This story was originally published at BiggerPockets.com
Berkshire Hathaway CEO Warren Buffett’s much-anticipated annual letter to investors is out. As is customary for the maverick investor, it’s peppered with headline-grabbing statements about Buffett’s disdain for investment advisors and unearned wealth.
But setting the flashy statements aside, Buffett’s latest letter contains some very valuable information. It’s worth paying attention to, even if you are at the very beginning of your investment journey because it concerns the future of one of the biggest, traditionally most profitable segments of the investment market.
The segment in question is the for-profit energy sector, once considered a fail-safe area of the economy to invest in. Yet, according to Buffett’s own admission, all is not well in the energy sector, and investors may need to think twice before committing to it.
Buffett explained in the letter that back in May 2023, he made two predictions. One was that although the energy sector was underperforming overall, the decline would be “cushioned” by Berkshire’s two largest noninsurance businesses, BNSF and BHE (Berkshire Hathaway Energy).
The other prediction was that “insurance would likely do well, both because its underwriting earnings are not correlated to earnings elsewhere in the economy and, beyond that, property-casualty insurance prices had strengthened.”
Only the second prediction came true. Buffett’s insurance businesses are doing well, and no wonder. With home prices and housing costs continuing to soar across the country, the property and casualty insurance business is booming.
“We have been in the business for 57 years, and despite our nearly 5,000-fold increase in volume—from $17 million to $83 million—we have much room to grow,” said Buffett.
In sharp contrast, Berkshire’s utilities businesses’ poor performance was the company’s most “severe” disappointment. What’s behind it, and what does it mean for investors, both real estate and stock alike?
Forest Fires Are Making For-Profit Utilities Less Profitable
The climate crisis is the largest cause of poor performance. The increase in the intensity of forest fires in California—and, more recently, Hawaii—has led to sweeping changes in energy sector regulations. According to Buffett, “The 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.”
Buffett is referring to the increased scrutiny the for-profit energy sector is facing in many states, not just California and Hawaii. In fact, Berkshire-owned PacifiCorp was found liable for the start of four forest fires in Oregon in 2020, with a total of $175 million awarded to the victims in subsequent trials. It’s a significant sum, BHE’s $2.3 billion profit notwithstanding.
Improperly maintained power lines are a persistent culprit of forest fires—and Buffett indirectly acknowledges that something will have to be done to mitigate the risks while also pointing out that the associated costs did not seem worth it back in the day: “Underground transmission may be required, but who, a few decades ago, wanted to pay the staggering costs for such construction?”
The reality is that changing infrastructure takes time and effort. Meanwhile, Buffett is clear-sighted about increasing losses caused directly by forest fires, “whose frequency and intensity have increased—and will likely continue to increase—if convective storms become more frequent.”
Utilities: Where to Invest and Where to Avoid
The question many beginner investors will undoubtedly be asking themselves right now is, should I just steer clear of investing in utilities? The answer is a reassuring no, with the caveat that you will need to do more research going forward as to where the companies you’re investing in are operating and what their infrastructure model is.
Investing in companies that made a successful transition to greener energy years ago, not recently, is key. An example is NextEra Energy. The company became the country’s first renewable energy company back in 2010, investing in seven nuclear power plants. It is now the second-largest utility by market cap in the U.S., and its adjusted earnings-per-share growth since 2012 is a staggering 9.8%.
It does help that NextEra is operating in Wisconsin, Florida, and New Hampshire. So far, these states have avoided the worst impact of the climate crisis.
On the flip side, look at Hawaiian Electric. Following the devastating 2023 Hawaii fires, the company could be liable for a total of $4.9 billion in claims. Forget stock performance; the company’s future viability itself is uncertain.
Final Thoughts
The sad reality is that investing in high-impact areas is becoming riskier. Buffett’s letter does urge a wait-and-see approach, “it will be many years until we know the final tally from BHE’s forest-fire losses and can intelligently make decisions about the desirability of future investments in vulnerable Western states.”
Buffett is also mindful of the fact that “it remains to be seen whether the regulatory environment will change elsewhere.” But, as an investor, right now, in 2024, do you really want to be investing in businesses that are likely to be affected by a problem that will only get worse?
Finally, for real estate investors, it’s important to keep monitoring the impacts that climate is having on markets across the U.S. Cities from Florida to Texas to Michigan are feeling the shocks of insurance premium hikes, as well as increased flood and storm damage. Buffett’s business outlook only makes the picture clearer—some places are set to struggle.
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