Public utility stocks were long viewed as a defensive asset, if not a bit boring, as supply and demand were relatively matched.
No longer. The growth of artificial intelligence and increased electrical demand on regulated utilities has upended that equation. Real estate firm JLL estimates nearly 100 gigawatts of new data centers will be added in the next four years, at 14% compounded annual growth through 2030.
Institutional asset owners and other investors are rethinking the role these equities play in their larger portfolios and looking at opportunities to take advantage of the growth in electricity demand beyond the blue-chip utility names.
Getting a Spark from Utilities
All regulated public utilities deliver electricity, but there are differences and they matter for investors, says Jay Rhame, CEO of Reaves Asset Management, which invests in publicly listed infrastructure equities. Regulated integrated utilities, such as Southern Company provide services to customers, own generation assets and negotiate rates with state government regulators which provides the company a set rate of return.
Independent power producers own power plants and sell into the market with no guaranteed rate of return. Many of them are negotiating longer-term contracts with data centers. Examples include Constellation, Vistra and NRG. They are regulated, but not like traditional regulated utilities, he says. Companies such as Exelon and First Energy are regulated transmission and distribution holding companies, owning the wires and acting as middlemen between the generation plants and customers.
Krishna Chintalapalli, co-manager of value equity strategies at Parnassus Investments, says the days of investors taking a simplistic approach to utilities stocks are over.
“I think this market definitely calls for more active discernment,” he says.
He owns a mix of names, including CMS Energy, which “has not been headfirst into this trend” as a defensive name, but also balances it with Brookfield Renewable, which has signed contracts with Microsoft and Google to generate renewable power.
Sustainably minded asset owners need to consider how the utilities they invest in generate power, as some have added coal-fired plants to increase generation which may not sit well, he adds.
Matthew Bartolini, global head of research strategists at State Street Investment Management, says asset owners are digging into the power supply subsector questioning how much of the return is connected to the AI value chain, but also asking about the power generation source, such as renewable energy or nuclear power.
Annika Ekman, executive vice president, investments, at Finland’s €70.4 billion Ilmarinen Mutual Pension Insurance Company, says because the pension has certain climate goals, they own many more European utilities, such as integrated utilities Enel SpA, Iberdrola SA and EDP, global leaders in clean energy, than U.S. ones. The U.S. utilities they own are Constellation Energy, which uses mostly renewable energy to generate power, and Sempra which supplies clean power.
Beyond the Blue Chips
Rhame says in the past two decades, utilities’ growth came from becoming more efficient and upgrading equipment. Now, he says, “the opportunities and kind of the dispersion amongst the sector, I think, is as wide as it’s ever been as well.”
Others agree. Ekman says better opportunities could be found beyond the regulated utilities, in areas such as companies that manufacture products related to on-site power generation and electrical infrastructure. Among some of Ilmarinen’s holdings in this theme include GE Vernova, which makes gas turbines; power management company Eaton; energy technology company Schneider Electric and engineering company Siemens.
“If you think about utilities, you don’t necessarily know as an investor today, which story is the winning story. On-site power generation is needed in any way. It’s kind of a win-win. Regardless of which utility wins, you need this on-site power and electrical infrastructure. It’s fair to say that we see that as a bit of a safer bet on this growth angle,” she says.
Chintalapalli concurs investors should look broadly at energy-related opportunities. In addition to GE Vernova, he owns Hubbell, an electrical and electronics product manufacturer, and Williams Companies, a natural gas processing and transportation firm.
Andrew Hill, president and portfolio manager at Ranger Investments, a micro and small-cap investor, says some of electrical power demand is “behind the meter,” where companies enter into leasing agreements with service providers to deliver a certain amount of power capacity through gas turbines when local power capacity is not available. In behind-the-meter arrangements power flows directly from the generation facility to the user’s electrical system, rather than through a public utility meter. The best-known example of this is Elon Musk building power generation outside of Memphis, Tenn., for his company SpaceXAI.
Hill owns the small-cap company Solaris Energy Infrastructure, which delivers power generation and distribution and was the service provider for SpaceXAI, and has two additional contracts that should begin ramping up, and providing the company revenue, next year.
Will Rising Insurance Costs Cause an Overload?
Insurance costs are rising across industries and utilities are not immune. In 2019, California utility Pacific Gas & Electric filed for Ch. 11 bankruptcy protection as it faced tens of billions in potential liabilities after its equipment caused deadly wildfire wildfires. The case is the best-known example, but higher insurance costs have vexed utilities for several years, no matter the type, says Ben Huffman, parter and co-leader, energy and infrastructure team at law firm Sheppard.
For example, Texas has many solar farms but also has hailstorms, which can damage power equipment. Wind farms are often sited in the panhandles of Texas and Oklahoma, areas also subject to tornadoes. Those are often clustered, which increases causality risk, or the exact chain of events that causes a loss.
“We have definitely seen casualty insurance, even for those types of generation assets, go up quite a lot over time, to the point where it’s uneconomic to carry … what we would consider full-loss coverage,” Huffman says, putting a strain on the asset owner.
Regulated utilities may be able to include those risks in their rate-base, spreading the cost and ultimately passing it along to electricity consumers, but independent power producers cannot do that, so the risk gets borne by the owners and investors, he says.
Other Risks to the Outlook
There are concerns that power-hungry data centers are increasing electrical costs for everyone at a time when affordability is a hot topic ahead of the U.S. midterm elections. Some states, such as Pennsylvania, have pledged a moratorium on building new data centers which causes volatility in the asset class, Rhame says. Even Texas is reviewing the impact of data centers. Governor Greg Abbott in late August issued a “pause” on approving new data centers until the state can audit the facilities’ energy and water usage.
Still, Rhame says, a supply and demand imbalance remains.
“We can build a whole bunch of Bloom [Energy] fuel cells and reciprocating engines and whatnot, but eventually the data centers want to be hooked up to the grid, and we just need a lot more power,” he says. Bloom Energy sells fuel cell power generators to produce electricity on site or near where the power will be used.
Hill says as AI has become more available, power demand has grown exponentially, but the risk is that as data centers become more efficient, the facilities’ demand for power may fall. However, he points out, efficiency does not necessarily mean demand will stay static. If prices fall, power demand could continue to rise since costs are cheaper which could again overwhelm the grid.
Conversely, the grid could get overwhelmed by additional demand that materializes when prices come down or compute power is more efficient.
“It’s hard to kind of model that out,” he says.
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Tags: Artificial Intelligence, data centers, electricity, Infrastructure, utilities