Warren Buffet, the chairman of Berkshire Hathaway and investing folk hero, has long had a rule for picking which companies to invest in.
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle,” he told a CNBC crowd in 1995. He has embellished the metaphor over the years — in some versions, sharks populate the moat — but the idea is the same. Seek out companies with a natural competitive advantage, even an inherent monopoly, and prosperity will follow.
For decades, investor-owned gas and electricity utilities have struck Buffett as businesses with a good moat. Over the years, Buffett has bought up a handful of utilities, including MidAmerican Energy Company in the Great Plains, NV Energy in Nevada, and PacifiCorp in the Mountain West and Pacific Northwest. Their climate record is mixed: The Berkshire utilities generate more power from renewables than the national average, but still operate several coal plants in Utah and Wyoming. Berkshire Hathaway says its utilities and pipeline companies serve about 12 million end customers in North America and the United Kingdom.
But Buffett’s faith in for-profit utilities as a sound and stable business is failing. In his latest letter to investors — an annual tradition known for its plain writing and folksy anecdotes — Buffett says that the future of for-profit utilities looks more ominous. Climate change and what he sees as higher regulatory standards are making it harder for utilities to make money, he says.
He’s speaking in part from personal experience. Last year, an Oregon jury found PacifiCorp liable for negligence that resulted in the start of four wildfires during Labor Day weekend in 2020. A series of “mini-trials” have since awarded at least $175 million to the fires’ victims, with more trials yet to come. These results didn’t take Berkshire Energy into the red — Berkshire’s utility businesses earned $2.3 billion last year — but it did result in much worse financial performance than 2022.
In his letter, Buffett says that “most” of the company’s utility businesses have done as expected. But he adds:
[T]he regulatory climate in a few states has raised the specter of zero profitability or even bankruptcy (an actual outcome at California’s largest utility and a current threat in Hawaii). In such jurisdictions, it is difficult to project both earnings and asset values in what was once regarded as among the most stable industries in America.
For more than a century, electric utilities raised huge sums to finance their growth through a state-by-state promise of a fixed return on equity (sometimes with a small bonus for superior performance). With this approach, massive investments were made for capacity that would likely be required a few years down the road. That forward-looking regulation reflected the reality that utilities build generating and transmission assets that often take many years to construct. BHE’s extensive multi-state transmission project in the West was initiated in 2006 and remains some years from completion. Eventually, it will serve 10 states comprising 30% of the acreage in the continental United States.
With this model employed by both private and public-power systems, the lights stayed on, even if population growth or industrial demand exceeded expectations. The “margin of safety” approach seemed sensible to regulators, investors and the public. Now, the fixed-but-satisfactory return pact has been broken in a few states, and investors are becoming apprehensive that such ruptures may spread. Climate change adds to their worries. Underground transmission may be required but who, a few decades ago, wanted to pay the staggering costs for such construction?
At Berkshire, we have made a best estimate for the amount of losses that have occurred. These costs arose from forest fires, whose frequency and intensity have increased – and will likely continue to increase – if convective storms become more frequent.
He later continues:
Whatever the case at Berkshire, the final result for the utility industry may be ominous: Certain utilities might no longer attract the savings of American citizens and will be forced to adopt the public-power model. Nebraska made this choice in the 1930s and there are many public-power operations throughout the country. Eventually, voters, taxpayers and users will decide which model they prefer. When the dust settles, America’s power needs and the consequent capital expenditure will be staggering. I did not anticipate or even consider the adverse developments in regulatory returns and, along with Berkshire’s two partners at BHE, I made a costly mistake in not doing so.
As has been noted elsewhere, Buffett is criticizing government regulation in this letter. But even if he has reached his conclusion spitefully, it is not necessarily wrong. In the coming years, America’s utilities will have to overhaul their infrastructure to decarbonize their power plants while also girding themselves against climate change’s effects. Both projects are expensive.
For years, most public officials have more or less assumed that the for-profit model is the best way to ensure such maintenance and upgrading get done in a timely and efficient fashion. But that may no longer be feasible or desirable.
