This article comes from consultants at Morningstar.com.
Despite increasing capacity and solid annual growth in the renewable energy space, Morningstar equity analysts anticipate a rockier path forward as more companies chase lower returns and policymakers revisit return-boosting incentives. In the latest Utilities Observer, Morningstar analysts offer equity investment ideas for renewable-energy exposure.
Key takeaways from the Utilities Observer include:
- Policy support will drive continued high investment, particularly in the large markets of the United States and China and emerging economies Mexico, South Africa, and Turkey. However, investment returns could fall as more players chase development and absolute subsidies shrink.
- Financial subsidies in key markets—China, Europe, and the United States—face increasing risks, but there is potential upside from new policies such as the U.S. Clean Power Plan and proposed EU policy changes. Europe’s trajectory is the least attractive, and Morningstar equity analysts recommend avoiding exposure to European renewable energy development relative to that in other markets.
- Renewable energy capacity should grow strongly during the next decade, requiring substantial investment in electric grid infrastructure—both distribution and transmission—to facilitate the new assets and power flows.
- Renewable-energy-focused utilities are on balance fairly valued, but Morningstar Best Idea ITC Holdings, along with Ormat Technologies, Edison International, and NextEra Energy emerge as primary winners from the long boom in global renewable energy investment.
- ITC has a Wide Economic Moat Rating and offers the best combination of valuation, competitive advantage, and growth. Morningstar analysts expect ITC’s capital expenditures to drive 8 percent average annual earnings growth and almost 13 percent annual dividend increases during the next five years, even with a potential cut in its federal allowed returns.
- Narrow-moat, pure-play geothermal developer Ormat is slightly overvalued but is the only independent power producer with an economic moat, or sustainable competitive advantage, and has a long and impressive growth runway.
- Edison International’s California electric utility is investing up to $4 billion annually to upgrade its distribution system. California’s aggressive renewable energy goals and market design have driven the highest levels of renewable energy output in the country.
- As the largest publicly traded renewable energy owner in the United States, NextEra Energy’s renewable energy assets provide about half of its cash flow, while the other half comes from its Florida regulated utility. NextEra’s experience developing and operating wind assets and a burgeoning solar business are advantages, but the shares are overvalued today.