Exposure to ESG themes, recent power price volatility and the need for energy security are shaking up the industry

The utilities sector has historically attracted investors for its defensive and reliable revenue streams which in turn funded a decent level of dividend income.

More recently, several connected factors have shaken up this industry. These include a transition away from fossil fuels into renewables in the face of a climate emergency, greater appetite for investments in ESG (environmental, social and governance) themes, the surge in energy prices and governments realising they need future energy security.

Utilities also offer a measure of protection against inflation, with regulated revenue linked to rising prices and demand for their essential services not as vulnerable to cost-of-living pressures.

Morgan Stanley sums up the sector’s appeal by saying: ‘We see a compelling argument for utilities to outperform the market given the confluence of policy and macro developments. The sector combines: 1) defensive qualities; 2) green growth; 3) earnings per share upgrades from higher power prices; and 4) reinforced policy tailwinds from energy security and climate considerations.’

REGULATED REVENUE

A key underpinning of utilities’ historic defensiveness is the way they are regulated. Energy regulator Ofgem and its water counterpart Ofwat set how much operators can earn for a multi-year horizon as well as mandating how much they need to spend on infrastructure improvements.

Regulators are balancing three main objectives in determining these frameworks. They want to keep energy prices as low as possible for consumers, encourage spending on improvements to the UK’s energy ecosystem (something which is even more crucial given the need to transition towards greener forms of power) and ensure utility providers offer the level of returns required to attract investors.

Because lenders to these firms have a high degree of confidence in their earnings, companies can borrow heavily to spend and have money left over to return to shareholders through dividends.

UTILITIES COMPANIES ON THE UK STOCK MARKET

If we leave aside telecommunications and waste management firms, there are eight utilities firms in the FTSE 350 index of UK stocks. Of these ContourGlobal (GLO) is a bit of an outlier as it invests in assets outside the UK.

From the remaining seven firms, National Grid (NG.) is focused on energy transmission infrastructure, SSE (SSE) on power transmission, distribution and generation, British Gas owner Centrica (CNA) on energy services and distribution, Drax (DRX) on power generation, while Severn Trent (SVT), Pennon (PNN) and United Utilities (UU.) specialise in the supply and management of water and wastewater.



The company to which you pay your household bills will often just be a middleman, purchasing power in the wholesale markets, with the big energy and utility firms responsible for supply and managing the network.

The surge in gas and electricity prices over the last 12 months has seen many smaller, independent outfits go to the wall, arguably improving the competitive position of their larger counterparts.

While Centrica still has its consumer-facing arm, British Gas, SSE sold its consumer operations to OVO Energy for £500 million in 2020.

LIMITS ON EARNINGS VISIBILITY

While utilities may seem like straightforward investments, there can be unforeseen events. For example, National Grid and SSE had a shock in 2020 when Ofgem halved the proposed return on equity in the next pricing settlement to less than 4% before easing up slightly and allowing a 4.3% return. The aim was to tip the scales more in favour of consumers than shareholders.

While actions such as these by regulators can constrain companies on the dividend front, utilities can still deliver a generous level of income, with the prospective yield for the FTSE 350 constituents averaging 4.6%.

There is no question which constituent of the sector can lay claim to the wooden spoon. Centrica shareholders have had a miserable time over the last decade as the company has been beset by operational problems, exposed to volatile commodity prices thanks to its oil and gas assets, and its British Gas retail business has  haemorrhaged customers.



Utilities’ exposure to the ESG theme is probably the biggest change over the course of Centrica’s troubled decade. Investment bank Berenberg comments: ‘Rich veins of ESG themes run through the utilities sector.



‘The list includes renewables development, supporting network infrastructure, the use of hydrogen (as a substitute for gas and for transportation), electrification (including vehicle charging and heating), the circular economy, water and energy efficiency, pollution control and a general need to cope with the increased complexity that comes with more responsible production, delivery and consumption.’

PUSH TO CAPITALISE ON ESG OPPORTUNITIES

The appetite for sector constituents to more fully embrace ESG opportunities is reflected in the pressure from activist investor Elliott at SSE to break up the group. It argues the renewables arm would attract a higher valuation as a standalone business.

While SSE has said it will sell 25% of its grid business to fund a £12.5 billion investment in clean energy projects through to 2026, it is resisting calls for a more dramatic restructuring.

SSE’s argument is that splitting up its businesses would result in a weaker credit position and a loss of shared skills and diversification benefits.

This argument was given some credence as profit for the six-month period to 30 September 2021 more than doubled after higher earnings at its distribution and transmission businesses offset a loss at its renewable energy unit.

The company has already raised forecasts twice in 2022 thanks to a strong performance from its thermal and hydro arms. SSE announces its full-year results on 25 May when you can expect its strategy to come under renewed scrutiny by Elliott.

As well as aiding the transition towards renewable energy, utilities firms will also be expected to play their part in keeping the lights on during a period when the UK and other countries are trying to wean themselves off Russian oil and gas.

Drax, the top performing FTSE 350 utility firm over the last five years as it has transitioned from fossil fuels to biomass and hydro power, was one of several producers asked by UK business secretary Kwasi Kwarteng to consider keeping its legacy coal-fired power plants in service beyond a planned shut down in September 2022.

WHERE TO INVEST

Our two favourite stocks in the utilities sector are SSE and Drax.

SSE’s shares have already enjoyed an impressive run, but the company should be able to achieve a big expansion in its renewables business, partnering up with other large energy firms to share the capital costs, while still sustaining attractive returns to shareholders.

Drax has equally been a strong performer but its plans to be a global leader in sustainable biomass justify the momentum behind the share price while elevated power prices offer a near-term catalyst  for earnings.

For broad-based exposure to the utilities sector, including in some of the larger continental European names, buy shares in exchange-traded fund SPDR MSCI Utilities UCITS ETF (UTIL) which has an ongoing charge of 0.18%. This ETF automatically reinvests dividends rather than paying them out in cash.


How are the big players performing?

Centrica

Owner of retail businesses British Gas and Bord Gáis serving the UK and Republic of Ireland respectively. It also offers energy solutions to businesses, trades energy markets, and holds oil and gas and nuclear assets.

Latest update (10 May): Strong operational performance in the first four months of 2022, full year adjusted earnings per share at the top of analyst expectations.

Drax

Owns several power generation assets including coal-fired power stations and renewables. It also supplies renewable energy to businesses.

Latest update (27 April): 2022 earnings at top end of analyst expectations, debt to be significantly below two times earnings by the end of 2022.

National Grid

Owns and operates the electricity and gas transmission network in the UK and similar networks in the US. Paid a regulated price by energy suppliers based on the size of its asset base as opposed to the volume of electricity used.

Latest update (14 April): Earnings per share for the year to 31 March 2022 to be moderately higher than previous guidance. The sale of a 60% stake in its UK gas transmission and metering business is expected to complete later in 2022.

Pennon

Provides water and wastewater services to customers through South West Water, Bournemouth Water and Bristol Water as well as water-related services through Pennon Water Services.

Latest update (12 April): Operational performance in line with management expectations, resilient financial performance in the year to 31 March 2022. Despite inflation-linked revenue, its cost base is expected to be impacted by index-linked debt and rising power costs.

Severn Trent

Operates Severn Trent Water and Hafren Dyfrdwy which are regulated water and waste businesses operating in the Midlands and Wales. It is also developing non-regulated businesses in green power and property development.

Latest update (2 February): Trading in line with expectations, strong operational performance reflected in positive recognition from the regulator.

SSE

Builds and operates onshore and offshore windfarms and has a large energy transmission and distribution business.

Latest update (29 March): Adjusted earnings per share for the year to 31 March 2022 expected in a range of 92p to 97p (previous guidance of at least 90p). It has received £1.29 billion from the disposal of investments in Scotia Gas Networks.

United Utilities

Provider of water and wastewater services for household and business customers across the north-west of England. Maintains and operates thousands of kilometres of pipes and hundreds of treatment-works.

Latest update (25 March): Trading in line with expectations for the year to 31 March 2022. Group revenue up 3% year-on-year, reflecting increased usage by commercial customers.

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