March 2023
 

The Inflation Reduction Act (IRA) seems to have incited a clean energy arms race among utilities regulators across the globe. Here Jim Lydotes, deputy CIO and head of equity income at Newton Investment Management, shares his perspective on the emerging regulatory dynamic in the utilities sector and what it could mean for investors.  

Highlights       

• As utilities often don’t have much competition and provide the public with indispensable goods and services, government regulators have historically served a critical function, to cap returns and thereby protect the consumer.¹
• Through the passage of the Inflation Reduction Act (IRA), the US government has boosted demand for domestic low carbon and clean energy service providers and incentivized US-based manufacturing, sparking investor interest.
• Lawmakers, particularly in Europe, have begun to pivot away from prioritizing price caps in these industries, focusing instead on new strategies to compete for investor resources.²

In 1900, 20 years after Thomas Edison founded the first centralized utility in New York City, the first piece of modern-day utility regulation was put into place. Since then, regulatory authorities across the globe have been tasked with keeping a lid on the profits generated by these essential businesses. As utilities often don’t have much competition and provide the public with indispensable goods and services, such as gas, electricity, and water - government regulators have historically served a critical function: to protect the consumer.

However, new legislation in the United States has sparked a shift in this traditional regulatory focus. Through the passage of the Inflation Reduction Act (IRA), the US government has boosted demand for domestic low-carbon and clean energy service providers and incentivized US-based manufacturing, sparking investor interest. At a time when governments and corporations worldwide are striving to reduce carbon emissions and meet ambitious net zero targets, investor capital is essential. For this reason, lawmakers, particularly those in Europe, have begun to pivot away from prioritizing price caps in these industries, focusing instead on new strategies to compete for investor resources.

The evolving utility business model 

Due to the highly capital-intensive and fixed-cost nature of their businesses, utilities tend to be natural monopolies, and there is a societal benefit for governments to permit them to operate as such. Understandably, natural monopolies draw the scrutiny of government regulators, and today most utilities across the globe have public utility commissions appointed or elected to oversee operations. These regulators function to ensure that a reasonable amount of capital is invested back into the infrastructure and business, to uphold basic quality-of-service standards for consumers, and to prevent price gauging, while concurrently allowing utilities to generate an acceptable level of return—but only an acceptable level of return. This dynamic has been firmly in place for more than 120 years, until recently. 

Over the last six months, we have seen this paradigm begin to change, most notably within the natural gas and electric industries. On August 16, 2022, President Joe Biden signed into law the Inflation Reduction Act, a US$370 billion spending package aimed at climate change and clean energy initiatives. The IRA includes funding and tax credits to support projects in clean energy production, lower-carbon technology and electrification, and to boost domestic manufacturing.³ These incentives have captured more of the attention of private investors, both domestically and abroad. Consequently, the passage of the IRA kicked off an arms race of sorts among regulators - particularly between those in the US and those in Europe - to compete for capital. In both regions, regulators that were once predominately focused on capping regulated returns found themselves searching for ways to bolster those returns to compete for private funding.

IRA incentives draw European investors  

Many European utilities have discretion as to where they can invest. When the IRA was established, several large European utilities were drawn to the return visibility and incentives put in place by the US government and took action, allocating their capital to the US, and likewise away from Europe. For instance, less than two months after the IRA was enacted, one of the largest natural gas and electricity suppliers in Germany spent nearly US$7 billion to purchase the clean energy business of a major US energy service provider. Leaders in the European Union were quick to push back. With a substantial amount of capital needed to fund the German energy transition, how could German utilities allocate all that capital outside their own country to the US?

Incentives drive behavior, and the US has put forth alluring incentives to attract private investors to fund its clean energy initiatives. The plan calls for 10-year tax credits for renewable energy projects, offering investors more visibility than previous tax-based incentives that were up for renewal every couple of years. The law similarly provides tax incentives for green hydrogen and carbon-capture projects, as well as stand-alone storage, an increasingly critical component of renewable energy.⁴

Amplified visibility on bolstered returns for a much longer period of time has made investing behind the energy transition much more attractive for renewable investors. As the management team of one large UK-based utility told us over the summer, it is not wedded to investing in the UK market if there are no incentives available; it has other options. Regulators in the UK, and Europe more broadly, are now faced with a choice - accept having less capital to push forward their own renewable-energy agendas, or counter those US incentives with incentives of their own. Belgium’s prime minister recently issued a statement calling the US IRA unfair and suggesting that the country’s only option would be to introduce similar subsidies.⁵ Additionally, the German chancellor has called for the European Union to create a new joint financing instrument to help member states compete against US incentives.⁶

Funding for renewable-energy generation is generally drawn more from private investors than from governments. In order to continue rolling out enough renewables to hit ambitious renewable-energy targets, investor capital is essential. To ensure that enough capital is allocated to the sector, the right incentives need to be in place, and regulators in the United States and Europe are recognizing this. Thus, an arms race between the US and Europe has emerged, as each region vies for the attention of private investors by attempting to establish more favorable regulation - an unprecedented notion in the 140-year history of regulation in the utilities sector. In our view, this competition is only the beginning, and the utilities with capital that is courted on both sides of the Atlantic are likely to triumph.  

Most US utilities focus primarily on their domestic market, and so while they could benefit from the incentives put into place in the US, they are also not likely to be swayed by incentives to invest in Europe, regardless of how favorable the outlook may be there. However, traditionally European utilities have been much more willing to invest in other regions of the world, and thus we believe they are well positioned to take advantage of this tug-of-war of enticements happening today. In our view, while utilities are already an attractive sector, given historically low valuations and increasingly favorable renewables growth, this emerging regulatory dynamic is yet another reason to be constructive on the group.