Are UK Utilities still a safe bet?

UK utility companies have for some time been regarded as a relatively stable investment opportunity, given the reliable, long-term nature of their income streams. Recently, utilities have been going through tougher times, with pressure from the government to reduce prices, and a less favourable outlook for the future. But does this mean that investment in the sector should be avoided?

Water

There are over 20 water companies operating in the UK, each of which is regionally based and regulated in terms of water supply in its region. The larger companies include United Utilities, serving the North West of England, Thames Water, serving the London area, Pennon (owners of Southwest Water), Northumbrian Water Group Plc, and Severn Trent .

During the recent recession, the revenue streams earned by water companies have suffered as both industrial and domestic demand has decreased, due to the number of failing businesses and the impact of the growing number of domestic customers having water meters installed.  As a result, the water companies submitted proposals to Ofwat in autumn 2007 to increase water prices in order to fund a collective £21bn investment in infrastructure.

The proposals have been rejected by the regulator, and instead, the majority of companies are under pressure to reduce customer bills to 2015, with the exception of Northumbrian and Essex and Suffolk, both owned by Northumbrian Water. Ofwat is proposing that the level of return that water companies are permitted to make on their regulated asset base (i.e. cost of capital) is set at 4.5%, whereas research commissioned by the industry suggests that a level of 4.6 – 5.1% is required to fund necessary investment. [ref] http://www.investorschronicle.co.uk/MarketsAndSectors/Sectors/article/20090728/df89c1cc-7a94-11de-a313-0015171400aa/Utilise-utility-weakness.jsp [/ref] Although the water companies will have the chance to lobby before Ofwat’s final price control announcement on 26 November, the news has had a negative impact on some providers’ share prices.

Pennon, who had modelled a cost of capital of 4.78%, saw its share price fall by 3%. United Utilities’ share price saw the biggest fall at 5.5%, although in a trading statement issued, the company announced that it would increase dividends by 5% this year. [ref] http://www.iii.co.uk/investment/detail/?display=news&code=cotn:UU-.L&action=article&articleid=7439339 [/ref] Severn Trent ’s share price also fell by 7.6% following Ofwat’s news.

With customers in some areas of the country living in ‘water poverty’, i.e. spending 3% or more of their income on water bills, Ofwat will be under pressure to come down on the side of the consumer, and is therefore unlikely to set the cost of capital at the rates sought by water companies. This may lead to increased borrowing during the regulatory period (2010 – 2015), which at some point may need to be passed onto the consumer [ref] http://www.utilityweek.co.uk/features/uk/can-water-companies-find-the-c.php [/ref] . 

Until recently, water companies have been an attractive prospect for investors, providing generous and predictable yields [ref] http://www.moneyweek.com/investment-advice/who-turns-water-into-money.aspx [/ref] Ofwat’s stance on price increases is likely to be much tougher than it was over the 2005 – 2010 pricing policy, and infrastructure investment funding will need to be found from somewhere other than the end consumer. Having said that, investors looking to the long term may see the water companies as an attractive prospect as share prices fall.

Looking beyond the water companies’ regulated businesses, for example, Severn Trent Water is building its presence in China, including building and supplying a customised water treatment operation that will serve over 3.3m residents in Zhejiang Province. [ref] http://www.moneyweek.com/investment-advice/money-morning-share-tips-four-stocks-the-market-has-ignored-93802.aspx [/ref]

If you're interested in investing in water and want to avoid traditional utility companies, a more compelling prospect may be "water scarcity" focused stocks like Halma (a company active in leak detection and water-quality analysis), Pico (Nasdaq:PICO, an owner and developer of water rights in the South Western US) or Doosan Heavy Industries & Construction (SEO:034020, a South Korean firm that makes desalination plants. As Moneyweek points out, there's even a US water focused ETF - the PowerShares Water Resources Portfolio [ref] http://www.moneyweek.com/investments/commodities/how-to-profit-from-the-worlds-water-crisis.aspx [/ref]

Energy

Unlike the water industry, the UK domestic energy market has been open to competition since 1997. In 1998, the electricity market, which at that time consisted of a number of privatised regional players, has been opened and a large amount of market consolidation has taken place resulting in six large remaining providers. UK companies include: Centrica, Scottish and Southern Energy, and Scottish Power. European providers include EDF Energy, E.ON, and RWE-owned npower. 

As with water suppliers, the revenue earned by energy companies has reduced during the recession, and bad debt is on the increase due to increased levels of unemployment and rising living costs. Energy companies are under pressure from regulator OFGEM to cut bills for struggling consumers, with particular concern for those living in fuel poverty. [ref] http://en.wikipedia.org/wiki/Fuel_poverty [/ref]

Wholesale gas and electricity prices rose significantly in 2008, and these increases were passed on to the consumer, with domestic bills increasing by an average of 42% last year. Wholesale prices have since fallen, although energy suppliers have reduced bills by just 5% in 2009. [ref] http://www.electric.co.uk/news/uk-utilities-fail-to-cut-prices-despite-drop-in-wholesale-market-12341159.html [/ref] , arguing that they protected consumers from even bigger hikes in 2008 by not passing on all of the wholesale increase. [ref] http://www.shopcorn.co.uk/uk-news/Utility-News/suppliers-warned-ofgem-pricing-issue-836.aspx [/ref]

Environmental issues are also high on energy companies’ agenda, in particular, renewable generation capacity, and the reduction of carbon emissions, although it is claimed that the big six energy suppliers are not investing sufficiently in this area. [ref] http://www.greenwisebusiness.co.uk/news/britain-failing-to-invest-in-renewables-green-energy-company-claims.aspx [/ref]

Energy companies have seen a fall in profits in the last trading year. Operating profits for British Gas fall by 20% in 2008 to £904m. Scottish and Southern Energy saw a slight increase in its operating profit of 2%, to £1,253.7m in the same period, although its share price has recently fallen despite announcing that profits are significantly up this year. [ref] http://investorcentre.scottish-southern.co.uk/servlet/HsPublic?context=ir.access&ir_option=RNS_NEWS&item=181520350367153&ir_client_id=2275 [/ref]

Renewable energy is likely to be the big story for investors over the next few years. Next year, ‘feed-in tariffs’ [ref] http://www.berr.gov.uk/energy/sources/renewables/policy/feed-intariffs/page50362.html [/ref] will be introduced into the UK. Dr Stephen Mahon [ref] http://www.zoominfo.com/people/Mahon_Stephen_383387919.aspx [/ref] from the Low Carbon Accelerator fund (LCA) believes that these tariffs, paid to independent generators for electricity fed into the national grid, will stimulate energy production from alternative sources. Dr Mahon predicts huge growth in small scale wind turbines, with almost half a million homes in the UK considered to be in sufficiently windy locations to generate energy. In addition to an increase in domestic wind turbines, Dr Mahon predicts that farmers and land owners will increasingly generate their own energy through the use of wind turbines, or lease their land to specialist operators. [ref] http://www.moneyweek.com/investments/investing-in-funds-green-energy-alternative-energy-93508.aspx [/ref] Solar power is likely to be another growth area.

Another area of clean energy generation is nuclear power.  Companies to watch include Ceres Power Hldgs and Ceramic Fuel Cells, the stocks of each of which have increased by 155% and 248%, respectively, since March 2009.

A further development to watch in the energy market is that of ‘smart meters’. [ref] http://www.energy-retail.org.uk/smartmeters.html [/ref] Smart meters involve a two-way communication system that displays accurate information on energy use in the home or business. The Government is planning to install smart meters in every UK home by 2020. [ref] http://www.dailymail.co.uk/news/article-1180365/Every-house-gas-electricity-smart-meter-2020--homeowners-foot-9bn-bill.html [/ref]

The installation of smart meters will enable consumers (businesses in particular) to sell back energy to suppliers, facilitating micro-generation technology such as solar panels or wind turbines. Smart meters will also facilitate better understanding of energy consumption, enabling consumers to adjust their behaviour to save energy and money. [ref] http://www.energy-retail.org.uk/SmartMetersFAQ.html [/ref]

Conclusion

Utility companies no longer represent the ‘safe bet’ that they once were, due to a more turbulent operating environment.  Regulation is becoming tougher, and as consumers feel the pinch of the recession, pressure is on companies to offer value for money and lower prices. However, the recent falls in some operators’ share prices may represent an attractive prospect for investors looking to the long term. In this author’s opinion, those with an existing stake in utility companies should hold, and those considering investing for the longer term may want to watch share prices during these uncertain times.