Utility Stocks And Tax Reform: What Investors Need To Know – Forbes

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At the Edison Electric Institute’s 2017 financial conference, utility executives expressed confidence that the tax reform pushed by the Trump administration ultimately would work in the sector’s favor. This optimism has become reality.

Regulated gas, electric and water utilities won’t benefit directly from the Tax Cut and Jobs Act’s signature change: a reduction in the top corporate tax rate to 21% from 35%. Utilities will pass through these tax break to ratepayers, who will also benefit when  these essential-service companies revalue the deferred tax liability on their books to the lower corporate rate.

However, lower rates for customers increase utilities’ headroom to step up capital expenditures and recover these investments in rate base.

Although utility-regulator relations vary from state to state, this development should make it easier to gain approval for investments in the power grid, renewable energy and gas-fired power generation that promise to reduce customers’ rates while driving earnings and dividend growth.

The utility sector also got what it wanted on new rules for the treatment of depreciation expenditures, which could also help to accelerate system investment.

Before Congress passed the tax bill, much of the scuttlebutt in the utility universe focused on a provision that restricts the tax deductibility of interest expense to 30% of operating cash flow. But the final law exempts regulated utilities from this rule, giving the sector another leg up on developers of rooftop solar power and other energy marketers.

This development should magnify utilities’ existing cost-of-capital advantage, as the debt markets become increasingly difficult to access for would-be disruptors of this long-standing business model.

In fact, the interest deductibility advantage could increase demand for utility bonds, as potential taxability issues encourage redemptions and make other corporations think twice about adding to their debt.

It’s Still Easy Being Green

The new law could also widen utilities’ advantage over rivals in renewable-energy investment.

All players will benefit from the continuation of federal tax credits on wind- and solar-power developments, but the potential for tariffs on imported solar panels will challenge the economics on new U.S. projects.

Regardless of the remedy which President Trump prescribes in this trade case, lower corporate tax rates should lessen the value of depreciation benefits associated with wind- and solar-power projects—and, therefore, the value of tax-equity investments by third parties.

Combined with the impact of a new minimum tax on large, multinational corporations, the amount of tax equity in a typical capital stack for wind- and solar-power projects could fall to 40 percent from 60 percent.

All else equal, this development will boost utilities’ cost of capital to fund new generation. However, this headwind will hit rival developers much harder, as they lack access to the range of low-cost funding options that utilities enjoy. Less competition for new renewable-energy projects and higher returns on investment should more than compensate utilities for this challenge.

Meanwhile, utilities and utility-owned wind- and solar-power developers will benefit from the elimination of the corporate minimum tax, which reduces the risk that the value of clean-energy credits will diminish because of tax-avoidance mechanisms. Wind and solar farms themselves will be taxed at lower rates and under favorable depreciation rules.

The January update to my Utility Report Card highlights how the tax bill will affect each of the more than 200 essential-service companies in my coverage universe.