Assumptions about particular sectors in financial markets can hold more power than they should. Ciaran Mallon, portfolio manager of the Invesco Income Growth Trust plc, reflects on why the reputation of utility companies is at odds with the value he sees in this area of the market.
We typically think of the Utilities sector as a classic defensive area of the equity market, one that is particularly attractive in the current environment. They are known for being stable businesses with a reliable dividend stream. During periods of market volatility, they tend to perform better than other areas of business more sensitive to the economic cycle.
People need water, gas and electricity regardless of where we are in the economic cycle, and the sector will be largely unaffected by a recession or indeed a pandemic. Together with government-backed revenue streams they have a reputation for providing steady, if unexciting, returns.
However, this is only half the story, and to not acknowledge the number of high performing businesses within the sector producing very decent returns, partly through capital growth, partly through the income they produce, would be to short-change a sector which has produced strong returns over a 20 year period.
Investors could also consider the impressive annual returns of individual utility companies on both a capital and total return basis. Some very respectable investments, in my view.
Another assumption relates to the fact that Utilities are highly regulated. It is sometimes viewed with cynicism that the Government (through the regulator) controls how much they can charge, how much profit they can make, and many other parts of the business besides. The regulator attracts its fair share of scrutiny too.
However, the regulator is dealing with monopolies, so in the absence of competition it limits how much companies can charge consumers through their energy bills via a ‘price control’ framework. It has a duty to determine that companies properly carry out their statutory functions, to set policy priorities and to make decisions on a wide range of regulatory matters, including price controls and enforcement. It also needs to ensure that there’s enough investment in the industry and looks to get the balance right between shareholders and customers.
All regulators need to make sure that the companies are doing the right things. They also need to ensure that companies are capable of financing their operations. If companies can do well in terms of capital expenditure, operating expenditure, and financing costs, then they can do a good job for shareholders.
In my experience, regulators should like companies to do well. In that scenario, everyone wins - society benefits from more efficient businesses and shareholders also stand to gain. Regulators reward well run businesses with attractive levels of returns for shareholders. Part of this return to shareholders comes through a dividend. Since regulators set prices to take account of inflation, this often means that companies in this sector have dividend policies which aim to grow dividends at least in line with inflation.
Ofwat, the regulator of water companies, carries out its price review every five years. The water companies have just come out of this five-year process - the new charge control period started in April this year – and should now be heading into a period of regulatory stability.
In July, Ofgem (the regulator for gas and electricity markets) set out its latest price cap proposals, under which household energy bills would be cut by about £20 a year as part of its aim to create further efficiency and savings for consumers. While the new price controls, which will come into effect from April 2021, have attracted some negative headlines for the companies affected, it’s important to remember that it’s a five-year regulatory cycle.
The review is currently in the negotiation phase and I would expect the regulator and the companies to come to some level of agreement. The periodic review means that, although utility companies might occasionally be subject to other influences such as legislation, it marks the start of the business cycle and that on the whole they are less exposed to events outside of this regulatory scenario.
As part of having their returns controlled by the regulator, the upside is that utility companies get definite levels of revenue coming in to cover costs. This helps to keep earnings stable and underpins their ability to pay dividends.
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 changes tend to be incremental and carefully managed. The regulatory backdrop has evolved over time to reward the best performers and the utility companies’ response has delivered both good outcomes to consumers as well as capital and income growth to shareholders.
Given that utility companies have very different considerations to most other businesses, I consider them to be very complementary in a portfolio of shares. However, I would happily enter a debate with anyone who calls them bond proxies. When there was a risk of a Jeremy Corbyn government last year and he threatened to nationalise utility companies, suddenly they didn’t look like bonds then. Clearly, interest rates alone do not determine the share price performance of utilities.
An unsung sector, I consider many utility companies to be high performing businesses providing very respectable levels of return through both capital and income. Investing in utility companies is not without its risks of course. Regulatory settlement and politics can interfere, and with prices linked to inflation, a deflationary environment is also unhelpful.
While the water businesses I hold (Pennon Group, Severn Trent, United Utilities) are mostly solely water suppliers (Pennon Group has just sold its waste business), the electricity businesses (SSE, National Grid provide electricity and gas) have a more diverse income stream. The UK regulatory aspect only relates to half of National Grid’s business, for example, the rest of its business is in the US.
For SSE, only about a third of the business is regulated, with wind farms, ‘run of river’ and pumped storage hydro assets (hydroelectric systems that harvest the energy from flowing water to generate electricity, responsible for fewer greenhouse gas emissions) making up much of the rest.
The ‘green agenda’ is another reason that I hold utility stocks in the portfolio. Electrical utilities increasingly deliver power from a variety of clean and renewable sources. A significant renewables player, SSE has the largest offshore wind development pipeline in the UK and Ireland.
National Grid also has strong ESG credentials: they have given themselves a target to become net zero by 2050; they are key to delivering the energy transition to low/zero carbon in their markets; they have a strong safety culture; and their track record of delivery to all stakeholders reflects strong governance.
Meanwhile, the water companies are key participants in lowering pollution, improving the quality of beaches and the wider environment, and in more efficient use of chemicals. They are on the leading edge of using green technology to provide and distribute water to households.
Therefore, instead of building a new water treatment site, for example, they are incentivised to be more efficient (and more resourceful), to go further upstream to look at where the water is coming from and to see if the water could be made cleaner at source. This might involve talking to the farmer whose land the water flows through and planting trees to improve water quality, for example.
Embracing the green agenda in the way they run their businesses is not necessarily about spending more capital on infrastructure but about working more efficiently, which is good for both customers and shareholders alike.
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