Clean Energy Provides Growth in Utilities Sector

Like many of us, utilities will be happy to say goodbye to 2020. The sector lost all of its early-year momentum when the pandemic hit and has yet to recover, still down about 10% from its February peak. Utilities close 2020 as the second-worst-performing sector behind energy and enter 2021 with a much more attractive investment proposition.

Utilities reached a record-high 22% premium to our fair value estimates in early 2020, suggesting investment dangers were ahead. We didn’t anticipate such a quick correction in March, but we’re not surprised by the weak second-half rebound. Utilities now enter 2021 fairly valued. The sector’s 3.3% average dividend yield remains exceptionally attractive relative to ultralow interest rates.

Utilities still haven’t recovered from market crash - Morningstar

Renewable energy will be the theme for 2021 and possibly the next decade. A Biden administration is sure to use all of its tools to accelerate renewable energy investment. And where governments stop, corporates have picked up, with widespread commitments to eliminate greenhouse gas emissions from their energy sources. In December, Amazon.com AMZN signed a deal for 3.4 gigawatts of global renewable energy projects, one of the largest corporate deals ever. Utilities will lead this clean energy movement as investors and facilitators. We think this offers far more upside than downside. Constructive policymaking could mean a decade or more of growth opportunities, resulting in annual earnings growth topping 8% for some well-positioned utilities. We expect better than 5% annual earnings and dividend growth across the sector for at least the next four years.

Utilities head into 2021 trading near fair value as a group - Morningstar

Utilities’ dividends are attractive relative to interest rates - Morningstar

The winners in 2021 and beyond will be the utilities that can execute. Relationships with regulators and policymakers will be paramount. Winners will complete projects on time and on budget, maintaining steady earnings growth. We were not surprised that the top performers in 2020 were utilities with the largest clean energy growth potential, including NextEra Energy NEE, Hydro One H, AES AES, and PG&E PCG.

Solar, wind top investment list; coal plant closures continue - Morningstar

Valuations for the highest-quality utilities with the best earnings and dividend growth are rich, and investors should be cautious. We think the best opportunities are those that aren’t obvious beneficiaries of the renewable energy movement, including Edison International EIX, NiSource NI, and Pinnacle West PNW. These trade below our fair value estimates, with attractive dividend yields and strong balance sheets.

Top Picks

FirstEnergy FE Star Rating: ★★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $43 Fair Value Uncertainty: Low

FirstEnergy's shares fell 30% in July and have not recovered following the arrest of the Ohio House Speaker and four others on racketeering charges. Although no FirstEnergy executives have been charged and FirstEnergy no longer owns the entity that benefited from the alleged bribery, we expect it will have to repair regulatory and political relationships in Ohio, which represents less than 20% of earnings. FirstEnergy's underlying businesses are solid. As the bribery headlines and COVID-19 issues fade, we estimate 4.8% annual EPS and dividend growth driven by strong FERC-regulated transmission investment.

Edison International EIX Star Rating: ★★★ Economic Moat Rating: Narrow Fair Value Estimate: $69 Fair Value Uncertainty: Medium

With the stock trading at a sizable discount to its peers and a 4% yield, Edison offers a triple play of value, growth, and income. California political risk will always be a concern for Edison. However, California’s progressive energy policies also create more growth opportunities than most other U.S. utilities. Edison’s electric-only business, recent regulatory success, and $5 billion annual investment plan give us confidence that it can grow earnings 6% beyond 2020. Management recently raised the dividend 4% and we expect that pace to pick up. Edison has stakeholder support to harden the grid against natural disasters, integrate renewable energy, and support electric vehicle adoption.

American Electric Power AEP Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $89 Fair Value Uncertainty: Low

Across much of AEP's vast service territory, states were slower than others to adopt renewable energy standards. This has resulted in slower renewable energy growth for AEP thus far. But state regulators overseeing AEP’s service territories are now embracing renewable energy development, providing significant growth opportunities beyond our five-year forecast. AEP will also benefit from investment opportunities in its transmission and distribution network, which is the largest in the U.S., as other utilities also connect renewable energy projects.