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Utilities Turn to Wires in Volatile Markets

Energy needs and high returns are boosting transmission investments.

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For many years, investors have counted on utilities for relatively consistent returns in turbulent times. But as markets have fallen this year, utility investors have been caught in the rain with no umbrella.

Why is this time different? First, many utilities now have significant exposure to commodity markets because of states' power market deregulation since the last major economic downturn in the United States. As prices for oil, natural gas, and coal have fallen some 50% from midsummer highs, so too have power prices and utility profits. Second, utilities are capital-intensive businesses. Tight credit conditions in today's markets have raised costs for the capital utilities needed to build power plants, connect new customers, and service networks. Many utilities are cutting back their investment plans, which could reduce future earnings growth.

Despite these challenges, we think several utilities still can provide the strong dividends and consistent earnings that investors seek in volatile markets. What these utilities have in common is their focus on investments in transmission--the middle-man wires that carry electricity from far-away power plants to local neighborhoods.

Why Transmission Investments Are Key to Returns
Transmission grids are essential to electricity usage. Failures in the grid, like the one in Ohio that caused blackouts as far east as New York City in 2003, can devastate entire regions. As concerns heighten around global warming, rising commodity prices, and alternative energy sources, electricity transmission will be even more critical to energy use worldwide.

But nearly all grids worldwide face problems. Many of the lines are decades old or insufficient to serve current power demand after years of under-investment. These constraints can lead to power prices that vary more than 100% even within states. Additionally, regions with the best renewable energy potential typically lack transmission to move that power to load centers.

In response, U.S. policymakers envision creating a transmission superhighway system. The Energy Policy Act of 2005 allows regulators to offer generous incentives for utility investments in transmission. Some projects are earning returns on equity above 14%, nearly 50% higher than the returns that typical utility projects earn. For well-managed utilities, virtually all of those returns should flow back to shareholders through dividends and earnings growth.

Our Favorite Firms
Warren Buffett is one of the notable investors who has bet big on transmission. In September 2007,  Berkshire Hathaway's (BRK.B) MidAmerican Energy utility entered a joint venture with Ohio-based utility  American Electric Power (AEP) to pursue some $9 billion in transmission projects in the United States. It already has $1.1 billion of projects in the works. Besides MidAmerican, we think the utilities listed below should benefit the most from transmission investments during the next five years:

 American Electric Power (AEP)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Low | Morningstar Rating: 4 Stars
MidAmerican's partner is the largest U.S. transmission owner and the leader in next-generation transmission. With MidAmerican, it plans to develop transmission projects nationwide similar to its precedent-setting $1.8 billion high-voltage line in West Virginia that regulators will allow to earn a 14.3% return on equity, or ROE.

 National Grid (NGG)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 3 Stars
National Grid, the largest transmission owner in the Northeast and the United Kingdom, expects to earn 11% average returns on $2.5 billion of projects planned in the United States and $7 billion of projects planned in the United Kingdom through 2012. Earnings in power transmission, its most profitable segment, should increase 6% annually through 2012 to contribute more than a third of total earnings.

 Northeast Utilities (NU)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 3 Stars
The Northeast has some of the worst transmission constraints in the United States and pending renewable energy requirements could strain the system even more. Northeast Utilities is finishing a $1.7 billion project in southwest Connecticut, is in the final planning stages of its $1.5 billion contribution to a regional project with National Grid, and is discussing ways to tap renewable power in Canada. On average, these projects earn 12% ROEs and should make transmission more than 50% of earnings by 2009.

 Northwestern Energy (NWE)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 3 Stars
As much as 65% of Northwestern's annual earnings growth for the next 10 years could come from two major projects in Montana, South Dakota and Nebraska. The estimated combined costs of up to $1.1 billion exceed the company's market capitalization as of mid-2008.

 Westar (WR)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
The Kansas-based utility is a 50% partner with AEP and MidAmerican in a major project to tap western Kansas' wind resources that should earn a 14% ROE. Several other projects are earning 12% average ROEs, helping to drive 14% annual earnings growth through 2011.

 Edison International (EIX)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
The largest utility in California is asking regulators to approve $5.5 billion in transmission projects through 2012. Regulatory delays have slowed projects, but the state's looming renewable energy requirements--the toughest in the United States--will require new connections to solar, wind, and geothermal energy sources.

Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
and  Public Service Enterprise Group (PEG)
Moat Rating: Narrow | Fair Value Uncertainty Rating: Medium | Morningstar Rating: 4 Stars
Although transmission is a smaller earnings contributor for these diversified utilities, regulators recognize that these companies' wires between eastern Pennsylvania and New York City are crucial to powering millions of homes and businesses. Incentive transmission returns should help diversify more-volatile earnings from the companies' generation assets.

Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.