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Our Outlook for Utilities Stocks

Fast-approaching environmental regulation could reshape the utilities sector.

Travis Miller, 09/29/2011

--Environmental regulation talk will accelerate this quarter as more rules are finalized and utilities plan their compliance strategy.

--Regulated utilities continue to outperform the market and still look rich given slowing growth and potential interest-rate headwinds.

--Regulators' rulings in five pending merger and acquisition deals representing $33 billion of combined equity value will provide a good judge of the regulatory environment. 

Change comes slowly in the utility industry, but it's about to ramp up. Not since deregulation in the late 1990s has the sector undergone the upheaval we expect during the next year. Barring last-minute legal or political meddling, the U.S. Environmental Protection Agency's environmental regulations are set to reshape the sector. Utilities are hustling to position themselves for tightening regulations in 2012, 2014, and likely 2015 covering coal plant emissions, coal waste disposal, and water use.

In response, utilities already have announced plans to close 26 gigawatts of coal plants, 8% of all coal plant capacity in the U.S. We think that number could double by 2015. More importantly, the closures are concentrated in the eastern half of the U.S., dramatically altering the source and price of power in states that derive a large share of their power from coal plants like West Virginia (97%), Kentucky (93%), Indiana (90%), and Ohio (82%). Already utilities have mounted legal appeals, but political momentum in Washington is strong, and we expect the rules will hold mostly intact.

Customers' sensitivity to higher rates while the economy struggles to rebound complicates the matter. We expect a boost in energy efficiency, more clean-burning gas-fired generation, and tough decisions from regulators regarding infrastructure investment. In some cases, a heat wave or cold snap like we've seen in Texas and the Southeast recently could lead to blackouts unless utilities and regulators address these key issues.

Despite these uncertainties, investors continue to flock to utilities. The Morningstar utilities index reached a three-year high during the second quarter and has outperformed the S&P 500 by 6.5 percentage points since January 2010. And the sector's 4.3% average dividend yield still looks attractive with its spread against 10-year U.S. Treasuries reaching a 20-year high in early September at 243 basis points. Now more than ever, we think investors must choose their utilities carefully to capture the winners and avoid the losers as the sector changes rapidly. 

Industry-Level Insights
Diversified utilities and independent power producers have the most to lose or gain from environmental regulation and legislation. We know the clear winners, but the market has yet to digest the more nuanced impact on others. Exelon EXC holds the biggest option upside with the nation's largest emission-free fleet located in regions with the highest concentration of dirty coal plants. Stubbornly low Midwest power prices finally began to move up in March with 2012 implied market heat rates in the region expanding 22% during the last six months and power prices far outperforming oil, natural gas, and coal during the same period.

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