Although renewable power has been making big headlines for years, the truth is that the industry is still quite new. And, equally important, there are years of growth ahead as renewable power expands its reach.
That's why the bankruptcy of giant California utility PG&E (PCG -0.23%) was so disconcerting. Effectively, it has tested some of the renewable power industry's core underpinnings. Luckily, it appears at this point as though everything will all work out in the end.
Here's what happened and why this event helps solidify the renewable power story.
The background
PG&E's bankruptcy goes back to a series of catastrophic California wildfires in 2017 and 2018. Essentially, it appears that the utility's power lines played a key role in starting the devastating blazes. That, in turn, put it on the hook for damages. The dollar figures being thrown around have been nothing short of astounding, with the utility facing $30 billion or more in liabilities. The issue wasn't lost on management, which eliminated its dividend in 2017 and took billions in one-time charges to prepare in 2018.
Image source: Getty Images.
With the size of the liability tally, though, there wasn't much chance PG&E was going to be able to survive without a trip through bankruptcy court. It made that call in April 2019, with the stock actually bouncing slightly higher on the news. That event was when the problems started for renewable power companies.
How the business works, still
Essentially, renewable power companies build solar and wind farms and sell the power these assets generate to utilities. The sales agreements are usually backed by long-term contracts with set prices for the energy. There are both big and small players in the space, including diversified giants like $100 billion market cap NextEra Energy (NEE -1.36%) and small, focused upstarts like $3.4 billion Clearway Energy (CWEN 0.26%). Both of these companies had deals with PG&E. Every renewable power company relies on the sanctity of the contracts backing their investments in long-lived power assets.
When PG&E declared bankruptcy, Clearway Energy cut its dividend by 40% because it was worried that its contracts with the utility were at risk. The potential for a negative outcome grew materially when a bankruptcy judge decided that PG&E could, in fact, renegotiate renewable power purchase contracts that had been signed when renewable power costs were higher than they currently are. In other words, the sanctity of those contracts was no longer a given, and Clearway feared it might be forced to take less than it had originally agreed to if it wanted to keep the power deals alive. That risk materially increased the uncertainty in the industry, especially when you note that The Southern Company was already stepping back, warning of increasing counterparty risk and falling returns.
Larger players like NextEra and Southern can handle some adversity, such as a few renewable power contracts being renegotiated. They have giant utility operations backing material renewable power businesses (NextEra is one of the largest renewable power companies in the world). But a smaller player like Clearway, which is focused on the renewable power space, doesn't have that backstop. Its entire renewable power business rests on the contracts it signs. If those contracts can be changed, its business is potentially much riskier than it seems.
Preserving the promise of renewable power
However, PG&E's decided in the bankruptcy reorganization plan that it submitted to the court that it would honor its renewable power contracts. That's a big issue on two fronts. The company has around $40 billion in purchase contracts. Killing all of those agreements would have sent shockwaves through the energy industry. Legal battles would have likely come into play on top of what would have probably been contentious negotiations with companies like NextEra, Clearway, Consolidated Edison, and even Berkshire Hathaway's utility arm.
But the bigger and longer-lasting issue may actually be the precedent PG&E has set. Essentially, PG&E's decision means the underpinning of the renewable power industry (the sanctity of power purchase contracts) has been preserved. That's not to suggest a future bankruptcy won't lead to a different outcome, of course, but PG&E has put a line in the sand. Every company from which it buys power has breathed a sigh of relief because of this specific case. But the entire industry is also likely to feel a sense of relief knowing that the next time it faces an issue like this, it can look back to PG&E as a reference point if negotiations are needed.
This is important when you consider the growth potential in the renewable power space. NextEra, for example, has plans to spend around $6 billion a year through 2022 on renewable power projects. All of that construction, projected to be between 11.5 and 18.5 gigawatts of power, is backed by the purchase contracts it signs. If those contracts can't be relied on, NextEra's growth plans suddenly seem a lot riskier. And that's just one of the many players in the space.
Err on the safe side
PG&E's bankruptcy isn't over yet, and despite the apparent positive outcome for renewable power, there's always a chance that the court won't approve the utility's reorganization plan. Investors more generally shouldn't get complacent with their renewable power investments. Smaller upstarts may have great growth prospects, but PG&E's bankruptcy and Clearway's dividend cut show that there are risks to consider.
For most investors, it would be better to focus on larger players with diversified businesses, such as NextEra. The growth opportunity may not be as robust since it ends up being diluted by other businesses, but when troubles arise, a larger, more diversified company will be better able to take the hit...and won't have to pray for another positive outcome.
