FTSE 350: Clearer path ahead for utilities

Meanwhile, water companies gained clarity over their allowed returns for the next regulatory cycle, AMP7, with Ofwat publishing its final determination in December. The level of allowed return on capital for the period 2020-2025 has been reduced to 2.96 per cent, the lowest level since the industry was privatised. The squeezed returns were not unanticipated, but the new level is an improvement from the 2.7 per cent guided to at the time of the draft determination in July. RBC Capital Markets expects Severn Trent (SVT) to be the best performer on outcome delivery incentive (ODIs) across AMP7, forecasting the company will achieve an average return on regulated equity of 7.9 per cent versus 7.8 per cent for Pennon (PNN) and 6.9 per cent for United Utilities (UU.).

The main issue for income investors is what will happen to their dividends. Pennon was able to keep increasing its payout throughout AMP6 while Severn Trent cut its dividend back in 2016 and United Utilities’ dividend growth over the period was relatively weak. Under the tougher regulatory regime, dividend cover could become more strained, bringing the sustainability of payouts into question. Pennon could find itself in a better position as it benefits from a growing stream of non-regulated profits from its waste management business, Viridor.

Meanwhile, energy regulator Ofgem is still in the process of determining the price controls for the next regulatory cycle, RIIO-2, commencing in 2021. Its final determination is due by the end of this year and will impact electricity and gas transmission and distribution businesses such as National Grid (NG.) and SSE (SSE).

As the UK looks to meet its next zero carbo emissions target, both companies are investing in a greener energy future. With the disposal of its energy services business to Ovo, SSE has become more focused on its renewable energy division, which it sees as a key driver of future earnings growth. Spread across wind, hydro and pumped storage, adjusted operating profit from the group’s renewable assets almost doubled to £150m in the first half of the 2020 financial year. It is aiming to treble its annual output of renewable electricity to 30 terrawatt hours by 2030 and is well positioned to capitalise on the surge in offshore wind.

National Grid will be key to ensuring that the UK’s electricity network is able to handle a changing energy mix as we shift towards more renewable sources. Its electricity systems operator is aiming to be ready to operate a zero-carbon electricity system by 2025. The group’s ventures business is also investing heavily in subsea interconnectors that will enable the import of decarbonised energy from Europe and smooth more volatile input from wind and solar farms.

Taking a long-term view, pure-play bets on renewables are becoming more popular. Greencoat UK Wind (UKW) is predominantly focused on onshore UK wind assets, which comprise 95 per cent of its operating portfolio by value. Meanwhile, The Renewables Infrastructure Group (TRIG) invests in a range of renewable energy infrastructure assets across the UK and Northern Europe, believing stable returns come from a diversity of technologies and geographies. The trust has 69 per cent of its assets invested in onshore wind, 19 per cent in offshore wind and 12 per cent in solar.