Investing in energy: the best and worst utility companies

The UK once had a substantial utility sector following the privatisation of the regional energy suppliers in the early 1990s, sold off alongside the power grid operator National Grid (NG.) and the primary generating business PowerGen. Gas had been privatised a few years earlier through the sell-off of British Gas in 1986. 

There has been considerable consolidation in this sector, with many combining and/or moving to foreign ownership, and the UK is now supplied primarily by the so-called ‘big six’ energy suppliers: Centrica (CNA), EDF Energy (FR:EDF), E.ON (DE:EOAN), Npower (a subsidiary of E.ON), Scottish Power – a subsidiary of Iberdrola (SP:IBE) – and SSE (SSE). Of these, only two are listed in the UK (Centrica and SSE), along with National Grid. The gas crisis of the past couple of years has seen a major contraction of the supply market, with more than 30 new-generation energy suppliers, created as part of the government’s drive for more competition, having failed, with their customers passing back into the hands of the majors.

Utility stocks have, historically, been seen as dull but dependable, with almost assured demand and a large measure of price indexation, but fettered profitability due to heavy regulation, prescribed capital investment levels and caps set on margins. They were also seen as regular dividend payers – bond proxies, in effect – with investors confident of solid passive income, low but reliable total shareholder returns (TSR) and relatively little capital risk. 

Today, however, the sands are shifting, meaning the complexion and the outlook for these few remaining UK-listed utilities is changing, and at a fairly fast clip. 

SSE: giving up dividends for growth

SSE is a complex, diverse business, largely now a generator rather than a full-service utility, having sold its consumer supply business to OVO in early 2021 (it remains a business energy supplier). It is a traditional thermal generator (gas power stations) while at the same time being the UK’s largest domestic onshore and offshore wind energy generator and leading hydroelectric generator. It has also sold its interests in the gas extraction sector ,but retains operation of the power grid in the Highlands and Islands of Scotland. 

SSE is clearly looking to change its spots and wants to be viewed in future as a growth business. To this end, it has slaughtered one of its sacred cows, the once perpetually rising dividend; the dividend rose by at least retail price index (RPI) inflation between 1998 and 2019, and was held by many to be one of the UK’s most reliable payers. SSE is able to invest an additional £10mn annually in growth projects for every penny shaved from its distributions, and has already lowered its annual payment by almost 20p a share. This plays a part in the group’s freshly ambitious plans to invest £12.5bn in growth areas (largely renewables) by 2030, a figure increased at the end of 2021 from £7.5bn. Part of this investment is just replacement, retiring gas-powered stations and replacing them with wind, solar, hydro and, potentially, hydrogen schemes. 

While this could mean little additional generation overall, the quality of earnings from ‘green’ versus ‘thermal’ power should be enough to drive a material, long-term rerating of the stock. Since the decision to cut the dividend and drive for growth was made in mid-2019, investors’ returns have accelerated dramatically – between 2008 and 2019 TSR averaged just 3 per cent, more than 100 per cent of which was dividends (ie the share price fell). In the past three years, it has averaged 21 per cent, and is mostly capital growth: in my view, this is likely to be the new trend for investors here, at a more moderate rate but streets ahead of the old 3 per cent TSR, and there is scope for considerably more mileage in the rerating, leaving SSE the most attractive of the three stocks here. 

National Grid: reassuringly dull?

National Grid operates the UK’s electricity grid, which connects electricity generation from all sources (power stations, wind farms, solar and hydro) to end users, balancing power input across all sources to ensure both adequate supply and the underappreciated function of keeping the electricity supply running as close as possible to 50Hz. NG also has energy investments in the north-eastern US and electricity interconnectors with Europe.

This business has been described as ‘reassuringly dull’, and there is a lot of truth in that, given that the business is more defensive than most other defensive stocks. The grid has to operate, and utilities and customers have to pay for it. It's not directly exposed to price volatility in the energy market (it only trades price differentials between upstream and downstream) and is able to grow earnings at a steady rate in excess of gross domestic product, funding a nicely above-average dividend yield. Today, however, there are a few clouds on the horizon that have caused a swing to a flat-to-negative TSR in the past year after a very stable 7 per cent annual TSR over the preceding 15 years. So what has changed?

• NG acquired a domestic supply business in the UK (WPD) and this raises the risk profile due to potentially volatile profits.
• NG has long been a business with a high debt/low equity capital structure, common before the global financial crisis but rare since. This was not a problem until global interest rates began to rise, an issue compounded by the bulk of the group’s debt having RPI-linked interest rates. A recent decision to sell the bulk of its investment in gas network Transco (if approved) will help lower debt and will also reduce exposure to a less desirable side of the energy market
• NG has run an inflation-linked dividend policy, fine in recent years but now potentially a burden, more so given that the index linking is to the higher CPIH rate (consumer price index including owner-occupiers' housing costs) than the much lower RPI. Given more expensive debt and a fresh commitment to extensive UK network upgrades, dividend growth (unbroken since 1996) starts to look far less assured. NG could even follow SSE’s lead of diverting more free cash flow into growth than distribution.
• There is something of a threat to the group’s long-held monopoly in power distribution. In the future, there is likely to be substantially more local or micro power generation from renewables that will not need to use the grid
• NG has come in for some major criticism for its perceived failure to keep up with growing and changing local demand. Large housing estates, major commercial schemes and plans for larger vehicle charging infrastructure often find it hard to secure adequate and/or timely power provision. Some see that NG risks holding back both economic growth and the pace of decarbonisation. 

NG de-rated a lot in 2022. Stronger recent updates and interim results in November stopped the rot, but with the dividend security looking less certain, the time to buy this one may have passed. 

Centrica: a potential value trap?

Centrica was formed through the breaking-up of British Gas in 1997 (the other parts being BG and Transco) and is a major supplier of electricity and the leading supplier of gas to UK consumer and business customers. It is also an upstream supplier of oil and gas, has a minority stake in UK nuclear and provides installation and servicing contractors for domestic gas customers. With 7.6mn domestic customers, it is the UK’s leading energy provider. While there are investments in green and renewable energy, Centrica is a business that is still largely skewed towards old-school energy sources. 

Centria has not been a great investment over the longer term, delivering -60 per cent TSR over 10 years and -25 per cent over five years. More recently, performance has improved sharply, with higher profits from upstream production, increased demand for nuclear generation, an about-face in its business operations, significant reductions in pension shortfalls and a substantial reduction in what was a burdensome debt pile (mainly through business sales). The share price has more than doubled since the recent low point in mid-2021, and this could suggest that the best of the value available here has already been used up. 

While trading was strong in 2022, Centrica’s business does face a number of pressures.

• Future UK government intervention, either in the form of less favourable price caps or windfall taxes.
• The risks inherent in energy trading in what is a much more volatile pricing environment than seen for decades.
• The risk of consumer default on bills and the likelihood of enforced forbearance by the government.
• potential declines in the numbers willing or able to fund one of the group’s lucrative service contracts.
• Gas is a declining commodity in the domestic energy framework and its continued use is seen by many as the main obstacle to reaching carbon net zero.

Centrica will need to follow its UK peers with heavy growth investment if it is to improve its rating.

The shares also present a potential ‘value trap’ – the illusion of significant value. Profits are high at present but are expected to fall back as the energy market begins to normalise. The consensus earings per share (EPS) forecast for the 2022 financial year (now ended but not reported until 16 February) is c22p per share, suggesting a price/earnings (PE) ratio of just over 4 times. However, for 2024, the consensus is just 15p, and for 2025 less than 12p, and these come with a huge amount of uncertainty – one might even say they are almost pure guesswork. While the 2025 PE is still only half the average for the UK market, that does not automatically equate to great value. There is a lot of risk in commodity pricing (wholesale gas has retraced recently to pre-Ukraine war levels), gas is increasingly a pariah from an ESG standpoint, and margins remain wafer-thin on core revenue (consumer supply). 

Outside the UK

Looking outside the UK, there is a far broader opportunity to invest in energy utilities, especially in the US and Europe. Businesses tend to be more regional in nature and more focused, allowing investors to ‘tune’ investments to suit narrower requirements. Also, the likely rate of growth from conversion to renewables in these markets should be higher: the UK is pretty advanced in its conversion, with renewables approaching 40 per cent of all energy generation. In the US, total returns have been high, with the likes of NextEra Energy making an average TSR of 21 per cent over 10 years and Brookfield Infrastructure 13 per cent. In Europe, the need to wean nations off Russian gas is likely to drive a renewables boom –Norway’s Ørsted (DK:ORSTED) is a leader in wind power, while Germany’s giants E.ON and RWE (DE:RWE) (the EU’s largest renewables business) look interesting, providing a back door to UK renewables. 

Buying UK utilities for ‘safe’ passive income and no sleepless nights is yesterday’s model and, generally, utilities should now be expected to be growth stocks as they help drive the decarbonisation agenda forward. This does mean heavy investment, sacrificed dividends and greater risk, but in the longer term for investors, growth-driven returns will always outplay those that are income-led and lead to higher-rated earnings.