There’s nothing glamorous about electric utilities, but their reliability has made them the bread-and-butter of income investors for decades. The deregulation experiment of the 1990s changed the rules of the game, and led to unpredictable revenue and earnings. One electric utility has restructured itself to operate primarily in regulated markets while adapting to potential shifts in carbon regulations.–The Editors

Regulated Returns

American Electric Power (NYSE: AEP), the largest coal-burning electric utility in the US, has come under pressure since President Obama took office. More than 70 percent of AEP’s fleet burns coal, leading some investors to worry that the company could be affected by the Obama administration’s focus on tightening carbon regulation. It’s a legitimate concern, but largely overblown.

AEP may have built its reputation on coal, but its energy generation capacity is more diversified than many realize–encompassing nuclear power, gas and hydroelectric power. The firm has also spent almost $2 billion over the past three years retrofitting its plants to reduce emissions.

Although new carbon regulations would likely require some outlay of capital, AEP is well-positioned for whatever may come. The utility has already recovered a large part of the investment it made in reducing emissions and should be able to recoup any future spending.

AEP was caught up in the rush to restructure itself amid deregulation in the 1990s. Because the deregulation experiment has failed in many states, more than 90 percent of the company’s earnings now come from regulated markets, which smoothes earnings expectations. Furthermore, renewed regulation allows AEP to recoup the cost of its infrastructure investments while booking a small return.

AEP has a long history of successfully securing higher customer rates from regulators, giving profits a boost. But electricity demand has fallen since the recession as consumers continue to deleverage their household balance sheets and search for work. Industrial demand slumped as factories reduced output or shut down. While that has the potential to dampen earnings, demand appears to be recovering.

Industrial demand accounts for a little more than a third of AEP’s total demand; the utility is well positioned to benefit from the domestic economic recovery. In 2010 industrial demand rose by more than 7 percent, outpacing the lower single-digit demand growth from commercial and residential customers as industrial activity ramped up in Ohio, West Virginia and Kentucky.

AEP’s valuations are extremely attractive at current levels. Trading at just 11 times price to forward earnings and on par with book value, AEP looks like a bargain when you consider its 5.2 percent yield and average 3 percent annual revenue growth.