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    An Expert Weighs In On Utilities

    Editor’s Note: I recently had a chance to talk with Roger Conrad, co-founder and co-editor of Capitalist Times and editor of Conrad’s Utility Investor. Conrad is one of the pre-eminent experts in the utilities and income sectors. It’s always interesting to hear what he has to say about these sectors.

    Early: As you know from all those years when I was editing your former utility letter, though, I’m not just a rubber stamp. I have some real questions about this industry you’ve been covering since 1988.

    Let’s start with renewable energy. I trust you’ve seen the article I sent you from Greentech Media regarding utility solar energy economics versus distributed generation solar. That doesn’t look so good for the industry, does it?

    Conrad: I very much agree with the authors of the article.

    First, it’s hard for electric companies to construct large, baseload power plants right now in most of the U.S. There’s the question of permitting (securing permits to build) in an era of rising environmental regulation, but also weak wholesale electricity prices.

    In fact, most of the new construction we’re seeing is renewable energy such as wind and solar, which enjoy tax incentives/credits and mandates in three States that force utilities to buy their output. Companies building under a regulated model are increasingly challenged to recover their investment in rates, particularly with officials anxious to keep those rates low at a time of modest economic growth in the U.S.

    Second, it’s obvious that there’s a boom going on in constructing distributed generation sources, from rooftop solar to gas-powered generators. The authors of the article cite a 90 percent cut in solar panel costs as one major catalyst. I think the increased power outages we’ve seen due to storms over the past year are another big factor, particularly in the Northeast.

    I also agree that at least some of the builders and operators of rooftop solar facilities have a very nice business model now. They’ve figured out how to get people hooked under long-term contracts that really amount to an annuity. And the more they build, the fatter the cash flows will be.

    Where I disagree strongly, however, is [with] their premise that a new breed of companies will eventually rule this business, rather than the incumbent utilities who already have the customer relationships and have seen the light, so to speak, with rooftop solar.

    Probably not a lot of people have heard of New Jersey Resources (NJR). But they’ve been making a tidy profit with rooftop solar for several years. And I have no doubt the “progressive” utilities cited in the article like Duke Energy (DUK) and Sempra Energy (SRE) will wind up doing the same.

    However, the electric utility industry isn’t known so much for visionaries as for trend followers. But it’s certain that once big utilities see the profit in this business, their push into it will be irresistible. And it’s hard to see how even a larger pure play like SolarCity Corporation (SCTY) that had just $133 million in revenue last month can keep up. In fact, I think the best end game for these companies is getting acquired.

    As for whether or not utilities will keep building solar and wind plants — or buying their output from others — that really depends on government policies.

    So long as the law requires these companies to buy output of large wind and solar farms under long-term contracts, they will. And the generators will be able to lock in those long-term cash flow streams, which is really all they’re after anyway.

    Early: It also raises another question. Natural gas has been very cheap, to the point where many utilities are closing their older coal plants and switching to gas-fired generation to cut costs. Do you see this trend continuing and, if so, how will it affect utility profitability, as well as use of renewables?

    Conrad: The real fault line here appears to be natural gas at $3.60 or so per million British thermal units (mmBTUs). So long as the price is below that, gas economics definitely beat coal economics.

    What we saw this winter, however, showcased the limits of that trend. That is, gas went above $4 and companies began switching back to coal in a big way.

    I think if you’re looking for a model here, look at what Southern Company (SO) has done. The company has basically built a system that can swap between coal and gas, depending on whichever is cheaper. If we get a carbon dioxide tax at some point, the inflection point for gas versus coal obviously rises a bit, since gas emits about half the CO2 that coal does.

    As for renewable energy, it comes down to extending the government policies that favor it. Renewing wind energy tax credits seems to be an annual event. I have to admit I was a bit surprised when Washington did it this year, though some of my contacts in the industry said they had more than an inkling that would happen.

    But if those credits end, you’d see new development fall off a cliff, which it did last year in anticipation of the wind power credits expiring for good.

    Obviously, if we ever get back to $5 gas, wind is a lot more competitive, even without the credits. And I think we will get back there eventually, once producers can export.

    That’s a few years off, however, as most of the planned liquefied natural gas export facilities in North America have yet to be approved. And then they have to get built.

    We will eventually get there. But it’s going to be five years down the road, which may not be in time to maintain new construction of wind and solar. That’s why long-term contracts for generators — or even rooftop solar companies — are so important.

    Early: Maybe we should talk a bit about what distributed generation is. How do you see it affecting the adoption or rejection of alternative energy resources into the power grid?

    Conrad: Distributed generation is really I think a natural offshoot of growing electrification. Mainly, the more dependent on power we’ve become, the less we can afford its interruption for any reason. Distributed generation — or basically having a power generation system in your home or business — cuts interruption risk. I think the economics are still a work in progress for the user. But they’re certainly not for the provider who can lock in a long-term contract and realize tax incentives at the same time.

    I think that, over time, distributed generation of renewable energy could wind up replacing quite a bit of the centralized generation we now have in this country. That could really, really help utilities who use their scale and customer reach to grab the lion’s share of the business. After all, who wants to take the risks of building a huge new power plant when they can replace the generation with distributed generation and keep the revenue?

    The real question for investors is going to be how their companies are responding. And if history is any guide, some will do well while others do far less well. That’s why we have to watch the earnings results every quarter.

    – GS Early

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