1. UK Utilities Sector Market Landscape

The changing climate and rising population have put pressure on water supplies and electricity transmission & generation. The clean energy transition has created new opportunities for the power and utility sector. Amid the pandemic, the utilities and power sector were focused on keeping the assets in line and supplies up and running.

Global energy demand is projected to more than double by 2050 due to population growth and economies. The global electricity demand was down by around 20% or more during periods of full lockdown in several countries, as upticks for residential demand are far outweighed by reductions in commercial and industrial operations, as per IEA.

The industry supply in the UK is expected to decline by 2% between 2015 and 2020. As per the National Grid, the electricity demand in the UK fell by around 20% during the lockdown due to the closedown of the commercial and industrial businesses. As per the Department of Energy & Climate Change UK, significant growth in energy demand is expected between 2020 and 2025. As per Modor Intelligence, offshore wind will drive the growth of the energy sector in the UK, and offshore wind energy is expected to grow at a CAGR of more than 9% between 2020 and 2025. The average daily water consumption in the UK is around 143 litres, which is constantly increasing. A significant portion of the water is lost in the leakage, and the agencies are putting effort to reduce the water leakage by around 16% between 2020 and 2025.

The quality and environmental standards will be affected by the UK's exit from the EU. The new environmental and quality regulations will have a key impact on the business. The investment in the utility sector will be driven by the government's initiative to make the UK net carbon-free by 2050. The government has also set up energy innovation funds of £1 billion to stay ahead of the latest technologies that will help in achieving energy targets.

Water Management

The sector provides great water means through the circular nature of the water cycle. The clean water is collected from the natural environment in rivers, lakes, open reservoirs, and boreholes, and cleaning processes are performed to make this water into drinkable form. The water management system also requires the separation and treatment of water flowing into sewers and drainages before it is clean enough to return to the natural environment. The wastewater is removed, and bioresources are separated to reduce the carbon footprint and energy costs. 

Energy Market

The UK has electricity and gas networks that transmit energy over long distances from where it is produced and distribute it locally where it is consumed. The key elements of the energy market include electricity generation, electricity transportation and selling it to the customer. The energy companies in the UK can work in any of these domains, and they are privatised in the UK. The electricity is generated at the large power stations connected to the national transmission network. Transmission networks carry electricity long distances around the country at high voltages, and the transmission system is run by National Grid, which is responsible for balancing the system. Suppliers buy energy in the wholesale market and sell it on to customers.

Key Trends in the Utilities Sector

• Focus on Customers – Data acquisition at the core of the utility sector that is helping in improving business operations such as detecting water leakage. The companies are focused on managing distribution demand and better networking to adapt to the changes in commercial opportunities and changes in distributed generation.
• Net Zero Emissions by 2050 – The Utility companies are focused on going 100% carbon-free by 2050 and 80% by 2030. The UK government is focused on sustainability, and it has passed laws to end its addiction to global warming by 2050. The UK is among the first major economies to take this initiative, and this serious ambition needs to be supported by the utility companies that will require more investment in renewable energy generation and decarbonisation of heating.
• Artificial Intelligence and Machine Learning – Smart metering and other technologies that help in tracking and capturing the consumption are being heavily used in the utility sector. Artificial Intelligence and Machine Learning are helping companies understand their customers and their needs better.

Risk Exposures to the Utilities Sector

• Conduct and Compliance – The failure to adopt or apply ethical standards and fulfil legal and regulatory obligations and responsibilities. It could lead to financial penalties, reputational harm and loss of customer and investor confidence.
• Cyber & Information Security – Any internal or external attack on the system and infrastructure can result in service unavailability or data breach. The potential for a loss of data or information could affect the service provision.
• Retail & Commercial – The failure to provide good and fair service to customers and retailers. Any disruption in the supply could impact profitability and could result in a risk of financial loss. The lack of customer-focused service can bring down the experience of the customers.

Benchmark Index Performance

Based on the three-month performance, the FTSE All-Share Gas Water & Multiutilities has generated a positive return, but the index underperformed the FTSE-100 and FTSE-250 index. The FTSE All-Share Gas Water & Multiutilities generated a return of about +0.64%; however, the FTSE-100 generated a return of around +6.7%, and FTSE-250 generated a return of close to +11.1%.   

Fig 3: Three Months Benchmark Index Performance

(Source: Refinitiv, chart created by Kalkine Group)

SWOT Analysis

Utilities Sector Outlook

The utility companies in the UK are defensive players as they pay a consistent dividend to the investors, with a significant shareholder return. These companies also have a large amount of money as pension assets, and many older people are dependent on such companies for a regular stream income.

The utility sector requires a long-term outlook given the cycle of the business. The sector raises and funds the projects based on a distinctive long-term horizon. It is heavily reliant on successfully raising long-term funding from banks and credit investors to fund our capital investment programme and refinance upcoming debt maturities. The sector will require additional investments to provide better service to customers and enhance the environment.

In November 2020, the UK prime minister outlined his plans for a Green Industrial Revolution. The UK government will contribute around £12 billion for the green mission, which will support around 250,000 jobs by 2030. Under this mission, close to 40GW of energy will be produced using offshore wind, and it will support around 60,000 jobs. It also aims to generate 5GW of low carbon hydrogen production capacity by 2030 for industry, transport, power and homes and to strive to develop the first town heated entirely by hydrogen by the end of the decade. The homes, schools and hospitals will be greener, warmer and energy-efficient, while 50,000 jobs will be created by 2030, and a target to install 600,000 heat pumps every year by 2028.

2. Investment analysis and stocks under discussion (UU, SVT, PNN, CNA)

After gaining insights into the utility sector, we would look at the business model of four utility players listed on the London Stock Exchange.

A. United Utilities Group PLC (LON: UU)

(Recommendation: Buy, Potential Upside: 23.46%, Market Capitalization: GBP 6.35 billion)

United Utilities Group is a UK based provider of water and wastewater services in North West of England. It delivers .8 billion litres of water a day to more than 3 million homes and businesses. United Utilities is listed on the FTSE-100 index.

Valuation Methodology

Our illustrative valuation model suggests that the stock has the upside potential of ~23.46% over the closing price of GBX 935.80 (as on 15 December 2020).

B. Severn Trent PLC (LON: SVT)

(Recommendation: Buy, Potential Upside: 16.56%, Market Capitalization: GBP 5.52 billion)

Severn Trent is a state-owned water authority based in Midlands, and it is engaged in water supply management and wastewater treatment & disposal. The Company is listed on the FTSE-100 index. 

Valuation Methodology

Our illustrative valuation model suggests that the stock has the upside potential of ~16.56% over the closing price of GBX 2,308.00 (as on 15 December 2020).

C. Pennon Group PLC (LON: PNN)

(Recommendation: Buy, Potential Upside: 11.29%, Market Capitalization: GBP 4.00 billion)

Pennon is a UK based company that provides Water and Wastewater Services. The Company offers service to around 1.7 million customers in Cornwall, Devon and parts of Dorset and Somerset and water only services to about 0.5 million in parts of Dorset, Hampshire and Wiltshire. Pennon Group is listed on the FTSE-100 index.

Valuation Methodology

Our illustrative valuation model suggests that the stock has the upside potential of ~11.29% over the closing price of GBX 943.20 (as on 15 December 2020).

D. Centrica PLC (LON: CNA)

(Recommendation: Hold, Potential Upside: 7.82%, Market Capitalization: GBP 2.42 billion)

Centrica is UK based multinational energy and services company headquartered in Windsor, Berkshire. The principal activity of the Company is the supply of electricity and gas to businesses and consumers in the UK. Centrica is listed on the FTSE-250 index.

(Source: Refinitiv, chart created by Kalkine Group)

Valuation Methodology

Our illustrative valuation model suggests that the stock has the upside potential of ~7.82% over the closing price of GBX 41.51 (as on 15 December 2020). 

*All forecasted data and peer information have been taken from Refinitiv, Thomson Reuters.

*The "Buy” recommendation is also valid for the current price as covered in the report as on 16 December 2020.

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