Much of the infrastructure that underpins daily life in the UK is in need of an upgrade. The owners of the country’s electricity transmission networks are being urged to speed up connections to the grid for renewable energy projects, while water companies are facing criticism for spilling sewage into rivers and seas. Investors have long prized utility companies for their stable earnings and reliable dividend payments. But whether these can be sustained through a period of demanding, albeit necessary, capital expenditure is uncertain.
Gearing and the grid
The task facing National Grid (NG.), the operator of much of the UK’s electricity network, is to integrate thousands of green energy projects within the existing system. Every new solar park or wind farm needs its own connection point, which itself requires higher-spec substations and local grid reinforcements. According to analysis from the BBC, there are currently more than £200bn-worth of projects waiting in the queue to be connected. Delays like these didn’t happen when the country depended on a smaller number of large fossil fuel plants to meet its energy needs.
However, underinvestment by National Grid is by no means the driver of the backlog. The rapid expansion of renewables and an outdated permitting process are among a number of contributing factors. Earlier this month, National Grid set out five “priority actions” to help industry, government and the regulator facilitate the decarbonisation of the UK power sector by 2035. The first item on its wishlist is a reform of the planning system, which would allow decisions about clean infrastructure to be taken more rapidly by policymakers.
“The scale of the transformation needed over the next decade and beyond is a level not seen for generations with a far greater level of investment needed over a much shorter timeframe,” National Grid chief executive John Pettigrew said. For its part, the company is expected to invest up to £40bn at group level in the five years to April 2026. Nearly a quarter of this total is likely to be earmarked for upgrading UK electricity transmission – meaning the country’s network of large, high-voltage lines.
Meanwhile, equity researchers at JPMorgan expect to see as much as £6bn invested in UK electricity distribution (ie smaller, low-voltage lines) over the same five-year period. This overall level of capital expenditure might make some investors uncomfortable, given National Grid’s sizeable, if shrinking, debt position. Its latest set of annual figures showed the company reduced its borrowings from £45.5bn last June to £43bn by the end of March. This is mostly thanks to the sale of 60 per cent of its UK gas transmission business to a consortium led by Australia’s Macquarie Asset Management.
For the current financial year, National Grid expects a £4.5bn uptick in net debt due to the ramping up of its capex plans. “Previously [management] had said that gearing – calculated as net debt divided by the regulated asset base – would be around 70 per cent,” said Tancrede Fulop, an equity analyst at Morningstar. “Now the group expects gearing to remain in the low 70s through 2025-26.”
The increase is not expected to impact the company’s credit ratings with agencies S&P, Fitch and Moody’s, however. All three groups last downgraded the company in 2021, stating that its forecast leverage and gearing figures were too weak to justify its previous rating. In a recent note, JPMorgan's analysts wrote that they “expect National Grid to fund its huge asset growth/capex plans mostly via senior debt and internally-generated cash”. This could mean a steady stream of new bond issuance in the coming years, as well as reduced profit figures, although further asset sales are also possible.
“According to my forecasts, even if the Macquarie-led consortium doesn’t exercise the option to buy the remaining 40 per cent of the UK gas transmission network, National Grid will still meet or exceed the credit rating ratios,” Fulop said. The other potential lever that could facilitate National Grid’s investment strategy, argue JPMorgan's analysts, is the curbing of the dividend. But as it stands, the company does not appear willing to consider this above its other available options.
“Ultimately, considering management rhetoric, we think National Grid’s two key capital allocation priorities accompanying its growth plan are: maintaining current ratings and retaining the current dividend policy,” they said.
This week, SSE (SSE) “rebased” its dividend to accommodate higher capital spending.
Dividend drought?
The UK’s three listed water companies – United Utilities (UU.), Pennon (PNN) and Severn Trent (SVT) – are also keen to safeguard their dividends in the face of enormous capital expenditure. But unlike National Grid, they’re not investing to enable a more sustainable future, they simply need to bring their infrastructure up to modern standards.
The entire water sector is currently under political scrutiny for dumping sewage into the UK’s waterways. While much reviled, the practice is technically legal bdue to a quirk in the design of the UK’s sewerage system (which means wastewater and surface water flow into the same pipes before being transported for treatment). The water companies must therefore use sewer overflow valves during periods of heavy rainfall to prevent waste from flooding into homes and businesses.
While these valves are only meant for emergencies, government data shows that the companies actually use them more than 800 times a day, on average. This is because of an uptick in the number of homes served by the sewerage system, as well as an increase in the number of extreme rain events leading to flooding. In some places, however, capacity is so constrained that even a light drizzle can prompt an overflow. Politicians and activists blame underinvestment by water companies for the crisis.
Earlier this month, Water UK, a membership body representing the sector, said all 11 companies had pledged a combined £10bn towards “the biggest modernisation of sewers since the Victorian era”. This will reportedly cut the number of sewage overflow incidents by up to 140,000 per year by 2030. There were more than 300,000 such spills recorded across the country last year.
Ofwat, the industry regulator, still has to sign off on the actual investment amount, which will be borrowed by the water companies and paid for by an eventual hike in customer bills. The plan has already faced backlash from campaigners, who believe that improvements to the water network should be funded through cuts to dividends. Analysis by the Financial Times revealed that water and sewage companies paid out £1.4bn in dividends last year, up from £540mn in 2021.
All of this attention on the sector should make investors wary for a number of reasons. The first is that the simple anticipation of a major regulatory clampdown can have downward pressure on share prices. Just this week, shares in Pennon, the owner of South West Water, dropped 3 per cent after Ofwat announced it was launching an investigation into spillage incidents detailed in the company’s annual report. Shares in Severn Trent and United Utilities also dipped on the back of the news.
Ofwat also has new powers to clamp down on water company dividends, should they fail to meet certain environmental or customer service benchmarks. Although the regulator has no powers to control profit, it does have the power to restrict the revenue companies can collect from their customers through bills. In setting these price controls, it must decide on a reasonable rate of return the companies can earn.
In an April note on Severn Trent, Deutsche Bank analysts said there could be significant upside to all three water companies' current share prices if they can meaningfully lift their allowed returns at the next regulatory review, which is set for next year. According to Deutsche Bank, Ofwat has thus far guided for “only a modest increase in allowed returns, that falls far short of the actual increase in cost of capital due to higher bond yields”.
JPMorgan said that pushback from customers on the proposed plans to increase bills will also result in “more scrutiny on allowed returns”. In analyst speak, there is “low regulatory visibility” for water companies at this stage – meaning that the potential penalties for poor environmental performance are a genuine risk to earnings and share prices.
Maintaining dividends and placating markets are not easy tasks for a company at the best of times. But they’re even trickier during a period of heavy capital expenditure. Investors should therefore exercise caution around the UK’s utility companies as they navigate an era of major infrastructure upgrades. Stability and reliability are not a given – even in sectors once known for their steady growth.
