From the time they were kids, today’s retirees have learned the same basics about investing in utilities: They may not grow any faster than the economy, but you can always count on them to pay hefty stock dividends and reliably cover the interest on their bonds.
Now solar power is posing a threat to that basic paradigm—not big enough to worry seniors already relying in part on utility stocks for income but serious enough that baby boomers and new retirees should keep it in the back of their mind, according to some bond analysts who cover the utility sector.
The threat to the utility status quo is distributed generation, a fancy name for solar electricity generated from thousands of small-scale projects—rooftops and backyards—rather than a handful of giant solar farms generating hundreds of megawatts (even gigawatts) of electricity, owned and operated by institutional investors and utilities.
At some point in the not-too-distant future, individuals could generate enough electricity on their own to chip away at utilities’ steady ability to churn out cash. It could even undermine their commitments to continue paying for today’s blend of coal, natural gas, nuclear power and renewables that they build on credit.
“It is not a risk that has yet emerged for the majority of the industry,” wrote Barclays bond analyst Y.C. Koh earlier this year, but he cut his rating on utility bonds as a group to underweight based on the threat. Why? “We are focusing on it now because we believe that the risk to our estimates is for quicker, not slower, disruption,” Koh said.
The grid’s lock
Far less than 1 percent of American electricity comes from solar distributed generation today, and for that reason, there’s plenty of skepticism about the pace of the disruption and whether it will be an issue in any near-retiree’s lifetime.
Companies, including SolarCity, can already build systems small enough to power a single house or a commercial building. That has made Solar City one of Silicon Valley’s most successful renewable energy start-ups, with its shares rising sixfold since its late 2012 initial public offering and its sales rising 57 percent, to $183.2 million, in the first nine months of this year.
But the grid isn’t going away. The distributed-generation solar customer still has to be connected to the utility grid, even with solar panels on the roof. Because electricity is a regulated business, in most states a policy called “net metering” requires utilities to buy the power homeowners generate but can’t use themselves. Utilities pay the full retail price for it, effectively subsidizing solar production, which is also supported by federal and state tax credits.
The other part of that deal is that the customer buys power from the utility when the home-based system isn’t generating enough power, either at night or when the weather doesn’t cooperate. Both parts of the deal force consumers to use the grid.
“Energy storage is not financially feasible. If it were, the utility industry would crumble. But it’s not.”
Consumers’ dependence on utilities won’t change until there are major advances in technology for batteries that can store the power a home-based system generates until it’s needed, said Matt Feinstein, senior analyst at Lux Research.
“Energy storage is not financially feasible,” Feinstein said. “If it were, the utility industry would crumble. But it’s not.”
Feinstein said those advances in energy storage are years away, and until that happens, the utilities will be similar to the businesses investors see today, paying out a higher dividend yield than any other sector and accounting for more than 7 percent of the value of U.S. corporate bonds, according to Barclays.
Bond rating agencies remain bullish on utilities. Moody’s raised its rating on the sector earlier this year. And according to Standard & Poor’s utility bond analyst Gabe Grosberg, “We’ve never cut a rating on a utility because of distributed generation. Its impact on the market is fairly insignificant at this point.”
The energy storage issue is the No. 1 reason why bond rating agencies have been calm about the threat from distributed generation, Grosberg said.
All of this is relatively uncontroversial, with even solar backers saying the conversion to more distributed power will be slow. But they argue the innovations will arrive sooner than the 30-year expected life of coal or gas plants financed by utilities’ bonds.
“If price parity doesn’t happen for 10 years, you’re still not halfway through the life of utility assets built today,” said Solar Energy Industry Association research director Justin Baca, pointing to a Rocky Mountain Institute study thatpredicts distributed solar will be as cheap as conventional electricity by 2030 and sooner in some parts of the country.
Utility dividend basics
(Source: Edison Electric Institute, index of 49 publicly traded US utilities)
The utility industry had the highest payout ratio (59.6 percent of earnings) of any industry in the yearlong period ended June 2014—historically, this has long been the case.
The utility industry dividend yield (3.8 percent) was the top among sectors as of Sept. 30, 2014.
Going back to 2004, a majority of utility dividend increases come in the first half of the year (the top quarter is typically Q1).
The percentage of utilities that increased dividends in 2013 (73.5 percent) was the highest percentage increase on record going back to the late 1980s.
In 2013 the utility industry paid out $20.9 billion in dividends to common shareholders (from 2003 through 2013, total payouts rose 70 percent, up from $12.3 billion).
Rating the threat
The other reason for the short-term bullishness is that utilities are really in two businesses. All the major U.S. utilities charge customers a separate charge for carrying power to their homes over utility-owned transmission systems, in addition to what the customer pays for the electricity itself. In much of the U.S., other power companies generate the actual electricity.
In states where utilities have spun off their former generation assets, investors are already getting their dividend or bond-interest payments out of just what customers pay for transporting electricity, Moody’s analyst Mihoko Manabe said. That means the companies only have to make sure they get paid enough for use of the grid to keep up with what income-oriented investors expect.
“We think the grid will be more valuable, not less” as people use electricity from different sources, Manabe said, at least until (or unless) on-site batteries let consumers cut off the utilities completely. He added, “We think utilities are in a better situation than they were before. The catalyst is a more supportive regulatory climate,” he said, referring to regulators’ willingness to give the utilities a break on net metering and other pricing details that will let them dilute the impact of distributed generation.
Investors who want to hold utility stocks or bonds should consider a few factors when deciding how long to hold on and when (or if) a move toward homegrown power threatens the big electric companies.
- The first is the most obvious: Utilities in areas with less sun are less exposed, Koh said. A utility in Washington State would be less vulnerable than a name like Southern California Edison, since Washington gets almost no power from solar and California gets more than any state but Hawaii.
- If there is a major breakthrough in battery technology, it would be widely reported and would give investors time to move to safer holdings before utilities suffered any large losses in revenues, Grosberg said.
- Data on how much electricity comes from solar is easy to find on government websites, Grosberg said. If the percentage of solar ticks up sharply from last year’s 0.2 percent, it may be time to consider selling.
If an investor wanted to play the other side of the same bet and wager that solar power will itself become a source of stable retirement income, they could bet on new investments, like bonds issued by SolarCity, backed by income streams from their long-term contracts with consumers. (The basic SolarCity agreement calls for the company to finance a solar system on a customer’s roof and sell the customer the power it produces. Any excess is sold to the local utility.)
A more niche option is making direct investments in small-scale solar projects that generate income, through companies like Mosaic, which offers individuals access to a solar project pipeline for investments as low as $25.
The SolarCity bonds, which pay up to 4 percent interest, were first issued in mid-October. Standard & Poor’s rates SolarCity bonds as investment grade, assigning earlier deals aimed at institutional investors BBB+ ratings. With new projects going up all the time, the company is selling small amounts of bonds continuously, said Tim Newell, vice president for financial products at SolarCity.
“You don’t have to wait for an offering,” Newell said. “You can buy our solar bonds 24 hours a day.”
Utility bond basics
(Source: Standard & Poor’s)
In eight of the past 10 years through 2013, there were no bond defaults in the utility sector.
Among all industries, the utility industry had the lowest average default rate in the period from 1981–2013 (0.32 percent weighted average).
Insurance was the only other industry with a default profile near utilities in the 1981–2013 period (0.49 percent weighted average).
Utilities are simultaneously confronting and seeking ways to cash in on the solar trend. They are asking regulators in several states to scale back net metering rules and take other steps to protect their financial positions, said Richard McMahon, vice president for energy supply and finance at the Edison Electric Institute, a lobbying group for utilities. The possible solutions take different forms, but what they have in common is a gradual shift away from charging customers for the amount of electricity utilities transport for them and a move toward paying a flat fee for the use of the grid, with supplemental charges based on usage.
Utilities are also trying to get into the distributed-power business. Many are working with smaller companies to foster the spread of systems like SolarCity’s in exchange for deals that continue to have end users sell their excess power to the grid and buy power at night and in bad weather (times when solar, an intermittent source of energy, will not be effective), said Mark Stutz, spokesman at Xcel Energy in Denver. Xcel is also running pilot programs to help communities start up medium-sized “solar gardens” to spread solar usage with the customers still connected to the grid, he said.
“The utilities do realize … a competitive threat to a certain extent,” Standard & Poor’s Grosberg said. “If they stood pat, it would become one.”