Utility Dividends Pressured by New Carbon Rules

The Environmental Protection Agency’s proposed rules on the reduction of carbon emissions could be a major step toward addressing climate change. They could also help reduce the longstanding attractiveness of power companies as dividend investments.

One way for power generators to comply with the proposed new rules is to switch from coal to natural gas, which results in less carbon pollution per unit of electricity produced. That switch has already begun because of market factors: Gas simply costs less than coal in the current market. (The Edison Electric Institute, or EEI, an industry trade group, says that coal accounted for 37.4% of fuel used by power companies to generate electricity in 2012. Natural gas was second at 30.3% of fuel used.)

Yet even though the industry would be given years to fully comply with the proposed EPA rules and might even reduce its fuel costs by complying, power companies would likely see major increases in capital expenditures to implement the changes. And that could squeeze company dividends.

ONETIME DIVIDEND CHOICE

Electric utilities used to be considered ideal investments for the proverbial “widows and orphans.” Regulated power companies were thought to be “natural monopolies” because it was prohibitively expensive to duplicate their local transmission facilities.

That natural monopoly status, however, began to crumble years ago. Back in 1996, the Federal Energy Regulatory Commission began to allow competitive power producers to sell to customers over the utilities’ lines. And 43 states now allow “reverse metering” -- which requires utilities to buy power from homeowners who can generate it from rooftop solar panels.

Credit ratings provide one indication of the reduced status of power companies. In 1970, virtually all investor-owned electric companies had a bond rating of A- or better. By 2011, only 26% did.

Advisors know that companies don’t need pristine balance sheets to pay dividends. What they do need, however, is cash flow -- and EEI’s numbers show that the electric power industry’s free cash flow has been negative for nine consecutive years.

The trade group defines free cash flow as cash from operations less capital expenditures and common dividends -- a definition it adopted because of “the utility industry’s strong tradition of dividend payments.” But even using a narrower (and more traditional) definition of free cash flow -- cash from operations less capital expenditures -- the industry’s numbers have been negative in four of the last nine years.

MORE TROUBLE AHEAD?

In October 2013 -- before the EPA announced its proposed rules -- EEI estimated the industry’s capital expenditures to be $93 billion this year and $85 billion in 2015. Over the past nine years, when free cash flow (under the traditional measure) was negative almost 45% of the time, the industry’s capital expenditures averaged $75.1 billion.

So far, the industry has been able to make up the shortfall by borrowing. Only one investor-owned power company cut its dividend in 2013, a year in which industry capital expenditures exceeded cash from operations by $2.6 billion. But, as rates rise in the coming years, financing dividends by borrowing will get more expensive.

The changing nature of power production and distribution may ultimately do more than capex to undermine the ability of electric utilities to pay rich dividends. The declining cost of solar panels and improvements in battery storage technology are likely to lead even more homeowners to become power generators rather than energy consumers.

Meanwhile, the poor history of grid reliability (Hurricane Sandy as well as blackouts in the Northeast in 1965, 1977 and 2003) could cause many to seek a more local solution. Should users turn to “distributed power generation” models -- smaller interconnections of local consumers -- the electric utilities could eventually face an existential threat.

Right now, investors seem unconcerned about the utilities sector's future. For the first five months of the year, the group was the top-performing sector in the S&P 500. Over that period, utilities rose 11.7% in price vs. 7.1% for the index as a whole.

But as prospectuses note: Past performance is no guarantee of future profits. Especially when an industry is facing major change.

Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook.

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