AI isn't the only boost for the power sector

Volatility in the Power subsector has been exaggerated in 2025. The segment has been connected to AI through data-center power demand, and investor sentiment on the theme has been shifting. There have also been delays to co-location contracts as state and federal regulators look to set the rules for grid payments from generators in those arrangements. While investors have been focused on AI, power markets are tightening related to non-AI-related industrial demand from the reshoring of supply chains, reindustrialization and electrification of industrial processes. Supply additions remain constrained as the low-demand period in the decade ending in 2020 left the grid unprepared for the current significant electric demand growth. Wind additions remain limited by the lack of federal permitting, coal is retiring with or without environmental rules given ever-higher costs of operations and there has not been the necessary ramp-up in turbine supply for the significant additions of combined cycle natural gas plants.  Simple cycle natural gas and solar plus storage are the most viable supply additions in the near term, but with 24 x 7 demand increasing, power prices will increase, and the volatility of power prices is likely to increase significantly.

 

This leaves power stocks poised to improve profits, in addition to the potential for lower risks through the signing of longer-term contracts with large off-takers like data centers at set margins. Power names trade at higher than mid-cycle valuations, although less than the peak seen in early 2025. We believe that AI data-center demand is not slowing and that contracts with large off-takers will be signed once rules are set or will be done with grid payments included, whether co-located or not. The largest risk to the power stocks remains recession rather than AI data-center dynamics in our view.

 

Unlike with power stocks, we’re fairly pessimistic when it comes to the regulated subsector as we continue to see significant headwinds for the space in 2025: (1) Fed rate cutting will likely slow or stop; (2) there’s political risk around the potential repeal or significant reformation of the Inflation Reduction Act; and (3) customer bill inflation within a general inflationary backdrop will make it difficult for regulators to accept the higher rates needed to manage the growth needs of the utility capital programs. In addition, valuations remain expensive relative to risk-free rates, and allocations to the utility sector from generalists are the least underweight they have been since the financial crisis in 2008 and 2009. The one positive backdrop for regulated utilities is demand growth, but only insofar as it lowers customer bill pressure due to higher volumes or drives needed capital investment that increases rate base growth significantly. The second factor tends to get priced into stocks relatively quickly and is hard for the market to predict. Across a longer time horizon, we do see risks to higher-than-sustainable growth rates should the demand growth fall off and should that demand not be covered by take or pay contracts. This can lead to overbuild conditions and the end of the capital investment cycle quickly, as was seen in the early 1980s.

 

We continue to see opportunities in the regulated utility space but with a keen eye toward valuation and the more traditional factors beyond higher growth that drive higher valuations in the long term: (1) stocks with exposure to geographies with constructive regulatory environments; (2) strong balance sheets; (3) consistency in earnings delivery and execution from management; (4) lack of large project risk; and (5) sustainable growth rates leading to bill increases that are in line with or below inflation.