Renewable energy will make life more complicated but could be a boon for the companies providing it.
The year is 2051 and newly married, first-time homeowner Olivia is driving to work. (Olivia was one of the most popular baby names in 2020, and she has just turned 31.)
She parks her electric vehicle at an office building at 6:45 a.m. and plugs in her EV, getting a free charge at work. About half of the vehicles sold in the U.S. are still gasoline-powered, but there are enough EVs that it makes sense to get there early. Just after lunch, Olivia gets an alert on her phone that her car isn’t charging. On this scorching July day, the electric company needs the energy to meet peak cooling demand. She understands—and also understands the opportunity it offers, as she taps a “sell” button on an app. Her car starts to discharge electricity to the building’s battery, which will power the lights and air conditioning during peak hours, lowering the building’s total cost of operating by not relying on the grid.
Olivia gets something, too. By the time she leaves work, her car has discharged about 40 miles worth of electricity, knocking $3 off her monthly bill. She could have sold more, but she wanted to make sure she had enough left to get home.
Olivia’s car isn’t the only thing responding to the heat wave. So does her two-bedroom bungalow in a nice suburban neighborhood, which uses a heat pump to cool down. In an alert on another app, she learns that the electric company had lowered her thermostat to 68 degrees in the morning, cooling her home ahead of expected peak demand. The utility then set the thermostat to 75 degrees in the afternoon, and reset it to 72 degrees about an hour before she got home.
Olivia isn’t surprised—she elected to allow the utility to change temperatures to get more favorable rates. Now she’s thinking about adding solar panels and battery storage to her home so she can sell power back to the grid when demand is highest. There would be an upfront cost, but her electricity bill would drop even further.
Sure, it’s complicated—and Olivia isn’t always a fan of the apps that keep pushing alerts to her phone. It’s worth it, though. Olivia spends less on electricity and gas than her parents did a generation ago. Welcome to the grid of the future.
Getting there won’t be easy. “The grid” refers to everything that goes into the production, storage, transmission, distribution, and consumption of electricity, and it’s set to go through big changes. Production of electricity will have to increase as power-hungry data centers proliferate along with EVs, and as home heating and cooling go electric. The sources of all that electricity will shift to more-renewable sources like solar and wind, which will also necessitate more energy storage assets—think batteries—as well as more-robust transmission lines. Behind the curtain will be more software and artificial-intelligence tools coordinating it all.
For homeowners, it means more complexity in exchange for a lower total energy bill. For utilities, it means growth. And for the companies that build grid infrastructure, make the electrical hardware, and write the software to control it all, it means big opportunities.
Not much has changed for the power grid over the past couple of decades. The U.S. consumed about 4.2 trillion kilowatt-hours of electricity in 2022, a record, but overall demand has been sluggish— just 0.4% growth annually since 2000. About 60% of that comes from burning coal and natural gas. Another 20% comes from nuclear power, with another 20% from renewable sources.
As of 2022, about 60% of electricity in the U.S. came from fossil fuels and 40% came from renewable energy sources, including nuclear.
The subdued demand growth has meant that the industry has been focused on the maintenance of existing assets, and not investing for the future. The transformers—those buzzing boxes that convert voltage into levels that can be used in homes and offices—are essentially identical to the ones used 20 years ago. The biggest change homeowners may have noticed is the automatic meters that have replaced the monthly visits by a utility employee.
All told, publicly traded electric utilities have spent some $134 billion a year on average maintaining their $2 trillion asset base, according to the Edison Electric Institute, with few dollars going to drive the modest growth.
Such complacency won’t cut it in the years ahead. Data centers are growing as more data move to the cloud. What’s more, AI computers are power hungry, needing five or six times more power compared with their less-sophisticated computing ancestors. Heat pumps, which are replacing conventional heating and air conditioning, shift demand from natural gas and heating oil to the grid. While the transition away from internal combustion engines to EVs hasn’t happened as quickly as some imagined, it’s still happening—and powering all of those cars will take a lot of electricity. Right now, EVs account for less than 1% of total electricity demand. That could be anywhere from 5% to 15% by 2050, depending on how fast EVs get adopted.
All told, electricity use could grow by 2% a year over the next decade, ending years of stagnation. “I just think we’re going to have massive amounts of electrification everywhere,” says Reaves Asset Management CEO Jay Rhame. “Every utility has a story where demand growth is the highest it has been in forever.”
Demand isn’t the only thing that’s changing—so is how electricity is produced. In the past, coal- or gas-fired power plants would be cranked up as needed to deliver electricity. For the most part, it has worked. But that’s about to change. New capacity is desperately needed—the Department of Energy sees capacity expanding by 2.6% annually over the next 20 years, about double the rate since 1990— making the grid 70% larger. Roughly 70% of that will be renewable, a source of energy that is more dependent on climate conditions than fossil fuels.
Production will also be increasingly decentralized. Utilities will still generate the bulk of the electricity, but it will also come from a Walmart store with a solar roof, a Tesla owner with a backup battery, or a homeowner with a standby generator made by Generac Holdings. They’re all potential producers that will be able to send electricity to the grid at times of peak demand.
All of that is still very much a work in progress. As unpopular as a local utility might be when prices spike, the U.S. grid is incredibly reliable. The average American spends about six or seven hours without power each year. Decentralization could lead to more price volatility, with electric-power prices rising faster than inflation at times, and customers will be forced to deal with a less reliable grid, with a neighborhood transformer going down when too many EVs plug in all at once—a problem that can be addressed with newer, more sophisticated equipment.
In the worst-case scenario, the result looks a lot like Texas in February 2021, when millions of residents lost power for as many as four days, due to severe cold. Both natural gas and wind assets failed, with a lack of gas production accounting for a significant portion of outages.
Some of the problems will be solved by creating better infrastructure, including the development of higher-capacity cables, which would add transmission capacity without increasing the number of transmission towers needed, and updated hardware designed to handle the ebbs and flows of demand. Texas, for its part, didn’t cast aside renewable energy after the blackout. Instead, it reassessed margins of safety and updated forecasting and interdependence methodologies.
The grid has “got to be slightly bigger, but a lot smarter,” says Thierry Godart, general manager of Eaton’s Energy Automation Solutions unit, which sells hardware and software ranging from smart electric meters to automation software and predictive analytics.
The industry already employs complicated acronyms, including Droms, Derms, and VPPs, for the kinds of software it needs to handle the grid of the future. Droms is short for “demand response optimization and management systems,” which can change the thermostats in houses to manage electricity demand when the grid is under strain. The more sophisticated systems include demand forecasts and logic to precool homes so there is no spike in demand following a weather event.
Derms, short for “distributed energy resource management systems,” can orchestrate the growing number of distributed generating assets including solar roofs, businesses with their own generators, and even battery storage owned by anyone. VPPs, or virtual power plants, will aggregate megawatts of electricity generation from things such as solar panels on top of a Walmart and sell them to a utility.
“It isn’t about putting in poles and wires,” says AutoGrid CEO Ruben Llanes. “Optimization and efficiency are very important.”
Over the next 30 years, some $9 trillion, or about $300 billion a year on average, should be spent adding generating, transmission, and distribution assets while upgrading in-home technology such as smart metering, connected thermostats, and smart, connected circuit breakers. Some of that will be spent by businesses looking to cut their utility bills, and some will be spent by homeowners adding solar panels to their roofs or adding batteries and backup generators to ensure they never go without power. Most of the spending will fall to the existing utilities and independent power companies.
The electrification of everything means big business for utilities and other stocks.
Utilities won’t mind. The grid of the future will mean more electricity to generate, distribute, and manage—and faster growth than they have had in the recent past. The capital spending means sales and earnings growth as regulators allow utilities to earn a return on their outlays. NextEra Energy, with about 34 gigawatts of clean generating capacity, is already the largest producer of utility-scale renewable power in the U.S., with roughly 10% of total U.S. nonnuclear renewable capacity.
More important for investors, it has grown earnings at a rate of about 11% a year on average for the past three years. While Wall Street projects growth to slow to about 7% for the coming three years, that slower growth may already be reflected in the stock, which trades for 18 times estimated 2024 earnings, down from a three-year average of almost 26 times.
Edison International should benefit from being based in California, an early adopter of renewable energy. California means wildfire risks, something that has kept a lid on valuations for utilities based in the state, but more than 20% of all the cars sold in the state during the first three quarters of 2023 were all-electric, which should drive demand for electricity. Edison International’s earnings are expected to grow at an 8% clip over the next three years, up from 1% annually over the past three. Shares trade for about 14 times earnings, in line with historical levels.
American Electric Power, one of the largest utilities in the U.S., serves more than five million customers across 11 states, including Oklahoma, Texas, and Tennessee. Those states are among the fastest-growing, and power demand is increasing with the population. That provides AEP with a kicker, with the utility expected to grow at a 6% annual rate over the next three years, about the same as the past three. It trades at 15 times 2024 earnings, down from an average of 18 times.
Growth has already started to show up for the established suppliers of electrical components and software, including Hubbell, Eaton, and France’s Schneider Electric. Those opportunities are starting to be reflected in the stocks. Hubbell, a key supplier of transmission and distribution equipment to utilities, has grown earnings at an average annual rate of about 26% a year for the past three years, including fourth-quarter estimates for 2023, but is expected to grow by just 8% over the next three years.
That is probably a conservative view. Mizuho Securities analyst Brett Linzey, who has a Buy rating and $370 price target on the stock, expects the inventory adjustments that hurt volumes in 2023 to have normalized in the fourth quarter, which should help earnings beat consensus estimates. Other stocks benefiting from that dynamic include Schneider Electric, which has grown earnings at about 22% a year on average for the past three years but is expected to grow them at a 10% clip over the next three, and Eaton, which has grown earnings at 29% a year for the past three years but is expected to grow by just 9%.
The expectation that growth will return to normal is playing out at infrastructure companies that will build out the grid, too. Quanta Services has grown earnings at about 23% a year on average for the past three years, but analysts project growth of 16% for the coming three years. That solid growth is reflected in the stock, which trades for about 24 times estimated 2024 earnings. Likewise, Sterling Infrastructure provides building services for data centers, transportation, energy, and other customers. It has grown earnings at 40% a year on average for three years, but Wall Street sees that falling to about 12% a year. Sterling shares are up 120% over the past 12 months, but the stock trades at less than 17 times 2024 earnings per share.
Clough Capital Partners CEO Vincent Lorusso is a fan of Sterling. “They are just so well positioned in areas where [the U.S. is] going to continue to invest a lot of capital,” he says.
Wall Street sees earnings growth decelerating at Hubbell, Eaton, Schneider, Quanta, and Sterling. That doesn’t mean they have peaked, just that analysts are loath to assume good times last forever and tend to project normalized results into the future.
Don’t expect rooftop solar stocks like Sun Power and Sunnova Energy International to get the biggest boost from the grid of the future. There is roughly 40 to 50 gigawatts of small-scale solar generating capacity in the U.S., representing some 3% of total U.S. generating capacity, and the $2.7 billion in sales expected to be generated in 2024 is a tiny portion of the hundreds of billions spent growing and maintaining the grid. What’s more, neither stock is profitable, and neither generates free cash flow yet. They are also as dependent on interest rates and capital markets to fund their growth as they are on the grid.
First Solar, on the other hand, is a leader in utility-scale solar technology. It has a market capitalization of about $18 billion and is profitable. Sales and earnings are expected to grow at about 25% and 60% a year on average, respectively, over the coming three years. Shares trade for just 13 times estimated 2024 earnings because sales and earnings tend to be cyclical and tied to government policy.
The grid of the future could make it a winner.
Write to Al Root at email@example.com