Utilities and Taxes, Regulation and Interest Rates

John Kohli, CFA¹, CPA
Portfolio Manager and Research Analyst
Franklin Global Advisers

There are currently several possible economic and political developments that may have implications for the utilities industry in 2010, including a permanent maximum tax rate on dividends and capital gains; a looming energy bill with a possible cap-and-trade component; and a period of rising interest rates in the not-so-distant future.

Taxes

We believe the permanent maximum tax rate of 20% on dividends and capital gains that is being proposed in President Obama's 2011 budget plan is a positive development for utilities. This would remove a huge uncertainty that has concerned investors regarding the future taxable returns on high-dividend paying securities, such as utilities. Presently, the tax rate on dividends that was put in place under the Bush administration in 2003 is going to sunset at the end of this year unless there is a resolution. So the President's budget announcement of a few weeks ago is a huge positive, in our view.

Regulation

We believe electric utilities companies do not necessarily need a federal energy bill to remain fundamentally sound and continue to grow their businesses and earnings. Having a cap-and-trade component, however, would help bring some long-term clarity to the industry. Even without this federal legislation, it appears that the Environmental Protection Agency is poised to use its powers to go after the so-called "dirty power plants" and to shut down older, less efficient coal plants. In addition, states have been proactive in implementing renewable energy mandates and energy efficiency metrics that reduce greenhouse gases.

In our search for opportunities in the utilities industry, we try to avoid companies that could be hurt by stricter environmental policies, whether at the federal or state level, and we tend to focus primarily on regulated utilities.

Interest Rates

Historically, utilities companies have underperformed during periods of rising interest rates, so it would be understandable to expect more of the same in the future as we expect the current low-rate environment to normalize. We believe the underperformance of utility shares we have seen since the beginning of March last year has been in anticipation of higher interest rates and inflation. Utility stocks tend to have a high correlation with longer-term interest rates, however, they are not necessarily impacted by the short-term side of the cycle. Also, because of the regulated nature of utilities, higher interest rates can be passed through to consumers. Lastly, rising interest rates typically have an impact on utilities, but we believe the sector is poised to counteract any pressures in the near term.

Overall, we believe valuations continue to be attractive for utilities. As we witness a strong recovery in the overall financial markets since the beginning of March 2009, we have seen significant underperformance in utilities over the same time period. Yet we continue to see positive fundamentals within the utilities space, particularly among regulated companies. Therefore, the relative underperformance of utilities companies has improved their relative attractiveness, in our view.

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Footnote

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