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It is easy to take for granted the many scientists and inventors who created lightbulbs, and even easier to forget how they light up every day. Perhaps only quarterly – when my electricity bills are due – do I think about the background, and how power is generated, stored, transferred and promised to end users.
Utility companies are an important part of British infrastructure and our daily lives.They also provide interesting investment opportunities for investors that can help diversify portfolios. Because the services that utilities provide are of great societal importance, regulators aim to keep utility companies stable through financial and macroeconomic fluctuations.
Let us first take a look at why utility companies are so different from high street retailers, tech companies and manufacturers that are more familiar to those who follow publicly traded markets. Utilities are responsible for providing crucial goods and services including electricity, natural gas and water to homes and businesses.
They are natural monopolies in that they have high fixed costs and low variable costs. Once the physical infrastructure is built – for example, pipes to deliver water or wires to deliver electricity to a neighbourhood – adding a new customer is relatively inexpensive.
For that reason, a second set of competing pipes or wires does not make economic sense. In most cases, utility services are non-discretionary expenses for the end user: it would be very unlikely that an office or home would turn off power or water services before many other less crucial expenses. Such natural monopolies are then regulated so that they do not charge monopoly prices to the end users.
While the prices are managed, regulators still need to attract investment to fund utilities. In return for providing capital to a utility and managing its operations effectively, investors are permitted to earn a fair return on equity (RoE) – as determined by the regulator – over the utility’s approved asset base.
The reason utilities are a good diversifier is that this RoE should exist even in times of economic slowdown. Even during the global financial crisis, residential and commercial consumption of electricity and natural gas was virtually unchanged, despite big shocks to the broader economy. Industrial consumption did see some weakness, with declines of 7 per cent and 11 per cent for natural gas and electricity, respectively, between 2007 and 2009. But while industrial demand declined in those years, utilities often have longer term contracts, which can protect revenues.
Another consideration for investors is inflation, which – as discussed last week – is on the rise. Utilities can offer inflation protection, since regulators can make adjustments to rates charged to the consumer. In certain regions, returns for utilities are explicitly linked to an inflation index. For example, regulators in the UK define the allowed weighted average cost of capital in real terms, so a higher RoE is automatically granted if inflation increases.
With commodity prices stabilising, asking if energy utilities will now suffer from these higher energy and crude oil costs is a fair question. In fact, utilities that distribute electricity, natural gas and water typically employ pass-through agreements, where the utility bears none of the cost of the product being delivered or transported.
While recession resistance and inflation protection are two key benefits, we should certainly acknowledge the risks of this asset class. Regulatory decisions that may make investors’ RoE lower is the top short-term risk. In the longer term, utilities are exposed to shifting demographics and potentially lower demand for power, water and natural gas.
For now, when diversification is increasingly important, investors may be keen to consider utilities through either the equity market or through direct exposure.
Nandini Ramakrishnan is global market strategist for JP Morgan Asset Management
