With the backdrop of energy transition, growing pressures for a more sustainable future, as well as an evolving policy environment, companies in the electric and gas utility sector are facing unprecedented change and uncertainty. Additionally, the volatility and uncertainty in both financial and energy markets more broadly are contributing to a challenging business environment for the utility sector.

To provide context for utility management on how to address these challenges, we analyzed the performance of 48 publicly listed U.S. utility companies over the past seven years. The primary objective was to draw lessons on how leading performers have navigated these challenges. As would be expected in a time of change,

it observed a wide gap between the top and bottom quartile performers in terms of total shareholder return (TSR) and terms of EV/EBITDA multiples, suggesting that the market sees very different growth and return potential across companies in the sector.

This article highlights six characteristics of top-tier performers and explores the drivers contributing to superior performance. Table 1 summarizes the financial performance of the 48 utilities in the analysis and highlights some of the factors that underlie the performance differentials.

Scale matters

The analysis points to a significant advantage of scale, with an average market capitalization of $33B for 1st TSR quartile performers, more than double that of the bottom quartile with an average market capitalization of $15Bn. Additionally, out of a total of 27 companies with market capitalization above $10Bn, 10 are in the top quartile, eight are in the 2nd quartile, with only five in the bottom quartile.

Scale provides the ability to invest in the growing requirements of the energy transition, including the systems and infrastructure needed to support changing customer needs, to participate in the growth of capital-intensive transmission, to modernize the grid and invest in growth areas like building needed EV infrastructure. Large market cap companies also tend to be more highly valued by investors since they provide better liquidity and often greater performance stability and predictability, in other words, lower risk.

Earnings growth is key

A notable characteristic differentiating the top and bottom performers is their earnings growth over the period. The top quartile performers have delivered an average annual EPS growth of 8%, whereas most of the bottom quartile performers exhibited less than 5% and, in some cases, negative growth.

Effective and disciplined cost management is certainly a key driver of earnings growth – operating expenses (O&M) of top quartile performers grew at an average of 5% CAGR over the past five years, vs. 7.6% for the average of the other three quartiles.

Foundational to delivering strong and steady earnings growth is the ability to drive top-line growth through consistent and focused capital spending.

Capital spending is a threshold requirement – investing in favorable trends is key

Active and focused capital deployment is a threshold requirement for leading performance in the utility sector. Having sufficient attractive investment opportunities in the core T&D infrastructure, in generation and in supporting evolving customer needs is the starting point, as these investments are essential to driving growth in rate base and earnings.

Year-on-year capex growth between top and bottom performers has been somewhat, but not materially, higher for top-tier performers over the past seven years. Leading performers generated 6% capex growth vs. 5% for the bottom quartile performers. However, most top performers augmented their growth by establishing meaningful growth platforms well aligned to favorable trends in the sector, sometimes quasi-regulated or non-regulated more competitive areas. Examples of such platforms include investments in renewables, competitive transmission, EV charging, as well as emerging technologies such as hydrogen and long-duration energy storage. Focused and targeted investments in such platforms help to drive earnings growth but typically require taking some measured risk.

The key challenge for utility executives is, therefore, to drive productive capital spending in the core regulated business without causing significant rate pressure, while investing behind selected platforms that can serve as sizable and sustainable growth drivers.

ESG is not just a buzzword

Another key characteristic of top performers is their superior ESG performance. Nine out of the twelve companies in the top TSR quartile have average or above ESG ratings vs. only four out of 12 in the bottom quartile. While social and governance issues are part of the ESG equation, environmental issues comprise more than 50% of the weighting for utility companies. The utility sector is evaluated on metrics such as carbon intensity, water intensity, environmental contaminations and their efforts to manage climate- and environment-related risks. It is not just about having ambitious ESG targets but delivering on specific programs and initiatives to drive sustainability.

Portfolio mix is key – electric-centric utilities have an edge

Most of the top-tier performers over the past seven years were combined electric and gas utilities typically with a significantly larger share of the assets and earnings in electric. Gas-only utilities were the weakest performers making up the majority of the fourth quartile while electric-only tended to be positioned in the second and third quartiles.

The weaker performance of gas utilities reflects in part the lack of meaningful demand growth, the relatively limited scope for capital investment when compared to electric and broader concerns over the longer-term role and value of natural gas in a decarbonized energy system. This is evidenced by the ongoing announcements by utilities of their plans to exit from their natural gas businesses.

Regulatory environment is not a deterministic factor

Lastly, and not surprisingly for the regulated utility sector, many of the top performers operate in jurisdictions with more favorable regulatory and policy environments. However, the regulatory environment is not a deterministic factor in TSR performance. Several companies in the top TSR quartile operate in states with “less favorable” regulatory environments.

If we measure the attractiveness of the regulatory environment on a 9-point scale, the average attractiveness of jurisdictions where companies in the 1st TSR quartile operate is somewhat better than those in the fourth quartile (4.1 vs. 4.7). Regulatory environment alone is not, therefore, sufficient to support leading performance. What is more important is how well utilities navigate within their jurisdictional regulatory construct, regardless of the “attractiveness” of the regulatory and policy environment.

What are the strategic implications?

Aligning strategy to be consistent with the characteristics of leading performers is the central challenge and opportunity for utility management. The extent and substance of the challenge are unique to individual utilities, as each has a very different starting point in terms of portfolio, regulatory environment, positioning vs. key trends and decarbonization pathways. No single characteristic is sufficient to drive leadership, and no lack of a single characteristic (e.g., being a smaller-scale utility) is sufficient to drive below-par performance.

Management will have to make some difficult choices about where and how to focus their capital and resources along several dimensions, including whether to participate in more competitive businesses, whether and how much to invest in emerging technologies such as hydrogen and renewable natural gas (RNG) and the degree to which to invest behind the delivery of solutions to meet customers’ changing needs. These choices also rest on each company’s willingness and ability to take on risk. While it is certain that making these choices will be difficult at times, maintaining a clear focus on the requirements for success offers an opportunity to drive substantial shareholder value while supporting the achievement of broader stakeholder goals.