EPA Ruling Just 1 More Reason to Be Careful With Utilities

Utilities have been a mainstay for income-minded investors for many years. But with the latest Supreme Court ruling on EPA regulation of CO2, the times are changing.

Jun 25, 2014 at 4:42PM

Byron Power Plant Michael Kappel

Byron Power Plant, photo by Michael Kappel

The Supreme Court just ruled on the EPA's authority to regulate CO2 emissions from utilities and other industrial sources, and the result doesn't look too good for business. In a 5-4 ruling the US Supreme Court confirmed that the EPA does indeed have limited authority to designate CO2 as a health hazard, and therefore regulate its emission from not only vehicles but also industry. 

The result of this ruling will likely be, among other things, a solidified mandate on states to create legislation which forces utilities to reduce CO2 emissions and increase relative exposure to sources of renewable energy. This, I believe, will cause increasing uncertainty for US utility companies. 

While proponents of renewable energy are indeed correct in pointing out that some sources of renewables are getting closer to commercial viability, they generally miss one point: Creating renewable energy generation infrastructure will require a replacement of already operational non-renewable generation infrastructure. This will mean a huge up-front investment with little economic benefit. For utilities, this 'investment' means higher debt and, most importantly, lower returns on equity. 

This is significant because most utilities in the US operate as quasi-monopolies, and are therefore regulated by state utility commissions which set a maximum return on equity. Spending to replace existing generation capacity is sure to put downward pressure on utilities' return on equity, unless those utilities raise electricity prices to compensate. In today's economy, passing such costs through to the consumer will be challenging, and that's assuming that the public utility commissions would even approve of such rate hikes. In other words, something has to give. 

What can an investor do?
Utilities are an important part of many income-oriented retail investors' strategies. If you're new to investing and looking for sources of income, it would not be wise to ignore utilities entirely, but it is important to be cautious and, when in doubt, lean to other sectors. That being said, if one wants to be invested in utilities, I believe there are two things to consider:

First, stick to areas which have growing electricity demand. Areas of growing demand will be better able to shoulder the costs of new infrastructure because that new infrastructure will actually go to satisfy new load demand. One great example of this is Entergy Corp (NYSE:ETR). Entergy has a Louisiana transmission business which is benefiting from the petrochemical renaissance along the Gulf Coast (which is thanks to low US natural gas prices). 

Second, stick with states that will go easier on utilities and will not be overzealous in CO2 legislation. The most obvious choice here is Texas, and American Electric Power (NYSE:AEP) is the publicly listed company with the greatest exposure to the Lone Star State. AEP also relies heavily on economical generation sources such as coal. Not incidentally, there is a lot of overlap in geographies which satisfy both points one and two. 

Foolish takeaway
While utilities have been a mainstay for income investors for a long time, the legislative environment is looking increasingly unfriendly to these companies and their shareholders. In my opinion, the writing is already on the wall, and so complacency is not warranted. "This, too, shall pass," is not the right attitude to have. I believe that investors should be cautiously selective with utilities at this time. 

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Casey Hoerth has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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