Regulated utilities are known for their ability to generate moderate but predictable returns regardless of market conditions. For this reason, we often describe utility stocks as the ‘lead in the keel’ of our infrastructure portfolios. They allow us to navigate shifts in global equity markets with confidence as we seek to deliver annualised returns of 5% in excess of inflation through a market cycle.
Consider the exhibit below, where allowed returns for a sample of regulated US utilities within our investment universe barely fluctuated as interest rates declined when economic growth slowed. Over time, the stable and reliable earnings derived from transmission and distribution assets should deliver income and capital growth for investors.
Return on equity for selected US-based regulated utilities
Utilities are companies that produce and deliver basic essential services such as electricity, natural gas and water. These services are delivered by a network of assets that require the use of public rights-of-way. Crucially, these networks exhibit attributes of a natural monopoly: the extensive investments required to construct the assets make it difficult for another company to compete profitably against the incumbent. Due to this natural monopoly, governments have generally operated utilities but in recent decades they have handed the responsibility to private operators under licence.
To gain this licence, a utility agrees to submit to regulations that govern the rates it can charge customers. In return, the regulator commits to set prices in a manner that allows the utility to earn a rate of return commensurate with the risk borne and the costs incurred. While returns set by regulators can be modest compared with other sectors, utilities are often assured of a minimum return regardless of how the economy is performing because demand for their services is constant. Thus, utility stocks can provide stable earnings and cash flows.
Key earnings drivers
Under the regulatory compact, the utility submits to rate regulation in exchange for exclusive rights to operate within a market. Regulation allows the utility to recover its costs, as well as earn a reasonable rate of return. For its part, the regulator defines what costs can be recovered and what is a fair rate of return, which help determine the prices a utility can charge.
The process by which utility charges, or rates, are determined differs across countries and jurisdictions. At its core, a utility’s rates are a function of its asset (or rate) base and the authorised rate of return.
One of the more common approaches used (particularly in North America) is ‘cost of service’. This approach requires the regulator to determine the revenue requirement, which reflects the amount a utility must collect from its customers to recover its costs and earn a fair and reasonable return. To put it another way:
revenue requirement = operating expenses + (rate base multiplied by the rate of return).
The utility tends to concern itself with its ‘rate base’, and the rate of return, because these factors typically exert the greatest influence on the company’s long-term earnings. By contrast, operating expenses assume less importance as a driver of returns, as these costs are typically passed onto consumers (i.e. utilities do not earn a return on expenses).
As noted, the approach to determining rates can differ across markets. In the UK, regulators use performance-based ratemaking to determine customer charges. While similar to cost-of-service ratemaking in some ways, performance-based ratemaking allows the utility to increase earnings by reducing or limiting costs (instead of increasing rates). The regulator, for example, may allow a utility to adjust its rates based on pre-determined productivity measures or other factors. The exhibit below provides a comparison of cost-of-service and performance-based rates.
|Cost of service||Performance based|
Rate in year 1
Incentive ratemaking is another regulatory approach that uses mechanisms to reward utilities for achieving certain operating targets (as opposed to performance-based cost metrics). Incentives may range from higher allowed returns for meeting energy-efficiency goals to return-on-equity adders for making specific investments. Conversely, (negative) incentives are tools used to penalise utilities for failing to meet certain operating standards.
The rate base
The rate base represents all capital employed by the utility to serve its customers. These might include buildings, power plants, poles, wires, transformers and pipelines.
Over time, the rate base declines as the capital base depreciates. Equally, the asset base grows whenever the utility invests in its capital base. For this reason, investors typically view most (regulated) capital investments as positive for earnings growth.
In countries such as Australia, Chile, New Zealand and the UK, the regulated asset base is the comparable reference used by regulators. It is, however, a term that carries no legislative backing. The regulated asset base, unlike the US ‘rate-base’ model, allows the regulator to amend contracts via an ordered review, or the revision or renegotiation of licences.
Rate of return
A utility’s rate of return is an aggregation of costs for the different sources of funding (i.e. weighted-average cost of capital based on the utility’s capital structure).
Hypothetical rate of return calculation
|% of capital structure||Cost of capital for element||% of capital structure|
+ preferred equity
|+ long-term debt||45%||7%||3.15%|
|+ short-term debt||5%||5%||0.25%|
|= rate of return||100%||8.30%|
As each source of funding has different costs, the mix can have a sizeable effect on the overall weighted rate of return. Moreover, a higher share of equity will usually translate into higher rates for consumers due to the higher cost of equity. This often requires regulators to establish limits on a utility’s capital structure.
US utilities have a capital structure that ranges somewhere between 40% and 60% equity, although this can be higher in other parts of the world. US utilities often only concern themselves with their return on equity as the cost of debt is passed through to the customer. In jurisdictions such as the UK, however, regulation considers the entire return on capital.
Those unfamiliar with utilities might find any company with debt comprising more than 50% of the capital structure surprising as other industries typically carry less leverage. But the ability to have a more highly levered balance sheet is a function of earnings predictability, which is borne out of regulation.
Key risks to investing in utilities
There are three key risks for investing in regulated utilities:
1. Regulatory risk
Utility investments are sensitive to changes in the rate-making and regulatory process. This could come in the form of changes to inputs for determining the rate of return to disallowances for cost recovery. The regulator could amend ratemaking such that it becomes difficult for the utility to earn its authorised return.
Financial results can also be affected by changes in environmental regulations, as well as changes to local, state and federal government policies. Jurisdictions where regulators are elected (as opposed to appointed) will tend to have more customer-friendly rates.
2. Interest-rate risk
Changes in interest rates can affect how investors view utility stocks. Rising interest rates, for example, can lead to underperformance for the sector. This can happen because income-seeking investors shift to higher-yielding investments and away from stocks with lower income growth such as utilities, or because higher rates increase interest payments for companies that are capital intensive and more heavily indebted.
3. Technology risk
Technological advancements pose a long-term risk for utilities, particularly for electricity utilities. Disruptive technologies such as rooftop solar and battery storage may prompt some customers to disconnect from the grid, which would reduce the value of transmission and distribution assets. In such a scenario, regulators could argue for less investment in the grid, therefore disrupting the reliable earnings profile from these assets.
Why do we consider regulated utilities infrastructure?
For an asset to meet our definition of infrastructure, it must have two traits. The first is that it must be essential to the efficient functioning of a community. The other is that it must have earnings that are not sensitive to competition, movements in commodity prices and regulatory risk
Regulated utilities are a staple holding for any infrastructure portfolio because of their highly stable and predictable stream of earnings that are secured by a lack of competition, regulation and their limited exposure to commodity prices and the economic cycle.