In May of 2024, the Canadian Gas Association (CGA) and the American Gas Association (AGA) engaged MCR Performance Solutions, a management consulting firm dedicated to serving utilities, to update and expand a 2022 study, Investor Expectations on North American Natural Gas Utilities.^[1] The updated report,^[2] was released on November 7, 2024 and concludes that investors view natural gas utilities as attractive investments for maintaining stability in their portfolios while supplying a reliable and predictable Return on Equity (ROE).

HOW THE RESEARCH WAS DONE

Working with a Steering Committee of AGA and CGA member companies, MCR updated the 2022 foundational research, rolled the data forward, and targeted a wider group of equity and debt capital market participants to inform the investor perspective discussions. The expanded group of participants included sell-side analysts, buy-side portfolio managers, investment bankers, and credit rating agencies as well as some AGA and CGA member company financial executives. To promote candor, confidentiality and non-attribution were strictly maintained.

KEY FINDINGS:

In MCR’s view, the gas utility industry’s underlying commercial foundation remains solid. But regional policy challenges coupled with rapidly growing energy demand (and the urgent imperatives of affordability, security, resilience, and reliability) suggest there is potential in considering new commercial avenues — avenues that can both sustain a mature industry and align business strategies with important public policy and social objectives.

Specifically, the report arrives at the following primary conclusions:

1. 1. While rising interest rates and bond yields have mitigated the risk of lower regulatory allowed ROE, the latter have begun an upward inflection after many years of gradual decline. As of June 2024, average allowed ROEs stand at 9.83 per cent for U.S. gas utilities and 9.28 per cent for Canadian utilities.
   2. Markets hold a consensus view that natural gas and related infrastructure will play a vital role in energy supply, security, and resilience for decades to come.
   3. Investors allocate capital based on perceived risk and reward and “vote with their feet.” To attract investment, utility regulatory returns need to exceed alternative investment opportunities—referred to as the opportunity cost of capital.
   4. So-called “gas bans” and environmental, social, and governance (ESG) considerations that dampened investor interest in gas utilities five years ago have been reshaped by geopolitical and other events that have put energy security, access, and affordability at center stage.
   5. Rising energy demand, including for electricity, presents an opportunity for gas utilities to play a key role in keeping North American energy secure, reliable, resilient, and affordable.

CANADIAN VERSUS U.S. RETURNS ON EQUITY CAPITAL

The research examined average allowed equity returns for Canadian gas utilities and concluded that they tend to lag those of their U.S. counterparts by 40 to 60 basis points, while equity as a percentage of total capitalization tends to average around 30 per cent versus 40 per cent to 50 per cent in the United States. Notably, a 2023 cost of capital decision^[3] by the British Columbia Utilities Commission set gas utility ROE at 9.65 per cent with a capital structure equity component of 41 per cent. That proceeding specifically recognized increased business risks faced by gas utilities, including energy transition issues. Chart 1 below provides a historical perspective of average Canadian and U.S. gas utility ROE compared with government bond yields.

Chart 1: Canadian and U.S. Gas Utility ROE and Bond Yield History^[4]

While the more modest returns on a smaller equity base arguably make Canadian utility investments less compelling on the surface, it was noted during the course of investor discussions that Canadian utility regulation typically uses forward-looking data, volume decoupling, and often greater flexibility for adjustment between regular rate cases. It was also noted that Canadian utilities rarely under-earn allowed ROEs and are somewhat more likely to over-earn.

Allowed ROE and capital structure drive investor capital allocation decisions. Over the past decade, several Canadian utilities have expanded southward into the U.S. market through merger activity, with Enbridge’s recently completed acquisition of three U.S. natural gas utilities the most recent example. That acquisition follows cross-border deals by AltaGas, Algonquin Power and Utilities, Emera, and Fortis. Conversely, no U.S. utilities have ventured northward. The relatively higher allowed equity returns and greater allocation to equity in the regulatory capital structure are often cited as key considerations by acquiring Canadian utility companies.

IMPORTANCE OF CAPITAL COST TO UTILITY CUSTOMERS

While the regulatory process is often viewed as a balancing act between the competing interests of customers and shareholders, utilities are infrastructure companies characterized by high levels of capital investment. As such, they need ready access to capital to finance not only the building, but also the maintenance of their systems. Like other costs of running the utility enterprise, financing is reflected in rates, meaning that customers benefit when utilities have ready access to capital on the most favourable economic terms.

THE ONGOING ROLE FOR NATURAL GAS

All of the study participants saw an ongoing role for natural gas over a period of decades. As one discussant noted, “No sophisticated person thinks gas is going away.” Analysts and investors pointed to the ongoing dependence on natural gas of states with even the most aggressive decarbonization policies. The ongoing use of carbon-intensive fuel oil in the Northeastern U.S. was also mentioned as being rather paradoxical, especially in states where natural gas supplies aren’t constrained. The ongoing use of natural gas in power generation was cited as well, although discussants didn’t see that as having much of an impact on gas LDCs. Investors expressed a clear preference to invest in states with more gas-friendly policies.

The challenges associated with phasing out natural gas were frequently raised. Investors, as well as a few combination utility company executives, observed that electrifying gas heating in cold climates could require a threefold increase in electrical capacity, an unrealistic scenario that most believe could exert massive upward pressure on customer rates, even if it were technically achievable. One combination utility executive noted that in order to address numerous investor inquiries about the strategic positioning of its gas LDC operations, the company added disclosure to an investor presentation quantifying the significant economic burden that full electrification would impose on its customer base.

The variable, non-dispatchable nature of wind and solar was also discussed. While battery deployment continues to grow, so does the demand for power. In several conversations, it was noted that battery storage is costly and inefficient compared to natural gas as a proxy for longer-term seasonal storage, as solar output declines in winter months.

CONCLUSION

A successful energy transition that sustains reliability and affordability for consumers will require continued investment in the systems that transport and deliver electricity and natural gas. Attracting investor capital on favourable economic terms depends on offering a compelling risk / reward profile relative to other investment alternatives. By speaking directly with investors, analysts, and other capital market participants, this study captures valuable insights into factors shaping the capital allocation process.

• * Sam is Vice President of Strategic and Financial Advisory with MCR Performance Solutions, a management consulting firm serving North American electricity and natural gas utilities. Sam’s background includes a decade in utility industry corporate planning and investor relations, fifteen years on Wall Street as a senior equity and credit financial analyst and nearly a decade as a utility and pipeline investor. His background includes electricity, natural gas, and renewable energy. Sam has worked extensively with federal and state policy makers as well as non-government organizations involved in the energy and utility sectors, and he has spoken at numerous industry conferences and investment forums.
• ¹ Guidehouse, Investor Expectations on North American Natural Gas Utilities, (Ottawa: Canadian Gas Association, 2022), online (pdf): <www.cga.ca/wp-content/uploads/2022/07/Study-Investors_View_Natural_Gas_Utilities_as_Desirable_Investments.pdf>.
• ² MCR Performance Solutions, Investor Perspectives on Natural Gas Utilities: A Canadian and United Stated Review, (Ottawa: American Gas Association, 2024), online (pdf): <www.aga.org/wp-content/uploads/2024/11/AGA-CGA_Investor_Report_FINAL_11-5-24.pdf>.
• ³ Generic Cost of Capital Stage 1 (5 December 2023), BCUC G-236-23, online: BCUC <www.ordersdecisions.bcuc.com/bcuc/decisions/en/item/521862/index.do#:~:text=For%20FBC%2C%20a%20deemed%20equity,allowed%20ROE%20of%209.65%20percent.&text=The%20Panel%20determines%20that%20the,%2C%20effective%20January%201%2C%202023>.
• ⁴ S&P Global, Analyst Estimates.