Regulated risks: opportunities in UK utilities
Article | 13 July 2017
Britain’s wires, pipes and waterworks were embroiled at the heart of the general election campaign as promises of caps, cuts and nationalisation weighed on the share prices of many of the UK’s key providers. Despite successive rounds of regulatory intervention, this area of the market has continued to deliver good outcomes to consumers and capital and income growth to shareholders.
Britain’s wires, pipes and waterworks were embroiled at the heart of the general election campaign as promises of caps, cuts and nationalisation weighed on the share prices of many of the UK’s key providers. Despite successive rounds of regulatory intervention, this area of the market has continued to deliver good outcomes to consumers and capital and income growth to shareholders. Ciaran Mallon, UK Equities Fund Manager at Invesco Perpetual, considers the outlook for the sector, outlining why he continues to see value in this area of the market.
Companies within the UK utilities sector have been hit by a slew of interventions over the years, a soft target for political posturing through successive election campaigns and governments. From caps on household energy bills, to the premature cessation of sustainable energy subsidies, the impact of shifting policy and regulation on sector earnings can be difficult to quantify.
As a long-term investor in the sector, I view regulatory change as an inevitable truth; it is not a case of if, but when and to what extent utility companies will be subject to new regulation. This is by no means a bad thing; by and large, the regulatory backdrop is well-established and any changes tend to be incremental and carefully managed. Utility companies’ response to the regulatory backdrop – which has evolved over time to reward the best performers - has delivered both good outcomes to consumers and capital and income growth to shareholders.
I hold several utility companies in the Invesco Perpetual Income & Growth Fund which are regulated to different degrees; power station Drax and energy & services provider Centrica have more autonomy over profits, pricing and returns relative to Severn Trent, Pennon and National Grid – all companies underpinned by monopoly networks.
Drax offers a particularly interesting investment case; historically a single asset – a power station - recent performance has been muted by falling electricity prices and rising regulatory charges for generators and users of fossil fuels. Debate over the merits of biomass as a green energy source continues, but in my view there is a weight of evidence in support of the case for biomass as a viable low-carbon alternative to coal. Today over 70 per cent of electricity produced by the business – enough to power Leeds, Manchester, Sheffield and Liverpool – is made using compressed wood pellets rather than coal.
Three of the six units at Drax power station are fully fired by biomass; as part of the government’s 2015 reform of the electricity market, the European Commission approved a contract for difference (CFD) from the UK government for one of these three units, with the other two regulated under a return on capital (ROC) basis. Through the CFD structure, Drax is paid the difference between the ‘strike price’ – a price for electricity reflecting the cost of investing in a particular low carbon technology – and the ‘reference price’– a measure of the average market price for electricity in the GB market. As a result, Drax has reduced its exposure to price volatility in the wholesale electricity market, improving stability of revenues, while also protecting consumers from paying for higher support costs when electricity prices are high.
Increasingly, however, sources of revenue for the business are no longer dependent on the price of electricity; Drax has diversified its generation network’s revenue stream, including providing services to the national grid including Blackstart1, and a move into supplying electricity to industrial and smaller companies. While recent profits have been hit by the high cost of the biomass conversion, management have reinvigorated the strategic direction of the business and shored up the dividend with additional income streams. The company recently announced a change to the dividend policy, with plans to grow the total dividend from £50m in 2017. Looking ahead, there are some headwinds on the horizon for Drax - notably the expected 2027 expiry date for biomass subsidies - but with a strong single asset and near unique market position, I believe the company continues to offer a strong valuation opportunity.
Valuation is also central to my investment case for Centrica, historically built around a strong cash-producing core in supplying electricity to UK domestic and business users. The last few years have seen management take some missteps, however, the most significant being the decision to invest the company’s cash core in upstream oil & gas, which coincided with a sharp decline in oil prices.
Under new management, I expect to see better use of cash investment and improved returns at Centrica, which can support reinvestment or returned to shareholders via dividends. A key driver of this performance will be Centrica’s US arm, structurally similar to British Gas; this business has grown from strength to strength through a series of acquisitions aiming to diversify the company’s revenue streams, particularly through its home services offering.
Centrica’s share price was negatively impacted by the Conservative party’s manifesto commitment to cap household energy prices. Standard variable tariffs – which enable customers to switch if providers instigate price hikes - came under particular fire amid widespread criticism of a lack of competition and switching in the marketplace. SVTs became a buzz word on the general election campaign trail, but beyond the initially headline-grabbing £100 saving for each UK household - a figure difficult to rationalise relative to the current sector market cap - there was little to no detail on how such a move would be implemented in practice. Subsequently, the Queen’s Speech provided the market with more clarity, omitting any mention of a price cap. Instead, the government intends to “deliver more transparent energy bills and allow households to monitor their use effectively” and outlined plans to make further changes to smart meter regulation and broaden its scope.
The cost impact of extending this structure across a wider proportion of the population is difficult to gauge, but my expectation is that any changes will be introduced pragmatically. To date, Centrica has acted responsibly as a business – it hasn’t implemented irresponsible price hikes and has introduced measures to encourage customer loyalty. Ultimately, the Conservative’s aim to encourage competition and drive down prices is nothing new; in 2016 the Competition & Markets Authority enquiry concluded that the energy market needed to encourage competition to drive down prices. Looking ahead, the strong and dialogic relationship between UK energy providers and Ofgem will continue to support transparent discussion, enabling shareholders good oversight of changes as they emerge. Ultimately, the recent political storm has hurt share price performance, but I anticipate any changes made to market pricing will be carefully managed.
Portfolio holdings Severn Trent, Pennon and National Grid fall into the sector’s ‘more regulated’ bucket, underpinned by Britain’s water and electricity infrastructure. All investments present a spectrum of risks, but these companies do not risk losing business to strong competitors or new market entrants due to their natural monopolies. Many investors regard these companies as ‘bond proxy’ type investments because ultimately, it is the government that stands behind these fundamental industries. Rather than viewing these companies as bond proxies, I take the view that the regulatory framework underpinning Britain’s water, gas and electricity networks has evolved over time to protect customers of these natural monopolies of wires, pipes and waterways from exploitation. Given the responsibility beholden on utility companies to keep the nation running, rigid regulation of this vital infrastructure is necessary, but also provides investors with a certain degree of certainty through fixed-term price controls and enhanced transparency – the product of continuous dialogue with regulators. When regulation works well it results in good outcomes for all stakeholders – consumers, investors and the company – which I believe improves the stability of company valuations.
UK water companies must operate within the structures of five-year regulatory review cycles and are currently two years into the current cycle. Amongst its statutory duties, regulator Ofwat - and Ofgem in the energy sector - are required to ensure that companies can finance their functions by assuming an appropriate rate of return on the capital utilised in providing regulated services. The rate of return, provided by setting a cost of capital, is crucial to maintaining investment in the waterways and wires which support both good outcomes for consumer and the wider UK economy, but also incentivises companies to run efficient businesses.
Water companies are thus incentivised to minimise operational and capital expenditure and funding costs by Objective Delivery Incentives (ODIs), designed to incentivise companies to deliver good outcomes to customers. These objectives are the product of ongoing dialogue between companies and their customers to align interests and ensure that companies are addressing key consumer concerns; crucially, both shareholders and customers will benefit from companies delivering against these objectives. Day to day, water companies are measured and accrue rewards or penalties from the regulator on the cleanliness of beaches, minimising pollution incidents, internal sewer flooding, external sewer flooding and leakage.
Ultimately, the dividend yields of these companies are attractive relative to the wider market; these companies have delivered good returns and growing, inflation-adjusted dividends for many years, successfully operating within a regulatory environment that I believe justifies their relatively higher-valuations.
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1The procedure implemented to recover from a total or partial shutdown of the transmission system which has caused an extensive loss of supplies. This entails isolated power stations being started individually and gradually being reconnected to each other in order to form an interconnected system again.