European utilities may be on the cusp of a new phase of significant growth that could last decades due to the expected growth of electricity and renewables in the energy markets. If proved correct, this super cycle could transform some utilities from bond ‘proxies’ into growth stocks. This transformation is not yet reflected in market valuations which continue to value the sector as long-term defensive holdings with modest growth expectations. The sector today continues to trade at a discount still substantially above that of Consumer Staples.
This has also been evident in recent weeks with Utilities penalised due to the risk of rising interest rates. Traditionally, Utilities operate with high leverage and are therefore quite sensitive to any rate hikes that affect their profitability. But will this dynamic persist? We believe not. At Plenisfer, we believe there are at least three reasons for the possible reclassification of some Utilities from lower-risk bond proxies towards growth stocks:
1. Electricity and Renewables are winning the energy battle
Energy transition represents such an enormous growth opportunity with electricity expected to represent about 70% of the energy mix by 2050 v c. 20% today. Energy consultants/agencies forecasts imply a potential range of 11,000 GW to 27,000 GW of additional renewables capacity by 2050. Since the development of 1 GW of renewable energy requires investments of over 1 billion euros (source: McKinsey), investments in the sector can be estimated between 12 and 24 trillion dollars.
2. A fragmented market ready for consolidation
75% of the renewables market is spread among smaller developers, mostly independent power producers (IPPs) with portfolios of less than 1GW. On the back of tighter credit conditions, a higher cost of capital and a more complex supply chain (owing to COVID restrictions), we expect that in the sector there may be a consolidation process led by large operators who will benefit not only in terms of market shares, but above all in terms of profitability.
3. Green Climate Policies now have cross-Atlantic support
The publication of National Energy Plans to 2030s (NEPs), the disclosure of the EU Recovery Fund (c.30% is for support of Green policies), and the US Climate plan presented by new US President Joe Biden are key support for ‘net zero’ green climate policies. These appear to anticipate an ongoing acceleration of clean infrastructure investments. Rising awareness around the issues of climate change is likely to continue to drive the Decarbonisation theme. For Utilities, this represents a growth opportunity above historical level. We expect the growth drivers of Renewables development and electrification to benefit from policy tailwinds. The growth dynamic of the Decarbonisation theme should warrant higher valuations.
Source: Plenisfer and Bloomberg
Within the sector, the fastest growing Utilities names are those with the most Renewables exposure. This is already delivering higher valuations consistent with these growth levels. In our view, integrated utilities are best positioned to benefit from these trends. They combine the scale required to add value through large-scale investments in Renewables with the low cost of capital supported by their regulated businesses. In addition, such companies pose low counterparty risk for government subsidy regimes. Furthermore, we believe that the integration of customer, network, and generation -both Renewables and Thermal- creates value opportunities throughout the supply chain. Consequently, we expect Integrated utilities to disconnect from the bond proxy dynamic and re-rate to growth multiples. Regulated utilities, in contrast, will most likely remain lower risk bond proxies. We, therefore, expect the divergence between Regulated and Integrated segments to become more pronounced, as materially different investment cases for each emerge. At Plenisfer, we see this as the start of a new distinctive growth phase, with ongoing consequences for valuation. We suspect this new phase could last for a number of years.
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