When a Storm Comes, Will the Grids be Ready?

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ANNOUNCER: Welcome to Viewpoint-- A TD Securities Podcast. Listen in as we draw perspectives from a variety of thought leaders on key themes influencing markets, industries, and the global economy today. We hope you enjoy this episode.

AMY VAN ARNHEM: Hello, and welcome to episode 19 of Viewpoint-- A TD Securities Podcast. My name is Amy Van Arnhem, and I will be your host for today's episode. I'm joined by my colleague, Linda Ezergailis. Linda is a top-ranked pipeline power and utilities analyst, who's been with TD Securities since 2003. In anticipation of our upcoming Power Utilities Conference on May 25, we are joined by Linda to speak to some of the key themes and trends in the power and utilities sector. Linda, thank you so much for joining us.

LINDA EZERGAILIS: Thanks for inviting me, Amy.

AMY VAN ARNHEM: So I noticed on the agenda for this year's conference that you'll be joined by a special speaker at lunch, our new colleague, John Miller, from TD Cowen's Washington Research Group.

LINDA EZERGAILIS: I am so excited to work with John. I've spoken with him on the phone, but it'll be my first time meeting him at the conference. And I am so excited to hear all his insights and leverage those in my work.

AMY VAN ARNHEM: Well, it's great to see the beginning of how our combined firms will be able to bring greater insights and value to our clients. So I look forward to that. So Linda, you've covered the power and utility space for over 20 years. What are some of the aspects of this sector that get you excited and that you think are unique? Basically, like, what gets you out of bed every day?

LINDA EZERGAILIS: So before we jump into our conversation, Amy, I should probably give you a bit of background from where I'm coming from and my perspectives, which inform my viewpoints. I once worked as an engineer in my youth before coming into the securities business, and my time in industry really motivated me to do an MBA. After which, I spent some time as a strategy consultant. So I bring all of those perspectives to the table in equities research. And I actually joined the business around when the dot-com bubble burst, and there was such disruption in the power market. So it was a very dynamic and sometimes stressful time in the capital markets, but it certainly informs my view of the importance of doing proper analysis and the rigors required to come to an appropriate investment thesis for the companies I cover. And a big reason why I gravitated to the energy infrastructure space was this need to understand some of the technical, political, as well as economic constraints that inform how companies make investments and their strategic choices. And I think my engineering and strategy background really contributes to a differentiated perspective, which I think clients value. Energy infrastructure really is an essential service and is so important as we go through this decarbonization journey in North America. They have operated under a regulatory compact for over a century, so there has been a lot of stability. But over the past couple of decades, nobody could have predicted how dynamic both the energy space as well as the capital markets have been. And that really gets me up out of bed in the morning because who knows what sort of adventure I'll be on, including this morning, from a news story that I just didn't expect to come out, so that's pretty exciting. And clients want to hear my updated views. So a timely refresh of my investment thesis and supporting clients in making their investment decisions is really what gets me out of the bed in the morning.

AMY VAN ARNHEM: The power and utility sector has been central, as you mentioned, to the evolution towards a lower-carbon future, and what you've also mentioned is that they've been operating under a rigorous framework for a long time. So maybe you could speak a little bit more to how the sector's managed, not only the environmental aspect of ESG but also the social and governance issues over time.

LINDA EZERGAILIS: Sure. So integrated electric utilities that I cover have been eliminating coal from their generation mix and introducing renewables, such as wind, solar, and hydro, where possible. Also, one thing that they have to think of is when they're adding this generation, which is quite intermittent sometimes-- the wind doesn't always blow, the sun doesn't always shine-- you have to really plan ahead and ensure that there's other ways that the grid can adjust for this intermittent load, and there's also limits to how much of that they can introduce over time. So there's a lot of planning behind the scenes beyond just the headlines that we read about in the papers in terms of what changes are coming. If you also look at what natural gas distribution utilities are doing, they're a little bit behind what we've seen electric utilities going on the decarbonization journey, but they're starting to add renewable natural gas from landfills and also starting to explore blending hydrogen as well. So this is really exciting. And as these new technologies and renewable sources increase in scale, they've come down the cost curve, which is great because that sometimes eliminates or reduces the need for government subsidies and ensures that customer bills can still be affordable. Another thing that utilities have been doing for quite some time is having something called demand-side management programs. And those help customers manage their consumption patterns of energy and the level of usage. So for example, utilities will help customers in procuring more energy-efficient appliances, for example, and that's a really good and efficient way to reduce emissions by just not consuming.

AMY VAN ARNHEM: Yeah.

LINDA EZERGAILIS: In terms of the S, or the Social side, of ESG, there's lots of ways that utilities have been working on this front. They need to serve society. And for everyone's benefit, things like consulting communities before they build large projects is an important part of how they consider the social side beyond just what they do in their companies. And they have diversity, equity, and inclusion programs that consider women and minority participation in the workforce. And a lot of utilities also have considerations around net economic benefits for Indigenous communities. And that involves education, employment, and also in some cases, co-investing in utility infrastructure projects, which is a great emerging opportunity that's still growing. In terms of the G part of ESG, or Governance, this is really something that companies have had to consider since I've started in the business, and it's so foundational to what they do. Really, boards of directors have key responsibilities. They have key metrics that they look at. And ultimately, how they do on governance influences their performance on the environmental side, on the social side, and at the end of the day, how much shareholder value they can create, which is what we measure here in equities research.

AMY VAN ARNHEM: One other area that I was hoping to chat a little bit more about was on inflation. So you had mentioned that as well, but the power utility sector is obviously impacted by inflation. So maybe you could speak a little bit about how that's impacting the capital and operating expenses for the sector and what mitigating measures they have to combat it.

LINDA EZERGAILIS: Sure. Well, inflation is certainly top of mind, both in the workplace and on the home front, for a lot of us. So the interesting thing about utilities is that it affects them on a number of fronts. So on the capital project side, not only are components and labor costs more expensive, but sometimes the supply chain disruptions we've seen add lead times and can cause delays in projects, and time is money, as we all know. So that's definitely a consideration. The one thing that these larger companies can do is even if they don't know what projects they'll have in a couple of years, they'll order components ahead of time and be quite confident that they'll get used in some way, even if they haven't been allocated to a project. The other thing they have to do is just stockpile parts, and there's a cost to that, to have that working capital sitting idle. But if an operating facility goes down, you need that part, so it certainly is important for reliability, and that adds costs. These inflationary pressures don't affect their margin, typically, because customers, ultimately, are billed for these prudently-incurred, inflationary higher costs. And customer rates tend to get adjusted either through automatic inflationary adjustment mechanisms, or sometimes the utility does have to apply to the regulator to increase rates. But they do it very mindfully around customer affordability. And sometimes, if there are some discretionary projects, they might defer them. Obviously, the ones related to safety and reliability, those projects do get done in a timely manner.

AMY VAN ARNHEM: So have those rate increases kept up with what the companies generally have been seeing from an inflationary perspective?

LINDA EZERGAILIS: It's hard to specifically measure that because sometimes weather has skated them onside. So we have had some hot summers, for example. And when it's hot in the summer time and customers are using more load, then they're paying more for their electricity, which sometimes more than offset, sometimes, the inflationary pressures. And sometimes regulatory decisions, especially in Canada, can be retroactive. So even if customer rates have not kept up, the revenues will catch up retroactively. So there's some--

AMY VAN ARNHEM: Some give and takes.

LINDA EZERGAILIS: Some give and takes, yes. The other thing to remember is that to the extent that interest rates are higher and nominal rates are higher, these companies are allowed to earn a fair return. That's one of the foundational principles of the regulatory compact. So customer rates will tend to reflect higher returns on equity that are allowed as well. And really, when you look at all of that together, there really is some pretty good inflation protection for the sector.

AMY VAN ARNHEM: Well, you did mention something on the regulation side, which does provide some protection here. Maybe you could talk a little bit more on policy and regulation. It is an important part of the power utility sector. Could you speak through some of the current issues that are being discussed right now?

LINDA EZERGAILIS: So companies in my coverage universe are in the front lines of delivering energy to customers and therefore have important views and insights as to how policy might affect their operations and customer experiences over the long term. So not only are they implementing policy over the long term, but a good practice for governments is to consult with all stakeholders, including utilities and customers. My view is that the biggest issue that we're systemically hearing across all jurisdictions is around decarbonization and emissions reductions. And how a jurisdiction goes along that path is very dependent on the starting point where they're at and the resources they have. So that journey will be different in different jurisdictions. But collectively, we're all doing that together, and there are interdependencies. I think one of the other issues that's emerged as a result of that is, who's going to pay for the cost of this transition equitably? There's intergenerational considerations in terms of the timing of when customers are charged for this, and all of these investments in decarbonization are being layered on top of the natural inflation that we're seeing. I'm of the view that customer affordability will continue to be an issue for some time. So stay tuned because we're going to be talking about this for years to come. Another issue is for jurisdictions that have experienced some pretty extreme storms, which seem to be coming from climate change, is, how are we going to maintain grid reliability and storm hardening to ensure that customer service is not interrupted, as we likely will see increasing volatile hurricanes in coastal areas, potential ice storms? And now, unfortunately, we're seeing more wildfires in certain regions in North America as well.

AMY VAN ARNHEM: Maybe let's talk a little bit more about the differences we've seen in the weather and some of the varying opinions out there in terms of how you have that balanced grid. So how does the politics come into play a little bit when you start talking about that right mix of renewable versus more traditional--

LINDA EZERGAILIS: Legacy.

AMY VAN ARNHEM: Yeah, legacy power grids. Is that something you can speak a little bit to?

LINDA EZERGAILIS: There's always a cost to storm hardening and grid reliability. And sometimes when these weather events are extreme and haven't been experienced before, various stakeholders start to try to find root causes and, quite frankly, finger pointing across where this could have been mitigated or prevented. And we're all learning, and there are ways that different levels of government can work together, different types of energy infrastructure can work together. So for example, when Texas experienced a pretty extreme storm a few years ago, we saw that natural gas storage played an important role in natural gas infrastructure in being able to service power systems that needed that natural-gas-fired power generation as an example of ways in which systems are being used differently under these extreme storm events. And we have to just, as a society, try to anticipate where the next weakness in the grid or energy infrastructure can be so that we can appropriately invest without gold plating the system too much because customer affordability is always a consideration.

AMY VAN ARNHEM: There's a constant balance of trying to get that right.

LINDA EZERGAILIS: Yes.

AMY VAN ARNHEM: Difficult. With all the factors that we've talked about today-- so ESG, inflation, policy and regulation-- how are your companies thinking about growth? And how are they going to fund that growth going forward, just given the high interest rate environment that we're in?

LINDA EZERGAILIS: My observation has been that utilities, typically, have pretty good access to the capital markets. Maybe the size of the debt or the equity offering might move around a bit, or the cost of that capital might shift around a bit. But I'm not aware of any time in the past couple of decades that things have truly been shut down for them. And just to give you a sense of how good that access is during the financial crisis, I hear that some energy infrastructure companies still had access, whereas some sovereign credit did not. And that's probably one of the most extreme times that I can remember in the capital markets. Having said that, utility management teams are quite careful or mindful of how volatile the capital markets can be, and that costs can move around. So they tend to prefund a little bit or not lag in their permanent financing of large projects as well. And they also manage their balance sheets towards an investment grade credit rating, which also helps keep customer costs down. And regulators, in fact, require an investment grade credit rating because they're also aware of the impact that high interest costs might have on customer bills. So that's something that all comes together to also impact how the debt rating agencies look at these companies. And because that regulatory compact has been so strong and stable, you will see relatively higher leverage in the utility space than some other sectors that might be similar in size or have different attributes that might not be quite as stable. In terms of more creative ways of raising capital beyond just plain debt or plain equity, some companies have also looked at sustainability linked bonds. Or they've looked at joint ventures with financial partners that might want an operating partner to directly invest in assets. And these are all ways in which capital can get raised that at times might be less expensive than going to the capital markets. And what we've also seen recently is some recycling of capital, where a company is happy with an asset-- it might be a little bit less core-- and another operating company might value that particular business or asset more highly in some other more optimal usage. And so you can see a transaction there as well, and those funds can be redeployed to investments that might be more core for a utility. So staying on top of all those moving parts really is what keeps me up in the morning.

AMY VAN ARNHEM: Yeah, it gets you up in the morning. One question just around the growth prospects for the sector. Is there sort of a growth rate you look for, generally speaking? Or is it really company dependent?

LINDA EZERGAILIS: I think mid-single digits is pretty good for a utility. Sometimes, they can increase that a little bit. Sometimes, there's natural lulls in activity levels, where that might dip a little bit, or there's other things going on, like during the pandemic. Sometimes, maybe companies held back a little bit in making investments just until they could see what was going on. But the business is not really that scalable without investing capital. So one of the considerations as well is the more companies grow and the more capital they need, incrementally, that marginal new unit of capital might start being a little bit more expensive. So that's something to consider as well. So mid-single digits is, I think, pretty good growth for a company long term.

AMY VAN ARNHEM: So what I've learned today is that there's a lot of moving parts with the power and utilities companies, and there's a lot of balance that's required. So ensuring growth, but prudent growth, ensuring that you're servicing your clients by doing it prudently and growing with the communities and society. So it's definitely a dynamic sector. And I really appreciate you being here with us today, and good luck on the conference.

LINDA EZERGAILIS: Great. Thanks so much, Amy. And maybe we'll see you there.

AMY VAN ARNHEM: Yeah, sounds good.

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