The Fed vs. Renewable Energy

Raising interest rates to crush investment means less of it

Q3 2023 will go down as a tough one for dividend stocks. And few sectors were hit harder than US utilities, America’s primary investor in renewable energy.

The Dow Jones Utility Average lost nearly -10 percent of its value in Q3, bringing year to date losses including dividends to almost -13 percent. Among the worst performers of its 15 stocks: NextEra Energy (NYSE: NEE) with a -22 percent loss.

NextEra Energy is the country’s leading investor in wind, solar and energy storage with a growing 20 percent market share. And its affiliate NextEra Energy Partners (NYSE: NEP)—a key financing vehicles for its projects—fared worse still, with a Q3 decline of nearly -50 percent.

NextEra Energy has a 55 percent economic interest in NEP and is its ultimate financial guarantor. It’s also NEP’s sole source of asset additions, which are primarily operating wind, solar and energy storage facilities.

NextEra launched NEP as an IPO in June 2014. That was the height of the master limited partnership IPO boom in oil and gas. And power companies like NextEra saw a similar opportunity to finance growth by selling partial ownership in operating assets to the public. They did this by launching MLP-like separate but closely tied entities called “yieldcos” that they kept control of.

NextEra Energy Partners’ share price since inception has been a series of peaks and valleys, which basically reflect its funding conditions. Management has issued stock, bonds and convertible securities when terms have made sense relative to prospective returns from buying ownership in assets already built and operated by NextEra Energy’s unregulated unit.

These “dropdowns” raised cash flow, providing firepower to raise dividends and pushing up NEP's share price often faster than NEE's. On the other hand, when conditions have worsened, the pace of drop downs has stalled and NEP's share price has often cratered.

That’s what happened in Q3. And in response, management last week announced it was basically putting NextEra Energy Partners on a shelf for now.

NextEra postponed a scheduled asset dropdown to NEP due to lack of financing on economic terms. It also scaled back the yieldco’s planned annual dividend increases for a second time this year to 6 percent, down from an initial target range of 12 to 15 percent—for the purpose of avoiding new equity issuance through 2026.

The MLP IPO boom ended abruptly in early 2015 as access to capital suddenly dried up in the oil and gas business. And since then, we’ve seen multiple energy companies take their former MLPs private, most recently big oils like BP Plc (London: BP, NYSE: BP) and Shell Plc (NYSE: SHEL).

In contrast, NextEra Energy has thus far remained consistently supportive of NEP remaining independent. The 2015 crash did dry up capital for NEP as it did for MLPs. And its share price fell to less than $20 in early October of that year, well below the IPO level and down from $50 just a few weeks earlier.

Many wondered at the time whether the parent would simply take NEP private at a rock bottom price. But NextEra cut its incentive distribution rights and fees to keep NEP profitable.

That proved to be the right move. Market conditions improved and drop downs resumed. And NEP has since grown its assets to $23.6 billion as of the end of Q2, up from zero nine years earlier.

NEP’s growth represents quite a bit of low cost funding for renewable energy deployment at parent NextEra Energy. And under the yieldco structure, it’s kept effective control of the assets as well as the lion’s share of economic returns.

It’s certainly possible capital market conditions will remain hostile to NEP as a funding model long enough for management to consider other options, including privatization. NEP currently trades at just 78 cents per dollar of book value. And no one knows its assets better than NextEra Energy.

But at least to date, there’s been absolutely no sign that the parent isn’t planning to fully support NextEra Energy Partners through this downturn. And it’s worth noting that’s been the policy since the yieldco was much smaller and therefore easier to wind up. 

On the other hand, NextEra definitely pulled in its horns meaningfully last week by essentially committing NextEra Energy Partners to funding CAPEX without issuing equity. The parent did not reduce earnings or dividend growth guidance through 2026. But management did emphasize conservative measures to reduce its own funding exposure, such as $13 billion in interest rate hedges through 2024.

That’s clearly retrenching. And it’s despite the positive financial impact of Inflation Reduction Act tax credits, as well as several other positive factors affecting its renewable energy business including falling components prices and less competition as rivals leave the business.

My bet is NextEra will indeed stay its current course. But when the leading company in a sector pulls back, it’s a safe bet the rest are already doing so. So far the only outright postponed or cancelled projects are giant proposed offshore wind facilities—particularly off the Atlantic Coast. But it’s a safe bet more utilities will view caution as the better part of valor with borrowing costs increasingly likely to stay higher for longer.

I expect similar retrenchment in coming weeks across a whole range of industries-basically any sector using debt to fund asset expansion. That includes housing as well as other real estate, as developers have already been pulling in their horns all year.

That means sharply reduced investment and less available supply later. And it adds up to higher prices and more inflation down the road, even though current Fed policy may push down headline inflation near term.

NextEra’s news shows unmistakably how Fed interest rate policy is squeezing renewable energy investment. That’s at the same time restrictive regulation, a prohibitive cost of capital and fear of recession crimp oil and gas supply.

The silver lining for energy companies: Squeezed investment now absolutely means tighter supplies, rising prices and higher profits later on. The timing of recovery is highly uncertain. But at the least, patient investors have a great entry point to buy best in class companies when the crowd has turned its back on them, including NextEra.