The utility that beat Big Oil to a climate model it needs for the future

Some high-profile companies on the forefront of technology innovation, including Apple and Tesla, split their stock earlier this year to make the sticker price more appealing to investors. Increasingly, retail stock investors are looking to buy smaller pieces of what many have come to see as big parts of the market’s future. One of the latest companies to split its shares, and that trades at an even heftier price-to-earnings ratio than Apple, is not a household name on the same order: NextEra Energy, the biggest company in the U.S. utility sector.

NextEra Energy did attract some headline attention this fall when it surpassed Exxon Mobil in market value for the first time. Leaving oil behind has not been so unusual for companies, across sectors, this year — Zoom Video Communications has been bigger than Exxon more than once in 2020. But NextEra is a more instructive case.

Many headlines abouts its leapfrog over Exxon noted it is a “clean energy” company. That’s true — it has the largest renewable energy project business in the country. But it is also among the largest utilities in the U.S. and still manages many fossil fuel plants, for subsidiaries like Florida Power & Light and Gulf Power. Utility experts say any climate contradictions in its current fleet — where coal and natural gas still play a large role, and there’s even a little oil-based power generation — ultimately may be less important with investors than how it is positioned for the future. It has grown to more than double the market weighting of any peer in the S&P 500 utility index.

Whether it is wind, solar or energy storage, NextEra is “No. 1 in all of them,” said Steve Fleishman, utility analyst at Wolfe Research. “They are a winner in the energy transition that is going on,” he said.

Even if short-term market cap gains or losses can be transient, passing Exxon Mobil is an important signal of the future.

“The same thing as when Tesla went over the market cap of traditional automakers. One thing we like to say is if Tesla is worth what it is right now, that’s a lot of electric vehicle sales that need to be fueled by electricity from our companies,” Fleishman said.

As the economy becomes more electrified and power fleets transition increasingly away from coal and to renewables, NextEra benefits from both: a growing utility customer rate base with more demand for electricity in the future from industries like autos, which helps them grow business and invest in the grid, while also being a major player in renewable energy project development.

As electric vehicles become more common, “it’s not helpful if we’re charging off coal power plants,” said Sophie Karp, utilities analyst at KeyBanc Capital Markets. “It has to be done in tandem. And that’s an opportunity for everyone in the power sector.”

As utilities face climate change, more are looking more like NextEra, complementing steady, cash flow-rich traditional businesses with renewable energy project development, or at least buying renewable power generation. There’s Xcel Energy, Berkshire Hathaway Energy, and others, even slower to embrace renewables but accelerating their climate path now, like Dominion Energy and Duke Energy.

It’s an approach to energy transition that the oil and gas sector, which also has a history of high cash generation, might have heeded sooner, according to analysts. But it will get harder to make the economics work in their favor.

While the returns oil and gas companies can get today from fossil fuel exploration may remain higher, longer-term there is less uncertainty around the viability of renewables. “At some point, energy companies have to decide where to invest that next dollar,” said Travis Miller, Morningstar utility analyst.

There is a tradeoff that will have to be made between absolute return today and investor belief in the future.

“I don’t expect that big of a transition from other E&Ps, but energy companies will have to make decisions at some point as to whether they can get the best returns investing in the fossil fuel business or renewable growth, and I think eventually we will see returns in the renewables remain positive and uncertainty around long-term viability of fossil fuels.”

BP recently slashed its dividend and under new CEO Bernard Looney has committed to renewable energy — but it’s not the first time BP has committed to alternative energy, as it was in and out of the solar business in the past, and under former CEO John Browne was speaking about confronting climate change under the “Beyond Petroleum” corporate motto two decades ago.

The economics of renewables have not yet changed as dramatically as investor sentiment about the future has recently changed, says Karp.

“A dollar of cash flow is a dollar of cash flow, and it can be coming from an oil well or a wind farm,” she said. “Right now, investors are clearly saying we will value the wind farm dollar higher than oil projects.”

In that regard, even as competition increases, NextEra has a big lead, and that’s likely to last for years in the U.S. renewable energy project market, analysts said.

Renewable energy development involves a lot of personal and political relationships, according to Morningstar’s Miller, such as with landowners, project siting boards, politicians, environmental review committees and taxing agencies, as well as suppliers of project materials in solar, wind and storage. “There is a large cast of characters that need to be involved in renewable energy development, so if you have those relationships you are most of the way there already in terms of putting together a project. And that’s what makes it the hardest for someone new to enter the renewable energy market,” Miller said.

Utilities including NextEra have another advantage: the right geography. Operating on the ground in Florida, for example, gives it a headstart in terms of experimenting with solar on a large scale. It has been in the wind business in Texas for over a decade. “Geography is a big thing in the utility business. Because they cover larger service territories they have access to substantial amounts of land, and most energy companies don’t have the on-the-ground knowledge and access to geography,” Miller said.

The degree to which the oil and gas companies in the U.S. transition won’t be as fast or wide as some European peers, such as Danish company Orsted, which used to be an exploration and production company and is now an offshore wind company. But Miller thinks the major energy companies will be among the biggest emerging investors, and competitors, with NextEra.

“The way the energy sector has traded, and the outlook for fossil fuels, suggests they should direct capital towards renewables. We’ve seen it in Europe. I think we will see incremental dollars of investment go into renewable energy,” he said. “There is still the shale business, it’s still an important source of energy in the U.S. and needs investment, but we will see energy companies increase direct investment toward renewables.”

But it won’t be easy.

“It will be difficult for Big Oil because they missed the boat on this,” Karp said. “They don’t have the cost of capital these guys have, and capital is the biggest input. … Majors are now penalized in the market for being basically oil companies,” she said.

That makes investing in renewable energy projects an even more difficult proposition, because the cost of capital has to be low given the lower-return profile of the renewable investments. Oil is also in secular decline as a sector. “That is not something too easy to overcome. NextEra pretty much has lots of growth opportunities ahead of it,” Karp said. 

Focus on investing in renewables for shareholders is distinct from investing for ratepayers, which many utilities have been doing as government policy drives their regulated business models. Xcel, based in Minnesota, buys as much renewable energy for customers as any utility in the country, but that’s different from being focused on the renewable energy project business directly. “You don’t get the as high a return by doing it that way, but you also take much less risk,” Miller said.

Corporate ESG policy and net-zero carbon goals also stand to benefit NextEra’s renewable project focus. “You hear of going carbon-free, net-zero carbon, and utilities are doing the heavy lifting on those corporate goals for ESG,” the Morningstar analyst said. The world’s largest technology companies are among the most aggressive, including Apple, Alphabet, Amazon and Microsoft, which has committed to a net-negative carbon goal.

With its warehouses alone, “Amazon has a lot of geography for solar panels,” Miller said.

With costs in solar, wind and storage decreasing, there will be more competition for NextEra, more players across industries that can afford to put capital into renewable energy projects. “The people trying to get in there is a large crowd,” Miller said. But he added, “the entire industry is chasing NextEra.”

BP cuts its dividend earlier this fall, and Exxon announced last week it would not increase its dividend for the first time since 1982, but NextEra has the regulated utility business to continue to appeal to the dividend-focused investor while using the markets to fund its renewable energy company. It can protect that existing investor base while also appealing to a more growth-oriented, climate-focused shareholder.

“The stodgy regulated utilities are a good mechanism for paying dividends. The renewable energy business is not going to be set up well for paying dividends,” Miller said.

BP’s recent move to focus more on renewable energy projects is not being made from a position of strength, according to a shareholder watchdog.

“They are being forced to as the future of their business model is crumbling before their eyes,” said Daniel Stewart, energy research associate at shareholder advocacy group As You Sow, which pressures companies to commit to climate goals.

The NextEra dividend is being funded from the regulated utility business, rather than the utility cash being used to fund renewables, but its business model does allow the company to access debt at attractive rates and raise equity to invest in its clean energy model.

“NextEra has been building that prowess for for decades. … for traditional oil majors, it will be tough for them to corner any other part of the energy market,” Stewart said, though he added the potential in hydrogen and geothermal energy might make more sense for these players since it speaks to where their existing strengths lie: engineering, and drilling and management.

Karp said other utilities will try to scale up in renewables and access capital, but NextEra will have an advantage for the foreseeable future because these are capital-intensive projects which require scale, as well as a low cost of capital. “By now their scale is so vast,” she said.

“Others will try. The market is rewarding other utilities perceived to be on the same path. Excel is an example of that,” Karp said. “If you are a utility and you want to branch out, you need to have this solid utility business that will pay dividends and keep those investors who want a dividend.” 

“They put themselves in a fantastic spot,” said As You Sow’s Stewart of NextEra’s regulated utility business, which generates the majority of its income, and the renewable energy business, which has huge potential in the future.

“And that’s where a lot of the value is coming from, that part of the business skating to where the energy transition is going,” he said. “Investors are looking at the macro level energy transition and how disruptive it is going to be, and how much faster it is unfolding. NextEra is really cashing in on that. … The volatility on the oil and gas side is just spooking lots of people and it is very scary when they think of how quickly the energy transition is ramping up.”

But there is a big caveat: a substantial part of its business is still reliant on coal and natural gas, and while NextEra has climate-based emissions reduction goals, it has not set carbon goals for its overall utility business as ambitious as some peers targeting net-zero in the decades ahead.

NextEra’s renewable business can distract from the regulated utility business. “It gives them room to not act as aggressively as others. … it buys them breathing room,’ Stewart said. “They are not showing support for ambitious climate policy in Florida. They can improve.”

But he added that unlike oil and gas companies, which are beginning to write down assets, NextEra’s renewable energy business is headed to the right place when it comes to how energy will be produced and consumed. 

“In the case of an Exxon or Chevron … when we see the market valuation of NextEra or Orsted, they missed the opportunity to buy up a large, disruptive renewable energy company. It is incredibly hard to catch up with that,” he said.