Clean energy credentials make this utility stand out

The chief executive of regulator Ofwat is among those who noted that investors are growing wary of the water suppliers. This is hardly surprising, given that rising interest rates are going to make the job of debt servicing harder. It has also been reported that government ministers are concerned that the failure of Thames Water would curb foreign investment in UK infrastructure. In response, the stocks of the three listed water groups have all fallen in recent weeks – though it seems market jitters aren’t merely confined to that sub-sector.

The FTSE’s two major listed electricity suppliers, National Grid (NG.) and SSE (SSE) have also seen share price declines over the last month. Pessimism around UK utilities appears to be growing. And at first glance, National Grid is navigating similar challenges to the water groups: it has a significant debt pile and needs to overhaul swathes of its infrastructure.

As of March, National Grid’s net debt stood at £40.2bn, equivalent to 136 per cent of shareholder equity. This was enough to make some observers, including this magazine, sceptical about its ability to deliver value for shareholders. While the figure may look intimidating, it should be noted that the company’s terms of repayment are not onerous. According to CEO John Pettigrew, some 79 per cent of the group’s debt is long-term and fixed, while 11 per cent is index linked and 10 per cent is floating.

The latter two categories are most exposed to the shock of rising interest rates. Of the 40 per cent increase in annual finance costs (to £1.5bn as of 31 March), more than half stemmed from higher inflation on index-linked debt. Management has also guided for gearing, or the ratio of debt to group assets, to reach the low 70s in percentage terms during the 2025-26 financial year – having previously sought to keep the balance at 70 per cent.

In other words, high leverage isn’t going away. But this should only become a problem for investors if its credit rating takes a knock. Analysts at Morningstar predict that National Grid’s gearing will average 77 per cent until the 2026 financial year – significantly above its own stated targets. But they also estimate that the retained cash flow to net debt ratio (a measure which compares cash flow generated from operations to total debt) will average 7.5 per cent through FY 2028.

To maintain its current Baa1 credit rating with Moody’s, National Grid needs to keep RCF/ND above 7 per cent. Different agencies have their own metrics for measuring a firm’s creditworthiness. S&P, for instance, uses the funds from operations (FFO) to total debt ratio, which acts as a proxy for a company’s ability to pay off its debt using operating income alone. National Grid currently has a BBB+ rating with S&P and would need to keep FFO to total debt above 10 per cent to remain in this bracket. Morningstar expects an average of 10.5 per cent in the coming years.

Put simply, it looks like National Grid will generate enough cash through its operations to service its debts without much issue – all while spending big on infrastructure. High capital outlay is inevitable if the company is going to rise to the demands of the energy transition. Connecting a multitude of electric vehicles and new renewable assets to the grid is going to be both costly and complex, but it’s also a huge opportunity for the group, and explains why analysts at JP Morgan estimate National Grid will spend around £40bn on infrastructure projects in the five years to 2026. Given the nature of this spending – expansionary and environmentally critical, rather than remedial – the group’s growth profile and returns also look far more politically acceptable than those of the water companies.

It’s expected that the company will fund its ambitions using senior debt, which is prioritised for repayment and is therefore lower risk, as well as cash. JP Morgan anticipates “steadily rising senior bond issuance at National Grid over the medium term”, with £6-8bn of paper issued annually from 2024, and rising as the decade progresses, given that “funding needs for offshore wind transmission connections in the UK are likely to step up materially over this period”.

As with any regulated utility, National Grid’s trajectory will be steered in large part by government policy. But across the company’s operating markets, political support for the energy transition is only growing, and a significant presence in the Northeast of the United States now means the company is highly exposed to the global exemplar of this trend. In fact, some 55 per cent of revenue was generated from across the Atlantic in the most recent financial year. The Biden administration’s Inflation Reduction Act, signed into law last summer, promises to provide subsidies and tax cuts to speed up the country’s move to renewable energy.

While it’s not yet clear exactly how the legislation will impact National Grid’s American operations, it does mark a significant shift in US attitudes toward clean electricity. Pettigrew has celebrated it as “one of the most significant investments the US has ever made to develop clean energy and slow the effects of climate change”. The war in Ukraine has also underlined the importance of energy security to many governments, including the UK. Domestic renewable generation is now a national security issue, as well as a climate priority.

All told, the momentum building behind the energy transition is good news for National Grid, which has a key role to play in developing and operating new transmission and distribution assets.

Some investors might view these prospects as priced in. With the shares trading at over 14 times’ earnings forecasts for the current financial year – equal to an earnings yield of 7 per cent – National Grid’s equity risk premium over safe-as-houses bonds looks slight on a one-year horizon. In part, this is down to the company’s lower perceived risk when compared with European peers. Deutsche Bank analysts noted last month that European utilities tend to trade at a discount to their US equivalents because they are viewed as riskier – yet National Grid's rating is closer to US than European valuations. The potential trade-off, for equity holders, is that National Grid has an opportunity to deliver decades of capital growth.

Of course, this narrative is not without risk. The company sold 60 per cent of its UK gas transmission business to a consortium led by Macquarie Asset Management at the start of this year, with the remaining stake still up for sale. While Macquarie is expected to exercise its option to acquire the remainder before the deadline at the end of this month. But if that transaction doesn’t go through, and another buyer cannot be found, it would weaken National Grid’s balance sheet.

When compared to the multitude of financial risks facing England’s water companies this is, of course, relatively minor. Investors seeking stability during a time of domestic and international upheaval may find that National Grid’s premium valuation is no real deterrent at all.