Why energy beats water

In addition to its outperformance, the the sector is also enjoying a 'Goldilocks' macro economic scenario. Steady inflation is supporting price increases, while record low interest rates are easing the cost of servicing debt. None of this is news to investors; shares are once again touching pre-credit crunch highs (see chart).

Utility shares move over more stately five and ten year cycle than the febrile market, because they're driven partly by regulatory conditions. And regulation is the key to the outlook, which is very different for the two constituent parts of the utility sector: water and energy.

Water is midway through its 2010 to 2015 regulatory period, which means it is at much less risk from government intervention and moving goalposts. This has given management teams good visibility for the period and they have responded by guaranteeing investors' returns for another two years with inflation beating dividend increases (see table). But as Mark Freshney, utility sector analyst for Credit Suisse points out, water sector valuations tend to peak midway through the cycle. He has recently turned negative on water, and suggests that investors chasing income may get scant share price growth from here.

He has a point about valuations. The table below shows PE ratios in the water sector to their ten-year averages; they are all trading at a chunky premium. Investors are paying a high price for their secure and growing income streams. Fom these levels, the sector experienced falls of up to 30 per cent in 2008 - we don’t expect such a sharp correction again, but with wrangling over the water sector's profits and regulation set to restart in 2014, it's difficult to get excited about the outlook.

Ill winds blowing

By contrast, the energy sector is feeling the full force of a regulatory and macroeconomic storm. Investors got a stark reminder of the impact regulation can have on shares prices two weeks ago when the Department for Energy and Climate Change (DECC) announced a new regime for renewable obligation certificates (Rocs). These provide incentives for generators to switch to low-carbon power sources, and the revised plans supported the outlook for wind generation, but greatly reduced support for Drax's plans to co-fire biomass and coal. The power generator must now accelerate plans to convert to full biomass burning, which will cost more to construct and more to run. Its shares sank 25 per cent in response.

The other source of major uncertainty for the energy sector is the draft energy bill. This is a big piece of legislation that seeks to redraw the map for the power sector and support £200bn of investment in the network and the next generation of UK power plants. Until the power utilities get clarity on returns they will receive on the capacity they construct, investment plans are effectively on hold.

The regulatory backdrop is further compounded by uncertainty over costs and prices. Water prices are fixed according to an 'inflation-plus' formula, but gas and electricity prices vary according to both demand - dependent on weather conditions and economic activity - and what's going on in the wholesale energy markets. The vagaries of regulation and pricing have weighed upon valuations - PE ratios are at or near historic averages.

However, electricity market reform is not quite the disaster for the sector it appears to be. A floor price for carbon is set to start on 1 April 2013 and run until 2020. This will steadily increase the cost of generating power from fossil fuels, making increasing amounts of coal and gas generating capacity uneconomic, and is designed to force a switch to renewables. As this happens, power prices will rise, to the benefit of all generators but especially those that are investing heavily in renewables, like SSE (formerly known as Scottish & Southern Energy). They're taking the pain of capital investment now, but will reap the benefit of high-margin generating capacity in future.

The draft energy bill will be working its way through parliament next year, but once key elements are agreed, it should unlock investment plans for the next generation of power in the UK. The energy sector will look a much safer place to invest once these details are clearer.

IC VIEW

Politicians and central bankers may have papered over the cracks for now, but only a foolish investor would give up on defensives like utilities. The benefits of the water sector look increasingly priced in and vulnerable on the downside, but the sector's still worth holding for income (and occasional takeovers). Valuations look much more sensible in the energy sector, and as the regulatory outlook becomes clearer througout the next 12 months we would look to add to positions here.