Morningstar Magazine - August/September 2018 - 68

Investors

owned by firms like Amazon.com AMZN and
Google GOOGL.

put wind farms up, put solar farms up. That lowers
the fuel costs that customers pay in the end.

a kind of mirror of Berkshire Hathaway Energy
right now.

How does Morningstar integrate environmental,
social, and governance analysis into the overall
stock analysis?

Subsidies in the U.S. and Europe have helped
renewable energy reach the point where
it can be economic worldwide. Europe is even
several years ahead of the U.S. in terms of
transforming their grid from legacy generation
sources to renewables.

As you noted earlier, value is not easy to find
in the sector, which makes some of the hairier names
interesting. Any other hairy picks?

Miller: We think there are two key issues for ESG
in the utilities sector. One is how utilities are
increasing their investment in renewable energy.
The other is how utilities are reducing their
exposure to coal and nuclear. It may be counterintuitive, but both are opportunities for growth.
Environmental regulations that lead to taking
coal off the grid, such as carbon emissions caps,
can actually be a growth opportunity for
utilities. Typically, these coal plants are old and
fully depreciated. If a utility can shut down
that plant and build a multibillion-dollar gas plant
or a multibillion-dollar wind farm or solar
farm, that's a big earnings growth opportunity
for a regulated utility.

Dominion Energy was once one of the larger
coal plant owners. Duke Energy is another great
example. They're transforming their fleet
and going from mostly coal to mostly gas and
renewables. Among U.S. utilities, Duke is
one of the largest investors in renewable energy.
What about the impact of government subsidies
on renewable energy?

Miller: Subsidies are going to run out in the next
few years for wind and solar, so it won't be
as attractive to invest in wind and solar. But wind
and solar technology has come so far that
utilities don't need the tax credits anymore to make
it economic to build large solar or wind farms.

Xcel Energy XEL is a good example. Most of its
service territory is in the Upper Midwest,
a great wind region, and Colorado, where you
have a lot of political and public support for
renewable energy.
Xcel can build wind and solar farms cheaper
than building any type of fossil fuel generation.
They've got such a good wind resource in
the Upper Midwest that they don't have the grid
reliability issues that we see in other places.
They call their investment plan "steel for fuel,"
where they're willing to put steel in the ground-

Morningstar August/September 2018

One of your top defensive picks is a U.K. company,
PPL PPL. How does it compare with Dominion
and Duke, given the different regulatory environment?

Miller: About half of PPL's business comes
from the Pennsylvania area and about half comes
from the U.K. Pennsylvania's a great place
for a utility right now with the transition from coal
generation to gas generation.

There are two concerns in the U.K. One is
that politicians on a local level are very concerned
about power prices and customer bills.
However, there's a distinction here between
suppliers and distribution utilities. Energy suppliers
are feeling the most political heat, and PPL
is on the distribution side, so we think it is better
insulated from the politics. Still, investors
are concerned that politicians will push back
against customer rates. The other issue
is currency: If the pound appreciates, that's going
to hurt PPL's dollar-denominated earnings.
But if you look at our analysts' projections
for U.S. earnings plus U.K. earnings, we don't see
any way to get to the current valuation.
The market's assuming an entire collapse in the
U.K. business earnings. We don't see that
on a currency basis. People are scared that
politicians will push back on the distribution rates,
but the key here is that distribution rates
are fixed. Supply rates in the U.K. are marketbased, and the politicians are most concerned
about that. We think investors have mixed
the two in a bit of a misunderstanding about
PPL's risk.
As an aside, Berkshire Hathaway Energy has
one of the largest U.K. distribution utilities,
very similar to PPL's. We don't hear any gnashing
of teeth about Berkshire Hathaway Energy's U.K.
distribution utility. PPL is a good way to get

Miller: FirstEnergy FE is a primarily Ohio-based
utility that we see as a very strong regulated
utility. They've just gone through a bankruptcy
situation in their nonregulated business,
and the market is still perceiving it as a struggling
diversified utility.

Almost their entire business on the nonregulated
side was coal and nuclear generation. Its territory
is right outside the Marcellus Shale, so they
were ground zero for the collapse in natural gas
prices and the collapse in economics for
coal and nuclear plants that created a distress
situation. They've resolved that and right
now you have a fully regulated utility trading
at a discount. There's also still a hangover
from a dividend cut FirstEnergy made several
years ago.
Our analyst in Europe thinks that Engie ENGI:FR
is one of the most undervalued names and
highest-quality businesses. They have operations
across the world, notably in Latin America where
they will get almost one third of their earnings.
In Europe, they have been slower than peers
to invest in renewable energy, but we think Engie's
hydro and nuclear fleet is solid. Engie has
refocused on regulated distribution operations in
France and other places in Europe that should
stabilize earnings and support a healthy dividend.
This is a great pick for anybody who's interested
in Latin American and European energy
use without as much commodity exposure as the
integrated oil companies. K
Laura Lallos is the managing editor of Morningstar magazine.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018