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FTSE 350: Utilities' fortunes split for 2016

Investing in utility companies typically provides meaty dividends, but changing government policy has increased risk in the sector
January 28, 2016

Bosses at the major UK-listed energy companies will have breathed a sigh of relief after swerving the Labour party's proposed price freeze on household energy bills at last year's election. Reliable returns are a major part of the utilities' investment case, yet policy changes have introduced uncertainty for energy suppliers, and investors hoping for a more benign regulatory backdrop in 2016 may have their hopes dashed.

The Competition and Markets Authority (CMA) is due to publish its final decision regarding its energy supply investigation in April this year, while its provisional findings are due to be announced in January. Unsurprisingly, the process has been a lengthy one. The investigation deals with issues including the effectiveness of price competition in the sector, the cost of low-carbon electricity as well as the role of regulator Ofgem.

Centrica (CNA) and SSE (SSE) are the main UK-listed energy companies affected by the outcome of the CMA's investigation. Initial findings suggested remedies that included imposing a safeguard regulated tariff for customers that do not shop around and may be paying more than necessary for their energy bills. Either the CMA or Ofgem could set a maximum price level for suppliers' default tariffs. This would likely erode profit margins for the larger players. However, the Department of Energy and Climate Change distanced itself from this type of remedy in its November submission to the CMA.

Of course, the challenges faced by energy companies are not just political. Falling wholesale gas prices have weighed on the upstream operations of Centrica and SSE. With natural gas trading at 12-month lows as we went to press, this pressure doesn't seem likely to let up anytime soon. As a result, Centrica is pressing ahead with its decision to focus on its retail business, allocating a further £1.5bn in operating capital and resources, while pledging £750m in group operational savings by 2020. It is still early days, but we will gain an idea of how the new strategy is progressing in February when Centrica delivers its results for the 2016 financial year.

Drax (DRX), which has converted three of its six coal-fired units into biomass burn, faced tough trading on both fronts last year. With the government prematurely ending guaranteed levels of subsidies for biomass projects, as well as the cost drag of operating coal power stations, it is unsurprising that its shares are trading close to their 12-month low. Despite regulatory pressures, increased biomass generation translated into a 20 per cent increase in turnover during the first half of the 2015 financial year ending 31 December. Perhaps the most eagerly awaited piece of news in the coming year will be the European Commission's (EC) decision as to whether Drax's third unit qualifies for state aid funding. It is unlikely that investor confidence in the company will pick up until the EC reaches its final decision.

National Grid (NG.) is a less risky option for investors wanting to gain a slice of the fat dividends on offer in the energy sector. In the UK, the company's revenues are regulated by Ofgem under its price control framework. However, there are incentives on offer if the group outperforms Ofgem's expectations for return on equity, something the group last year managed to do. Management is also increasing its focus on growing its US business - essentially a conventional utility. National Grid stands to make gains here via work updating gas mains and providing customers with access to natural gas.

The water utilities are a much safer bet for investors looking for reliable income. The industry is already in the AMP6 regulatory period, which runs between 2015 and 2020, meaning regulators have signed off companies' business plans and dividends for that period. Judging by first-half results for the 2016 financial year, which were released in November, United Utilities (UU), Pennon (PNN) and Severn Trent (SVT) have got off to a good start. Admittedly, tighter regulatory price controls have put a dampener on revenue. However, this was to be expected. The real buying case for the water utilities is the solid dividend maintained until 2020. Buoyed by receiving 'enhanced status' for its South West Water business plan for the current regulatory period, Pennon has been able to guarantee the most generous dividend increases. It promises to increase its dividend by 4 per cent a year plus inflation, as measured by the retail prices index, during this time.

However, regulator Ofwat has introduced a new measure to gauge the water companies' performance: outcome delivery incentives. Each company has specific outcomes they must deliver, for which they will either gain rewards or incur penalties depending on their achievement. This is a marked departure from the incentive mechanism used during the previous regulatory period, which focused on the performance of companies' capital projects. There is big money up for grabs, too. Pennon secured £2.2m in benefits during the first half for outperforming in areas including bathing water quality and odour complaints.

NAME Price (p) Market cap (£m)PE (x)DY (%)1-year change (%)Last IC View
CENTRICA         209                10,616 10.05.7-20.9Hold, 270p, 5 Aug 2015
DRAX GROUP         212                    861 8.55.8-40.7Sell, 283p, 28 Jul 2015
NATIONAL GRID         945                35,407 14.94.62.6Buy, 911p, 10 Dec 2015
PENNON GROUP         878                  3,620 21.53.7-2.7Buy, 838p, 10 Dec 2015
SEVERN TRENT      2,117                  4,979 37.93.9-0.5Hold, 2,188p, 27 Nov 2015
SSE      1,423                14,317 10.26.2-4.4Hold, 1,473p, 11 Nov 2015
UNITED UTILITIES GROUP         921                  6,277 18.44.1-4.3Buy, 953p, 25 Nov 2015

Favourites

We think Pennon remains the pick of the water utilities for 2016. Its South West Water business has 23 outcome delivery incentives, more than its listed rivals and a sign of management's confidence in the ability of South West Water to outperform these measures. Its waste management business, Viridor, is also going from strength to strength after a difficult couple of years. The shift from landfill contracts towards energy recovery helped generate a sizeable increase in cash profit during the first half, a trend that should continue as it transforms more of its facilities for this purpose. A sure-fire income buy.

Outsiders

Things are a lot trickier for Drax. Changes to government renewables policy last year did the group no favours and it is not hard to see why the shares are trading at an almost 12-month low. Admittedly, an increase in the biomass generation of its two units operating under renewables obligation certificates did provide a significant boost to cash profit during the first half. However, management has said the government's decision to scrap the group's exemption from the Climate Change Levy will drag on performance during the second half. Government policy makes investment in Drax a risky move. Add in the cost of coal-firing stations and we maintain our sell rating.