This article first appeared in The Edge Malaysia Weekly on October 17, 2022 - October 23, 2022

Investing in electric utility stocks might not make immediate sense to environmental, social and governance (ESG) investors, since electricity production is one of the most carbon-intensive sectors and relies heavily on fossil fuels. However, investors can potentially gain from looking into “new age utilities” that are rapidly expanding into renewable energy (RE).

This is the investment case that Jigar Shah, CEO of MIB Securities India and head of sustainability research at Maybank Investment Banking Group, made in an April report on regional utilities. In his view, the large-scale shift to RE, triggered by climate change, geopolitics and the need for energy security, will drive this theme.

Electric utilities in Asean and India, in particular, are attractive despite their slower pace of transition. Currently, these utilities are trading at a 30% to 40% price-to-earnings ratio discount to the average of their global peers, according to the report. But now that these utilities are transitioning decisively, the gap in their risk profile and valuation should shrink.

“The decarbonisation of utilities is inevitable and it has already started. In fact, if you look at European utilities in the past decade, they have achieved that to a substantial extent. Formerly fossil fuel-based utilities have transformed into RE-based utilities,” says Jigar.

This is also seen in the US and Australia. Utilities in these countries were at this stage a decade ago. Now that they have diversified into RE, their risk profiles have improved, he adds.

“You’ll see that some of the European utilities today have a Carbon Disclosure Project (CDP) rating of B or above because their risk has come down systematically. Similarly, their ratings on emissions and water security have improved. CDP ratings are extremely stringent when it comes to these criteria.”

The ESG risk ratings of these utilities have a direct bearing on their market valuations, according to the report. Most Asean and Indian utilities have high to severe ESG risk, and it shows in their market valuations in comparison to those in developed markets.

Among various sectors, electric utilities face the most significant risk in the transition to a low-carbon economy. That’s because energy is the largest source of greenhouse gas (GHG) emissions globally, and electric utilities are among the most polluting industries, producing 31% of annual GHG emissions.

With RE expected to be the dominant energy force, its upsurge will depend on a few factors. This includes innovation in battery storage technology, which can address the intermittent nature of solar and wind energy. Another is the commercialisation of green hydrogen, which is produced through the electrolysis of water using RE.

The electrification of transportation and industries is another driving factor.

“Today, only 18% to 20% of the energy mix is converted into electricity, because it is not so much used in industries or transportation. But in the future, electricity will have to become 50% of the total energy mix,” says Jigar.

Russia’s invasion of Ukraine, of course, has highlighted the need for energy security. While it has driven some countries to reopen their coal power plants, he observes that the policy direction still points towards RE.

“We’ve seen Europe give a lot of incentives for RE. Some countries have removed the environmental assessment requirements for setting up offshore wind projects because they want to get it up quickly,” Jigar notes.

The business model of global power utilities is changing. Fossil fuel-based utilities are going into the RE space, retiring coal plants earlier, modernising transmission grids, investing in new digital technologies and ending monopolistic business models, Jigar observes in the report.

He believes that utilities in Asean and India will either become “pure-play” RE companies or will significantly reduce their fossil fuel exposure over the next decade. Some companies are spinning off their RE business into a separate unit, so they can achieve better cost of capital and gain better price discovery in the equity market.

India’s Tata Power is a good example of a “new age” utility that is adopting a new business model.

“They’re not just generating and distributing energy but also have a wide model that increases energy equality. They are putting up utility-scale solar and wind projects, and setting up micro-grids so they can provide energy to the remote parts of the country. They’re doing significant work on solar pumps, helping the agriculture sector [to gain access to electricity] and scaling up on solar rooftop [installations],” says Jigar.

“They are installing electric vehicle charging stations across the country, doing RE projects for other companies and manufacturing their own solar modules. I believe they will be going into green hydrogen. This suddenly opens up 10 different business areas within a utility.”

The “new age” utilities have clear net-zero targets, interim milestones and an all-encompassing business model like Tata Power, he adds.

“As long as you are metamorphosing, then it’s an interesting model, with much less risk from transition, climate change, cost of capital and enterprise value,” says Jigar. Utilities that do so will also experience better market perception and valuation.

In the report, Tenaga Nasional Bhd (Tenaga) is shown to have a D and F score under the CDP for climate change and water security, a BBB score by MSCI, a high risk rating by Sustainalytics and an above-average score according to Maybank IB.

Tenaga is clear about its move towards net zero, observes Jigar, and while it still has a huge portion of fossil fuels in its energy mix, it is investing in RE.

“It has a strong balance sheet, good standing among its customers and the mindset for the transition,” he notes.

However, despite the announcement that no new coal plants will be built, the prevailing structure of power purchase agreements in Malaysia means coal will still feature prominently in Peninsular Malaysia’s generation mix (currently at over 50%) for at least the next decade.

This results in a “coal stigma” that will follow Tenaga for the foreseeable future and could pressure it to accelerate its expansion into RE or spin off its generation unit.

Could Tenaga be more aggressive in its RE expansion? When asked, Jigar remarks that “we cannot expect ESG to yield results very quickly. This has long-term implications on the capital expenditure, cash flow and balance sheet of a company. It will have to take it in a very calibrated manner”.

He believes that Tenaga is heading in the right direction. “The ambition can be more aggressive. They could get into the backward integration of solar models and metals, which also need to be timed with government policies.”

This transition took five to 10 years to happen in Europe and the US, Jigar adds. “As long as the company has very clear policies and strategies and is able to fund it, I think it’s a good direction.”

Utilities have traditionally been a dividend play for investors, thanks to their steady growth in tandem with the demand for energy. But utilities also typically have high capital expenditure and cost uncertainty due to the fluctuating prices of fossil fuels.

Things are different with RE says Jigar, and the costs are mostly fixed.

“The environment or the financial [expectations] of the lenders [for utilities] have become more predictable. That’s why I think renewable utilities are going to see more growth,” he says.

The share of coal and oil in the energy mix is expected to decline, while natural gas will remain flat. RE, meanwhile, will see double-digit volume growth for the next few decades, Jigar believes.

“From there, the equation will change more from price-to-book and dividend yield to growth in earnings. If you have an all-encompassing business model where you’re not just a power producer, you will have multiple areas of growth. Therefore, the whole focus shifts to growth and risk reduction because whatever you do, you’re at lower risk in terms of emissions and carbon taxes that may be imposed on you,” he says.

In the report, it was shown that between 0.4% and 72.2% of the utilities’ net profits annually will be shaved off with a carbon price between US$10 and US$100. The valuation of utilities that do not transition will take a hit.

“We will see a shift towards ‘new age’ utilities and they will be the winners. This could be a megatrend because there is no other avenue for them to go but RE on a large scale,” says Jigar.

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