Shares in regulated utilities companies can seem like a low-risk investment. Utilities companies have infrastructure that is virtually impossible to replicate. Their earnings are protected from competition by regulators. And they provide an essential service for which demand is highly unlikely to subside.
It’s easy to see why owning stock in utilities companies, such as National Grid (LSE:NG) might offer excellent protection against inflation. Even better — regulation in the UK (unlike the US) typically allows utilities companies to pass through inflationary price increases to customers. I think, however, that National Grid shares might not offer the kind of inflationary protection that an investor like me hopes for.
Regulation
Utilities companies like National Grid have their profits protected by independent authorities. In the UK, that’s Ofgem. The problem is that, as well as protecting a company’s profits, regulators also have the ability to take them away. Allowed rates of return are reviewed periodically and can go down as well as up. Recently, National Grid has been finding this out to its cost.
In the UK, regulators use the RIIO (revenue = incentives + innovation + outputs) price control framework. The 2013-21 RIIO period allowed National Grid to generate a 7% return with the possibility of further incentives. The 2021-26 RIIO framework (known as RIIO-2) proposes to cut National Grid’s returns. Its allowed returns are now 4.3% for its electric transmission network and 4.6% for its gas transmission.
Impact
I think that the cut to National Grid’s allowed rate of return is significant. For one thing, as a result of the RIIO-2 framework, National Grid’s credit rating has been downgraded by each of the three major ratings agencies. The downgrades leave National Grid’s credit rating dangerously close to falling below investment grade. More importantly, they make it more difficult for National Grid to borrow money to fund its infrastructure investments and achieve its incentives.
National Grid has written to Ofgem to object to the RIIO-2 framework. It’s not yet clear whether or not it will be successful. If it isn’t, then the company might have to think carefully about its capital allocation. The obvious risk here is to National Grid’s long-standing dividend. If the dividend comes under pressure, I expect the company’s share price to fall significantly.
Even if National Grid is successful in its campaign, the ratings agencies have indicated that it is unlikely to have a material effect on their ratings. It’s also worth noting that not all of National Grid’s operations are based in the UK. Those that are not are outside the scope of RIIO-2. Around 40% of the company’s profits come from its US operations. But I’m not sure that this offers any greater inflationary protection, since US regulators don’t typically afford utilities companies the kind of inflation protection that their UK counterparts do.
Overall, I’m wary of National Grid shares. While I like investing in utilties utilities companies, I think that there are better options available at the moment for my portfolio. As a result, I’ll be staying away from National Grid shares and looking for inflation protection elsewhere.
