05 Jun 2019
Companies backed by assets, with a history of paying dividends to shareholders? Or targets for overregulation? Ciaran Mallon considers the case for regulated utilities.
The UK utilities sector is a well-worn political target. In successive election campaigns – and under different governments – it has seen everything from caps on household energy bills to the premature cessation of sustainable energy subsidies.
In 2017, the UK General Election brought Britain’s wires, pipes and waterworks back under the spotlight, as the threat of nationalisation under a Corbyn-led Labour Government weighed on the share prices of many of the UK’s key utility providers. Recent political developments have led to a resurgence of this political promise – bringing conversations of public ownership – and regulatory oversight more broadly – back into the spotlight.
However, as a long-term investor in the utilities sector, I take the view that the likelihood of our utilities being nationalised remains remote. The Labour Party has recently provided greater clarity on its plans for the UK’s electricity grid, but fundamentally nothing has changed. Expanding on its reasoning makes it no more, or less, likely that this policy would be successfully imposed on British businesses. In offering greater clarity on its plans, Labour has provided companies with the opportunity to counter the legitimacy of this argument ahead of any general election.
More broadly, I view regulatory change as inevitable, and not necessarily a bad thing. The regulatory backdrop is well-established in the UK and changes have historically proven incremental and carefully managed.
Within the sector, companies such as Severn Trent Water, Pennon Group and National Grid are among the most heavily regulated: they are natural monopolies and are required to keep our nation running. However, at the heart of this regulation is a relationship that rewards companies for doing the right things. Companies that invest in infrastructure and provide good customer outcomes can pay a reasonable return to shareholders through dividends.
Fixed-term price controls – where regulators set and review industry prices periodically - offer customers a certain degree of certainty on prices and enhances transparency. Ofwat, the regulator for water utilities has just completed the first phase of its periodic review. Of all the UK’s water suppliers, United Utilities, Pennon Group and Severn Trent Water (holdings within the Invesco Income Growth Trust plc) have received ‘fast track’ status. The regulator has deemed their business plans to have “set a new standard for the sector”.1 Fast track status offers both financial and reputational benefits to these firms. When regulation works well, it results in good outcomes for all stakeholders, investors included. I believe this clarity can also support company outlooks and the stability of underlying fundamentals.
Historically the UK utilities sector has responded well to evolving regulation. Dividend yields within the sector are attractive, as many companies have delivered growing, inflation-adjusted, dividends over time. Regulation also requires companies to invest in their underlying asset base. This is a further benefit to investors, who can gain from the potential associated capital growth of the assets that the utilities companies own.
However, heightened political scrutiny can lead to the inherent strengths of the sector becoming lost in the fog. The potential threat of nationalisation under a Corbyn-led Labour Government remains a valid headwind. However, the failure of Labour to capitalize on the chaos within the Tory party during 2018, coupled with a very volatile end to the year saw investors flock to so-called ‘safe haven’ equities, including regulated utilities, suggesting the market does recognize the value in the sector.
As a long-term investor I always prefer to take a longer view on the investments I make. There is a high probability of further political uncertainty ahead, but fundamentally, good regulation and good outcomes for investors can go hand-in-hand. A truth that should not be lost amid political posturing.
1 Ofwat, www.ofwat.gov.uk/regulated-companies/price-review/2019-price-review/draft-determinations/
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