They say bull markets climb a wall of worries and this year has been a great example. November was a breakout month for the S&P 500 (up 3.4%) and a breakdown month for defensive sectors like utilities (down 2.3%). The market is now up 25.3% for the year beating utilities by 680bps. This is despite a nearly 100bps decline in 10-year Treasury bond yields YTD. In retrospect, utilities moved ahead of bonds with their strong yearend 2018 move so they had less room to run once it happened. And lower bond yields and Fed easing have helped the market even more than utilities. While there is a lot to worry about in 2020, not the least of which is the election, we remain underweight utilities and wait for the current 10% premium to get closer to its historic 4% average.
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After close on 11/25, a CPUC ALJ issued a proposed decision in the Cost of Capital applications, which will set allowed returns and capital structures for each CA utility’s respective state-regulated rate base in 2020-22. The ROEs would be unchanged for EIX (10.30%) and PCG (10.25%). SRE’s SDG&E electric would get 10.20% vs 10.15% currently. EIX’s SCE would get a 52% equity ratio (vs 48%) – in line with the other two utilities. Balancing fire and inverse risk against a lower interest environment, we see the PD as in line with expectations. The ROEs would be close to the midpoint between the utilities’ requests and intervenors’ recommendations: 115-220bp increases due largely to wildfire risk vs 150-185bp decreases. And the political backlash from recent shutoffs does not appear to have significantly impacted the PD.
This morning, it was announced that Dutch energy company Eneco would be purchased by Mitsubishi (80%) and Chubu Electric Power (20%) for $4.1B Euros. This followed a sale process that kicked off almost a year ago, which garnered interest from the likes of Shell, KKR, Macquarie, and EDF as well (Total and Enel dropped out earlier). This got us thinking. Asian investors have already shown a keen interest in U.S. power plant investments, as seen by the readily available financing in CCGT new build. Why couldn’t one of these foreign power companies buy a U.S. IPP? Granted, Eneco is a bit different, in that it has a quasi-regulated gas and electric retail business, as well as growing investments in renewable energy that includes offshore wind. But clearly there is an interest here to diversify out of Asia. When we published our annual power supply update back in September, the number of Japanese and Korean utilities investing in U.S. gas plants was endless.
We’ve now been waiting 17 months for FERC to decide on new PJM capacity auction rules since determining its tariff was unjust/unreasonable. There have been a few false starts, but with Commissioner Glick’s recusal on the issue set to end on 11/29 and James Danly’s nomination as commissioner moving one step closer this week, we feel as though an actual order is finally upon us. In this note, we’re simply reviewing exposures to hypothetical scenarios. At the end of the day, it’s probably fair to say that EXC and VST have the most at stake here. However, it’s important to note that the PJM capacity auction is simply not as important as it used to be. EXC has the most capacity in PJM and addressing its subsidized (and non-subsidized) nuclear plants is critical in how this plays out. VST has the second most capacity in PJM, with about 25% of its EBITDA coming from energy/capacity revenues combined in the region.
FERC issued an order today in two MISO transmission ROE complaints, setting a methodology that differed from its last proposal, establishing a 9.88% base ROE and dismissing the last of the two complaints. That 9.88% base is lower than the 10.3% that FERC set a few years ago under a methodology that has since been vacated. FERC did not rule on the four New England ISO ROE complaints, as Comm. Glick – one of the three seated FERC commissioners (two vacancies) – cannot vote on those. But that base ROE also likely would decline under today’s order. Transmission makes up less than half of earnings for the impacted utilities (FTS and ES almost 40%, AEE 20%). To the negative, the base ROEs are now under 10%, which optically looks bad, given they were around 12% earlier this decade and are now in line with the 9.7% average awarded at the state level. But the MISO names will still earn about 10.4% – when including the 50bp RTO/ISO adder.
This week, CA Gov Newsom met with parties to PCG’s bankruptcy proceeding, as he vowed to push them to resolve the matter more urgently, given the 6/30/20 deadline to exit BK under AB 1054 and given the recent fires and power shutoffs. For similar reasons, BK Judge Montali last week ordered the parties to mediation, which PCG had requested for months. The two competing plans are from PCG, who has a deal with subrogation holders, and from the Ad Hoc Creditors and Torts (fire victims). The latter’s plan would effectively wipe out existing shareholders. Despite the push from both the Gov and from Judge Montali, we are cautious on a quick resolution. In its 10Q, PCG said it has met with individual victims over the past several months. And reps from debt- and equity-holders have met with individual wildfire claimholders, including recently, and offers may have been made. But there is no certainty a deal will be reached. And we are still in fire season, so we remain on the sidelines.
After a long headline-filled year, the S&P 500 broke out to new highs last month and caught up to utilities, both up a little over 21% through October. The market has climbed a wall of doubters, while our recent poll shows utilities continuing to gain investor support. From a contrarian standpoint, we take the market. Investors have been leaning defensive most of the year such that a typical year-end defensive trade seems unlikely. In fact, the defensive trade over the past few weeks has been to buy depressed value stocks and cyclicals. Utilities still trade at a 17% premium to the market and we would like to see them closer to the average to be more constructive.
Now that we had a few days to reflect without an imminent new fire threat, our take is that it was a severe over-reaction by everyone (including us). The fire damage is likely to be largely covered by PCG and fully covered by EIX insurance with no meaningful impact on the wildfire fund. SRE said Friday (11/1/19) they do not see the other utilities’ damages impacting the fund. The Governor has re-doubled his commitment to making sure the PCG BK gets done by the June 2020 deadline, which is helpful for the fund and for the PPA suppliers. The success in limiting damages should be viewed as a good sign of the wildfire fund durability. Conditions the last two weeks were among the worst ever in CA and the framework held up. But the political and investor reaction may take time to resolve.
Wolfe Research's Senior Utilities & Midstream Analyst Steve Fleishman hosted a webcast to discuss the Kincade fire, PCG implications, operational and political rissk, Wildfire Fund impacts, EIX value, and renewables PPAs.
The Kincade fire exploded over the weekend amidst record high winds meaningfully increasing damages. PCG’s T-line tripped around the time the fire started. If they are found to be the cause, PCG could be responsible for billions of post-petition claims that come ahead of all current claimants in the PCG BK. Equity value, which was already under pressure from rising claims, could be wiped out. The current Creditor-led BK exit plan will also likely need to be re-worked. Logistically, the targeted June 2020 BK exit deadline for PCG to participate in the wildfire fund now looks very difficult to meet. All this has implications for PCG’s PPA suppliers and the other CA utilities as well. This is the worst case event for CA we hoped would not happen and it raises a lot of questions on how the state will handle this crisis from here. We lower our PT to $3 reflecting a higher likelihood of $0 value.
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