Document Text Content
CONFIDENTIAL
Global Utility White Paper
A Primer on Long/Short Investing in the
Global Utilities & Infrastructure Sector
Jos Shaver
Portfolio Manager
Electron Capital Partners LLC
March 08, 2013
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Global Utility White Paper
CONFIDENTIAL
1. Executive Summary ................................................................................................................................................ 3
2. Structural Change – Advantageous Time for Global Utility Sector Long/Short Investing ..................................... 5
� Structural Change in Electron’s Research Process ....................................................................................... 5
� Structural Change Cycle ............................................................................................................................... 5
� Investors Not Positioned for Structural Change Pickup ............................................................................... 5
o Long‐Only Investors Substantially Underweight but Hedge Funds Turning ......................................... 5
3. Regional Structural Changes Driving Alpha Opportunity ....................................................................................... 7
� US Utilities ................................................................................................................................................... 7
� European Utilities ........................................................................................................................................ 9
� Asian Utilities ............................................................................................................................................. 10
� Japanese Utilities ....................................................................................................................................... 11
� Latam Utilities ............................................................................................................................................ 12
4. Global Structural Changes Driving Alpha Opportunity ......................................................................................... 12
� Power Prices are Skewed to the Upside .................................................................................................... 12
� Capex (ex‐US) is Rebounding Post‐Recession ............................................................................................ 14
5. Substantial Alpha Opportunities Follow Periods of Underperformance .............................................................. 14
� Record Duration and Depth of Underperformance ................................................................................... 14
� Reasons for Underperformance ................................................................................................................ 15
� Potential Exists for Sharp Outperformance ............................................................................................... 15
o Post‐Dotcom Rallies ............................................................................................................................ 16
o Japan Rallies ....................................................................................................................................... 17
o Potential for Yield Catch‐up ................................................................................................................ 18
6. Interest Rate Risk – A Common Misperception .................................................................................................... 19
Appendix 1: The Team and Our Process ...................................................................................................................... 20
� Electron Focus ............................................................................................................................................ 20
� Electron Team ............................................................................................................................................ 20
� Track Record (7 years) ............................................................................................................................... 20
� Process ....................................................................................................................................................... 20
o Why We Take a Global Approach ‐ The “Greatest Gift” ..................................................................... 21
o Capitalizing on Structural Change Timing ........................................................................................... 22
� Portfolio Construction ............................................................................................................................... 22
� Shorting Global Utilities ............................................................................................................................. 23
o Experience with Dividends and Investor Behavior ............................................................................. 23
o Key to Electron’s Process to Identify Dividend Change Candidates ................................................... 23
Appendix 2: Global Utility Sector Background ............................................................................................................. 25
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1. Executive Summary
This White Paper discusses Electron Capital’s (“Electron”) views on the global utility sector and outlines why
now is a particularly advantageous time for long/short investing in the sector using Electron’s research
approach that focuses on structural change.
Electron’s 5 investment professionals, working together an average of 6 years, have generated a 7‐year track
record of long/short investing in the global utility sector. Returns have annualized 10.3% and have been
characterized by strong alpha generation (80% of returns; Jensen’s alpha calculation) in a dismally‐performing
global sector (‐0.2% absolute).
Electron will continue its approach with the Electron Global Fund, an absolute return product. (See
Appendices 1 and 2 for Electron’s process and the sector’s history.)
Electron invests in a deep universe of utility and infrastructure stocks, comprising 375 companies with a
market cap of $2.8 trillion. Our approach is truly global as 40‐60% of the portfolio’s historical gross has been
allocated outside the US. Stocks covered include the electric, gas, water and waste utilities in addition to
infrastructure companies (defined as those levered to utilities or utility‐like). For the sake of simplicity, the
rest of this White Paper will focus on the electric utilities, the largest subsector; we refer to this subsector
when we reference “utility”.
� Advantageous time to be long/short investing in the global utility sector (Section 2).
o Structural change in the sector has been accelerating after a recession‐induced slowdown.
o Long‐only investors are not positioned for such structural change in what is the world’s most
underweight sector.
o We believe hedge fund investors have already begun to make this turn as evidenced by a
significant increase in net exposure over the last 6 months.
� Structural changes will drive the largest alpha opportunities in all major regions (Section 3).
o US utilities will face the strongest headwinds, yet structural change will occur which will drive
alpha opportunities. We believe the most interesting US structural changes will have a magnified
effect internationally given commodity interlinkages.
o European and Asian utilities offer the most abundant and attractive alpha opportunities.
o Japan and Latam will be more trading markets over the near term.
� Some structural changes will have a global impact (Section 4).
o The shale gas and coal price washout (with its knock‐on effect on global power prices) is largely
over; the global utility sector has substantial optionality to any increase in power prices due to
natural gas and coal prices, which will be heavily influenced by trends in the US.
• On the supply side, US spot gas at $3.42/mmbtu is below the breakeven full‐cycle
natural gas production cost of $3.50‐4.00/mmbtu. We believe this provides downside
protection to the current gas price despite the proliferation of shale gas.
• Potential additional demand for natural gas is enormous:
� In the US power sector (37% of demand), EPA mandates will force coal plant
closures (e.g. potentially adding 10% to natural gas demand) and increase the
marginal switching cost for the most efficient plants to $4/mmbtu, providing a
runway for structurally higher gas demand/prices.
� Other large potential structural sources of demand arise from LNG exports
(also 10% of US demand), a gas‐intensive industrial renaissance (also 10%), and
substitution of LNG/CNG for oil‐based vehicle fuels.
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o
• Leverage to higher power prices can be substantial. For example, in the US every
$1/mmbtu improvement in natural gas prices increases Exelon’s long‐term earnings by
more than 20%, whereas for pure generators such as NRG the leverage exceeds 30%.
• In Europe, where power is generated at close to cash production cost in many markets,
even a modest (e.g. 10%) combination of changes in coal, carbon and Euro prices can
have a 25‐50% earnings impact on several European utilities.
Global utility capex (ex‐US) is rebounding after a recession‐driven slowdown:
• System‐enhancing transmission capex is accelerating in Europe and Asia and is firm in
the US.
• US, European and Asian utilities are building much of the infrastructure needed to
capitalize on the global shale gas boom underway.
• In emerging markets, infrastructure spending is occurring across the entire value chain.
� Substantial alpha opportunities follow periods of underperformance (Section 5).
o Current MSCI World Utility Index underperformance against the MSCI World Index is the deepest
(‐67%) and longest (4 years) of the modern utility era, caused by a perfect storm of factors (see
page 15).
o Despite the strong rally in equity markets since the depths of the financial crisis, the global utility
sector is still down ‐11% in absolute terms and has underperformed the second‐worst sector
(telecom) over the same period by ‐23%. Previous periods of underperformance have set the
stage for substantial alpha opportunities driven by fundamental investors re‐entering the sector.
o The global utility sector does not need to outperform for Electron to generate solid performance;
80% of our 7‐year return (10.3% per annum) is from alpha (Jensen’s alpha calculation).
� Investing in the global utility sector does not mean taking undue interest rate risk (Section 6).
o The interest rate sensitivity of the sector has declined steadily since the modern utility era began
in the early 1990s. US utilities remain the most interest rate‐sensitive companies regionally.
o We track interest rate risk for all positions in our risk model, and the portfolio’s net interest rate
risk is kept within acceptable limits as we select stocks. In addition, Electron’s return correlation
to interest rates historically is slightly lower than the HFRI Equity Hedge Index’s return
correlation to interest rates.
o This process has worked well for us as Electron has posted strong returns and alpha generation in
both increasing and declining interest rate environments.
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Investors should always have an allocation to the global utility sector.
o This is a large‐cap, dividend‐generating sector that is vitally important to national economies, and
which is subject to undercurrents of deregulation and competition. This has produced ample
long/short opportunities in the past and will continue to do so for the foreseeable future.
o Moreover, an allocation to global utilities provides a diversification benefit to investor
portfolios. The risks affecting a global utility sector fund are very different from those affecting
other long/short funds and diversification enables higher returns per unit of risk. Electron’s 7‐
year track record correlation to the S&P 500 and HFRI Equity Hedge indices is .41 and .68,
respectively (.18 and .55, respectively, in down markets).
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2. Structural Change – Advantageous Time for Global Utility Sector Long/Short Investing
The high level of structural change occurring around the globe makes this a particularly advantageous time
to be long/short investing in the global utility sector. The various examples for each region, the importance
of structural change to each region and the opportunities are listed in Section 3.
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Structural Change in Electron’s Research Process
Since the original Electron was formed in 2004, Electron’s research process has focused on structural
change to determine its impact on the underlying future earnings potential of our companies (see
Appendix 1, page 22). Whenever there is structural change, distortions and inefficiencies arise. These
invariably result in both winners and losers among utility stocks, in large part because of the heavy
influence of public policy on the sector (e.g. governments and regulators). Policymakers will never want to
knowingly provide windfall profits to utilities; if a structural change is producing a winner, we look for the
loser. If a loser cannot be found, we keep looking: the loser will eventually surface.
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Structural Change Cycle
As cycles are an important feature of life, so are cycles of structural change important in the global
industry. During the recession following the financial crisis, the activity level of structural change did
slow down around the globe. This is not surprising as governments, regulators and other stakeholders
slowed the pace of structural change (i.e. a hunkering down mentality took hold among utility
stakeholders) and companies slowed their rate of capital spending (because of uncertain economic
growth prospects). As time has passed, the outlook for global growth has stabilized, tail risks have been
managed and confidence has returned, and companies have begun spending previously‐delayed capex
needed to ensure system reliability. This collectively has prompted utility stakeholders to pick up the
pace of structural change. Given that we track structural change globally, we estimate that this inflection
point of increased structural change occurred approximately 12‐18 months ago.
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Investors Not Positioned for Structural Change Pickup
That we are at an inflection point for a pickup in structural change is underappreciated by the market.
Moreover, it is occurring at a time when there are fewer eyes focused on global utilities. The
underappreciated pickup in structural change activity levels combined with low investor involvement
spells opportunity for the Electron Global Fund as it plays to the Electron team’s competitive advantage.
This driver was critical to the investment professionals’ decision to re‐launch the independent Electron.
o
Long‐Only Investors Substantially Underweight but Hedge Funds Turning
The global utility sector is the world’s most‐underweight sector by a large margin. Moreover, the
underweighting has dipped to a comparably extreme level only 4 times (including now) over the last
10 years. Each time this extreme has been crossed, over the next 24 months global utilities rose by
38% on an absolute basis and outperformed the global broad market by 20%, on average.
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Global Sector Positioning
Substantially
underweight
Source: Bank of America Merrill Lynch Global Fund Manager Survey, Feb 12, 2013
Net % Overweight Global Utilities
+1σ underweight vs mean
‐1σ underweight vs mean
Red circle =
crossing below
1σ underweight
Source: Bank of America Merrill Lynch Global Fund Manager Survey, Feb 12, 2013
The sector has been not only a substantial long‐only underweight, but also a wholesale short for
many macro/generalist hedge funds. However, it is very interesting to note that an inflection point
appears to have occurred in the middle of 2012, with hedge funds increasing their net exposure to
the global utility sector after a long period of reducing net. The long/short ratio of utility stocks held
by hedge funds fell from 3.0x in Jan 08 to about 1.7x in Jan 12 (4 years), but has since risen by 60% to
2.7x, which is more than twice the increase for hedge funds’ overall net exposure during the same
period (source: Goldman Sachs).
Based on discussions with the Street, it appears that this short exposure has been expressed via ETFs,
regional utility indices or large bellwether index utility proxies. Individual name crowdedness has
continued to remain at a low level (e.g., utilities rarely show up Goldman Sachs Hedge Fund VIP list –
ticker GSTHHVIP). Today, utilities account for the lowest in gross assets held of the 10 global
sectors. (Source: Goldman Sachs Hedge Fund Trend Monitor analysis of 700 hedge funds with $1.3
trillion in gross assets.)
In addition, global QE programs have boosted demand for higher‐beta stocks, which has contributed
to the recent relative underperformance of and lack of interest in utilities. However (see below), the
underperformance of US utilities has diminished with each successive QE round (QE1
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underperformance ‐39%, QE2 ‐12%, QE3 ‐5%), which signals exhaustion of selling pressure as the
relative value of the S&P versus utilities has stretched further. Given widespread use of QE, a similar
effect can be found in other regions.
US Utilities Price/S&P 500 Price
Source: Bloomberg
3. Regional Structural Changes Driving Alpha Opportunity
Structural changes are occurring in all regions. Those in which Electron is currently investing or tracking closely
are as follows:
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US Utilities
Of the global utility markets, we expect the US utilities market to face the strongest headwinds and be
the least‐attractive market for alpha generation over the next 2 years. Since the financial crisis, the US
has been the best‐performing region for utilities of all the developed markets, outperforming European
utilities by 40% over the last 4 years, and it is the region which is only slightly underweight by investors.
The US is the most defensive of all regions because of the large weighting of regulated names. Since 2008,
US utility earnings have been flat (versus a ‐45% decline in Europe), as consistent regulated earnings
growth of 3‐5% offset unregulated utility earnings declines resulting from lower power prices driven by
falling natural gas prices. Notwithstanding flat earnings growth, investors have re‐rated the US utility
sector’s PE multiple relative to the S&P as they sought more yield in a low‐yielding QE environment.
Today, US utilities are close to the sector’s pre‐crisis record valuation peak (trading at a 7% PE premium to
the S&P 500) when investors were discounting higher earnings growth from tightening power markets
(see below).
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Close to record
relative PE
Source: Bloomberg
While we will continue to see solid growth from the regulated names, and a total return argument can
still be made that justifies the current premium valuation of US utilities, we do see capex growth starting
to level off. This is the opposite of what will happen in Europe and Asia, where we expect regulatory capex
to increase. Moreover, we believe US utility regulators will continue to pressure returns on equity
(ROEs) as interest rates remain low. We believe there is greater opportunity among companies with nonregulated
power generation assets, as we expect firm natural gas and thus power prices to flow through
to earnings. Note, for example, that every $1/mmbtu improvement in natural gas prices would increase
Exelon’s long‐term earnings by more than 20%, whereas for pure generators such as NRG the leverage
exceeds 30%.
Below is a partial list of structural changes driving long/short opportunities in the US:
Electron’s structural changes: US
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Coal retirements’ impact on power markets
Change in competitive generation market structure as a result of the shale gas boom
Transmission spending to integrate renewables/improve reliability, and its impact on power prices
Obama initiatives on climate change legislation, and the EPA threat
Energy efficiency initiatives – utility uncoupling , demand growth
Nuclear assets facing closure – impact on power markets
Renewables’ power markets distortions (impact on peak and off‐peak power prices)
Increased infrastructure spending to move shale gas from basins
LNG export impact on gas and power markets
Regulatory ROE changes with low rates, higher capex, declining load growth, commodity price changes
Increased generator retail selling versus wholesale
Capacity market in TX, CA
State generation subsidy impacts on capacity markets
M&A and asset divestitures’ impact on power markets and utility risk profiles
Oil‐to‐gas residential switching
Electric vehicle demand impact
Regional load growth changes – manufacturing renaissance, state taxes, etc.
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�
European Utilities
We believe European utilities have the potential not only for the strongest outperformance but also for
the greatest alpha generation. Since the financial crisis, European utility earnings have declined
approximately ‐45% which is slightly less than European broader market earnings declines of ‐51% (Stoxx
600 or SXXP) and ‐58% (Stoxx 50 or SX5E). Prior to the crisis, European utilities used to trade at a 20%
premium to the broader market. During the recovery, European utilities suffered a ‐43% derating and
now trade at a 31% PE discount to the broader market. Most of this derating is explained by the
European utilities’ lack of participation in the European broad market PE multiple re‐rating (SX5E +115%,
SXXP +76%) since the recovery beginning in 2009. Moreover, approximately 40% of the sector is now
trading below book value.
Clearly, investors appear to believe that earnings have troughed for European companies broadly, but not
for European utilities. Concerns about political intervention along with low power and carbon prices have
prevented a re‐rating of the sector. However, we are comfortable that we are close to a bottom, and that
optionality is asymmetrically skewed to the upside for the European utilities, as many generation assets
are producing power at close to cash cost.
Relative to US utilities, European utilities have underperformed by ‐40% and the relative PE has de‐rated
by ‐11% since the crisis. The average European utility’s relative dividend yield is now 95% higher than that
of US peers before the crisis. Although some would argue that dividend cuts are coming (we agree
broadly, and see several interesting short opportunities), we do not see the entire sector’s dividends
being cut by 50%, as stock prices imply. As such, the sector today has dividend support even though some
dividend cuts will undoubtedly happen.
In addition to dividends, potentially higher power prices from both higher European coal and carbon
prices could also provide support. At present, the carbon market (EU ETS) in Europe is dysfunctional, with
carbon trading at €5/tonne, well below the cost required to spur investment in low‐carbon generating
capacity. We expect the carbon market to be restructured (already being discussed), thus raising the
price of carbon and increasing power prices. Moreover, with China’s GDP growth reaccelerating and 70%
of the resulting rise in electricity production generated from coal, we would anticipate a modest growth in
coal consumption in the Asian seaborne market, thereby supporting South African and European coal
prices. Given our view of rising US natural gas prices, we expect coal exports from the US to Europe to
fall. These are all factors that should support European coal prices even before accounting for greater
demand for coal that might come from Europe should growth return. Notwithstanding, short
opportunities will remain in several European markets due to the influence of renewables.
Moreover, if the European Central Bank were to lower its Main Refinancing Operations rate, currently 75
bps, and provide other monetary policy support, we would expect not only increased demand for
electricity (which would increase coal consumption) but also a weaker Euro would increase the Euro price
of coal (in Europe) and thus power prices. There are a number of factors at work here, and it is difficult to
predict levels with any degree of accuracy, but even small changes would have a significant impact on
the sector. For example, a combination of a +10% increase in coal prices, ‐10% decrease in the Euro/$
exchange rate, and a rise in the carbon credit price from €5 to €10/tonne would produce 25‐50% earnings
upside in many continental European utilities.
Below is a partial list of structural changes driving long/short opportunities in Europe:
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Electron’s structural changes: Europe
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EU energy efficiency directive and load growth
EU ETS (carbon market) changes
Renewables build and power market distortions
Mismatches between tariff rises and costs/capex
Infrastructure spending impact on energy costs and power/gas competition
UK capacity markets
Large combustion plant directive (LCPD) (UK)
Power market impact of nuclear phase outs (Germany) and new nuclear build (UK)
Political interference on the continent (taxes, return formulas, tariffs)
M&A, divestitures, privatizations’ impact on power markets and changing utilities’ risk profiles
Bifurcation of sector valuation because of WACC changes
European gas price delinkage from oil
Ongoing renegotiation of Gazprom contracts
European utility non‐regulated investments moving offshore
Erosion of the Italian power price premium
New Italian water regulations
Shale gas potential in Europe
Implementation of Russian RAB‐based regulation
Electric vehicles
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Asian Utilities
The Asian utility sector is a tale of two worlds. One enjoys a stable regulatory environment and solid
power purchase agreements, as in Hong Kong and Thailand; the other is a victim of government
intervention, as in Korea and China. The two worlds can coexist in the same country, for example in
Malaysia where independent power producers enjoy solid power purchase agreements while utility
Tenaga, which is a large employer and which faces the consumer directly, suffers from political meddling.
Capex cycles and potential regulatory changes, respectively, tend to dominate performance of the two
sides. For example, Korea Electric Power has outperformed sharply at times in the past on even small
steps toward fuel cost passthrough implementation. In India’s chaotic power markets, outperformance
could arise from even small steps toward implementation of urgently‐needed reform, e.g. any movement
to improve access to fuel supply (notably coal) for independent power producers. The dichotomy
between the two “worlds” of the Asian utility sector provides ample opportunities to generate alpha.
The vast population and developing nature of the region, and consequent issues of energy security and
environmental sustainability, create additional forces for structural change. For example, as China
increasingly promotes natural gas usage, we will see gradual pricing reform, more natural gas imports,
greater natural gas vehicle adoption and accelerating shale gas development.
Below is a partial list of structural changes driving long/short opportunities in Asia‐Pacific (ex‐Japan):
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Electron’s structural changes: Asia‐Pacific ex‐Japan
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China power market policy changes to address record pollution levels
Impact on China’s power market of selective coal plant approvals
Accelerating development of shale gas in China
Urgently‐needed power reform in India to address fuel, power tariff and grid issues
Potential carbon trading and Renewable Portfolio Standards (RPS) in China
Increasing promotion of natural gas usage and price reform in China
Fuel cost passthrough implementation amid a potential power shortage in Korea
Continued support for nuclear power by China – new‐build approval delay impact
Increased robustness of fuel cost passthrough regimes
Indian import duties on equipment
Increasing pressure on electricity tariffs in HK
Rising Australian domestic gas prices on LNG export arbitrage
Australian carbon market future
Consolidation of the Australian supply market into an oligopoly
Australian state regulatory evolution (e.g., electricity in Queensland)
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Japanese Utilities
The impact of the Fukushima incident on Japanese utilities will last for years. Nuclear policy will continue
to be reviewed – notably the decision whether to restart nuclear power plants – which will affect the
utilities’ long‐term fuel mix and therefore cost base.
For example, Kansai Electric Power, which has the largest exposure to nuclear generation after Tokyo
Electric, stopped paying dividends after the nuclear shutdown. Every 1% change in its nuclear fleet
utilization rate will affect earning by almost 10% over a normalized level; nuclear policy decisions can thus
create outcomes for share prices of +/‐ 50%.
The ripples from changing nuclear policy will have a long‐lasting impact, both negative and positive, on
companies involved in the nuclear value chain (e.g., reactor manufacturers such as Mitsubishi Heavy) and
other power‐related sectors such as gas and renewable energy. Relative to other regions, Japanese
utilities will be the most affected by macro factors (e.g. the Yen, interest rates, fossil fuel prices, etc.).
Below is a partial list of structural changes driving long/short opportunities in Japan:
Electron’s structural changes: Japan
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Fukushima incident’s impact on Japan’s power‐related sectors such as LNG and power equipment
Derating of sector as a result of the government’s response to Fukushima
Restart of nuclear plants with Abe administration and prefecture support
Fuel cost impact from Yen depreciation
Movement to higher value‐added renewable energy systems
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Latam Utilities
Latin America will be a trading market for the next year or two. These markets, with the exception of
Chile, are subject to significant government intervention, which follows long cycles; Brazil is early in the
interventionist cycle (e.g., Brazilian President Dilma Rousseff’s recent politicization of electricity tariffs),
while other countries such as Argentina are closer to the end.
Below is a partial list of structural changes driving long/short opportunities in Latin America:
Electron’s structural changes: Latin America
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Brazil’s tariff intervention and consequent derating of sector
Argentina’s increasingly urgent need for system investment and tariff increases
Shale gas development in Argentina and its impact on power prices and regional markets
4. Global Structural Changes Driving Alpha Opportunity
In addition to region‐specific structural changes, there are structural changes that have a global impact on the
utility sector.
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Power Prices are Skewed to the Upside
The cost of natural gas and coal sets the marginal power price in many power markets around the globe.
The rapid rise in US shale production that began in 2007 caused domestic gas prices to decline much more
rapidly than other fuels and put downward pressure on power prices both in the US and globally. For US
gas‐fired generator Calpine, lower fuel costs offset lower power prices and the company emerged a
relative winner. Virtually all other US generators employ a mix of assets fired by costlier fuels and suffered
a tremendous margin squeeze, with – in the most extreme example – coal‐fired generator Dynegy
declaring bankruptcy in 2012. We believe the downward trend in US natural gas prices has flattened for
reasons noted below, and upward optionality remains, which will affect power prices not only in the US
but also Europe and Asia given cross‐border commodity linkages.
In Europe, in an example of the regional, non‐correlated character of the global utility sector, a quite