Barclays this week downgrades the entire electric sector of the U.S. high-grade corporate bond market to underweight, saying it sees long-term challenges to electric utilities from solar energy, and that the electric sector of the bond market isn’t pricing in these challenges right now. It’s a noteworthy downgrade since electric utilities which make up nearly 7.5% of Barclays’ U.S. Corporate Index by market value. From Barclays credit strategy team:
Electric utilities… are seen by many investors as a sturdy and defensive subset of the investment grade universe. Over the next few years, however, we believe that a confluence of declining cost trends in distributed solar photovoltaic (PV) power generation and residential-scale power storage is likely to disrupt the status quo. Based on our analysis, the cost of solar + storage for residential consumers of electricity is already competitive with the price of utility grid power in Hawaii. Of the other major markets, California could follow in 2017, New York and Arizona in 2018, and many other states soon after.
In the 100+ year history of the electric utility industry, there has never before been a truly cost-competitive substitute available for grid power. We believe that solar + storage could reconfigure the organization and regulation of the electric power business over the coming decade. We see near-term risks to credit from regulators and utilities falling behind the solar + storage adoption curve and long-term risks from a comprehensive re-imagining of the role utilities play in providing electric power.
Barclays says bond risk premiums for the electricity sector indicate investors are ignoring these risks for now:
Valuations suggest credit investors are depending on the “regulatory compact,” (whereby the monopoly utility agrees to invest in assets to service customers in return for prices that are set to allow them a reasonable return) to give sufficient protection from industry changes. While the regulator/utility construct has usually resulted in low-risk returns to credit in the past, technological change creates precisely the environment where slower-moving incumbents and their regulators can fall behind the curve, risking credit volatility, or disrupt the regulatory compact, possibly leading to unexpected losses for bondholders. Investors may be also wary of optimism about solar power, given a recent history of losses in that industry. We believe that sector spreads should be wider to compensate for the potential risk of regulator missteps and/or a permanent change in the utility business model.
Whether because of biases or analytical complexity, the market (and its constituent prognosticators) has tended to be late in pricing technology-driven shifts, particularly in industries that have had stable operating models (such as telcos and airlines).
Barclays says it sees “a rare opportunity for investors to express views about a potential for a major change at low cost and with good liquidity,” and recommends investors who can do so should underweight the electric sector versus the broader U.S. Corporate index, and rotate out of bonds issued by utilities in areas “where solar + storage is closer to competitiveness” into bonds issued by companies “where solar + storage grid parity are more distant.”