FTSE 350 Review: Debt casts a shadow over utilities’ income prospects

It’s over 40 years since Stephen Littlechild was commissioned by Margaret Thatcher’s government to design an equitable mechanism that would underpin the privatisation of BT. By the professor’s own admission, it was something of a rush job, but his attempt to square the competing interests of consumers, shareholders and the state provided a template for the raft of utility privatisations that was to follow.

What followed could neatly be described as a reliable stream of income for shareholders, coupled with a vast expansion of industry balance sheets. Nowhere is this better illustrated than the English water companies that were taken private in 1989. Last year, industry regulator Ofwat criticised the performance of water and wastewater companies, citing the fact that in many cases their operating cash flows were well in advance of expenditure on fixed assets and network infrastructure. At the same time, net borrowings increased dramatically, probably to fund financial returns to investors.

None of this has gone unnoticed through the years, and there are parallel criticisms aimed at the power companies. Yet it was the successive hikes in base rates that exposed the debt-laden utilities and raised doubts over their stability. There is no shortage of examples, but you get some idea when you look at the balance sheet of Pennon (PNN), the owner of South West Water, Bristol Water and Bournemouth Water. At its September half-year, the group’s net debt stood at £2.94bn, equivalent to 248 per cent of shareholders’ funds, or 22 per cent above its market capitalisation. The group forked out £347mn in lease/loan repayments, dividends and share repurchases over the six months, but closed out the period with £217mn in the bank.

Such profligacy is by no means uncharacteristic among the privatised utilities, but the main threat to shareholder returns, at least in the medium term, no longer has quite such a political dimension. Sir Keir Starmer has pledged not to take the energy or water companies back under public ownership, although an incoming Labour government could conceivably reform the role of the industry regulators, shifting the balance in favour of capital investments over distributions. 

The vagaries of pricing aside, it's also significant (and topical) that energy utilities are faced with obligations linked to the ongoing energy transition. The extent to which they can allocate capital towards the development of new infrastructure is regulated to a large extent, so shareholder returns may have to take a back seat: any reduction in payouts can be put towards the development of sustainable energy sources. SSE (SSE) has trimmed its distributions on this basis. True, energy utilities aren’t struggling with debt issues to the same extent as the water companies, but the government’s commitment to net-zero policies will force their hand.

It’s doubtful whether Littlechild anticipated the eventual extent of government intervention when he cobbled together his initial regulatory framework. The expansion of the oil and gas windfall tax – the Energy Profits Levy – to include utilities, along with the increased willingness of government to impose price caps, suggests that political expediency rather than shareholder considerations now holds sway in Whitehall. So the broader sector’s investment case, centred as it was on reliable income generation, is no longer quite so straightforward.