Terry Dimock (TD) and Brock Campbell (BC)
TD:
Welcome to NBI Quick Takes. My name is Terry Dimock, Head Portfolio Manager for National Bank Investments. I’ll be your host for a three-part series focused on real assets.
First of all, a disclaimer. BNY Mellon Asset Management Canada Ltd. is the portfolio manager of the NBI Global Real Assets Income Strategy and its affiliate, Mellon Investment Corporation, is the subadvisor. Today, we are joined by Mellon portfolio managers, Jim Lydotes, and Brock Campbell, to chat about real assets. This discussion is for general information only and should not be taken as advice or a recommendation to purpose individual securities.
My guest for this first podcast is Brock Campbell, co-manager of the NBI Global Real Assets Income Fund. Hi Brock!
BC:
Hi Terry! Thanks for having me on today.
TD:
So, let’s start with the basics. You know, two basic questions. What are real assets, and why are they attractive?
BC:
Ya, sure Terry, So, you know, there are three reasons why we want to own infrastructure assets or real asset equities. First, let’s just discuss what we mean when we say real assets. What we’re talking about are companies that have three key characteristics. First, these are asset owning or rent-collecting business models. These are often natural monopolies with a high degree of upfront capital investment required, and with that, generally a degree of guaranteed revenue to recover the return on those investments. Second, these are companies that generate stable cashflows. Think of companies like utilities, transportation infrastructure, energy pipelines with long-term contracts. These are some of the most expensive assets in the world.
The services these assets provide are generally removed from the business cycle and they enjoy relatively inelastic demand. As a result, the cashflows coming off of these businesses are incredibly stable which makes them a natural source for income-paying businesses. And the last characteristic is regulatory predictability. All of these businesses are heavily regulated, and this regulation serves as a further barrier to entry. Understanding the regulatory framework and the motivations of the respective regulator: that’s a key part of our analysis.
Why does anyone want to own them? Well, these assets historically are less economically sensitive. So, when the world changes, their cashflows typically do not. You know, stable services with stable end demand, leads to stable cashflow supporting stable dividends.
These assets are also incredibly long-dated. So when you build a pipeline or a toll-road, you need to pay a lot of money upfront to put that asset in place, but once it’s in place, it requires very little capital going forward. People often look at these as rent-collecting business models because that’s really what they are. These characteristics all lend themselves to be more stable businesses that generate more stable income, which makes them a natural spot for the income-generating part of a portfolio.
TD:
Thanks Brock. That was a really good description. Let’s start with one of the categories that’s really important in real assets: utilities. Tell me: how do utilities make a profit?
BC:
Absolutely. Utilities are a hallmark asset in the infrastructure space. Think of all the characteristics we talk about when we discuss infrastructure: stability of earnings, consistent income generation, downside protection, and these attributes are really a function of the utilities’ very unique business structure. They are what we refer to as a natural monopoly. What does that mean?
It’s generally accepted that consumers benefit from competition, where companies compete against each other to provide the highest quality product at the lowest price. While those are the objectives of utility too, under their structure, having competition wouldn’t make sense. Let’s look at this in practical terms. Look outside your window. There’s one set of powerlines going down your street. Would it make sense to have two or three or maybe even four sets of powerlines? No. So this means the industry is a natural monopoly, where it naturally makes sense to have only one competitor.
Obviously, monopolistic structures could lead to outsized profits for the industry, so one caveat or requirement for acceptance of this structure is a heavy regulatory presence. The structure under which utilities are regulated is called cost of service regulation, which essentially means utilities are able to ern a reasonable return on investments they make. The reasonable return is key to understanding the profitability of a utility, and that is set during a process called a rate case.
Without diving too deep into the details, a rate case is much like a court case, where you have two sides present their case to the Public Utility Commission, or PUC. On the one side, you have the utility, presenting why they feel their rates should be set at a certain level, and on the other side, you have a consumer-focused arm countering the utility proposal with a lower level of accepted returns. The Commission listens to both sides, weighs the arguments, and generally comes up some agreement in between the two. In addition to the allowed return, the regulatory construct dictates approval of capital expenditures, which as a reminder, utilities are able to earn a return of and return on its investments. They naturally want to spend as much as possible.
From this rate case, you can see now we have clarity on two key elements on utility earnings power. First, the size of the asset pool they can earn a return on, also called a rate base, and second, the allowed level of return they can receive on these assets called the allowed return on equity.
That’s really a big picture review of how utilities make money, but one clear takeaway is, as utilities spend more, they also earn more, which generally peaking, should promote infrastructure investments.
TD:
Now, you and Jim and the team at Mellon select stocks. For utilities, what makes a good investment and what doesn’t make a good investment?
DC:
We like to pride ourselves on being stock pickers and there are many factors that go into our knowledgebase of a good utility versus a bad utility. But clearly one key element of this analysis is the regulatory construct. Again, this is the agreement between the company and the regulator that provides a framework for how much a company can invest and how much they can earn on that capital invested. And there are many factors that are implicit in this analysis. Some key ones we watch are reliability of service, price and place of the consumer, and efficiency.
Generally speaking, a well-run utility that provides reliable service at a reasonable price should have a favourable regulatory construct. Our analysis does not entirely focus on those companies with very strong regulatory constructs, though to be fair, these companies can have the ability to enjoy sustainable growth. But we also look at the companies that may have weak regulatory constructs where we envision a path for that construct to improve.
Generally speaking, companies with weak company constructs trade at discount valuations. And if we can successfully predict an improvement in that regulatory construct, then shares tend to recover from that discounted valuation level leading to possible outperformance relative to broader group. Lastly, we should also point out that some utilities have underappreciated growth opportunities, especially given the recent trends toward decarbonization. And to be honest, Terry, recently we’ve been finding more and more of these growth opportunities for the fund.
TD:
You’ve talked a lot about capital spending that is very important for utilities. So what do they need to do to stay operational and who pays for this?
DC:
Unfortunately, all these things we want, things like smart bridges and renewable energy, not to mention turning on the lights, it all needs to be paid for. Utilities are capital-intensive businesses. They have vast networks of distribution and transmission lines, as well as many generating units that all require consistent investment. There is considerable capital required to maintain these businesses, though there is also a good deal of growth capital that is required to be spent just to ensure future reliability.
Utility capital investments are conducted through long-term analysis. Many of these assets have duration in the decades, so when a utility embarks on a capital program, it’s gone through a very thorough and a very thoughtful analysis. At the end of the day, as I noted earlier, utilities are able to earn a fair return on these investments as stated under the regulatory construct.
Ultimately, these investments are recovered through electric rates, so this allows return on investments plus all the costs associated with delivering electricity, things like fuel, operations and maintenance, taxes, interest, etc., that are all rolled into that final electric rate that you and I pay. The goal of that regulator is to set up a regulatory framework that provides for safe and reliable power at the lowest possible cost.
This balancing act is key to understanding how fast the utility can grow, because if bill inflation is too high, it is unlikely that utility will be able to spend as fast, and if utility cannot spend as fast, that is going to impact their growth.
TD:
We hear about electric outages in the last few weeks so can you tell us what is the physical and economic state of the electric grid in North America, and maybe what are the implications from secular changes (renewable energy, electrical vehicles, decentralization, and maybe ESG issues)?
DC:
Great question. Utility is a very localized business and the quality of the infrastructure is also very localized, meaning some utilities have much better infrastructure in place than others. Despite this, in the U.S., the American Society of Civil Engineers took a stab at looking at the infrastructure assets across the country and gave the broad U.S. energy infrastructure asset a B+. So, not the best rating and much of that poor showing was that the U.S. grid relies upon infrastructure built during the 50s and 60s which is getting beyond its useful life.
Having a grid that operates reliably is a pure necessity and this is made all too apparent most recently during the blackouts in California. To rectify this underinvestment, we’re going to have to spend a lot on the grid. In fact, the American Society of Civil Engineers estimates our infrastructure will be underfunded by some $177 billion. I would point out that this could actually underestimate the ultimate funding requirement given emerging decarbonization goals. We have a fundamental belief that aging infrastructure coupled with secular trends of decarbonization will result in a period of growth for utilities well in excess of historical averages.
The big secular theme impacting the group, which has been broadly labelled energy transition, describes our shift away from consuming molecules to power thing, i.e. burning fossil fuels, to instead consuming clean electrons, i.e. powering everything with renewable sources of electricity. This will unleash huge capital investments opportunities for our utilities, and the duration of this trend will be measured in decades.
We’re already seeing the signs of this with a recent statement from the U.S. Energy Company, where they announced a $43 billion investment program over the next 15 years to help transition them to clean energy. We expect many companies will follow this path of announcing very large capital programs with very long visibility.
We believe renewable energy is entering the growth sweet spot, with very compelling demand from governments, corporates and consumers, coupled with dramatic declines in cost. For example, both wind and solar costs have dropped by around 80% since 2010, and in many places across the U.S., these sources of electricity are now cheaper than fossil fuels.
TD:
Wait a second, Brock. I just want to make sure I heard this part correctly. You’re saying that wind and solar today are cheaper than fossil fuels? I guess these assets can be good for the environment and good for the pocketbook as well.
DC:
Oh, 100%! And that’s the clear inflection point that we are seeing in the market and that’s why we are so bullish on renewable energy. In many parts of the U.S., a regulator can retire a dirty coal plant and replace it with wind or solar and save the consumer money. We believe that is an extremely compelling proposition and one that will unleash a massive build-out of renewable energy. Not to mention how favourable this trend is for ESG scores, particularly the environmental score. While the utility group has historically been one of the largest emitters in the economy, this energy transition will go a long way in cleaning up their act.
Additionally, with all these renewables coming online, the grid needs to become much more dynamic: the wind doesn’t always blow, the sun doesn’t always shine, so the grid needs to be able to cope with these disruptions. The recent blackouts in California actually highlight some of the issues with renewable energy. The state took a lot of their electricity from renewables, especially from solar, and when the solar resource isn’t as strong, the grid needs to import electricity from other states. The problem recently was that the areas where the state typically imports power from were also going through a heat wave and there just wasn’t enough power to be exported.
We think storage could have helped ease some of these issues. We have seen batteries, where again prices there have fallen precipitously, now being installed in concert with renewables. For utility, this changes the profile of the renewable assets from intermittent to one that is more firm and that is a very valuable change for reliability.
We’re also encouraged by new technologies outside of batteries, notably green hydrogen. More to come on the green hydrogen front, but we think it could soon become a key piece in reshaping the global energy landscape.
We talked a lot about changes on the supply side of electricity with renewable energy and battery storage, but there are equally big changes on the demand side with electric vehicles. We’re very encouraged about the demand prospect that EVs present, but we’re also very concerned that the current grid is not suited to handle high levels of electric vehicle penetration.
We believe to get the grid ready for this new demand, the grid will require big investments and importantly technological improvements. As a result, one area that we are becoming increasingly bullish on is the digitalization of the grid, or also known as building a smart grid. With a smart grid, we believe utilities can better serve the shifting dynamics of intermittent renewable energy, battery integration and electric vehicle load shaping.
To be clear, this is a massive task for the utility space, but we believe there is a roadmap for success here and see the result of a decades-long investment opportunity for the group and above-average growth opportunity for investors.
TD:
Thank you, Brock, for taking the time to talk with us today. You gave us a lot of detailed information. On this podcast, we talked about real assets and specifically about utilities. These assets offer stable and predictable returns and they’re now investing in renewable energy which will be good for our planet. Definitely learned a lot and definitely see that it needs a lot of research, a lot of analysis to be able to select the right companies in this universe. This is the end of our first podcast on real assets, so thank you very much and have a great day.
Terry Dimock
