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CONFIDENTIAL
Global Utility White Paper
A Primer on Long/Short Investing in the
Global Utilities & Infrastructure Sector
Jos Shaver
Portfolio Manager
Electron Capital Partners LLC
March 08, 2013
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Global Utility White Paper
CONFIDENTIAL
1. Executive Summary ................................................................................................................................................ 3
2. Structural Change – Advantageous Time for Global Utility Sector Long/Short Investing ..................................... 5
� Structural Change in Electron’s Research Process ....................................................................................... 5
� Structural Change Cycle ............................................................................................................................... 5
� Investors Not Positioned for Structural Change Pickup ............................................................................... 5
o Long‐Only Investors Substantially Underweight but Hedge Funds Turning ......................................... 5
3. Regional Structural Changes Driving Alpha Opportunity ....................................................................................... 7
� US Utilities ................................................................................................................................................... 7
� European Utilities ........................................................................................................................................ 9
� Asian Utilities ............................................................................................................................................. 10
� Japanese Utilities ....................................................................................................................................... 11
� Latam Utilities ............................................................................................................................................ 12
4. Global Structural Changes Driving Alpha Opportunity ......................................................................................... 12
� Power Prices are Skewed to the Upside .................................................................................................... 12
� Capex (ex‐US) is Rebounding Post‐Recession ............................................................................................ 14
5. Substantial Alpha Opportunities Follow Periods of Underperformance .............................................................. 14
� Record Duration and Depth of Underperformance ................................................................................... 14
� Reasons for Underperformance ................................................................................................................ 15
� Potential Exists for Sharp Outperformance ............................................................................................... 15
o Post‐Dotcom Rallies ............................................................................................................................ 16
o Japan Rallies ....................................................................................................................................... 17
o Potential for Yield Catch‐up ................................................................................................................ 18
6. Interest Rate Risk – A Common Misperception .................................................................................................... 19
Appendix 1: The Team and Our Process ...................................................................................................................... 20
� Electron Focus ............................................................................................................................................ 20
� Electron Team ............................................................................................................................................ 20
� Track Record (7 years) ............................................................................................................................... 20
� Process ....................................................................................................................................................... 20
o Why We Take a Global Approach ‐ The “Greatest Gift” ..................................................................... 21
o Capitalizing on Structural Change Timing ........................................................................................... 22
� Portfolio Construction ............................................................................................................................... 22
� Shorting Global Utilities ............................................................................................................................. 23
o Experience with Dividends and Investor Behavior ............................................................................. 23
o Key to Electron’s Process to Identify Dividend Change Candidates ................................................... 23
Appendix 2: Global Utility Sector Background ............................................................................................................. 25
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1. Executive Summary
This White Paper discusses Electron Capital’s (“Electron”) views on the global utility sector and outlines why
now is a particularly advantageous time for long/short investing in the sector using Electron’s research
approach that focuses on structural change.
Electron’s 5 investment professionals, working together an average of 6 years, have generated a 7‐year track
record of long/short investing in the global utility sector. Returns have annualized 10.3% and have been
characterized by strong alpha generation (80% of returns; Jensen’s alpha calculation) in a dismally‐performing
global sector (‐0.2% absolute).
Electron will continue its approach with the Electron Global Fund, an absolute return product. (See
Appendices 1 and 2 for Electron’s process and the sector’s history.)
Electron invests in a deep universe of utility and infrastructure stocks, comprising 375 companies with a
market cap of $2.8 trillion. Our approach is truly global as 40‐60% of the portfolio’s historical gross has been
allocated outside the US. Stocks covered include the electric, gas, water and waste utilities in addition to
infrastructure companies (defined as those levered to utilities or utility‐like). For the sake of simplicity, the
rest of this White Paper will focus on the electric utilities, the largest subsector; we refer to this subsector
when we reference “utility”.
� Advantageous time to be long/short investing in the global utility sector (Section 2).
o Structural change in the sector has been accelerating after a recession‐induced slowdown.
o Long‐only investors are not positioned for such structural change in what is the world’s most
underweight sector.
o We believe hedge fund investors have already begun to make this turn as evidenced by a
significant increase in net exposure over the last 6 months.
� Structural changes will drive the largest alpha opportunities in all major regions (Section 3).
o US utilities will face the strongest headwinds, yet structural change will occur which will drive
alpha opportunities. We believe the most interesting US structural changes will have a magnified
effect internationally given commodity interlinkages.
o European and Asian utilities offer the most abundant and attractive alpha opportunities.
o Japan and Latam will be more trading markets over the near term.
� Some structural changes will have a global impact (Section 4).
o The shale gas and coal price washout (with its knock‐on effect on global power prices) is largely
over; the global utility sector has substantial optionality to any increase in power prices due to
natural gas and coal prices, which will be heavily influenced by trends in the US.
• On the supply side, US spot gas at $3.42/mmbtu is below the breakeven full‐cycle
natural gas production cost of $3.50‐4.00/mmbtu. We believe this provides downside
protection to the current gas price despite the proliferation of shale gas.
• Potential additional demand for natural gas is enormous:
� In the US power sector (37% of demand), EPA mandates will force coal plant
closures (e.g. potentially adding 10% to natural gas demand) and increase the
marginal switching cost for the most efficient plants to $4/mmbtu, providing a
runway for structurally higher gas demand/prices.
� Other large potential structural sources of demand arise from LNG exports
(also 10% of US demand), a gas‐intensive industrial renaissance (also 10%), and
substitution of LNG/CNG for oil‐based vehicle fuels.
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o
• Leverage to higher power prices can be substantial. For example, in the US every
$1/mmbtu improvement in natural gas prices increases Exelon’s long‐term earnings by
more than 20%, whereas for pure generators such as NRG the leverage exceeds 30%.
• In Europe, where power is generated at close to cash production cost in many markets,
even a modest (e.g. 10%) combination of changes in coal, carbon and Euro prices can
have a 25‐50% earnings impact on several European utilities.
Global utility capex (ex‐US) is rebounding after a recession‐driven slowdown:
• System‐enhancing transmission capex is accelerating in Europe and Asia and is firm in
the US.
• US, European and Asian utilities are building much of the infrastructure needed to
capitalize on the global shale gas boom underway.
• In emerging markets, infrastructure spending is occurring across the entire value chain.
� Substantial alpha opportunities follow periods of underperformance (Section 5).
o Current MSCI World Utility Index underperformance against the MSCI World Index is the deepest
(‐67%) and longest (4 years) of the modern utility era, caused by a perfect storm of factors (see
page 15).
o Despite the strong rally in equity markets since the depths of the financial crisis, the global utility
sector is still down ‐11% in absolute terms and has underperformed the second‐worst sector
(telecom) over the same period by ‐23%. Previous periods of underperformance have set the
stage for substantial alpha opportunities driven by fundamental investors re‐entering the sector.
o The global utility sector does not need to outperform for Electron to generate solid performance;
80% of our 7‐year return (10.3% per annum) is from alpha (Jensen’s alpha calculation).
� Investing in the global utility sector does not mean taking undue interest rate risk (Section 6).
o The interest rate sensitivity of the sector has declined steadily since the modern utility era began
in the early 1990s. US utilities remain the most interest rate‐sensitive companies regionally.
o We track interest rate risk for all positions in our risk model, and the portfolio’s net interest rate
risk is kept within acceptable limits as we select stocks. In addition, Electron’s return correlation
to interest rates historically is slightly lower than the HFRI Equity Hedge Index’s return
correlation to interest rates.
o This process has worked well for us as Electron has posted strong returns and alpha generation in
both increasing and declining interest rate environments.
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Investors should always have an allocation to the global utility sector.
o This is a large‐cap, dividend‐generating sector that is vitally important to national economies, and
which is subject to undercurrents of deregulation and competition. This has produced ample
long/short opportunities in the past and will continue to do so for the foreseeable future.
o Moreover, an allocation to global utilities provides a diversification benefit to investor
portfolios. The risks affecting a global utility sector fund are very different from those affecting
other long/short funds and diversification enables higher returns per unit of risk. Electron’s 7‐
year track record correlation to the S&P 500 and HFRI Equity Hedge indices is .41 and .68,
respectively (.18 and .55, respectively, in down markets).
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2. Structural Change – Advantageous Time for Global Utility Sector Long/Short Investing
The high level of structural change occurring around the globe makes this a particularly advantageous time
to be long/short investing in the global utility sector. The various examples for each region, the importance
of structural change to each region and the opportunities are listed in Section 3.
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Structural Change in Electron’s Research Process
Since the original Electron was formed in 2004, Electron’s research process has focused on structural
change to determine its impact on the underlying future earnings potential of our companies (see
Appendix 1, page 22). Whenever there is structural change, distortions and inefficiencies arise. These
invariably result in both winners and losers among utility stocks, in large part because of the heavy
influence of public policy on the sector (e.g. governments and regulators). Policymakers will never want to
knowingly provide windfall profits to utilities; if a structural change is producing a winner, we look for the
loser. If a loser cannot be found, we keep looking: the loser will eventually surface.
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Structural Change Cycle
As cycles are an important feature of life, so are cycles of structural change important in the global
industry. During the recession following the financial crisis, the activity level of structural change did
slow down around the globe. This is not surprising as governments, regulators and other stakeholders
slowed the pace of structural change (i.e. a hunkering down mentality took hold among utility
stakeholders) and companies slowed their rate of capital spending (because of uncertain economic
growth prospects). As time has passed, the outlook for global growth has stabilized, tail risks have been
managed and confidence has returned, and companies have begun spending previously‐delayed capex
needed to ensure system reliability. This collectively has prompted utility stakeholders to pick up the
pace of structural change. Given that we track structural change globally, we estimate that this inflection
point of increased structural change occurred approximately 12‐18 months ago.
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Investors Not Positioned for Structural Change Pickup
That we are at an inflection point for a pickup in structural change is underappreciated by the market.
Moreover, it is occurring at a time when there are fewer eyes focused on global utilities. The
underappreciated pickup in structural change activity levels combined with low investor involvement
spells opportunity for the Electron Global Fund as it plays to the Electron team’s competitive advantage.
This driver was critical to the investment professionals’ decision to re‐launch the independent Electron.
o
Long‐Only Investors Substantially Underweight but Hedge Funds Turning
The global utility sector is the world’s most‐underweight sector by a large margin. Moreover, the
underweighting has dipped to a comparably extreme level only 4 times (including now) over the last
10 years. Each time this extreme has been crossed, over the next 24 months global utilities rose by
38% on an absolute basis and outperformed the global broad market by 20%, on average.
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Global Sector Positioning
Substantially
underweight
Source: Bank of America Merrill Lynch Global Fund Manager Survey, Feb 12, 2013
Net % Overweight Global Utilities
+1σ underweight vs mean
‐1σ underweight vs mean
Red circle =
crossing below
1σ underweight
Source: Bank of America Merrill Lynch Global Fund Manager Survey, Feb 12, 2013
The sector has been not only a substantial long‐only underweight, but also a wholesale short for
many macro/generalist hedge funds. However, it is very interesting to note that an inflection point
appears to have occurred in the middle of 2012, with hedge funds increasing their net exposure to
the global utility sector after a long period of reducing net. The long/short ratio of utility stocks held
by hedge funds fell from 3.0x in Jan 08 to about 1.7x in Jan 12 (4 years), but has since risen by 60% to
2.7x, which is more than twice the increase for hedge funds’ overall net exposure during the same
period (source: Goldman Sachs).
Based on discussions with the Street, it appears that this short exposure has been expressed via ETFs,
regional utility indices or large bellwether index utility proxies. Individual name crowdedness has
continued to remain at a low level (e.g., utilities rarely show up Goldman Sachs Hedge Fund VIP list –
ticker GSTHHVIP). Today, utilities account for the lowest in gross assets held of the 10 global
sectors. (Source: Goldman Sachs Hedge Fund Trend Monitor analysis of 700 hedge funds with $1.3
trillion in gross assets.)
In addition, global QE programs have boosted demand for higher‐beta stocks, which has contributed
to the recent relative underperformance of and lack of interest in utilities. However (see below), the
underperformance of US utilities has diminished with each successive QE round (QE1
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underperformance ‐39%, QE2 ‐12%, QE3 ‐5%), which signals exhaustion of selling pressure as the
relative value of the S&P versus utilities has stretched further. Given widespread use of QE, a similar
effect can be found in other regions.
US Utilities Price/S&P 500 Price
Source: Bloomberg
3. Regional Structural Changes Driving Alpha Opportunity
Structural changes are occurring in all regions. Those in which Electron is currently investing or tracking closely
are as follows:
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US Utilities
Of the global utility markets, we expect the US utilities market to face the strongest headwinds and be
the least‐attractive market for alpha generation over the next 2 years. Since the financial crisis, the US
has been the best‐performing region for utilities of all the developed markets, outperforming European
utilities by 40% over the last 4 years, and it is the region which is only slightly underweight by investors.
The US is the most defensive of all regions because of the large weighting of regulated names. Since 2008,
US utility earnings have been flat (versus a ‐45% decline in Europe), as consistent regulated earnings
growth of 3‐5% offset unregulated utility earnings declines resulting from lower power prices driven by
falling natural gas prices. Notwithstanding flat earnings growth, investors have re‐rated the US utility
sector’s PE multiple relative to the S&P as they sought more yield in a low‐yielding QE environment.
Today, US utilities are close to the sector’s pre‐crisis record valuation peak (trading at a 7% PE premium to
the S&P 500) when investors were discounting higher earnings growth from tightening power markets
(see below).
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Close to record
relative PE
Source: Bloomberg
While we will continue to see solid growth from the regulated names, and a total return argument can
still be made that justifies the current premium valuation of US utilities, we do see capex growth starting
to level off. This is the opposite of what will happen in Europe and Asia, where we expect regulatory capex
to increase. Moreover, we believe US utility regulators will continue to pressure returns on equity
(ROEs) as interest rates remain low. We believe there is greater opportunity among companies with nonregulated
power generation assets, as we expect firm natural gas and thus power prices to flow through
to earnings. Note, for example, that every $1/mmbtu improvement in natural gas prices would increase
Exelon’s long‐term earnings by more than 20%, whereas for pure generators such as NRG the leverage
exceeds 30%.
Below is a partial list of structural changes driving long/short opportunities in the US:
Electron’s structural changes: US
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Coal retirements’ impact on power markets
Change in competitive generation market structure as a result of the shale gas boom
Transmission spending to integrate renewables/improve reliability, and its impact on power prices
Obama initiatives on climate change legislation, and the EPA threat
Energy efficiency initiatives – utility uncoupling , demand growth
Nuclear assets facing closure – impact on power markets
Renewables’ power markets distortions (impact on peak and off‐peak power prices)
Increased infrastructure spending to move shale gas from basins
LNG export impact on gas and power markets
Regulatory ROE changes with low rates, higher capex, declining load growth, commodity price changes
Increased generator retail selling versus wholesale
Capacity market in TX, CA
State generation subsidy impacts on capacity markets
M&A and asset divestitures’ impact on power markets and utility risk profiles
Oil‐to‐gas residential switching
Electric vehicle demand impact
Regional load growth changes – manufacturing renaissance, state taxes, etc.
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�
European Utilities
We believe European utilities have the potential not only for the strongest outperformance but also for
the greatest alpha generation. Since the financial crisis, European utility earnings have declined
approximately ‐45% which is slightly less than European broader market earnings declines of ‐51% (Stoxx
600 or SXXP) and ‐58% (Stoxx 50 or SX5E). Prior to the crisis, European utilities used to trade at a 20%
premium to the broader market. During the recovery, European utilities suffered a ‐43% derating and
now trade at a 31% PE discount to the broader market. Most of this derating is explained by the
European utilities’ lack of participation in the European broad market PE multiple re‐rating (SX5E +115%,
SXXP +76%) since the recovery beginning in 2009. Moreover, approximately 40% of the sector is now
trading below book value.
Clearly, investors appear to believe that earnings have troughed for European companies broadly, but not
for European utilities. Concerns about political intervention along with low power and carbon prices have
prevented a re‐rating of the sector. However, we are comfortable that we are close to a bottom, and that
optionality is asymmetrically skewed to the upside for the European utilities, as many generation assets
are producing power at close to cash cost.
Relative to US utilities, European utilities have underperformed by ‐40% and the relative PE has de‐rated
by ‐11% since the crisis. The average European utility’s relative dividend yield is now 95% higher than that
of US peers before the crisis. Although some would argue that dividend cuts are coming (we agree
broadly, and see several interesting short opportunities), we do not see the entire sector’s dividends
being cut by 50%, as stock prices imply. As such, the sector today has dividend support even though some
dividend cuts will undoubtedly happen.
In addition to dividends, potentially higher power prices from both higher European coal and carbon
prices could also provide support. At present, the carbon market (EU ETS) in Europe is dysfunctional, with
carbon trading at €5/tonne, well below the cost required to spur investment in low‐carbon generating
capacity. We expect the carbon market to be restructured (already being discussed), thus raising the
price of carbon and increasing power prices. Moreover, with China’s GDP growth reaccelerating and 70%
of the resulting rise in electricity production generated from coal, we would anticipate a modest growth in
coal consumption in the Asian seaborne market, thereby supporting South African and European coal
prices. Given our view of rising US natural gas prices, we expect coal exports from the US to Europe to
fall. These are all factors that should support European coal prices even before accounting for greater
demand for coal that might come from Europe should growth return. Notwithstanding, short
opportunities will remain in several European markets due to the influence of renewables.
Moreover, if the European Central Bank were to lower its Main Refinancing Operations rate, currently 75
bps, and provide other monetary policy support, we would expect not only increased demand for
electricity (which would increase coal consumption) but also a weaker Euro would increase the Euro price
of coal (in Europe) and thus power prices. There are a number of factors at work here, and it is difficult to
predict levels with any degree of accuracy, but even small changes would have a significant impact on
the sector. For example, a combination of a +10% increase in coal prices, ‐10% decrease in the Euro/$
exchange rate, and a rise in the carbon credit price from €5 to €10/tonne would produce 25‐50% earnings
upside in many continental European utilities.
Below is a partial list of structural changes driving long/short opportunities in Europe:
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Electron’s structural changes: Europe
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EU energy efficiency directive and load growth
EU ETS (carbon market) changes
Renewables build and power market distortions
Mismatches between tariff rises and costs/capex
Infrastructure spending impact on energy costs and power/gas competition
UK capacity markets
Large combustion plant directive (LCPD) (UK)
Power market impact of nuclear phase outs (Germany) and new nuclear build (UK)
Political interference on the continent (taxes, return formulas, tariffs)
M&A, divestitures, privatizations’ impact on power markets and changing utilities’ risk profiles
Bifurcation of sector valuation because of WACC changes
European gas price delinkage from oil
Ongoing renegotiation of Gazprom contracts
European utility non‐regulated investments moving offshore
Erosion of the Italian power price premium
New Italian water regulations
Shale gas potential in Europe
Implementation of Russian RAB‐based regulation
Electric vehicles
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Asian Utilities
The Asian utility sector is a tale of two worlds. One enjoys a stable regulatory environment and solid
power purchase agreements, as in Hong Kong and Thailand; the other is a victim of government
intervention, as in Korea and China. The two worlds can coexist in the same country, for example in
Malaysia where independent power producers enjoy solid power purchase agreements while utility
Tenaga, which is a large employer and which faces the consumer directly, suffers from political meddling.
Capex cycles and potential regulatory changes, respectively, tend to dominate performance of the two
sides. For example, Korea Electric Power has outperformed sharply at times in the past on even small
steps toward fuel cost passthrough implementation. In India’s chaotic power markets, outperformance
could arise from even small steps toward implementation of urgently‐needed reform, e.g. any movement
to improve access to fuel supply (notably coal) for independent power producers. The dichotomy
between the two “worlds” of the Asian utility sector provides ample opportunities to generate alpha.
The vast population and developing nature of the region, and consequent issues of energy security and
environmental sustainability, create additional forces for structural change. For example, as China
increasingly promotes natural gas usage, we will see gradual pricing reform, more natural gas imports,
greater natural gas vehicle adoption and accelerating shale gas development.
Below is a partial list of structural changes driving long/short opportunities in Asia‐Pacific (ex‐Japan):
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Electron’s structural changes: Asia‐Pacific ex‐Japan
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China power market policy changes to address record pollution levels
Impact on China’s power market of selective coal plant approvals
Accelerating development of shale gas in China
Urgently‐needed power reform in India to address fuel, power tariff and grid issues
Potential carbon trading and Renewable Portfolio Standards (RPS) in China
Increasing promotion of natural gas usage and price reform in China
Fuel cost passthrough implementation amid a potential power shortage in Korea
Continued support for nuclear power by China – new‐build approval delay impact
Increased robustness of fuel cost passthrough regimes
Indian import duties on equipment
Increasing pressure on electricity tariffs in HK
Rising Australian domestic gas prices on LNG export arbitrage
Australian carbon market future
Consolidation of the Australian supply market into an oligopoly
Australian state regulatory evolution (e.g., electricity in Queensland)
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Japanese Utilities
The impact of the Fukushima incident on Japanese utilities will last for years. Nuclear policy will continue
to be reviewed – notably the decision whether to restart nuclear power plants – which will affect the
utilities’ long‐term fuel mix and therefore cost base.
For example, Kansai Electric Power, which has the largest exposure to nuclear generation after Tokyo
Electric, stopped paying dividends after the nuclear shutdown. Every 1% change in its nuclear fleet
utilization rate will affect earning by almost 10% over a normalized level; nuclear policy decisions can thus
create outcomes for share prices of +/‐ 50%.
The ripples from changing nuclear policy will have a long‐lasting impact, both negative and positive, on
companies involved in the nuclear value chain (e.g., reactor manufacturers such as Mitsubishi Heavy) and
other power‐related sectors such as gas and renewable energy. Relative to other regions, Japanese
utilities will be the most affected by macro factors (e.g. the Yen, interest rates, fossil fuel prices, etc.).
Below is a partial list of structural changes driving long/short opportunities in Japan:
Electron’s structural changes: Japan
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Fukushima incident’s impact on Japan’s power‐related sectors such as LNG and power equipment
Derating of sector as a result of the government’s response to Fukushima
Restart of nuclear plants with Abe administration and prefecture support
Fuel cost impact from Yen depreciation
Movement to higher value‐added renewable energy systems
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Latam Utilities
Latin America will be a trading market for the next year or two. These markets, with the exception of
Chile, are subject to significant government intervention, which follows long cycles; Brazil is early in the
interventionist cycle (e.g., Brazilian President Dilma Rousseff’s recent politicization of electricity tariffs),
while other countries such as Argentina are closer to the end.
Below is a partial list of structural changes driving long/short opportunities in Latin America:
Electron’s structural changes: Latin America
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Brazil’s tariff intervention and consequent derating of sector
Argentina’s increasingly urgent need for system investment and tariff increases
Shale gas development in Argentina and its impact on power prices and regional markets
4. Global Structural Changes Driving Alpha Opportunity
In addition to region‐specific structural changes, there are structural changes that have a global impact on the
utility sector.
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Power Prices are Skewed to the Upside
The cost of natural gas and coal sets the marginal power price in many power markets around the globe.
The rapid rise in US shale production that began in 2007 caused domestic gas prices to decline much more
rapidly than other fuels and put downward pressure on power prices both in the US and globally. For US
gas‐fired generator Calpine, lower fuel costs offset lower power prices and the company emerged a
relative winner. Virtually all other US generators employ a mix of assets fired by costlier fuels and suffered
a tremendous margin squeeze, with – in the most extreme example – coal‐fired generator Dynegy
declaring bankruptcy in 2012. We believe the downward trend in US natural gas prices has flattened for
reasons noted below, and upward optionality remains, which will affect power prices not only in the US
but also Europe and Asia given cross‐border commodity linkages.
In Europe, in an example of the regional, non‐correlated character of the global utility sector, a quite
different dynamic has taken shape, with coal‐generated power margins remaining attractive relative to
natural gas‐fired generation margins. Coal prices in Europe have declined as a result of cheaper US and
Colombian coal imports (because of US shale gas) and the knock‐on effect of softening Asian coal prices.
Carbon costs (i.e. EU ETS) embedded in power prices also have declined, from €16/tonne 2 years ago to
€5/tonne today, largely as a result of the European recession. With European natural gas prices at 3x US
prices (unlike in the US, natural gas prices in Europe are linked by convention to oil), European utilities
have been minimizing natural gas generation and maximizing coal generation. So, unlike the situation in
the US, coal generators such as Drax in the UK have enjoyed better margins on higher power output (see
below) as gas plants sit underutilized.
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Source: Bloomberg, Electron Capital Partners
We believe a floor price exists for natural gas despite shale production. We fully acknowledge that the
US has large reserves of shale gas awaiting development. However, the current spot price ($3.42/mmbtu)
sits below the breakeven full‐cycle cost of most US basins ($3.50‐$4.00/mmbtu), which has led producers
to focus on liquids‐rich plays and de‐emphasize dry‐gas production. Accordingly, the gas rig count is at a
decade low and the Energy Information Administration expects gas production to be flat through 2014.
With the wide spread between oil and U.S. natural gas prices likely to continue, we expect the growth in
liquids shale production to remain much higher than gas.
On the demand side, the power sector is the largest consumer (37%) of natural gas in the US. At prices
below $5/mmbtu, coal switching begins, and at prices below $3/mmbtu, gas‐fired power generating units
become competitive against even the most efficient coal units. Importantly, the breakeven point for coalto‐gas
switching will rise materially due to EPA mandates. By 2015, these standards move the breakeven
point for the most efficient coal units from $3/mmbtu to approximately $4/mmbtu, close to where
current forward prices sit.
Large potential structural changes in demand create upside optionality. There has been much media
focus on the growth of shale gas production, so much so that we believe potential demand drivers are
underappreciated. For example, currently‐planned US coal plant retirements, if repowered with gas,
would support an additional 6 billion cubic feet per day (bcf/d) of gas demand, adding nearly 10% to total
US demand. In addition, we see the potential for LNG exports to exceed another 6 bcf/d (27 bcf/d of
project capacity awaits US Department of Energy approval). Cheap gas is also spurring an industrial
resurgence, with new petrochemical plants being proposed in the Gulf and traditional coal users such as
steel mills contemplating refiring their facilities with gas instead of metallurgical coal. Longer term, LNG
as a vehicle fuel substitute for long haul trucks and CNG for lighter vehicles could also add materially to
gas demand. Given the number of possible structural demand changes and the enormous potential from
each, we believe the optionality for natural gas prices is clearly to the upside.
We believe the recent trend of softer US natural gas prices leading to a deflationary impact on global
utility sector earnings is, then, largely played out. Longer‐term, we see many positive demand
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fundamentals that are supportive of higher natural gas prices; while we don’t expect a return to the
commodity boom times of 2003‐2007, a turn in trend will be very supportive of higher share prices.
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Capex (ex‐US) is Rebounding Post‐Recession
Capital spending precedes earnings, and utility capex (ex‐US) is rebounding after a recession‐driven
slowdown. In particular, transmission spending is accelerating in Europe (Germany, Spain, France) and
Asia while remaining firm in the US. Transmission capex not only enhances system reliability but also
system efficiency, by enabling the delivery of the most efficient generation to meet demand. Many
transmission grids face bottlenecks because of the inclusion of intermittent renewable generation in areas
with ample wind and solar resources but located far from customers. Companies such as Northeast
Utilities (US), National Grid (UK) and Elia (Belgium/Germany) are prime beneficiaries of this transmission
capital spending, along with equipment providers such as ABB (Switzerland).
In addition, many global utilities will be viewed as back‐door beneficiaries of the shale gas boom
globally given the substantial amount of capex required to build new or upgrade existing infra‐structure.
US utilities are building much of the infrastructure to export gas out of the shale basins (Dominion,
NiSource) and are building LNG liquefaction facilities (Dominion, Sempra) that are at the front of the
queue for US Department of Energy approval. Several European utilities, such as GDF Suez
(Belgium/France) and Gas Natural (Spain), and Asian utilities such as Kunlun Energy and ENN Energy
(China; note that China has 2x the shale gas reserves of the US) are exposed to LNG infrastructure
spending.
Finally, because of emerging markets’ growth rates and a higher intensity of energy use, emerging market
utilities will benefit from infrastructure spending across the entire utility value chain.
5. Substantial Alpha Opportunities Follow Periods of Underperformance
The global utility sector has experienced record underperformance and often this precedes substantial
alpha opportunities.
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Record Duration and Depth of Underperformance
We have analyzed the price performance of the global utility sector since 1995, when MSCI introduced its
Global Sectors. Although the period includes only 18 years of data, this is the relevant time frame as it
effectively covers the entire period of industry deregulation (see Appendix 2, page 25).
As can be seen below, the current period of global utility underperformance is the deepest (‐67%) and
longest (4 years) of the modern utility era. Even with the strong rally in equity markets since the financial
crisis, the global utility sector is still down ‐11% on an absolute basis. It has not only been the worstperforming
MSCI global sector but has also underperformed the second‐worst global sector by ‐23%.
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Source: Bloomberg
Price
MSCI Global Sectors
1/1/2009 12/31/2012 Performance
Consumer Discretionary 68.5 132.4 93%
Information Technology 54.2 96.9 79%
Materials 146.1 237.2 62%
Industrial 101.4 155.8 54%
Consumer Staples 104.7 160.5 53%
Health Care 89.1 128.4 44%
Energy 181.9 238.9 31%
Financials 63.0 82.0 30%
Telecom 51.0 56.9 12%
Utilities 113.4 100.9 ‐11%
Source: Bloomberg
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Reasons for Underperformance
Much of this recent underperformance can be explained by investors’ textbook preference, coming out of
recession, to add high‐beta stocks and shed low‐growth utilities. This was exacerbated by:
o soft power demand growth (particularly in Europe);
o generation overcapacity;
o delays in capital spending;
o lower commodity prices (particularly as a result of US shale gas production);
o central banks’ quantitative easing;
o political interference (notably in Europe);
o high debt loads;
o the Fukushima nuclear disaster in Japan; and
o concerns about interest rate rises from today’s very low levels.
It is hard to imagine a more perfect storm for the global utility sector than that which has played out
over the past 4 years.
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Potential Exists for Sharp Outperformance
Globally or regionally, it is not unusual to find long and/or sharp periods of utility underperformance (as
with the current record period). During such periods, when combined with wholesale shorts and market
underweighting, the sector becomes poised for extended outperformance rallies. This results from
fundamental investors (both long/short and long‐only) rotating into the sector en masse, bidding up the
best value and growth utilities and underweighting or shorting utilities with poor business
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models/prospects. This can be triggered by improving sector fundamentals, better data points, or
conversely by events that instead lower investors’ perception of economic growth prospects (e.g., policy
errors, rising European sovereign yields, higher commodity prices, etc.).
As noted above (page 5), each time the sector’s underweighting reaches 1 standard deviation below the
mean, over the next 24 months global utilities rise by 38% on an absolute basis and outperform the global
broad market by 20%, on average (see graph below).
Cumulative
outperformance
Source: Bank of America Merrill Lynch, Bloomberg
When these outperformance rallies occur, the potential massive alpha opportunity can be substantially
greater than the return from a fund’s net position.
As examples, we highlight the lessons from the dotcom period (second only to today’s record
underperformance) and lessons from Japan (given the deleveraging environment of today).
o
Post‐Dotcom Rallies
The last time we saw underperformance anywhere close to today’s magnitude was during the 3‐
year run‐up to the dotcom bust (see graph below) as investors grabbed for growth in the “new
economy”. During the run‐up (Jan 97‐Jan 00), tech and telecom were the best‐performing sectors,
+322% and +162%, respectively. The global utilities sector was the second‐worst‐performing global
sector, +12% and in line with the +9% worst‐performing materials sector.
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Source: Bloomberg
Of course, not all investors sold utilities – some were astute buyers. Warren Buffett (at the time,
thought to be a bit out of touch with the new economy) acquired $12 billion worth of utility assets
between 1999 and 2002, namely MidAmerican ($9 billion), Kern River Gas Transmission ($960 million)
and Northern Natural Gas ($1.9 billion).
Following the dotcom bust (Mar 00‐Sep 01), global utilities staged a sharp catch‐up rally over a 1.5‐
year period, generating +33% outperformance (‐5% absolute). During this period, US utilities (which
previously were the worst‐performing region for utilities during the run‐up) outperformed +68%
(+37% absolute). But the averages conceal some outsized moves in utility stocks as investors
returned to the sector en masse. Early investors realized enormous absolute returns on low‐beta US
utility stocks (e.g. SO +114%, ETR +114%, FE +99%, AEP +91%, PEG +78%) while the S&P sank ‐31%.
Still, investors were discriminating as several stocks (e.g., CVA ‐45%, AES ‐34%, EIX ‐19%, PCG ‐16%,
NU ‐3%) suffered absolute declines.
In Europe, the UK water utility stocks (among the lowest‐beta/volatility stocks in the global sector)
were wholly ignored during the dotcom rally despite their improving fundamentals. Following the
dotcom bust (Mar 00‐Sep 01) they also staged a fierce outperformance rally, and early fundamental
investors realized very attractive absolute returns (e.g. Pennon +80%, Severn Trent +52% and United
Utilities +21%), and enormous outperformance of the broader market (FTSE 100 Index ‐33%). This is
all the more impressive when you consider that these water utility stocks have betas of
approximately .43, less than half that of the broad market.
Again, fundamental investors were discerning as several European utilities experienced absolute
declined during this same period (e.g., EDP ‐31%, Enel ‐30%, Endesa ‐20%, Centrica ‐19%).
o
Japan Rallies
Japan offers insights into potential utility outperformance during periods of private sector
deleveraging similar to what developed markets have experienced since the financial crisis.
Richard Koo, Chief Economist of the Nomura Research Institute, cites two major policy errors that
extended Japan’s long balance sheet recession: increased taxes in 1997 and expenditure cuts in 2001.
Both policy errors were preceded by a long or sharp period of utility underperformance relative to
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the broader market. Following the policy errors, Japanese utilities staged exceptionally strong
outperformance rallies lasting over 1.5 years, on average, and outperforming the Topix by 30‐40%
(graph below).
Source: Nomura Research Institute, Bloomberg
During the Jan 97–Nov 98 policy error period, fundamental investors bid up the better prospects
(Tokyo Electric Power and Osaka Gas each rose 34%) while the Topix declined by ‐19. During this
same period, some Japanese utilities also posted sharp absolute declines, such as Hokkaido Gas ‐49%,
Saibu Gas ‐30% and Okinawa Electric ‐27%. During the May 01‐May 03 policy error period, Okinawa
Electric and Hokkaido Gas rallied +40% and +23%, respectively, while the Topix declined ‐44% and
Tokyo Electric Power and Osaka Gas declined ‐13% and ‐7%, respectively.
The Japanese utility experience is very interesting as several economists question whether the US is
currently committing similar policy errors while deleveraging is still occurring in the private sector
(e.g. the US just increased income and payroll taxes and is implementing austerity measures). The
Japanese experience demonstrates the potential for strong outperformance rallies during periods of
deleveraging, demonstrating the alpha opportunity arising from an influx of fundamental investors
into the sector after periods of limited interest.
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Potential for Yield Catch‐up
Unlike other income‐oriented investments such as Treasuries, German bunds, UK gilts, investmentgrade
bonds, high‐yield bonds, emerging market bonds and MLPs, all of which have rallied strongly –
some believe as the result of a yield bubble – the global utility sector has been left behind; yet
certain parts offer a compelling investment yield opportunity today. If some fixed income cross‐over
investors become more concerned about inflation (because of economic growth), yet continue to be
squeezed by the QE programs of the Fed, BOE, BOJ, etc., then they could begin shifting into global
utilities. This seems logical, as such investors would look for the closest bond proxies in the equity
market, the utility sector, rather than bypass utilities for high‐beta broad market stocks. Given the
enormous amounts of capital controlled by fixed income cross‐over investors, even a small
reweighting could have a significant effect in bidding utility stock prices up and yields down.
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6. Interest Rate Risk – A Common Misperception
We find a common misperception among investors to be the degree of interest rate risk in the global utility
sector, as interest rate sensitivity has declined steadily since the modern utility industry came into being in
the early 1990s.
There is a relatively higher degree of interest rate risk in the defensive, fully‐regulated utilities given their
bond‐like returns and the capital‐intensive nature of the industry, which demands heavy use of debt financing.
Such defensive fully‐regulated utilities can be found in all regions, however the highest concentration is found
in the US. European, Asian and Latam utilities are more levered to economic growth and therefore tend to be
no more interest rate‐sensitive than broad market equities.
Even the performance of the more interest rate‐sensitive US utilities is not fully determined by interest rates.
For example, during the market rally from fall 2002 to summer 2007, the US utility sector generated a nonbeta‐adjusted
annualized total return 5.2% higher (2.8% from better price appreciation and 2.4% from
dividend reinvestment) than the S&P 500, while the 10‐year Treasury yield rose from 3.6% to 4.9% (+130 bps)
over this period. Valuation re‐rating and earnings growth from generators, as economic growth tightened
power markets and raised commodity prices, outweighed the negative impact of rising interest rates.
We would note furthermore that yield relationships have moved to unprecedented extremes such that, for
example, the dividend yield for US regulated utilities versus the 10‐year Treasury yield currently sits at 7
standard deviations above the mean from the historical pre‐2008 environment (see graph below). An even
more dramatic relationship exists for the European utilities. This suggests that policy rates are at such levels
that there is substantial cushion against rising rates.
Source: Bloomberg
Finally, we track interest rate risk in the Electron risk model for all positions. We are not looking to make
macro calls, and the portfolio’s net interest rate risk is kept within acceptable limits as we select stocks in the
global utility sector. This process has worked well for us as over 7 years we have posted strong returns and
alpha generation in both rising and falling interest rate environments. As a result, many investors are
pleasantly surprised to learn that despite perceptions of the global utility sector’s interest rate sensitivity,
Electron’s return correlation to interest rates is slightly lower than the HFRI Equity Hedge Index’s return
correlation to interest rates.
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Appendix 1: The Team and Our Process
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Electron Focus
Electron’s universe of utility and infrastructure stocks is deep, comprising 375 companies with a market
cap of $2.8 trillion. Stocks covered include the electric, gas, water and waste utilities in addition to
infrastructure companies (defined as those levered to utilities or utility‐like). Our approach is truly global
as 40‐60% of the portfolio’s historical gross has been allocated outside the US.
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Electron Team
Electron’s cohesive, long‐standing team consists of 8 members, including 5 investment professionals who
have worked (with Jos Shaver as Portfolio Manager) at SAC Capital and the original Electron Capital for an
average of 6 years. In addition, 4 of the 5 investment professionals have lived outside the US, a distinct
competitive advantage given our global approach. Each investment professional brings his/her own
specific expertise and diligent research to our process, working collaboratively across regions to conduct
deep‐dive research on the most compelling opportunities in the global utility sector.
The other members of Electron complement the skills and experience of the investment team. Electron’s
experienced operations/investor relations professionals are former Intrepid Capital employees who
worked with the Electron team during the first iteration of Electron (2005–2008) when the firm had a
services agreement with Intrepid Capital.
Finally, a Senior Advisory Board consisting of former C‐level utility executives from around the globe has
been with the team since the launch of the original Electron Capital in 2005, and all have rejoined for
Electron’s re‐launch.
As Portfolio Manager, Jos Shaver has covered the global utility and infrastructure sectors for the past 21
years, and his sector perspective benefits from his having lived 10 years abroad (5 years in Asia covering
the Asian utilities and 5 years in Europe covering European utilities) and 11 years in the US. In addition, as
Managing Partner, Jos controls all major decisions at Electron.
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Track Record (7 years)
Electron’s 7‐year track record (3 years audited from the original Electron and 4 years from SAC Capital)
has annualized 10.3% since inception and has been characterized by strong alpha generation on both the
long and short side (80% of returns, based on Jensen’s alpha calculation). Electron generated this 7‐year
track record during an exceptionally challenging period for global utilities – the MSCI World Utility Index
has been the worst‐performing MSCI Global Sector ex‐financials over the track record period, down ‐0.2%.
Notwithstanding, Electron’s track record has bested the MSCI World Utility, S&P 500 and HFRI indices by
91%, 67% and 61%, respectively.
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Process
First, given Electron’s global approach to utility research, we tend to have a clear competitive advantage
with respect to early recognition of cross‐border structural change (e.g., how a change in Asian seaborne
coal market might affect off‐peak power prices and thus earnings for a Midwest US utility). Moreover,
our global research approach allows us to gain perspective on structural change outcomes given our
knowledge of global precedents and the likely reaction from various interested parties (e.g., governments,
regulators, managements, customers, consumer groups, rating agencies, shareholders, debt holders, et
al.) We analyze other global precedents, develop a thesis and then conduct deep‐dive research to gain
conviction. Once we have developed a structural change thesis, we proceed to a full bottoms‐up analysis
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of the earnings impact for the relevant companies, and assess what might be priced in by thoroughly
reviewing the Street’s numbers and commentary. It should also be noted that the same structural event
often affects not one but several companies, and the implementation of these structural changes are
typically not one‐day events. As such, depending on the situation, we may have the opportunity to
capitalize on the same structural change event several times as it develops.
Our research process is our primary idea generator. We travel extensively and, collectively, the 5
investment professionals will have between 600 and close to 1,000 meetings a year as we speak with
companies, regulators, consultants, sell‐side analysts and governments.
o
Why We Take a Global Approach ‐ The “Greatest Gift”
Electron takes a global approach (historically, 40‐60% of gross allocated outside the US) to the
utility sector: i) to spot structural change and resultant inefficiencies early, ii) to provide a wider
canvas to allocate capital around the globe to the most attractive (from a risk/reward point of view)
alpha opportunities and, most importantly, iii) to enable the Electron Global Funds to take advantage
of the global sector’s very low inter‐regional correlation (i.e., correlation of regions within the global
sector; lowest of all MSCI global sectors – see below).
One of the least
correlated sectors
Source: MSCI, 7 years’ weekly trailing correlation
We call this very low regional correlation the global utility sector’s greatest gift to long/short
investors as it provides a greater return per unit of risk if one has the ability to dynamically allocate
capital to and generate alpha in all regions. There are few long/short global utility funds today given
the global utility experience required to capture the greatest gift, as different countries have different
utility market designs and structures.
The Electron process starts with a focus on structural change and we embrace the myriad of utility
markets’ differences around the globe because this approach leads to the most attractive alpha
opportunities and the benefits of the “greatest gift”. We allocate capital dynamically to the most
attractive alpha opportunities in the global utility industry. As a result, the Electron Global Funds is
only one fund, yet the “greatest gift” provides the diversification benefit of 4 relatively uncorrelated
regions and concentration in the globe’s most attractive alpha opportunities.
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Capitalizing on Structural Change Timing
Although some of the structural changes discussed earlier happen in days or weeks, e.g. fuel cost
passthrough adjustments, others will take years to implement, for example, new capacity payment
structures. Because of the sector’s high earnings visibility, however, we do not have to wait until a
particular structural change occurs for a thesis to play out. Utilities often have earnings visibility 2‐3
years out (including Street estimates) which is in contrast to other sectors (e.g. tech) which often
times do not have 2‐3 quarters of visibility. As such, utility stock prices (and the Street’s estimates)
will begin to discount even some of the longer dated structural changes as clarity surfaces in the early
stages. Therefore, there is a distinct competitive advantage for those who have an early
understanding of such structural changes and the resulting earnings impact on affected utilities. We
therefore focus our efforts on discerning the structural change opportunity early in an effort to come
up with a view before it becomes obvious to the broader market.
Moreover, there are often several opportunities over an extended time period to trade the same
structural change as numerous stakeholders (e.g. government, regulator, company, customers, et al.)
involved in the process distort market perceptions of the final outcome.
Although structural changes are the “home run” opportunities, Electron returns are not limited to
such changes, as we also consistently play for “singles and doubles” in the global utility sector with
earning releases, regulatory reviews, dividend increases and decreases, relative value, regulatory
arbitrage, etc.
As evidence of Electron’s ability to successfully trade both shorter‐ and longer‐term structural
changes, please note our sweet spot for generating returns over the 7‐year track record has tended
to be 45‐90 days.
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Portfolio Construction
Typically, the portfolio has 70‐100 positions, but concentration is very important to generating returns.
Historically, the top 10 longs represent 40‐50% of the Fund’s value, and top 10 shorts represent 30‐40% of
the fund’s value. Typically we will have a 10% position in the portfolio; this is invariably a liquid, big‐cap
utility name with limited downside and a good degree of upside which is expected to be favorably
affected by a key, underappreciated structural change.
The stronger the conviction (from a risk/reward point of view) in the alpha opportunity, the higher the
gross we run. This flexibility in portfolio construction (which we successfully proved over 3 years during
the first iteration of Electron) provides a distinct advantage given the utility sector’s many low‐beta, lowvolatility
stocks. During the original Electron Capital period, gross ranged from 150% to 215% and a
median of 185% over the period. We see maintaining a similar operating range for gross for the re‐launch
for Electron.
Regarding nets, we will always have a properly hedged product as there are always opportunities on the
short side to generate alpha. Over our 7‐year track record period, the net averaged 22% net long. During
the first 3 years of Electron, our net averaged 30% long. Given our bearish view on utilities over the last 4
years, the net averaged 17% net long.
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Risk Model and Risk Management
We view utilities as distinct bundles of risk. Just as we are staunch supporters of sum‐of‐the‐parts (SOTP)
valuation, we are also believers in SOTP risk monitoring. As such, our risk model developed over the last
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8 years tracks approximately 60 industry, commodity, and financial risk metrics and is a focus for the
Electron team. For example, consider oil price risk; although there may be no direct oil exposure in the
portfolio, there is indirect oil exposure if we were to be short Drax, a coal‐fired generator that sells power
into the UK power market. In the UK, natural gas sets the marginal price of power, and in Europe, by
convention, natural gas is linked to the oil price; as such, a short position in Drax represents an effective
short position in oil. We track this risk along with numerous other factors that affect utilities, with the
purpose of minimizing risks for which we have no competitive advantage that would justify taking on the
exposure. We describe the risk model in more detail in the marketing book. In addition, we make the
Electron risk model available for all prospective investors’ due diligence.
Each position in the risk model contains a thesis write‐up (to avoid thesis creep); upside, downside and
relative targets (for valuation discipline); and a time frame (to avoid collecting stocks). In addition to
tracking numerous industry, financial and macro risks, we also track alpha generation for all of our
regions, sectors, subsectors and sub‐subsectors, which provides the added benefit of a granular window
on market flows. Finally, we incorporate an exponential function into the risk model that provides an
early alert and focuses our attention when something is not working. For example, we might be short
XYZ utility with 30% downside potential over 3 months, and put in a 15% loss limit. If in the first week XYZ
runs up 5%, it will trigger a “FAST” move alert in the risk model. If we cannot explain why the position is
moving against us, we will cover (i.e., when in doubt, get out). As mentioned, this is not a crowded space
(rarely do utility names appear on the Goldman Sachs Hedge Fund VIP list) and many names are low‐beta,
low‐volatility stocks. However, often when money is lost on the short side, it is the result of small daily
losses that would not be noticeable on any given day, but over even short periods of time can add up to
sizeable losses.
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Shorting Global Utilities
o
Experience with Dividends and Investor Behavior
During the underperformance of the global utility industry over the last 4 years, Electron generated
very strong alpha on the short side. We spend almost twice as much time on the short side as we do
the long side; this is driven not only by the need for more short positions (given the asymmetry of
risk) but also because of the effect of utility dividends on investor behavior. For example, we might
be short a large cap utility with a 4% dividend yield that we believe to be a structural loser. The stock
might decline 25%, which would push the dividend yield up to 5.5%. Even though our valuation
models might tell us there is still another 10‐15% valuation downside, we will tend to cover (unless
we believe the dividend is materially at risk), as the dividend yield will begin to provide support for
the stock. The precise level of the dividend yield at which we would cover is as much an art as a
science, as it is based on our experience in a variety of situations and our views on investor behavior
(particularly income funds) gained over many years of covering the sector. As such, you will find us
trading around our short positions more frequently than our long positions.
o
Key to Electron’s Process to Identify Dividend Change Candidates
We also have developed a certain expertise in being early and correctly calling dividend changes – an
event that can have a dramatic impact on the performance of utilities given the make‐up of the
investor base. In our long experience, utility CEO/CFOs will strongly defend the company’s dividend
(often borrowing or selling assets to fund it). As such, when they do finally cut the dividend, or talk
about the possibility, they often surprise the market.
It pays to be diligent in assessing the potential for a dividend cut, and to be early, since once
CEO/CFOs accept that their business model is deteriorating, they will quickly take action, especially if
their companies have less flexibility (particularly with respect to cutting capex and opex). Large‐cap
utility managements desire strong credit ratings and are reluctant to risk an investment grade rating.
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They are in a capital‐intensive business and need to preserve deep, low‐cost access to both the equity
and debt capital markets. Moreover, collateral requirements for forward power price hedging
typically will spike if a utility loses its investment grade rating, which can spur concern about liquidity.
Building conviction around a dividend cut thesis requires more than screening. Our process focuses
on researching capex flexibility, cost‐cutting potential and asset divestiture potential to determine
the flexibility a company has under various scenarios. Our research process breaks capex into 3
buckets: i) committed capex (e.g. required by the regulator), ii) nondiscretionary capex (e.g. major
plant overhauls – CEOs tend to avoid delays so as not to jeopardize billion dollar‐plus assets), and iii)
discretionary capex (CEOs can delay but may jeopardize future growth).
Regarding opex, we look for cost‐cutting capability, which we estimate by breaking apart the opex
line or by global benchmarking. Finally, we estimate the potential impact from possible asset
divestitures and the resulting impact on earnings and leverage. Once we have completed the
research work on capex, opex and potential divestitures, we model various sensitivities from
structural changes or other key drivers that might cause a deterioration or improvement in a utility
company’s business model against forward‐looking credit rating agency (S&P, Moody’s, etc.) ratios.
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Appendix 2: Global Utility Sector Background
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History
To gain a deeper appreciation of why the global utility sector is attractive for long/short investing, it is
helpful to briefly survey the history of the sector and describe the utility value chain’s components.
The utility industry as we know it began in 1882 when Thomas Edison built the world’s first generating
station on Pearl Street in downtown Manhattan. In the early decades the industry evolved along multiple
lines but eventually settled into an integrated, fully‐regulated model, deemed appropriate as utilities
were considered to have monopoly power. During the era of full regulation, utility stocks were often
characterized as low‐risk “widow and orphan” stocks in the US, and large parts of the global utility
industry remained government‐owned. During these early days, long/short investing could not have
existed at scale, as the ability to find and generate short alpha would have been difficult given the sector’s
government ownership and bond‐like nature of returns.
In the 1980s, Lord David Howell (formerly UK Secretary of State for Energy in the Thatcher government)
advocated having then‐fully regulated power plants compete to sell their production into a competitive
power market (a “power pool”) where the price of electricity would be set at the intersection of supply
(power plants) and demand (industrial users and electricity supply companies selling to households). This
led to the world’s first competitive power pools being rolled out in the UK in the early 1990s. While
based in Asia, Jos Shaver led UBS’ Asian utility industry group and had the privilege of working with Lord
Howell when UBS acted as advisor to the State Power Corporation of China on the restructuring of that
country’s national power industry.
Competitive power pools have since sprung up all over the world, and regulators have pulled apart
previously fully‐integrated utilities in the name of efficiency and maximizing competition. In addition,
governments around the world have begun to privatize their state utility industries and organize bespoke
competitive market structures that best meet their needs. These changes have resulted in a hybrid
modern industry which continues to evolve.
The deregulatory impulse has brought tremendous benefits to national economies, driving down costs
and improving efficiency and system reliability, but has also produced unintended consequences, e.g., the
high‐profile bankruptcies of Enron, British Energy, Dynegy, NRG, PG&E and others. As such, although one
can still find low‐beta, low‐volatility defensive stocks, the global utility sector has not been for “widow
and orphan” investors for quite some time due to structural changes in an evolving industry that
continue to alter the investment landscape.
It is important to note that the modern utility industry is still in its infancy, having begun in the early
1990s, and its continued evolution – structural change – will provide ample long/short opportunities for
the foreseeable future. Structural change catalysts are driven by: i) a utility’s various stakeholders,
including governments, managements, consumers, et al. which seek to mold the utility to their needs and
objectives, or ii) variables outside of stakeholder control such as commodity prices and new technologies.
A specialist approach to the global utility sector is essential as each country’s market structure (and often
that of regions within countries) can be very different as a result of the varying levels of competition,
market concentration, geographic constraints, infrastructure bottlenecks, regulatory constructs, fuel
supply availability and so on.
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Utility Value Chain
The electricity value chain for a modern day fully integrated utility consists of Generation + Transmission
+ Distribution + Customers (see diagram below). Each segment of the value chain is a different business,
with distinct risks and economic drivers. Competition has surfaced in each part of the value chain other
than transmission and distribution (which are fully‐regulated assets as they are deemed to be natural
monopolies). Still, regulators have learned to bring indirect competition even to monopoly‐regulated
businesses by encouraging returns based on efficiency improvements or benchmarking to comparable
companies.
Source: US Department of Energy
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Disclaimer
This report, which is attached as an exhibit to the Investor Presentation, is presented by Electron Capital Partners
LLC (“Electron”) solely for information purposes to provide recipients with general information regarding Electron’s
current view of the global utility sector. This report is a summary and does not purport to be complete.
This report does not constitute an offer to sell, or a solicitation of any offer to buy or sell, any securities or to
provide any investment advisory services. Any such offer will be made solely to qualified investors by means of a
final offering document and related subscription materials, which will contain material information not contained
herein and to which the prospective investors are directed. This report is not intended to supplement, modify or
replace such documents, which should be carefully read prior to investing.
An investment in any security involves a high degree of risk. No assurance can be given that Electron’ investment
objectives will be achieved and investment results may vary substantially on a quarterly, annual and/or other
periodic basis. Past performance is not necessarily indicative of future results. The nature of, and risks associated
with, the investments to be made by Electron may differ substantially from the nature of, and risks associated
with, investments undertaken historically by the principals of Electron.
Recipients should not construe this report or any other communication received in connection with Electron or any
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in part, or the divulgence of any of its contents, is unauthorized.
Any projections, forecasts, opinions and estimates contained in this report are necessarily speculative in nature
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materialize or will vary significantly from actual results. Accordingly, actual results will differ and may vary
substantially from the results shown.
Electron has prepared this report, in part, on the basis of information and data filed by issuers with various
government regulators or made directly available to Electron by the issuers or through sources other than the
issuers. Although Electron evaluates all such information and data and may seek independent corroboration when
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completeness, genuineness or accuracy of such information and data and, in some cases, complete and accurate
information is not available.
For exclusive of Jeffrey Epstein
27
Electron Capital Partners, LLC