Regulated electric utilities unlock the path to net-zero

“We are on the verge of the abyss, and we cannot afford a step in the wrong direction”, warned United Nations Secretary-General, Antonio Guterres, addressing the narrowing path that humanity needs to traverse if it is to avert a climate disaster. 

The second volume of the Sixth Assessment Report by the Intergovernmental Panel on Climate Change (‘IPCC’), issued in 2021, confirmed that global surface temperatures are already 1.1 degrees Celsius above their pre-industrial level. 

Under current policy settings, the IPCC anticipates median global warming of 2.4 to 3.5 degrees Celsius by 2100. Climate scientists warn that such an outcome would yield increasingly severe droughts, lethal heatwaves, and sea level rises that would displace millions. 

To limit global warming to 1.5 degrees Celsius, a level that scientists agree would prevent the most dangerous impacts of climate change, the IPCC estimates that we must cut global greenhouse gas emissions by 50% during the 2030s and achieve carbon neutrality by mid-century. 

With nearly 200 countries reaffirming their resolve to limit global warming to 1.5 degrees at the COP26 Climate Summit in Glasgow in November last year, the pursuit of these targets promises to give rise to the most significant economic transformation since the industrial revolution.

Investors seeking to position themselves for this opportunity are confronted with a multitude of potential paths, many of them perilous. 

The energy transition will require vast increases in renewable energy generating capacity, but intense competition amongst incumbent developers, reforming oil and gas majors, and financial investors carries the risk that returns on these projects are bid in to subeconomic levels. Similarly, while the transition carries the potential to reward investors in clean technology innovators lavishly, picking winners carries inordinate risk; an investor who purchases a basket of listed clean technology businesses is prone to suffer a permanent loss of capital if dominant technology solutions emerge from venture backed startups or privately held businesses, for instance.

In our assessment, the regulated electric utilities that comprise more than 45% of the MFG Core Infrastructure Fund represent the surest path for investors to profit from the energy transition. The replacement of legacy thermal generating fleets with renewables, the electrification of vast swathes of the economy, and efforts to harden electricity networks against the unavoidable impacts of climate change promises to sustain high rates of capital investment for these businesses for a generation. 

Crucially, under the regulatory construct, every dollar of authorised investment by the utility earns the allowed rate of return set by the regulator, implying that a generation characterised by high rates of capital deployment ought to give rise to a corresponding period of attractive growth in earnings and dividends. 

With North American regulated electric utilities (which dominate the global-listed opportunity set by number and market weight) guiding to long-term growth in earnings per share of around 5 – 8% p.a. and offering a dividend yield of 2 – 3%, investors can expect a total shareholder return of about 7 – 10% p.a from businesses that exhibit limited sensitivity to economic conditions and have a nearly unblemished record of recovering their historical investments in thermal generating assets under the regulatory framework. 

These settings support compelling risk-adjusted investment returns that are likely to compound reliably over a multi-decade investment horizon.

Our conviction in this opportunity rests upon the critical role of electric utilities in unlocking the path to a net-zero economy, the enormous investments required to facilitate the energy transition, and the meaningful economic value set to be created by the energy transition.

Electric utilities unlock the path to a net-zero economy

Electrification lies at the heart of the world’s plans to combat global warming. While electricity currently supplies just 20% of global energy demand, the International Energy Agency, a Paris-based intergovernmental organisation, projects that the electrification of transportation, building heat, and parts of industry will see zero-carbon electricity meet close to 50% of global energy demand by 2050 in a net-zero economy. 

While this implies a significant role in the future energy mix for hydrogen and advanced biofuels, particularly in hard to electrify applications like heavy duty transportation, cement, and steel production, it is likely that much of this fuel will be synthesised in electrolysers and ‘Power-to-X’ facilities that utilise renewable electricity as an input to production, further boosting demand for electric infrastructure. 

The International Renewable Energy Agency estimates that renewable energy supply and electrification will deliver 75% of the emissions reductions required to limit global warming to 1.5 degrees Celsius. 

With policymakers so reliant upon electricity networks to deliver ambitious environmental targets, investors can be confident that significant network investment is likely to attract regulatory support.

A generation of extraordinary investment and growth

Laying the groundwork for a clean energy revolution will require regulated electric utilities to deliver staggering levels of investment over the period to 2050. The International Renewable Energy Agency forecasts that limiting global warming to a level well below 2 degrees Celsius will require cumulative global investments in renewables, electrification, infrastructure, and energy efficiency measures totaling US$90 trillion over the period to 2050, an amount roughly four times US GDP. 

A study released by Princeton University in 2020 projected that for the United States to achieve net-zero greenhouse gas emissions by 2050, its utilities will need to invest US$3.4 – 6.2 trillion in new wind and solar generating capacity, and a further US$2.5 – 3.7 trillion towards new transmission capacity over the period to 2050, implying an annualised run-rate of investment nearly twice that delivered by the country’s investor-owned electric utilities in 2020. 

Augmentations to distribution networks to support the electrification of transportation are likely to require yet further meaningful investment. These staggering sums highlight the duration of the opportunity available to investors in regulated electric utilities.

A source of economic value creation

In addition to delivering clear environmental benefits, economists project that the energy transition will create meaningful economic value. The International Energy Agency forecasts that average household energy bills in advanced economies will decline modestly over the period to 2050, after adjusting for the effects of inflation. 

This seemingly counterintuitive result reflects the superior energy efficiency of electric technologies relative to technologies that utilise fossil fuels: electric vehicles use on average 70% less energy to travel one kilometre than a conventional car, for instance, while electric heat pumps are roughly 3 – 4x more energy efficient than gas boilers. Reinforcing this result, the International Renewable Energy Agency estimates that every US$1 spent on the energy transition will deliver cumulative savings of US$3 – 7 over the period to 2050, with the bulk of savings attributable to avoided subsidies paid to the fossil fuel sector. These cost savings provide further confidence that the investments that underpin our thesis will be delivered.

The surest path to a viable future and attractive risk-adjusted returns for investors

Antonio Guterres’ warning that mankind stands on the verge of a climatic abyss is a chilling reminder that the path to averting a global climate disaster is growing increasingly narrow. If we are to traverse that path, regulated electric utilities will guide our way, rewarding investors in the process.