Key Takeaways
- The utilities sector has tended to be resilient to changing economic conditions, making it a relative ‘safe haven’ during a recession.
- Debt levels, interest rates and regulatory changes are the key risks in 2023.
- Longer term, clean energy initiatives could be a major growth driver for the industry.
What is the utilities sector?
The utilities sector consists of companies that provide the basics like electricity, natural gas and water, which most consumers usually use on daily.
The sector is largely non-cyclical, meaning demand tends to stay relatively constant year-round, regardless of the health of the broader economy. After all, water and power aren’t things we can live without.
The ability to offer healthy and relatively reliable dividends also feeds into their ‘safe haven’ status. Though as with any investment, nothing is guaranteed.
Although many UK utilities are private, for-profit companies, they’re an important part of the public service infrastructure and are heavily regulated.
How has the sector performed?
Over the past five years, the UK utilities sector has outperformed the wider UK market. This is thanks to the sector’s defensive qualities, which look attractive to investors seeking to shelter from economic uncertainty. It was around the onset of the pandemic that the outperformance began to take hold.
UK utilities sector performance
Past performance isn’t a guide to the future. Source: Refinitiv Eikon, 31/07/23 (UK utilities sector represented by the Refinitiv UK Utilities Index).
More recently, sticky inflation, rising interest rates and mounting global tensions have meant that investors continue to favour more defensive corners of the market. Remember past performance isn’t a guide to the future.
On the flip side, when the economy is healthy and consumers' wallets are bulging, growth’s unlikely to be spectacular. That’s seen by the sector tracking closely with the wider market over the earlier stage of this five-year period. It turns out, even in good times, people only need so much power and water.
What are the biggest opportunities?
The current cocktail of headwinds like rising interest rates, persistently high inflation, and bubbling global tensions look set to continue – at least in the near term. That’s not necessarily great news for the economy and markets.
But because the utility sector’s defensive characteristics provide a bit of a cushion against these market wobbles and economic uncertainty, it’s likely to remain in favour with investors in the near term. Reliable revenues, steady cash flows and healthy dividends should remain relatively robust going forward. As ever though, no dividends are guaranteed.
Longer term, Utilities are at the heart of the transition to renewable energy sources. That means that companies that are investing in their renewable energy assets and infrastructure now could reap the benefits in the future.
Coupled with the fact that consumers, businesses and governments are all actively seeking to reduce their carbon footprint, there’s serious interest to develop “green” infrastructure. We see this as a huge potential growth opportunity, especially for those companies that expand their renewable energy offerings early.
Historically, consumers have been slow adapters. But behaviours are changing, thanks largely to the increased level of information and awareness around climate change. Improved digitisation within the industry’s also handing customers more flexibility and control - like being able to turn your heating on or off remotely via your smartphone. Companies that integrate these digital offerings into their product stand more chance of retaining customers.
As we head towards a greener future, companies that embrace these changes, rather than resist them, will be well prepared to benefit.
What are the biggest risks?
A key sticking point in the energy transition is that renewables are not always reliable. If the sun doesn’t shine and the wind doesn’t blow, then the power doesn’t come. That means other forms of power generation will still be needed, at least in the near to medium term, to bridge the energy gap.
Utilities also require a significant amount of expensive infrastructure which needs to be kept well-maintained. Consequently, these companies are currently carrying large amounts of debt on their balance sheets.
The large debt loads mean utilities are very sensitive to changes in interest rates, with higher rates making it more expensive to service debt. As a result, we could see some utility companies’ margins come under pressure and cashflows squeezed, raising some questions about the sustainability of dividend payments.
And while the transition from fossil fuels to renewable energy sources looks to be a long-term tailwind for the sector, the switch won’t come cheap. These companies are likely to take on more debt to fund the new infrastructure, putting further stress on the sector’s debt reliance.
This came to a boiling point this year, with liquidity issues at Thames Water putting a spotlight on what is a debt-laden water industry. According to the water regulator, Ofwat, the water sub-sector’s total debt reached £60.6bn in 2022.
In this sub-sector, the next regulatory price review is nearing. There are set to be much bigger demands from regulators on improving infrastructure, reducing sewage spills and meeting net-zero targets. All of which point towards increased capital spending and rising debt across the sub-sector.
And across the whole sector, regulation remains a key risk. Regulators effectively have the final say over utility companies’ profit potential. If current cost-of-living pressures persist, we could see some of the utilities’ profits clamped to ease the pain on consumers. However, the extent of this remains to be seen.
Our view
The utility sector has held up well given the rollercoaster ride of events over the past few years.
Debt levels and interest rates will be key metrics to keep an eye on. With interest rates now expected to remain higher for longer, the cost of servicing high debt levels will become more expensive. That means it’s important to assess a utility’s ability to service its debt on an individual company basis.
Ultimately, most utility companies should be less sensitive to changes in the health of the economy. A lot of the defensive benefits look to be priced in already, but we still think there’s potential for growth on a long-term view as the energy transition continues.
This article isn’t personal advice. If you’re not sure an investment is right for you ask for advice. Investments and any income they produce will rise and fall in value, so you could get back less than you invest.
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