Algonquin Power & Utilities: Rushing To Adapt
By: David Hammond & Will Currie
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Utilities: A Mature Industry Braced for Change
Investing in utilities has long offered investors stable returns, a strong dividend, and often resilience to economic turbulence. Utility providers are low-risk investments due to limited competition, and their designation as ‘legal monopolies’ allows the government to impose barriers to deter potential entrants. However, in recent years, the rate-regulated utility business model has been challenged by the need for new capital investments to support decarbonization and a changing supply and demand landscape.
Rate-regulated utilities – namely electrical, natural gas, and water – are distinct in that government agencies and commissions guarantee fair and reasonable rates, service quality, and financial stability. Regulators generally establish a rate that enables utilities to cover their expenses while earning a predetermined return on capital investments. The main objective of rate regulation is to strike a balance between consumer interests and the utility company's pricing and service quality objectives.
Lighting Up the Electrical Industry
For nearly a century, the electrical utilities industry in the U.S. has relied on centralized generation and transmission systems to distribute energy. Recently, however, this model has faced challenges from the rise of renewable energy solutions. Renewable portfolio standards and the emergence of non-utility generators, along with net metering, behind-the-meter storage, and other distributed energy solutions, are shifting revenues and customers away from traditional utilities. This shift is problematic for existing utility companies, as their aging grids were not designed to integrate and store power from distributed, renewable sources. There is a growing need to modernize the electrical grid infrastructure to efficiently manage and transport power from renewables, often over long distances. Additionally, robust energy storage solutions are essential to balance the intermittency of supply and demand in renewable energy.
Firin’ Up the Natural Gas Industry
Fossil fuel combustion in buildings is responsible for 13% of the U.S.'s greenhouse gas emissions and has been a cornerstone for home heating, powering appliances, and water heaters. However, the sector faces challenges as regions transition to electric alternatives, driven by consumer demands for lowering carbon emissions. Despite this shift, opportunities abound in the energy-efficient natural gas market. Ontario's investment in new natural gas infrastructure, catering to communities reliant on electric heat, underscores this potential. Simultaneously, the rise of renewable natural gas (RNG) aligns with environmental concerns, offering emissions reductions and addressing carbon tax issues. Yet, the industry contends with increasing natural gas prices influenced by carbon taxes and consumer pressure. Legislative developments, such as New York's statewide ban on natural gas connections in new buildings, further complicate the landscape. Striking a balance between meeting consumer needs, reducing emissions, and adapting to evolving regulations is essential for the natural gas utility sector's sustained growth amid this intricate environment.
Gushing Over the Water Industry
In the current U.S. market, nearly 270 million people rely on the public water supply annually, representing over 85 percent of the country's population. Municipal water suppliers are crucial in delivering clean water to homes and businesses. The trend of governments privatizing the water supply creates significant opportunities for private companies, contributing to cost reduction for both entities and citizens.
The biggest concern for water utility companies in the year 2023, as revealed by a survey conducted by the American Water Works Association, revolved around two key issues: aging water infrastructure and the availability of a sustainable, long-term supply of drinking water. The exponential growth of the U.S. population has elevated water scarcity to a critical juncture, with water sources largely unchanged over the past 70 years despite a population increase of nearly 190 million. Common sources of water in the U.S. include rivers, lakes, and groundwater aquifers.
A critical concern is the depletion of freshwater sources at a rate that surpasses the rate of natural replenishment. The impact is evident as the Colorado River, the fifth-largest river in the U.S., no longer reaches the Gulf of California. Meanwhile, Texas' Rio Grande, the fourth-largest river in the country, has hit unprecedented low levels. Arizona faces enduring droughts and South Florida's aquifers are increasingly susceptible to saltwater intrusion. Water utilities persist in over-extracting from existing sources, highlighting the pressing need for new water sources or sustainable practices to meet rising demand.
An Overview of Algonquin
Algonquin Power & Utilities (AQN), a provider of rate-regulated water, electricity, and gas services in North America, has seen a substantial downturn, with its share price plummeting 54 percent over the past year. This decline is mainly due to internal issues specific to Algonquin, particularly its foray into the non-regulated renewable energy sector. The aggressive expansion under previous leadership led to operational struggles, a lack of profitability, and a significant increase in debt to $7.7 billion, partly due to variable interest rates. The failed attempt to acquire Kentucky Power further eroded investor confidence, resulting in AQN's stock dropping from over $15 to just below $7. In response to these challenges, Algonquin has confirmed it would divest its renewables business, heeding the advice of activist investor Starboard Value LP. This strategic shift aims to reduce debt, improve earnings, and stabilize the balance sheet.
Updating the Utility Model
Upon initiating the sale of its renewables business, Algonquin should consider spinning off its rate-regulated water utilities business, Liberty Water, into a new entity, SpinCo. The primary benefit of this would be an increase in value for Algonquin's shareholders. A McKinsey report highlighted that private equity and infrastructure funds have shown a growing interest in the sector. This interest is reflected in the higher stock prices of water utility companies, which trade at substantially higher multiples than their counterparts in the electrical and gas sectors. The average gas and electric utility companies are trading at 11.6 times EV/EBITDA, whereas water utilities are trading at an average of 17.0 times EV/EBITDA. This difference underscores the significant value investors place on pure-play water utility businesses, suggesting that spinning off this sector could redistribute lost value back to shareholders. In the event of the spinoff, we recommend Algonquin Power & Utilities retain at least a 19.0 percent stake in SpinCo to maintain future capital flexibility. This retained stake can be leveraged to reduce debt or invest in future initiatives such as grid modernization.
Furthermore, the water utilities business would yield positive strategic outcomes for both the new water utilities and the now separate electrical and natural gas utilities business. The previous grouping of these businesses kept the identifiable synergies the same. By separating the water utility business into SpinCo, both SpinCo and Algonquin Power & Utilities could establish management teams with specialized expertise tailored to the distinct strategies of these utilities. Historical data has shown that effective management is a key factor in the success of Algonquin Power & Utilities. Having management teams with specific knowledge and experience in water or electric/natural gas utilities would further enhance shareholder value. Additionally, the capital flexibility gained from the renewables sale would enable Algonquin to better adapt to the increasingly capital-intensive trends in the industry by creating different go-forward benchmarks for each segment.
Glass Half Full: Liberty Water’s Future
Relying on aquifers and surface water, Algonquin’s current water utility business, Liberty Water, primarily utilizes fresh water, which represents only 2.5 percent of the world's water. There exists a significant opportunity for expansion into ocean water, which, though not consumable in its natural state, can be transformed into drinkable water through desalination. While desalination is not a novel concept, it does come with high energy costs as it is energy-intensive to break the chemical bonds in water. This energy-intensive process constituted up to a third of the overall production cost for creating drinkable water. However, recent advancements, particularly in reverse osmosis (RO), have significantly improved energy efficiency, making desalination more economically viable. In RO, seawater is forced through a membrane at high pressure to remove minerals.
Given the escalating issue of water scarcity and the need for sustainable solutions, investing in desalination plants, especially in regions facing water supply constraints like California, Arizona, and Texas, is a strategic imperative for Liberty Water. Recognizing the growing importance of such technologies, one of Liberty Water's competitors has already begun investing in desalination, securing approval for a $95-million plant in southern California. With a substantial customer base in supply-limited locations, staying ahead of the competition in pursuing desalination projects would not only position Liberty Water as an industry leader but also address the pressing water challenges in critical geographic areas. The now separate electrical and natural gas utilities business would also benefit from a dedicated management team focused on a pure-play strategy.
Digging Deep on Electrical & Natural Gas Businesses
Traditional electric and natural gas utilities, including Algonquin, must evolve to meet the changing demands of the industry, necessitating specialized managerial expertise and strategic planning for a smooth transition to a decarbonized power utilities space. Notably, nine of the thirteen states where Algonquin operates have implemented renewable portfolio standards (RPS) legislation, in an attempt to urge utility companies to supply power from renewable sources and lessen fossil fuel dependence.
Given that a majority of Algonquin's electrical utilities already utilize renewable sources, the company should concentrate on two key improvement areas in its electrical utilities business: enhancing energy storage facilities and strengthening its transmission network. Investing in battery energy storage systems is vital for applications such as peak shaving, optimizing self-consumption, and providing backup power during outages, which can lead to significant cost savings for Algonquin. Additionally, as consumers increasingly adopt electric vehicles, Algonquin could open another revenue stream by selling stored energy back to consumers. Upgrading the transmission network also presents an opportunity for considerable cost savings. A McKinsey report estimates that a typical Southeastern U.S. utility company would require $700 million to $1 billion to prepare for climate change impacts. This investment is substantially lower than the current 20-year storm costs of $1.4 billion and far less than the projected future storm costs of $1.7 billion. Such upgrades could yield both financial benefits and enhanced resilience for Algonquin.
A more focused approach to natural gas utilities from the spinoff of Liberty Water into SpinCo could also benefit Algonquin during this period of decarbonization. Algonquin should consider integrating RNG into its natural gas operations. RNG has the potential to significantly reduce emissions, and the current macroeconomic and political landscape is increasingly supportive of adopting this fuel source. As market trends shift and consumer demand for lower emissions grows, and integration is further enabled through technological innovation, RNG stands out as a more efficient and feasible choice for Algonquin.
Moreover, adopting RNG aligns with Algonquin's broader sustainability benchmarks and corporate social responsibility goals. It underscores the company's commitment to environmental stewardship and positions Algonquin as a leader in the transition to a low-carbon future. By integrating RNG, Algonquin would not only decarbonize its operations but also realize the full value of its natural gas business in an increasingly eco-conscious market.
Pouring Over Prospects: The Future of Water Utilities
In conclusion, the utilities industry, encompassing electrical, natural gas, and water utilities, is undergoing a significant transformation driven by regulatory changes, evolving market demands, and technological advancements. Water utilities, while stable, are grappling with aging infrastructure and the growing need for sustainable water sources. Electrical utilities are adapting to the rise of renewable energy and the need for modernized grid infrastructure. Natural gas utilities face the challenge of balancing demand with environmental considerations, with RNG emerging as a viable alternative. Algonquin Power and Utilities, in particular, is navigating these changes amidst its internal challenges. The proposed spinoff of Liberty Water, its water utility business, into SpinCo, could strategically position the company for future growth, allowing for more focused management and efficient capital allocation in each segment. This move aligns with the broader industry trend towards specialization and efficiency, as utilities seek to balance shareholder interests with sustainable and reliable service delivery in an increasingly complex and dynamic energy landscape.
