Big utility companies are synonymous with generous dividends, and are loved by income-seeking investors for just that reason. Indeed, a combination of regulated returns, an indispensable service and, in many cases, a monopolistic hold on the market, means they can afford to shoulder huge debt and still hand money back to shareholders.
The question is, as challenges mount against the sector, have the most prominent companies prioritised shareholder returns at the expense of customers, the environment and other stakeholders? Some challenges are common – such as the widespread political uncertainty caused by Brexit – but others, such as the recent suspension of the UK capacity market following a surprise EU ruling last November, affects only some.
Obstacles faced by the energy and water companies are also varied: the re-emergence of nationalisation in mainstream UK politics, tighter regulatory policies, the unknown consequences of Brexit, to name but a few. Yet their impact is, arguably, already clear. Over the last two years, the gas, water and multiutilities sector has significantly underperformed the FTSE 350 index.
Some will rightly counter that, since investors buy such stocks with the intention of holding them for the long term, share price fluctuations are of less importance than in the case of a pure growth play. But any sustained fall in the share price is likely to be indicative of real struggle, which gives way to a highly inflated dividend yield – often a signal of more trouble ahead.
On this note, anxiety is building around the high dividend yields seen across the UK stock market more generally. Data from shareholder services group Link Asset Services shows dividend yields from UK shares is at the highest level since March 2009, with £99.8bn declared in 2018. This might sound like a good thing for investors, but depending on just what it is suppressing the share price, it could eventually prompt a dividend cut if payments are deemed unsustainable against the company's performance.
For utility stocks specifically, data compiled by S&P Capital IQ shows a clear peak in water company dividend yields during 2009 – in the wake of the financial crisis –before moderating to a more stable level of between 4 and 5 per cent in recent years. Midway through 2017, dividend yields started to travel north again, although this recent momentum pales in comparison to gas and electricity stocks – SSE (SSE) is included here due to its similar business model to both Centrica (CNA) and National Grid (NG.) – where dividend yields are climbing to worrying levels. It follows a lacklustre share price performance from these groups in the face of increased market competition and energy price caps.
Water yields have steadied over the past decade...
...while energy yields have grown higher
The threat of nationalisation is a significant factor in this poor share price performance. Under Jeremy Corbyn, the Labour Party has been clear about its intention to nationalise the water, energy and rail sectors should it come to power. But how it will achieve this is still the subject of some debate. Either way, the arguments can largely be split into whether former public companies could still provide the same services at the same rate and whether they are currently deemed to be making too much money.
Viewed in this way, the reaction of the government and regulators has been entirely predictable. Theresa May has adopted an old Ed Miliband policy of capping prices on the standard variable tariff. Meanwhile, Ofgem and Ofwat have reduced the allowed returns and made consumers the focus of regulatory changes. The only remaining question is, whether this is enough to temper support for public ownership.
Water companies stem the flow
Self-preservation dictates that regulators talk up how strenuous their regimes are. Our coverage prior to the introduction of the current water company regulations noted they were "likely to be particularly unforgiving". But Ofwat is backing up its words. The new regulatory regime known as AMP7 comes into effect at the beginning of next year, with only three of the UK’s water companies – Pennon (PNN), Severn Trent (SVT) and United Utilities (UU.) – deemed to have business plans ready for implementation. The regulator has told 10 other companies they have further work to do, while four will need to "substantially rework and resubmit plans" under increased scrutiny.
No listed water company has announced a formal dividend policy in regard to the upcoming regulatory period between 2020 and 2025. But early approval from the regulator is still a positive sign – enough to prompt modest forecast upgrades from RBC analysts.
In any event, regulatory change is likely to mean lower returns for shareholders. All three of the large water companies have dividend policies which aim to increase payouts in line with the retail price index (RPI). In fact, Pennon and Severn Trent have both pledged increases of RPI plus 4 per cent. However, as of 2020, both consumer bills and the companies’ regulatory capital value – which is used to measure the value of assets of regulated monopolies such as utilities – will increase in line with CPIH (a measure of consumer price inflation and a measure of owner occupiers' housing costs). CPIH is arguably less volatile and often lower than RPI, suggesting shareholder returns will grow more modestly. Case in point, RBC has estimated the change will lower returns by 100-140 basis points over the next regulatory period compared with the current one.
Energy facing increased resistance
Similar to the water regulator, Ofgem has proposed tightening returns under the next regulatory regime. As a set of price controls for energy networks, RIIO 2 comes into effect in 2021. Late last year, the regulator surprised by proposing an allowed return on equity of just 3 per cent in RPI terms, down from an earlier proposal of 3 to 5 per cent. Such a change would constitute a 50 per cent drop in baseline returns from current levels of 7 to 8 per cent.
National Grid stands to be worst affected by the change, with roughly 40 per cent of operating profits coming from its networks business, versus a quarter at SSE. However, National Grid bosses have said that while the consultation over RIIO 2 is in its early stages, its dividend policy remains unchanged.
Elsewhere in the energy sector, the suspension of the UK capacity market has suppressed earnings. The market – which pays companies developing low-carbon forms of generation – was suspended in November last year after the European Court of Justice ruled it breached state aid rules. Now, previously agreed payments won't be paid until the market is reapproved by the European Commission (EC). And while the Department for Business, Energy and Industrial Strategy expects the EC’s investigation to be concluded by October 2019, RBC notes that approval of the French and Polish capacity markets has taken nine and 20 months, respectively.
In the meantime, companies expecting payments are missing out. In early February, SSE said the suspension would result in a 6p reduction in adjusted EPS for the year to March 2019, bringing the forecast range down to 64p to 69p.
External threats
Beyond localised regulatory challenges or even sector-wide political risk, the uncertainty created by Brexit has had a profound effect across several sectors, and cannot be ignored as a challenge facing the utilities.
The very uncertainty that makes Brexit damaging in the short term, however, makes it impossible to say how it will affect companies in the long term. Broadly speaking, there are three possible outcomes: a ‘hard’ Brexit, in which the UK leaves the EU without a deal, a ‘soft’ Brexit, where it leaves with some agreement – most likely that agreed by Theresa May – and no Brexit, where the government revokes article 50 and opts to stay in the EU after all.
JPMorgan Cazenove judges a "smooth transition" – that is, a soft Brexit – would be the most favourable outcome. Strong GDP growth and a rally in domestic stocks would likely follow an agreed deal, in turn, feeding through to the utility companies. Both 'no-deal' and 'no-Brexit/general election' outcomes are broadly negative in the brokerage's view, due to weaker economic growth stemming from the former option and the increased likelihood of a Labour government in the latter.
In the meantime, Brexit uncertainty has had one positive side-effect. The Bank of England has opted not to increase interest rates, citing concerns over the UK's economic outlook. Interest rate rises are a key risk for the utility sector. Income stocks are frequently used as bond proxies when rates are low, but when interest rates rise they lose their appeal.
