The US utilities sector is undergoing a transformation amid a state-wide push towards a low-carbon economy and increasing pressure on big energy companies to “go green”. As the shift to clean power accelerates, we assess the investment landscape in the US utilities sector.
Lacklustre demand for power has been driven by, among other things, energy efficiency measures. Today, the adoption of LED lighting is rapidly rising, electrical appliances and equipment performance standards have improved, household thermal insulation is more efficient and conscious efforts have been made to be less wasteful of electricity. On the supply side, excess capacity is to blame.
Meanwhile, lower commodity prices and cheaper renewable energy generation and storage costs are adding to the woes of US independent power producers (IPPs) – that is, utilities operating in the unregulated power sector. These adverse effects have reverberated across a number of key US regional electricity markets. For example, demand in New England’s grid (IS-NE) has fallen by about 0.5% year-on-year for the past three years. Moreover, the challenging operating environment has resulted in a wave of bankruptcies and mergers, with companies scrambling to scale up and cut costs in a bid to survive.
Against this backdrop, conventional US independent power producers are also competing with renewable energy producers and what’s more, they are gaining ground. Last year, renewable energy accounted for 17% of total US power, up from 15% in 2016.
Figure 1: Fossil fuels are still the most common source of electricity generation in the US
Source: US Energy Information Administration as at Dec 2017
Clean-power push: solar and wind producers gain ground in the US
Solar and wind energy penetration have picked up significantly over the past decade with financial backing from the government. Investment tax credits (ITC) implemented in 2006 have been one of the most important policy decisions supporting the spread of solar panels in the US to date. Although the tax credit will be tapered from 2020, they should offer valuable support during this incubation period for the industry. Furthermore, solar and wind power have become cheaper to produce thanks to economies of scale and technological improvements.
Renewable energy policies and an increasing interest in environmental conscience among corporates have been important drivers of demand for renewable energy. Many states across the US have actively adopted renewable portfolio standards (RPS) – policies that require utilities to source a certain amount of energy they generate from renewable energy. For example, California’s RPS requires all utilities in the state to source half of their electricity sales from clean, renewable sources by 20301. Meanwhile, large-cap corporations are emerging as key consumers of renewables: about 60% of companies on the Forbes Top 100 list are setting targets to reduce greenhouse gas emissions or buy clean energy2.
There is over 89,000 megawatts (MW) of wind power installed in the US. Texas and Oklahoma have installed the most wind capacity in the US, at 22,637MW and 7,495MW respectively3. This upswing in demand for renewables represents investment of about $143bn in the US wind power sector4. Indeed, similar growth has been reported in the solar industry.
Moreover, the potential for further growth in the renewable energy market is evident: last year, almost a third of new power capacity came from the renewable sector, second only to natural gas, which accounted for 43%5.
At Hermes, we see renewable energy as a core resource in the future of US power generation, and we think capital markets will support the sector’s development in the short and long term.
Figure 2: There is over 89,000 megawatts (MW) of wind power installed in the US
Source: American Wind Energy Association (AWEA) as at January 2018
Retrenching: NRG Energy
A number of independent power producers sell electricity directly into wholesale. Over the last decade they’ve seen their profits squeezed by the low price of natural gas and the emergence of renewable energy resources – NRG Energy is one such company. Its path has been tumultuous, transforming from a sprawling giant with significant clean energy holdings to a simpler electricity generator.
Pummelled by the Enron California energy crisis, NRG Energy declared bankruptcy in 2003. It emerged from Chapter 11 bankruptcy later that year. Furthermore, long-running CEO David Crane was ousted in 2015 as shareholders did not share his vision for the company that renewables were the future. Following his departure, the company shifted its focus away from renewables and back to fossil fuel generation. Last year, its subsidiary GenOn filed for bankruptcy.
NRG Energy is targeting $3.2bn in cash proceeds from asset divestments, including NRG Yield and its pipeline of renewable assets in 2018, and is committed to reducing net leverage to a target of 3.0x. And while renewables have propelled much of the company’s recent growth, NRG Energy has taken a new direction – to transform into an integrated retail and generation business with more stable earnings.
We think that NRG Energy’s transformation plan – from independent power producer to an integrated retail and generation utility – is respectable, but it is not without risk. Aggressive cost savings and margin targets may be difficult to meet, there are execution risks and low barriers to entry and high competition in retail are often underappreciated.
Pressing for change
In 2017, Elliott Management disclosed an activist stake in NRG Energy and it gained two seats on the company’s board. Since then, Elliott Management has been an influential force in restructuring the business, pressing it to cut costs and streamline operations amid stagnant demand for electricity. And last month, the company announced a $1bn share repurchase programme, which we believe is taking value out of the company.
We believe shareholder returns will remain Elliott Management’s point of focus after NRG Energy delivers on its commitment to reduce leverage. However, this also raises the prospect of a leveraged buyout to take the company private in the future, which would be a potential risk to the downside for bondholders. We are therefore cautious of further – and potentially creditor-unfriendly – actions that NRG Energy will take in response to pressure from the activist investor. Additional moves could also have an impact on governance.
We have engaged with the company, expressing our concerns about the potential impact that climate change may have on the company’s long term investment portfolio following the implementation of the UN Paris Agreement on climate change in 2016. NRG Energy is, however, one of the most progressive companies in the US. It set its first carbon reduction target in 2014. And despite shifting its focus back to fossil fuel generation in recent years, it currently aims to further reduce its greenhouse gas emissions by 50% by 2030 and by 90% by 2050 compared to current levels. Moreover, its corporate governance sub-committee is responsible for monitoring progress against the targets.
NRG Yield: clean-energy assets
NRG Yield, a former subsidiary of NRG Energy, is the largest yieldco – companies set up by a parent company to hold and sell on power from renewable energy resources under commercial contracts – in the US by installed capacity. Yieldcos are dividend-growth oriented and benefit from tax efficiencies.
A breakdown of NRG Yield’s revenue sources shows the dominance of wind energy (38% of revenue). Meanwhile, solar energy accounts for 30% of the company’s revenues, 25% conventional energy and 7% thermal energy. Indeed, NRG Yield has an attractive growth profile compared to conventional IPPs thanks to a sustained uptick in demand for sustainable energy sources from companies and consumers. Moreover, the company boasts higher margins than traditional IPPs, at about 60-70% adjusted EBITDA and about 25% adjusted EBITDA respectively. Meanwhile, long-term sales contracts with investment grade-rated customers results in stable cash flow generation.
The company also has a high quality, diversified portfolio. In 2014, NRG Yield issued a green bond to finance the acquisition of Alta Wind Farm, the largest operating wind farm in North America. Power from this wind farm prevented the creation of about 1.5m metric tons of CO2 emissions and the use of 300 annual acre feet of water.
In February, NRG Energy announced the sale of its stake in NRG Yield to New York’s Global Infrastructure Partners (GIP). Indeed, the deal is advantageous to NRG Yield as it presents the company with a new sponsor that has invested and committed renewable energy assets worth $9bn – a potential pipeline of acquisitions available to NRG Yield. In the past, NRG Yield has turned down acquisitions of certain assets from its former parent that were not right for its portfolio and stakeholders, demonstrating strong and independent corporate governance.
A sunny outcome?
Since NRG Energy’s GenOn business filed for bankruptcy and announced restructuring plans, the company’s credit default swaps (CDS) – financial instruments that provide insurance-like protection for bondholders – have outperformed their peers. However, at current levels, we believe their valuation no longer fully reflects the risks of holding them. For this reason, we have changed our long NRG Energy five-year CDS position to a core defensive trade – and such a move demonstrates the importance of flexibility within our investment strategy.
Figure 3: Spread differential between NRG Energy and NRG Yield
Source: Bloomberg as at April 2018.
We also hold NRG Yield’s unsecured bonds due in 2026. In our security selection process, we consider the convexity profile of high yield bonds with call structures and we see these bonds as good value with better scope for capital appreciation than bonds of other maturities issued by the company.
As a pair trade, our positions in NRG Energy and NRG Yield reflect our view that the valuations of NRG Energy five-year CDS are expensive, while we have a positive fundamental view on NRG Yield. We also believe NRG Yield has the ability to capitalise on demand for low-cost, clean, renewable energy.
At Hermes, we seek the most attractive securities within capital structures worldwide. And defensive pair trades in the utilities sector provides us with an opportunity to capture the market upside while also minimising downside market risk.
This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
1 “Renewables Portfolio Standard Guideline Revisions,” published by California Energy Commission in January 2018
2 “US wind industry fourth quarter 2017 market report,” published by the American Wind Energy Association on 25 January 2018
3 “US wind industry fourth quarter 2017 market report,” published by the American Wind Energy Association on 25 January 2018
4 “US wind industry fourth quarter 2017 market report,” published by the American Wind Energy Association on 25 January 2018
5 “US wind industry fourth quarter 2017 market report,” published by the American Wind Energy Association on 25 January 2018