continued rollout of smart meters and other smart grid technologies to collect data from and exercise control over the distribution system; investments to enhance grid reliability in response to a declining tolerance for outages, including storm hardening power networks in coastal states; and preparations to integrate renewable generation, electric energy storage and a rising number of electric vehicles.
  • Over the long term, however, we could see a shift in the current pattern of capex and thus rate base growth, driven by rapidly rising retirements of existing generation capacity over 2025-2040.
  • Capital expenditures on transmission and distribution currently dominate the investment plans of the publicly traded regulated utilities, dwarfing utilities’ planned investment in generation (Exhibit 13).
  • However, as set out in our research report of April 19, The Next Wave of Rate Base Growth – Half of U.S. Generating Capacity Will Retire by 2040: Who Wins and Who Loses?the aging U.S. generation fleet will require the replacement of a large portion of existing generation capacity over the years 2025-2040. We calculate that a fifth of U.S. generation capacity in operation today is likely to be retired by 2030, over a third by 2035, and over half by 2040, adding materially to rate base growth (Exhibits 15 17).
  • The scale of generation capex required from mid 2020s through the 2030s will be reflected in a recovery in rate base growth among vertically integrated utilities relative to the transmission and distribution companies, rendering the former more compelling investments than they are today.

Exhibit 1: Our Preferences Among Utilities, IPPs and Clean Technology Companies

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Source: FERC Form 1, company reports, SNL, SSR analysis

Rate Base Growth Has Accelerated, Reflecting Higher Capex Budgets and Tax Reform

Based upon an analysis of U.S. regulated utilities’ capex plans, depreciation rates and prospective deferred tax liabilities, we forecast ~7.5% compound annual growth in the industry’s aggregate electric plant rate base over 2017-2022 (Exhibit 2). This forecast rate of growth is well in excess of the 6.5% compound annual growth in aggregate electric rate base realized by the U.S. regulated utilities over the last five and ten years (see Exhibit 3).

Exhibit 2: Historical & Estimated Growth of the Aggregate Electric Plant Rate Base of

U.S. Investor Owned Utilities, Including Construction Work in Progress (2007-2022E) (1)

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1. Growth estimates for 2018-2022 reflect the announced capital expenditure plans of those publicly traded utilities that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to ~80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

Exhibit 3: Historical and Forecast Growth of the Aggregate

Electric Rate Base Plus CWIP of U.S. Investor Owned Utilities (1)

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1. Includes electric plant rate base plus construction work in progress. Our 2017-2022 growth estimates reflect the announced capital expenditure plans of those publicly traded utilities that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to ~80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

Our forecast of 7.5% annual growth in electric rate base over 2017-2022 materially exceeds the 6.6% growth that we forecasted for 2016-21 based on utilities’ capex guidance at Q3 2017. In large part, this reflects continued rapid growth in electric utilities’ capex plans. The aggregate capex on electric plant planned by the publicly traded utilities for the five years 2018-2022 exceed by 6.7% the capital expenditures planned by these companies for the five years 2017-2021, which in turn exceeded by 7.2% the capital expenditures planned by these companies for 2016-2020 (Exhibit 4.)

Exhibit 4: Growth in the Aggregate Electric Capex Planned

by the U.S. Publicly Traded Utilities for the Following Five Years1

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1. Based upon the disclosed capex plans of the U.S. publicly traded utilities as of Q3 2016, Q3 2017 and Q3 2018.

Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

For any given rate of growth in rate base to be maintained over time, the capital expenditures that drive it must increase at a similar rate. Continued robust growth in regulated utilities’ planned capital expenditures is therefore necessary if rate base is to continue to grow at the 6.5% compound annual rate realized over the last ten years. A slowdown in utilities’ aggregate capex may be a legitimate concern for investors in the long run, a: over the last three decades, the average rate of capital expenditures realized by the U.S. investor owned utilities has been consistent with long term growth in electric rate base of just ~5% p.a. (see our research report of October 2, 2017, If This Is the Golden Age of Electric Utilities, What’s Next? Or, How Fast Can Rate Base Grow in the Long Term and on What Will Utilities Spend?). However, the robust growth in the capex plans of the publicly traded utilities in recent years (up 7.2% in 2017 and 6.7% in 2018) suggest that this is not an immediate concern. We will continue to aggregate and monitor the planned capital expenditures of the publicly traded utilities as an early indicator of a potential deceleration in the rate base growth of the sector.

A second factor behind the increase in our forecast rate base growth for 2017-2022 (7.5% p.a.) compared to our forecast for 2016-2021 (6.6% p.a.) is the passage of the Tax Cuts and Jobs Act of 2017 (the Tax Act of 2017). By curtailing the tax deductions enjoyed by the regulated utility industry, and radically reducing the corporate tax rate, the Tax Act of 2017 materially decreased utilities’ annual provision for deferred income taxes. As deferred tax liabilities are offset against property, plant and equipment in the calculation of regulated rate base, the impact of the law has been to increase the pace of rate base growth among U.S. investor owned utilities relative to what it would have been under the prior tax code.

Specifically, the Tax Act of 2017 reduced both the amount and the value of the tax deductions available to regulated utilities, reflecting:

    • The prohibition on regulated utilities making use of the bonus depreciation deduction on all capital investments placed into service after September 27, 2017, investments which, under the prior tax code, would have been eligible for bonus depreciation at a 50% rate in 2017, 40% in 2018 and 30% in 2019; and
    • The reduction in the corporate tax rate from 35% to 21% as of January 1, 2018, which will decrease by 40% the tax savings resulting from those tax deductions that remain available to utilities, including the repair deduction, which permits immediate expensing of certain transmission and distribution capex, as well as accelerated depreciation under the IRS’ Modified Accelerated Cost Recovery System (MACRS).

Thus utility capex now generate far fewer tax deductions, and far lower deferred tax liabilities, than under the prior tax code. As a result, every dollar of capital expenditure by regulated utilities now generates ~17% more rate base than previously.[1]

Regulated Electric Utilities Combine Robust Rate Base Growth with Historically Low Betas

We are reiterating our recommendation to overweight the regulated electric utility sector in light of our updated and extended forecasts of electric plant rate base growth. Regulated utilities combine (i) prospective returns competitive with our expectations for the broader equity market with (ii) a very low beta and a track record of significant outperformance during major market downturns.

Over the medium term, growth in electric base should drive commensurate growth in the regulated earnings of the electric utilities (see the Appendix to this research note). However, our forecast of 7.5% annual growth in electric plant rate base over 2017-2022 does not take into account the non-plant components of rate base (e.g., nuclear fuel or net regulatory assets on which utilities are allowed to earn a return). Based on historical rates of earnings dilution during periods of similar rate base growth, and the slower growth from non-plant components of rate base, we expect our forecast of 7.5% growth in electric plant rate base to drive 5.0%-5.5% compound annual growth in earnings per share.

Given the 3.5% dividend yield of the sector, we see regulated electric utilities offering the potential for ~8.5% to 9.0% compound annual returns, absent a significant change in sector PE. We believe these returns compare favorably with long run expected returns for the S&P 500. The forward earnings yield of the S&P 500, based on 2019 consensus eps, is currently 6.1%. Inflation expectations are ~2.1%, based on the difference between the yield on 10-year U.S. Treasury notes and 10-year TIPS, suggesting that investors expect long run nominal returns of ~8.2% on U.S. equities.

While regulated electric utilities appear poised to offer returns competitive with the S&P 500, the three-year beta of the sector is only 0.25[2] (Exhibit 5). Adding regulated utility stocks to a diversified equity portfolio can thus reduce portfolio volatility without sacrificing returns.

Exhibit 5: Beta of the Philadelphia Utility Index Relative to the S&P 500 (1)

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1. The Philadelphia Utility Index comprises primarily regulated electric and regulated electric and gas utilities. The component stocks of the index are AEE, AEP, AES, AWK, CNP, D, DTE, DUK, ED, EE, EIX, ES, ETR, EXC, FE, NEE, PCG, PEG, SO and XEL.

Source: Bloomberg and SSR analysis

Finally, we note that, across all the major market downturns since 1994, regulated utilities have materially outperformed both the S&P 500 as well as other traditionally defensive sectors (consumer staples, health care, telecoms, REITs and MLPs) (Exhibit 4). In our research report of April 6, 2017, Utilities and Other Defensive Sectors During the Trump Era: Which Perform Best – Particularly Against Tweets?, we analyzed the relative performance of the principal defensive sectors during all market downturns over 1994-2017 where the decline from peak to trough was larger than 8.25%, equivalent to two standard deviations of the 30 day returns for the S&P 500 since 1994. On average over these market downturns, utilities outperformed both the S&P 500, by an average of 860 basis points, and the other defensive sectors, by a range of 150 to 640 basis points. As can be seen in Exhibit 4, utilities were particularly effective defensive investments during downturns triggered by global events and financial crises.

Exhibit 6: Average Outperformance vs. the S&P 500 of Indices of the Principal Defensive Sectors (1) During the Largest Market Downturns, 1994-2017

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1. NASDAQ PHLX Utility Index (UTY); Dow Jones U.S. Telecommunications Index (DJUSTL); Dow Jones U.S. Heath Care Index (DJUSHC); Dow Jones U.S. Consumer Goods Index (DJUSNC); Dow Jones Equity All REIT Index (REI); Alerian MLP (AMLP)

Source: Dow Jones, Bloomberg and SSR analysis

Which Utility Stocks Fail to Capitalize Correctly Their Long-Term Growth Prospects?

In choosing among regulated utility stocks, we favor utilities whose forward PE multiples are at or below the industry average, but whose rate base growth over the next five years is expected to significantly exceed the industry’s, creating the potential for long-term earnings growth that is materially more rapid than their peers. In the screen below, therefore, we highlight the currently prevailing mismatches between regulated utility valuations and expected rate base growth. (Our preferences among regulated utilities, set out in Exhibit 1, reflect this assessment, but are based on a broader set of quantitative and qualitative factors.)

In Exhibit 7, we rank the regulated electric utilities into quintiles based upon (i) their forward PE ratios (price to consensus 2020 earnings), and (ii) the rate of growth in their regulated electric rate base. With respect to both of these criteria, a first quintile ranking is the most favorable and a fifth quintile ranking the least favorable. The table also presents the contribution of regulated electric earnings to each utility’s EBITDA.

Exhibit 7: Forecast Growth in Electric Plant Rate Base, Plus CWIP,

for the Primarily Regulated Utilities

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1. With the bankruptcy of FirstEnergy Solutions and planned liquidation of its assets, FE’s principal operating subsidiaries are now all regulated utilities.

Source: FERC Form 1, SEC Form 10-Q, SNL and SSR analysis

We have highlighted in green three utilities whose 2020 PE multiples rank in the two cheapest quintiles among their regulated peers, but whose estimated rate base growth over the next several years ranks in the top two quintiles. These are FirstEnergy (FE), Entergy (ETR) and PG&E (PCG):

  • FE: With the bankruptcy and planned liquidation of FE’s competitive generation subsidiary, FirstEnergy Solutions, FE’s principal operating subsidiaries are now all regulated utilities. Some 90% of their combined rate base, moreover, comprises transmission and distribution assets, which historically have experienced much lower construction, operation and regulatory risk than generation assets. Yet FE continues to trade at a 10% discount to its regulated utility peers. We find this valuation particularly attractive in light of FE’s expected rate base growth over 2019-2022, which, based upon management’s disclosed capital expenditure plans, we estimate at 7.7% p.a., some 100 basis points above the industry average of 6.7%. Our assessment of the age of FE regulated assets, moreover, suggests that the company’s planned capital expenditures are equivalent to only some 80% of the estimated replacement cost of its pre-1988 assets (i.e., those assets that have been in service 30 years or longer).[3] In light of this apparent under-investment, and the fact that growth in transmission and distribution rate base is poised across the industry to exceed that of generation, we expect FE’s rate base growth to continue at a pace well in excess of the industry average over 2022-2026 (~6.5% p.a. as against an industry average of 5.2%).
  • ETR: ETR trades at an 11% discount to the regulated utilities’ average 2020 PE, despite prospective rate base growth well above the industry average: based on management’s announced capex plans, we estimate ETR’s rate base growth over 2019-2022 at 7.7% p.a., some 100 basis points above the regulated utility average. We see ETR’s 2020 PE discount relative to the regulated utilities gradually closing as the company retires it merchant nuclear fleet and evolves to a fully regulated utility. Our view reflects management’s decision to retire its merchant nuclear plants by 2022, the fully funded status of the nuclear decommissioning trusts for these plants (which hold $4.0 billion of assets against $3.2 billion in estimated decommissioning liabilities), and management’s plan to sell most of these retired units to companies specializing in decommissioning. Following its exit from merchant generation, ETR will comprise a group of vertically integrated, fully regulated utilities that benefit from strong growth in industrial demand, driven by the expansion of the petrochemical industry around the Gulf of Mexico.
  • PCG: PCG, a fully regulated electric and gas utility, currently trades at a 34% discount to the regulated utility average; however, when we adjust the stock’s valuation to reflect our estimate of the cost to settle the third-party liability claims pending against the company in connection with the 2017 northern California wildfires, we calculate this discount to be closer to 10%.[4] In contrast to this discount, our estimate of PG&E’s rate base growth over 2019-2022 is 7.9% p.a., some 120 basis points in excess of the regulated utility average. Moreover, PG&E’s regulated electric business is exclusively focused on transmission and distribution, where we expect rate base growth to continue to exceed the industry average. This will be particularly true in California, which has taken the lead in the deployment of electric vehicles, distributed solar generation, and electric energy storage, implying a need for sustained capital investment in the distribution grid to integrate the capabilities of these new technologies while mitigating their disruptive impact.

We also highlight in Exhibit 7 three utility stocks whose prices appear not to capitalize properly their very poor prospects for rate base growth: ALLETE (ALE), IDACORP (IDA) and Portland General Electric (POR). ALE’s 2020 PE multiple is 13% higher than the average for the regulated utility industry, yet we estimate that its rate base growth from 2019 through 2022 will average only 2.4 p.a., lagging the industry average by 430 basis points p.a. IDA’s 2019 PE multiple is even higher, some 28% above the industry average, but its estimated rate base growth from 2019 through 2022 is expected to lag the industry average by 300 basis points p.a. Finally, POR’s 2020 PE multiple is 7% above the industry average, yet from 2019 through 2022 we estimate that rate base will grow by only 2.5% p.a., lagging the industry average by 420 basis points p.a. We recognize that these three small cap utilities are perceived to be a potential acquisition targets in a consolidating industry. However, if no offer is forthcoming, the underlying growth prospects of these utilities may be insufficient to sustain their current valuations.

Through 2022, Growth in Transmission and Distribution Rate Base Will Remain Strong, While Generation Capex Will Remain Too Low to Drive Robust Growth

Through 2022, we favor utilities whose current rate base and future rate base growth are weighted toward transmission and distribution assets. Utilities’ announced capex plans point toward far more rapid growth in transmission and distribution rate base (estimated at 10.8% and 8.7% p.a. respectively over 2017-2022) than in generation (estimated at 5.8% p.a.) (Exhibit 9).

  • Since 2002, the year by which state deregulation of utility generation was broadly complete, the aggregate generation rate base of U.S. investor owned utilities has expanded at a compound annual rate of 7.1%, far exceeding nominal GDP growth of 3.9% over the period (Exhibit 8). Critically, however, the drivers of this growth – the need to augment the reserve margin of the bulk power system in the early years of this century, followed by a decade of environmental upgrades to the coal fired fleet – are now behind us. Generation capex over the next five years appears to be driven primarily by growth in utility-owned renewables, combined with a handful of new gas-fired power plants in the few regions with demand growth and accelerated retirements of older generation.
  • By contrast, over 2002-2017 distribution rate base grew at only 4.4% p.a., lagging the 6.8% CAGR in aggregate electric rate base (Exhibit 8) and leaving distribution rate base at its lowest share of aggregate rate base in 15 years (see Exhibit 11). Over the next five years, however, distribution capex benefits from the continued rollout of smart meters and other smart grid technologies designed to collect data from and exercise control over the distribution system; investments to enhance grid reliability in response to a declining tolerance for distribution system outages, including storm hardening distribution systems in coastal states; and replacement of aging distribution plant. Looking out further, the integration of distributed solar generation and electric energy storage and the strengthening of distribution circuits to permit the charging of a rising number of electric vehicles will support continued growth. (See Electric Vehicles and the Grid: The Impact of EVs on Power Demand, Peak Load and Electric Energy Storage — and the Impact of the Grid on EVs, May 1, 2017.)
  • Transmission rate base has grown most rapidly of all over the last 15 years, expanding at a compound annual rate of 9.3% (Exhibit 8). As a result, transmission rate base now constitutes a larger proportion of aggregate rate base than it has at any point since the deregulation of generation was substantially completed in 2002 (Exhibit 11). Over the next five years, transmission capex is driven by the completion of a number of large transmission projects, investments to eliminate bottlenecks on the grid, and the ongoing need to replace obsolete assets and increase grid reliability. Looking further ahead, slow demand growth and a trend towards siting of new renewables closer to load (e.g. distributed generation, solar and off-shore wind) could result in a slowdown in transmission capex growth.

Exhibit 8: Historical 15-Year CAGR in Exhibit 9: Forecast 5-Year CAGR in Electric

Electric Plant Rate Base Plus CWIP (2002-2017) Plant Rate Base Plus CWIP (2017-2002)

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Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

Exhibit 10: Rate Base of the Publicly Traded Exhibit 11: Breakdown of the Rate Base of the

Utilities by Asset Class (2002 = 100) (1) Publicly Traded Utilities by Asset Class (1)

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1. Historical based on the FERC Form 1 filings of each company’s operating utility subsidiaries; forecast based on managements’ disclosed capital expenditure plans by segment and SSR’s estimates of accumulated depreciation and deferred tax liabilities.

Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

We provide in Exhibit 12 a breakdown of the forecast growth in electric plant rate base of the publicly traded electric utilities into its generation, transmission and distribution components. At ED, ES, and PCG growth in transmission and distribution rate base accounts for 100% of forecast rate base growth over 2017-2022. At four other utilities, EIX, EVRG, FE and AEP, the contribution of transmission and distribution to total rate base growth is estimated to exceed 90% over the same period. At the other extreme, growth in generation rate base is expected to make up more than 40% of total rate base growth at LNT, ETR, DTE, EE, HE and SO.

Exhibit 12: Breakdown of 2017-2022 Growth in Electric Rate Base by Class of Asset

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Source: FERC Form 1, SEC Form 10-Q, SNL, SSR analysis

What May Change Utility Capex in the Longer Term?

We may be witnessing the beginnings, however, of a change in the composition of planned capex. Capital expenditures on transmission and distribution dominate the investment plans of the publicly traded regulated utilities, currently comprising 73% of utilities’ planned capital expenditures over the next five years and dwarfing planned investments in generation (Exhibit 13). However, planned transmission capex grew by only 2.0% in 2018 from 2017, while planned capital expenditures on generation rose by 8.1% (Exhibit 14). If it continues, this shift of utilities’ capital expenditure from transmission to generation will accelerate the growth in generation rate base while slowing that of transmission rate base.

Exhibit 13: Breakdown by Segment of Exhibit 14: Growth in Utilities’ Planned Capex

Utilities’ Planned Capex, 2017-2022 for the Following Five Years1

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1. Based upon the disclosed capex plans of the U.S. publicly traded utilities as of Q3 2016, Q3 2017 and Q3 2018.

Source: FERC Form 1, SNL, SSR analysis

While we do not expect a rapid change, this shift in the composition of utility capex away from transmission and toward generation could gain momentum in the mid-2020s. As set out in our research report of April 19, The Next Wave of Rate Base Growth – Half of U.S. Generating Capacity Will Retire by 2040: Who Wins and Who Loses?, the aging U.S. generation fleet will require the replacement of a large portion of existing generation capacity over the years 2025-2040. Reflecting the need to replace nuclear and coal fired power plants built in 1970s and, more importantly, the pending retirement of the ~250 GW of gas fired generation capacity added over the years 1998-2005, a fifth of the generation capacity operating in the U.S. today could be retired by 2030, over a third by 2035, and over half by 2040 (Exhibits 15 and 16). The scale of generation capex required from mid 2020s through the 2030s will likely be reflected in a recovery in rate base growth among vertically integrated utilities relative to the transmission and distribution companies, rendering the former much more compelling investments than they are today (Exhibit 17).

Exhibit 15: Generating Capacity Retirements Exhibit 16: Cumulative Generating Capacity

by Period (% of Total 2016 Capacity) Retirements (% of Total 2016 Capacity)

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Source: Energy Information Administration, S&P Global, SSR research and analysis

Exhibit 17: Aggregate Estimated Cost to U.S. Regulated Electric Utilities to Replace Retiring Generation Capacity, 2018-2040

In Billions of Constant 2018 $ As % of Estimated 2017 Electric Plant Rate Base

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Source: Energy Information Administration, S&P Global, SSR research and analysis

Appendix 1: Growth in Rate Base vs. Growth in Regulated Utility Earnings

Growth in rate base is one of the fundamental drivers of long-term earnings growth among regulated electric utilities.[5] As set out in Exhibit 18, a regression analysis of the five-year CAGR in electric rate base against the five-year CAGR of electric operating income of U.S. investor owned utilities results in an r-squared of 0.31, suggesting that rate base growth explains approximately a third of the growth in operating income among electric utilities. Other key drivers of long-term earnings growth include the frequency with which individual utilities file rate cases to adjust their regulated revenues to the reflect the rise in rate base; changes in the allowed return on equity used by regulators to set utilities’ allowed revenues in these rate cases; and utilities’ success or failure in realizing that allowed return through the control of operating and financial expenses. Looking ahead, we expect rate base growth will be an even more important driver of earnings growth as the decline of allowed ROEs levels off and the frequency of rate case filings continues at its current high level.

Exhibit 18: The Relationship of Rate Base Growth to Operating Income Growth at Investor Owned Electric Utilities in the United States, 1993-2013

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Source: FERC Form 1, SNL, SSR analysis

In choosing among regulated utilities, investors particularly value management forecasts of rate base growth not only because of the visibility they provide into the long-term growth of earnings but also because the other earnings drivers listed above are so much more difficult to predict. At the annual financial conference of the Edison Electric Institute, rate base forecasts feature prominently in management presentations and discussions with investors.

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. Prior to the passage of the 2017 tax reform, a regulated utility placing an asset into service in 2018 could expense 40% of it immediately and apply accelerated depreciation to the remainder. Given the 35% corporate tax rate then prevailing, a tax deduction equivalent to 40% of the value of the asset placed in service resulted in a deferred tax liability equivalent to 14% of the value of the asset (14% = 40% x 35%). Taking into account the accelerated depreciation (MACRS) permitted on the 60% of the asset’s value that was not immediately expensed, the total deferred tax liability booked by the utility was equivalent to ~16% of the value of the asset. As deferred taxes are offset against net property, plant and equipment in the calculation of rate base, under the prior tax code only ~84% of the value of the asset would have added to rate base. By contrast, with bonus depreciation no longer available to regulated utilities under the Tax Act of 2017, the deferred tax liability arising when a new asset is placed in service is dramatically reduced. The new tax code continues to permit the use of MACRS, but combined with the new lower tax rate of 21%, this gives rise to a deferred tax liability equivalent to only 2% of the value of the asset. As a result, in utilities can now include in rate based 98% of the book value of new property, plant and equipment placed in service, up from 84% previously. For a more detailed explanation of the implications of the Tax Cut and Jobs Act of 2017, please see our research report of January 16, 2018, Final Analysis of Tax Reform Shows Substantial Boost to Utilities’ Rate Base Growth: By 2019, Rate Base Will Be 6 to 10% Higher at LNT, XEL, AGR, and PCG
  2. To estimate the beta of the publicly traded, regulated electric utilities in the United States, we have calculated the beta of the Philadelphia Utility Index (UTY), which comprises primarily regulated electric and regulated electric and gas utilities. The component stocks of the index are: AEE, AEP, AES, AWK, CNP, D, DTE, DUK, ED, EE, EIX, ES, ETR, EXC, FE, NEE, PCG, PEG, SO and XEL. 
  3. See our analysis of October 25, 2017, Antiquated Power Grids: What Can Age of Plant Tell Us About Future Rate Base Growth?
  4. See our research reports of June 12 and August 29, 2018, PCG and EIX Remain Compelling Investments Given the Legal and Financial Implications of the Cal Fire Reports and California’s Senate Bill 901 Could Materially Reduce Shareholder Exposure to Wildfire Risk, but 2017 Exposure for PCG is All About the Cap. PG&E’s current valuation discount reflects the uncertainty attending the company’s exposure to third party liability suits arising not only from the 2017 northern California wildfires but also future wildfires of similar scale. Were PG&E to settle the claims against it for the 2017 wildfires at an average of 65 cents on the dollar (as San Diego Gas & Electric did with respect to the claims arising from the 2007 Guejito, Rice and Witch Creek fires), we estimate that PG&E’s current share price values the company at ~10% discount to the PE multiple of the regulated utilities as a group. We expect this discount to diminish as PG&E settles over time the claims arising from 2017 fires and to be permanently reduced if Gov. Brown signs Senate Bill 901, passed by the California legislature on August 31. Senate Bill 901 would not do away with inverse condemnation or the principle of tort liability, under which California’s utilities may be held responsible for damages caused to third parties by their assets or operations. However, with respect to wildfires occurring in 2019 or later, the bill instructs the California Public Utilities Commission (i) to make a balanced assessment of a utility’s responsibility for the wildfire and the damage it causes, and (ii) to allocate wildfire-related expenses to utility ratepayers or shareholders in a manner that reflects the relative prudence or negligence or the utility’s actions. Senate Bill 901 would thus materially strengthen the position of California’s utilities in securing recovery from ratepayers of catastrophic wildfire-related costs, including damages paid by utilities to third parties in compensation for their losses. 
  5. Rate-regulated utilities are allowed to recover their prudently incurred cost of service in rates, including all costs to procure fuel and purchased power, operation and maintenance expense, depreciation expense, income and other taxes, and a fair return on rate base. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas) and is roughly equivalent to the net depreciated historical value of the utility’s plant, property and equipment. Rate base may be funded by common and preferred equity, long term debt and net deferred tax liabilities. On the debt portion of rate base, utilities are generally allowed to earn a return equivalent to their embedded cost of long term debt. A similar approach is to taken the recovery of the cost of preferred equity. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on deferred taxes. As a result, rate base is generally calculated as the net depreciated historical cost of a utility’s property, plant and equipment net of the utility’s deferred tax liability. Finally, on the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Given this regulatory framework, it is common for investors to estimate future utility earnings as the product of rate base, the utility’s equity ratio and its allowed ROE. 
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