News flow on utilities has been almost unremittingly bad in recent years. The sector has been hit by a multitude of problems including tougher regulation of regulated networks, increased competition and lower margins in retail supply, the collapse of profits in thermal generation, and to top it all, the threat of nationalisation. Many investors have folded, and who can blame them?
So it should come as no surprise to learn that the UK utilities sector has lagged wider markets. In fact, over the five years to the end of June 2019, the FTSE All-Share Utilities Index has produced a total return of about zero, with any dividends paid being offset by falling share prices. Over the same period the FTSE All-Share Index has returned 36%, and the FTSE All-World Index has produced 87% (although the latter has had the benefit of a fall in sterling).
Is the sector worth a second look, or should it still be avoided? In my opinion the assessment of any investment should start with valuation, and on this the sector scores well. The FTSE All-Share Utilities Index currently trades on a P/E ratio of 12.9 which puts it in line with the FTSE All-Share Index. However, the wider market’s dividend yield of 4.7% falls shy of the 6.3% offered by the utilities index.
I also believe that many of the risks seem to be receding. It is correct that returns on regulated assets are coming down, but this mainly reflects the regulator resetting tariffs to take account of lower interest rates.
While, the previously healthy profits available in retail supply and thermal generation have now largely gone, the damage is done and has been reflected in share prices. Companies, such as SSE but also the foreign owners of integrated electricity businesses such as Npower, are now considering the long-term future of supply businesses and look likely to divest or otherwise ringfence these activities. Unprofitable coal power stations are being closed to stem losses.
Talk of the Labour Party’s plans to nationalise water and energy companies and resulting levels of compensation needs to be considered, but we believe the political, practical and legal barriers to achieving this are higher than perceived by the market. Furthermore, we believe that share prices reflect a level that would ultimately be deemed fair compensation for the risk.
Range of Listed Renewable Companies
Our discussion so far has in reality focussed only on the incumbent companies that make up the utilities index, such as National Grid (NG.), SSE (SSE), Centrica (CNA), and the three water companies, Pennon (PNN), Severn Trent (SVT), and United Utilities (UU.). For those wishing to invest in the sector, but wanting to avoid most of the regulatory and political risk, the choice of alternative investments is greater than ever.
A first grouping of companies are renewable energy specialists, with relatively simple business models, to buy and operate renewable energy assets such as wind and solar farms. They have the benefit of having strong and visible cash flows, and have, to date, offered high and stable dividends to investors. Companies such as Greencoat UK Wind (UKW), John Laing Environmental Assets (JLEN), Bluefield Solar (BSIF), plus several others, all now offer a simple route to invest in UK renewable electricity generation.
There are myriad exciting technology opportunities for the more adventurous investor. These range from battery storage companies, for example Gresham House (GHE) and Gore Street storage (GSF) funds, which are required to manage more erratic energy flows produced from renewables, to offshore tidal turbines developers like Simec Atlantis (SAE), to fuel cell companies like Ceres Power (CWR), and companies involved in hydrogen production from renewable energy, for example ITM Power (ITM).
So there are many reasons to be cheerful. The legacy sector could turn a corner and begin to produce positive returns again as risks dissipate. The UK renewables sector offers the potential of high, asset-backed yields. And finally the UK investor has access to companies that could prove to be the energy technology leaders of the future. Surely time to take a second look.
We spoke to Morningstar analyst Tancrede Fulop for his view on the European Utilities sector:
