High returns are usually a reward for taking on elevated risk. In recent years, shares in regulated utilities have turned that maxim on its head, generating handsome profits and dividends from relatively low-risk businesses. But conventional theory might be about to reassert itself.
Companies that transmit gas and power over trunk networks are inherently monopolistic so their returns are regulated, typically with reference to their capital spending, inflation and the cost of equity and debt. This has made them attractive to investors compared to generators and suppliers, which are more exposed to commodity prices and end-user demand. In the UK, for instance, shares in Severn Trent and National Grid have outperformed those of Centrica. In southern Europe, prices have been even more exuberant. Italy’s Terna has given an annual return, including dividends, of almost 12 per cent since 2008.
The obvious risk is political: regulators impose lower caps on returns. For years, this was the dog that did not bark. Now, it is baring its teeth. Last month, the UK’s water regulator proposed a reduction in allowed returns. Ofgem, the energy regulator, may follow suit. UBS points out that where the UK leads, others tend to follow. In Spain, press reports about deep cuts to allowed returns have prompted a flurry of broker downgrades on companies such as Gas Natural, Enagas and Red Electrica. Shares in Gas Natural fell for 10 days in a row.
Politics is not the only headwind. The ‘boiling frog’ rally in bond yields might eventually limit the scope for refinancing utilities’ significant borrowings at ever lower rates. Capital spending on new infrastructure looks set to moderate, if forecasts from the companies themselves prove correct. And new yardsticks for deciding permitted returns may be introduced in the coming few years, as countries review their regulatory regimes.
Those affected could try to boost profits from non-regulated operations. The talk of a clampdown could just be for domestic political consumption, with final reckoning much less draconian. Borrowing will still be cheap by historical standards. But after years of great returns, and with enterprise values above regulatory asset values, the golden decade for such utilities could be drawing to a close.