The first quarter of 2018 saw a “perfect storm” for listed infrastructure stocks in the UK, and particularly for regulated utilities.
Political pressure had been building from all sides through 2017, with the Conservative government mandating the introduction of price-caps on domestic energy supply and the Labour shadow chancellor outlining an aggressive nationalisation agenda including water, gas and electricity utilities should his party form a government.
In March 2018, the environment secretary Michael Gove addressed the Water UK City Conference and pulled no punches in reminding water companies of their responsibilities as operators of monopoly businesses to be “transparent and accountable”, and criticising some companies for “playing the system for the benefit of wealthy managers and owners, at the expense of consumers and the environment”. There is little doubt he was focusing on some of the egregious behaviours of unquoted companies in the sector, but inevitably the listed stocks were caught in the crossfire.
Alongside the growing political pressure on the UK utility sector, Q1 saw the regulators indicate that real equity returns would fall in the next regulatory cycles. Both Ofwat and Ofgem (the regulators for water and waste, and for gas and electricity respectively) are independent but, given the tenor of political debate, both are keen to show that they are very much on the side of consumers and will regulate accordingly. In addition to these political and regulatory factors weighing on the sector, the rise in sovereign bond yields during the quarter pressured the quoted companies further, with the perception that “bond proxies”, such as regulated utilities, were less valuable in a rising interest rate environment.
Many of the factors which weighed on the regulated utility sector also had a negative impact on the share prices of the London-listed infrastructure investment trusts. Whilst the returns for PFI and PPP (private finance initiative and public-private partnership) projects are not subject to regular regulatory review, the concerns over nationalisation, ownership by offshore companies incorporated in low-tax domiciles and the impact of rising interest rates were front and centre through the quarter.
Furthermore, investment trusts such as HICL, (through the water utility Affinity and INPP, and through the gas distribution company Cadent), have UK regulated utility investments in their portfolios, so the factors which weighed on listed utilities were also germane to these investment trusts.
However, in recent weeks we have seen a reversal of the underperformance, as both regulated utilities and infrastructure investment trust share prices have started to rise from multi-year lows.
As investors, we constantly assess risk and return, and whether the valuations and future dividends accurately reflect the risks and opportunities inherent in these stocks. So, has anything fundamental changed, or are we simply looking at investors assessing valuations and concluding that all the risks above are more than discounted in share prices?
The major change has been a strong response from the various parties highlighting both the societal and environmental benefits which have accrued from private ownership of infrastructure, and also the legal and practical impediments to a widespread Labour nationalisation agenda. The legalities are complex, but our conclusion is that nationalisation at a price below “fair value” (for which we read regulatory asset base – or RAB – for utilities) would be potentially illegal and hugely detrimental to any future inward investment into the UK. On this basis, we see the RAB as potentially creating a floor for utility valuations. For the investment trusts, a realistic net asset value (NAV) should similarly underpin valuations, although in our opinion, there is little prospect of stock prices returning to sustained and significant premiums to NAV, as in recent years.
As global investors, we also assess the UK regulated utilities in our investment universe against regulated utilities in other major markets. The impact of sentiment around rising rates has weighed on share prices of utilities in many other regions since the beginning of 2018, and with the regulatory and political factors outlined above specific to the UK, we believe that the risk & reward balance overseas is generally more favourable for investment.
Our utility investments are particularly focused on the US, where we see the long-term transition from coal to renewable generation as driving strong and sustainable growth in the regulatory asset base of stocks such as NextEra and Xcel Energy.
Jim Wright is fund manager of LF Miton Global Infrastructure Income fund. The views expressed above are his own and should not be taken as investment advice.