Fund manager Jim Wright looks at whether regulated utilities and renewable power developers can follow merchant power companies and become among the strongest performers in the S&P 500 Index in 2024.
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Merchant power companies have been among the strongest performers in the S&P 500 Index in 2024; can regulated utilities and renewable power developers follow?
In January this year we wrote about the generational change in the US electricity market, where, after almost 20 years of flat demand, a structural growth theme is emerging. We discussed the three main drivers of this growth: electrification, the onshoring of heavy industry and manufacturing, and the rise in demand for electricity from the data center sector due to the increased use of artificial intelligence.
The most obvious companies to benefit from this theme in the first instance are those with merchant generation – capacity which is sold directly into electricity markets, and which is not remunerated based on regulated returns or long-term power purchase agreements (PPAs). At the time of writing in May, three of the top five performers in the US S&P 500 Index year-to-date are electricity generation companies – Vistra and Constellation Energy (owned in the Premier Miton Global Infrastructure Income Fund), and NRG Energy. For investors in US infrastructure the interesting question right now is whether the positive share price momentum broadens out to encompass the regulated electricity utilities and the renewable power generation specialists, and the extent to which they can benefit from the energy expansion in the USA. Past performance is not a reliable indicator of future returns.
The case for renewable energy companies to power this growth
The case for renewable energy companies to power the growth in US electricity demand is more nuanced than for merchant generators with fossil fuel or nuclear assets. Renewable energy sources such as solar and wind are intermittent – you get the electricity when the sun shines and the wind blows. Clearly this may not coincide with periods of peak demand and doesn’t meet the 24-7-365 needs of a data center. Battery storage technology continues to evolve and is now explicitly subsidised by the US Inflation Reduction Act. Batteries provide a short-term solution to this intermittency problem, but don’t solve the issue of what happens when there are longer periods of low-level electricity production from the renewable sources.
Regulated utilities can build resilient systems using nuclear for baseload power (where available), renewables plus battery storage and then dispatchable power sources – predominantly gas-fired generation – to effectively fill in the gaps in demand. However, many data center customers such as Microsoft and Meta Systems have their own ambitious net-zero carbon targets, so will look for solutions which don’t involve fossil fuel generation.
How to overcome the challenges
The CEO of the biggest renewable energy owner and developer in the USA, NextEra Energy, made a strong case for renewable power to meet the needs of data centers during the company’s recent 2024 first quarter results call. His view was that the challenges can be overcome by over-building the batteries and through the use of Renewable Exemption Certificates, effectively creating a portfolio effect on the grid where renewable generation elsewhere is swapped into the data center Power Purchasing Agreements (PPAs). In this way the data center operators can benefit from long periods of cheap renewable energy and can meet their decarbonisation goals through synthetic zero-carbon PPAs. And the owners and developers of renewable generation assets in the USA such as NextEra and Clearway Energy (holdings in our fund) can benefit from the electricity demand growth dynamic.
In principle, the growth in demand is very good news for regulated electric utilities. As well as growing their own generation fleet, the electricity transmission and distribution grids will also require investment to support the expansion in demand. The reality is that demand growth will vary by region, and the attitude of regulators at state level will also be a factor in determining which of the regulated utility stocks are able to grow their asset base to respond to the new demand environment. We would look at high-growth states such as Texas, as well as states such as Wisconsin, New Jersey and North and South Carolina, as regions where regulated utility growth will respond to the wider electricity market dynamics.
The final word
Overall, we view the generational change in the US electricity market as one of the most constructive investment themes we have seen in the global listed infrastructure sector in many years and believe that it could benefit the entire sector as companies and regulators respond to the new market dynamics.
