The FTSE 350 utilities index – somewhat against type – has seen plenty of volatility since the Bank of England put the interest rate screws on in late 2021. The index value slumped midway through September 2022, which coincided with the unveiling of the much-derided mini-Budget of the short-lived Liz Truss administration. In fairness, fast-rising wholesale energy prices had wrought havoc in the energy sector in the run-up to the budgetary mishap. Despite this, however, the index has been one of the better performers since inflationary pressures started to bubble up in September 2020, rising by a third since that date as of January this year, and still offers a dividend yield of 4.8 per cent.
It remains to be seen whether the negative correlation between the valuation of utility stocks and changes in interest rate expectations continues to hold true. In any case, a steady fall in the base rate would not only render the sector’s average dividend yield more attractive when compared with gilts, but also reduce refinancing costs – a significant advantage given the debt overhang of certain profligate constituents within the sector. Utilities have been allowed to expand their balance sheets to meet capital demands and fund shareholder returns, a consequence of their seemingly predictable cash flows. However, the sector’s ‘bond proxy’ status could be imperilled by the mandated rush towards net-zero and the capital demands this entails.
The energy transition will not only draw in capital, but it could be an increasingly disruptive factor going forward, particularly as we can't be sure of the life cycle costs for new-generation power plants. It’s worth remembering that decommissioning and remediation costs for both the UK’s nuclear industry and North Sea oil were woefully underestimated at inception.