EBGEF - ESG Wars: Dominion Takes A Punt On Offshore Wind As Enbridge Piles Up Debt On Risky Gas Bet

2023-09-11 12:59:58 ET

Summary

• Dominion Energy reached a deal to sell its natural gas utility business to Enbridge for $14 billion. Dominion also is planning on investing $10 billion into offshore wind.
• Dominion's business plan has problems because offshore wind is potentially political and subject to cost overruns and Enbridge has issues because its cost of capital is too high.
• With interest rates continuing to climb, you can safely sell both of these companies and watch from the sidelines.
• I don't think either deal is likely to go particularly well. You can find safer yield and less drama elsewhere.

Last week, Virginia-based Dominion Energy ( D ) reached a deal to sell three natural gas utilities to Enbridge Inc. ( ENB ) for $14 billion. Dominion is using the money to fund previous commitments to reduce debt so it can invest in renewable energy, spending $10 billion on an offshore wind project near Virginia Beach (roughly five years of Dominion's profit). The market gave the deal a thumbs down, sending both stocks lower after the deal was announced. Dominion is down roughly 44% over the last year, while Enbridge is down about 22%. So what's going on?

Dominion Is In The Doghouse

Like many utilities, Dominion Energy rose throughout the 2010s on the back of falling interest rates. Borrowing money cheaply is one thing, but investing it productively for the long run is another. Demographically, Dominion should have been in good shape. The company serves much of Virginia and parts of the Carolinas in areas that are seeing strong population growth. But Dominion borrowed too much and ran into trouble during the pandemic. In 2020, D was forced to cut its dividend.

Then there's the environmental aspect. As of 2020, according to data from the Political Economy Research Institute, Dominion was the 11th largest polluter in the United States . Neighboring utility Duke Energy ( DUK ) is the second biggest polluter in America, nearby Southern Company ( SO ) is the third highest, and in Western Virginia and Ohio, American Electric Power ( AEP ) is fifth. For those wondering, Vistra Energy ( VST ) is the top polluter in America. Vistra owns TXU, the main utility in Dallas. What many of these companies atop the pollution list have in common is a reliance on cheap Appalachian coal to make power. There are costs. Studies from the US and China tell us life expectancy for coal miners is somewhere in the neighborhood of 20-30 years shorter than the general population, with massive incidences of black lung, cancer, etc. When coal is burned, the costs spread far outside the mines as well, with air quality from burning coal affecting millions in the US alone. There are huge negative externalities to burning coal, but the upfront cost is cheap, which is one reason why Dominion has historically spent big on lobbying.

Along comes the Biden administration's "Inflation Reduction Act." One big idea here is to replace the heavily polluting Appalachian coal used by the Eastern Seaboard with offshore wind. While it's great in theory, the early evidence is that this is not going to be successful in the US. To me, so many aspects of this plan seem to be done for political reasons rather than economic or environmental reasons.

• 100-year-old protectionist legislation known as the Jones Act drives up the cost of offshore wind by requiring American crews and ships for construction, these largely don't exist yet.
• Most of the expertise in offshore wind comes from places like Denmark, Norway, and the UK. But why rely on them when you can give bids to companies and labor unions that support your election campaigns? European companies are dropping out of deals to help build wind power in the US. Danish company Orsted is threatening to drop out, and British SSE is declining to enter the US market.
• Even so, offshore wind is struggling worldwide as a concept, while solar energy tech just keeps getting better. A recent UK auction for offshore wind got zero bidders.
• Cue the NIMBYs . Not only are there demands for US union labor, US parts, etc., but individual states like New York are putting stringent permitting requirements and requiring their own residents to be used for labor. Local officials are often able to block wind projects or demand money to let the projects go through. Even the Pentagon is looking to block the Biden administration over the wind project in Virginia–I guess they don't want any windmills in their combat training areas.

If the administration truly cares about the environment, they'll either need to get all these laws on the books that make this a huge political giveaway to big business and donors, or they'll need to drop the project. It's not clear which way they'll go. Against this background, Dominion is looking to invest $10 billion in offshore wind (or more if the costs overrun, as their first estimate was $8 billion). This could be a financial disaster in the making. Ultimately I don't think you can trust the Democrats here if you're Dominion or any other utility company looking to invest in offshore wind. And if Trump wins in 2024, he'll likely look for a way to blow up the project anyway. By simultaneously standing in the way of the free market and allocating jobs to prosperous coastal areas, these offshore wind projects are likely to draw fire from both sides of the political aisle.

Compare this with solar, which you can literally put on your roof and nobody can tell you not to. On a broader scale, utilities can buy farms and set up huge amounts of capacity, and the project won't overrun by $5 billion because the state/local government decides to shake you down. Dominion is currently building a solar farm at Dulles Airport. There's the typical NIMBY opposition but I can say with a high degree of confidence that the Dulles project will be successful, while the wind project will fail or overrun its cost projections. The trouble is that they're betting so much on wind that it could be all that matters.

Dominion is worth watching here, but I think tying their company's future to offshore wind is extremely risky at best. I'd sell here, despite the stock trading at a steep discount to the market. The company still trades at a 14x PE. You can get as much tax-qualified yield in megabank preferreds like those of Morgan Stanley ( MS.PR.A ) or Bank of America ( BAC.PR.L ) without the existential risk and debt load that you have for D stock. Dominion has BBB-rated credit , so I suppose you could buy the company's bonds as well. I think shareholders are getting a ride they're not going to want here.

Enbridge Also In The Doghouse, For Different Reasons

Following a long tradition of music as protest, "Rich Men North of Richmond" recently hit No. 1 on the US music charts. The song's popularity likely isn't due to Oliver Anthony's lyrical genius, but by saying out loud what millions of Americans think but are largely censored from saying about their employers and the government.

But if you're listening to "Rich Men North of Richmond" and deciding that you're going to invest in whatever pollutes the most, you're likely to lose just the same. The truth is that the environment doesn't care if you call yourself a Democrat or Republican. If you trash your environment, you're going to suffer economic consequences. My great grandparents were forced into poverty by the 1930s Dust Bowl when short-sighted agricultural practices and drought briefly turned the American Great Plains into a desert landscape. Summer highs then repeatedly topped out close to 120F in a series of brutal heatwaves, and they were forced to leave. John Steinbeck's The Grapes of Wrath is based on true stories of Oklahoma farmers like them. Prior to that, many of my ancestors found work in coal mines, where they died young. History tells us that depending on how the climate plays out over the next few years, we might not have much of a choice whether to accelerate the energy transition or not.

In any case, natural gas won't be the first fuel to go. But paying 16.5x earnings for Dominion's gas utility business is not cheap. Enbridge's main problem here isn't really about ESG or not, but that they're issuing more shares and going even deeper into debt, and are buying assets whose economic return may not pay their cost of capital as interest rates continue to rise. If you've held Enbridge for the last 10 years , you haven't made much money at all. The obvious reason is that the company has too much debt and has issued too many shares for it to be a good investment. They're about to issue even more, at an 8% yield! If I was running Enbridge I'd probably be trying to do the opposite. Warren Buffett bought Dominion's LNG interests but presumably passed on the gas utility business. At the very least, we can likely infer that Enbridge is paying more than Buffett would.

A huge problem for utilities and pipelines in general is that they're highly capital-intensive businesses. This was no big deal when interest rates only went down in the 2010s – if you need money just borrow more. But with inflation and higher rates, these companies' debt is eventually going to reset at higher rates, crushing their earnings power. Companies that don't have the free cash flow to pay their large dividends often end up being akin to pyramid schemes and end up massively cutting the payout in the end. As such, research shows that companies in the top 10% of dividend yield tend to underperform companies with modest and growing dividends.

Buying Enbridge here isn't the same as buying Exxon Mobil ( XOM ) in 2020 when Zoom ( ZM ) had a bigger market cap. The problems at Enbridge are more structural, and this deal reinforces them. You can cross compare the different press releases and see with your own eyes how this deal dilutes shareholders. Seeking Alpha author Gary Gambino recently built a full spreadsheet warning about the deal and highlighting the dilution. My guess here is that the income statements will show this deal is clearly diluting shareholders, while the company will declare "adjusted profits" from the acquisition.

Bottom Line

Trillions will be made in renewable energy, but not here. Offshore wind is showing early signs of being another government spending issue, with Dominion Energy potentially on the hook for billions as well. On the other hand, Dominion has struck a deal to sell its natural gas business to Enbridge, which is raising capital at a very steep price to buy. Both of these approaches are weak, and I believe that the true winners of the energy transition will be the companies that don't virtue signal for or against ESG, but those that invest in the most profitable technology.

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