In this feature, we explore the key issues sapping the strength of the big utility companies. While these problems are complex, it is still possible to highlight a selection of four stocks that we think will fare the best in the ensuing power struggle. These are National Grid, International Power, Scottish & Southern Energy and Centrica, all of which we currently rate as buys.
Arguably, there has not been a better point to buy into the sector all year. Following the recent rout in share prices, the FTSE 350 Electricity sector is trading at a 25 per cent discount to the wider market, with a 40 per cent higher dividend yield (see Brewin Dolphin graphs below). The water sector faces a different set of challenges, although as a sector play we favour Pennon and Northumbrian.
However, our advice comes with a clear caveat: do not expect an overnight recovery. If you look further out, and are happy to tuck these away as long-term investments, your patience will be rewarded as the cyclicals boom runs out of steam.
Electricity sector & FTSE 350 PE ratios
Electricity sector & FTSE 350 dividend yields
Under pressure
For the electricity sector, the last six months has seen two of the worst quarters of industrial demand destruction due to weak economic output. For the first six months of 2009, electricity demand in European countries fell on average 5.5 per cent. "After constant month-on-month deterioration until May – at which point year-on-year demand was down by 8.9 per cent – UK demand has slowly started to recover," says Elaine Coverley, utilities analyst at Brewin Dolphin. Part of the recovery can obviously be attributed to seasonal gains.
Falling demand coupled with increased supply (and a global gas glut) has led to falling wholesale prices. However, the listed utilities are unlikely to see any benefit, as with a cold winter approaching they are under increasing political pressure to pass on the cuts to their customers, and to do so quickly.
Further ahead, the looming generation gap is a troubling subject for politicians and utility companies alike. With North Sea gas running out, not to mention the planned decommissioning of old nuclear and 'dirty' coal-fired plants, the UK faces a tough choice. Invest in green energy-generating infrastructure, or compromise energy security by relying on expensive imports from potentially unstable territories.
"The crunch point comes in 2014 when a large amount of fossil fuel generation capacity is closed due to environmental legislation, and many of the current nuclear plants are shut," Ms Coverley explains. "With few new plants planned, with the exception of wind, the UK faces an electricity shortage. The current fall in demand may have pushed out the inflection point, but it has by no means solved the problem."
Infrastructure investment
The investment required to bridge this generation gap is staggering. Published earlier this month, Ofgem's Project Discovery report concludes that £200bn is required to secure energy supplies and meet carbon targets over the next 10-15 years.
The regulator assessed the risks for energy security by envisaging four separate 'energy scenarios' for the next decade, all involving differing levels of investment spend from utility companies and reductions in carbon emissions. In all four scenarios, domestic energy bills will rise between 14 and 25 per cent from 2009 levels.
Worryingly, a 60 per cent hike in annual power bills could also materialise if there is a spike in wholesale power prices – a scenario that the national papers predictably seized upon.
Headlines such as "Families face nuclear tax on power bills" show just how political the utilities sphere has become. The story coincided with a report from the Citizens Advice Bureau reporting a near 50 per cent jump in enquiries from consumers struggling with fuel debts, compared with a year ago.
"Lack of clear direction from government has not given privately-owned energy companies confidence in investing in the UK's energy market," says David Hunter, energy analyst at McKinnon & Clarke. "This has lead to ageing power stations not being replaced, a lacklustre approach to developing new technologies such as carbon capture and clean coal, and poor gas storage facilities. Some tentative steps have been taken such as the opening up of the nuclear debate, and the recession has bought us a couple of years as demand has weakened, but the reality is playing catch-up will cost the country significantly more. The forecast that power bills will rise between 25 and 60 per cent by 2020 is a stark reality."
"The utilities sector is saturated with political and regulatory risks," argues Jan Luthman, fund manager at Walker Crips. Mr Luthman jettisoned all utility holdings in the three funds he has under management at the end of last year.
"For the less well-off families, the choice is to 'heat or eat' – they must cut back on food bills in order to pay the utility bills," he says. "Fuel poverty is a popular political tub to thump. Anybody who thinks the utilities sector is going to pay out bumper dividends when families are struggling to pay their bills in the run up to a general election is living in cloud-cuckoo land."
A load of hot air
The government has already signed up to some challenging targets. Its Renewable Energy Strategy sets out the low carbon transition plan to 2020, by which point the government aims to cut emissions by 18 per cent from 2008 levels. By 2050, it has adopted the even more ambitious target of cutting emissions by 80 per cent from 1990 levels.
The government has also signed up to the European Union's Renewable Energy Directive, targeting 15 per cent of energy to be generated from renewable sources (wind, solar or tidal generation) by 2020.
Mr Luthman is convinced that the move towards wind power will puff bills up. "Wind power by its very nature is intermittent," he says. "A very good study done by the House of Lords' Economics Affairs Committee concluded that power prices would have to rise by 39 per cent in order to incorporate wind power – that is the best guess of the government's own experts. But how much of that cost will be passed down to consumers? And who will pay for the balance – the utility companies or the state? The price of power will not be generated by a free-market process, but by a political process. At which point, I believe it also becomes a rotten investment."
To meet the government's targets for renewable electricity generation, the UK requires a seven-fold increase in its renewable electricity generation – the largest increase of any EU member state. Installed wind capacity is still way behind other countries globally – figures from the Global Wind Energy Council show that India has nearly four times as much as the UK.
New nuclear could be the solution to bridge the generation gap – but, again, this is a deeply political area.
"The industry is in a strong bargaining position as the UK desperately needs the first new nuclear plant to come online on schedule in 2017," argues Ms Coverley. "The government may have to back down and subsidise some of the estimated £40bn future nuclear cost, despite previous promises that new nuclear would not be funded by taxpayers."
Whether it's nuclear, wind power or carbon capture technology that comes to the rescue, there's one small problem. What the government has failed to do is provide any indications of the likely return on investment.
"In the end, we believe equity investors will inevitably have to underwrite a substantial share of the investment boom, and they will need to be properly remunerated," says Stephen Flynn, utilities analyst at Macquarie. "The danger is that it is shareholders' equity that is currently being asked to underwrite a renewal of the power fleet, without a clear policy framework to underpin future returns, even at a basic level – for example, a longer-term signal on carbon pricing. The major UK utilities groups understand this, we believe, and will not invest on political whim. These are challenging times, but we think the opportunities are there."
Don't bitch – switch!
Power companies are notoriously slow to pass on lower prices. But two new entrants are shaking things up
Despite the collapse in wholesale power prices, the UK's big six power companies will not be dropping the prices they charge consumers this winter. However, you could save up to £600 a year by changing supplier.
Two new independent suppliers are now on the market, and offer rates that substantially undercut the average annual fuel bill of £1,239. By contrast, First Utility's internet i-Save comes in at £954 a year, and Ovo New Energy could cost as little as £978 a year. To find out how much you could save, go to a price comparison website such as uswitch.com, theenergyshop.com or energyhelpline.com. And it's up to you whether you invest your annual savings into cheap utility shares.
