Utilities Under Trump: How to Assess the Risks and Rewards
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Nov. 9, 2016
Utilities Under Trump: How to Assess the Risks and Rewards
The election of Donald Trump as President of the United States implies a new set of risks for investors, in response to which portfolios must be rethought and restructured. The unique business model of regulated utilities ensures that these stocks will react differently to these risks than the more competitive, economically sensitive, and internationally integrated segments of the market. To assist PMs in the reconfiguration of their portfolios, we outline here how we believe the regulated utilities will perform in response to the risks of a Trump presidency.
Portfolio Manager’s Summary
- Risk. The non-partisan Committee for a Responsible Budget, in its Fiscal Guide to the 2016 Election, estimates that over ten years Trump’s proposed tax cuts and infrastructure and entitlement spending plans would raise the federal debt from $14 trillion in 2016 to $19 trillion by 2026, increasing the ratio of federal debt to GDP from 77% in 2016 to 105% by 2026. The scale of the federal government’s funding requirements, and an increasing tendency within the GOP to challenge the independence of the Federal Reserve, suggest that a potential long term risk of a Trump presidency may be rising pressure on the central bank to monetize the fiscal deficit, leading to a meaningful acceleration in the rate of inflation.
- Should a rising federal deficit contribute to higher inflation, companies in competitive sectors would see an increase in their pricing power and hence in revenue, but regulated utilities would not. Rather, utilities could expect to see their operating and maintenance costs rise, while their rates would remain fixed until their next rate case, depressing earnings in the interim.
- Utilities with a large share of rate base in transmission assets with forward looking formula rates, such as AEP, Avangrid, Eversource and PSEG, will be partially insulated from impacts of inflation as they will be able to increase rates to reflect forecasted expense increases.
- Rising inflation would also erode the real value of utilities’ regulated rate base, which in the United States reflects the historical, depreciated cost of the utility’s plant in service, with no adjustment for inflation. The real earnings power of utilities’ rate base would therefore fall until allowed returns on equity were adjusted upward in each utility’s next rate case or cost of capital proceeding.
- Whereas companies in competitive sectors of the economy would benefit from Trump’s proposal to cut the corporate tax rate from 35% to 15%, regulated utilities will not. Under cost of service regulation, utilities are allowed to recover their income taxes in rates, but would be required by regulators to cut rates if their income taxes were to fall.
- However, the lower tax rate would reduce the impact of bonus depreciation and the drag of deferred taxes on rate base growth, accelerating earnings growth for most utilities. This could be partially offset by an increased need to issue equity among the less liquid companies.
- The lower tax rate would also cause an immediate reduction in accumulated deferred taxes, which could boost rate base and thus regulated earnings for some utilities. State and federal regulators may react, however, by requiring the utilities that so benefit to book an offsetting regulatory liability.
- Finally, a lower tax rate will hurt the economics of new renewables, as almost half of the value of their tax subsidies is the result of their accelerated depreciation rate for tax purposes (renewables are depreciated for tax purposes over a five year period).
- Risk: Trump advocates a far more aggressive stance with America’s three largest trading partners (Canada, China and Mexico), threating tariffs and quotas on these countries’ exports to protect vulnerable U.S. industries. In response, these countries might impose retaliatory trade sanctions on U.S. industry. Increased risk of a trade war contributed to a 1.5% decline in the U.S. dollar index (DXY) last night.
- With limited exceptions (see below), U.S. regulated electric utilities have no international markets or operations, rendering the sector’s earnings much less vulnerable to trade frictions.
- PPL would benefit if the dollar weakens versus the British pound because it generates a majority of its income from its British utility subsidiaries.
- Sempra, with significant investment in Mexico, could be hurt by the weakness of the Mexican peso versus the dollar, as well as by the economic consequences of a trade war.
- Allete could underperform if trade with China is disrupted or international trade in steel declines, reflecting its large power sales to taconite producers in Minnesota.
- Outside the industry, exporters and companies with international operations should benefit from the dollar’s weakness. An exception would be companies, such as the auto manufacturers, whose integrated North American supply chains could be disrupted if NAFTA were to break down. Purely domestic U.S. utilities would be generally unaffected by either development.
- Risk: The reaction of U.S. corporations to the potential unravelling of major trading frameworks such as NAFTA, and the threat of worsening relations with America’s largest trading partners, is unlikely to be a surge of confidence. Their concerns about trade may be compounded by Trump’s proposed immigration policies: the deportation of illegal immigrants en masse could raise the cost of unskilled labor, while stricter immigration controls could limit access to highly skilled immigrants. Given uncertainty regarding trade and immigration policy, corporate investment and hiring may slow, and U.S. GDP, which over the last year has expanded at a 1.5% annual rate, could decelerate further.
- The limited sensitivity of utility revenues and earnings to changes in GDP growth, and greater sensitivity of utility valuations to changes in long term interest rates, imply that the sector may outperform if, in the months following the election, policy uncertainty contributes to a slowdown in investment, hiring and GDP growth, thus weakening the case for further tightening by the Federal Reserve and limiting upward pressure on long term interest rates.
- Risk: Trump increases the risk of an international crisis with systemic impacts. Trump combines strongly held views on foreign policy with a deep ignorance of and lack of experience in international affairs. Certain of his personality traits, including an aggressive and impulsive personal style, are poorly suited to defusing international confrontations.
- International political, economic and financial crises tend to have a lesser impact on regulated utility stocks than they do on the more competitive, internationally exposed sectors of the economy. Reflecting utilities’ lack of international exposure, as well as the regulated status of their business and the critical nature of their assets, periods of rising systemic risk have thus tended to be periods of regulated utility outperformance.
- Conclusion: Domestically focused regulated utilities may offer a haven against the risks of international trade tensions, the potentially destabilizing impact of a Trump presidency in international affairs, and the risk that uncertainty over the new administration’s trade and immigration policy could slow corporate investment and hiring, creating a drag on the nation’s already sluggish economic growth.
- However, a long term risk of Trump’s aggressive tax cuts and spending plans may be to increase pressure on the central bank to monetize a rising fiscal deficit, leading to a meaningful acceleration in the rate of inflation. If so, regulated utilities are likely to fare materially worse than companies in competitive sectors of the economy, for whom inflation implies pricing power. Utilities, by contrast, will suffer regulatory lag in the recovery of any cost increases. They will also see the real value of their rate base erode, in turn reducing the real value of their regulated earnings until their allowed ROEs are re-set at levels reflecting the higher rate of inflation. Partially offsetting the negative impact of inflation will be the boost to rate base and earnings growth as a lower tax rate diminishes the offset to rate base from deferred taxes.
Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology
Source: FERC Form 1, company reports, SNL, SSR analysis
©2016, 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.