At first sight, it’s harder to imagine a more reliable passive income investment than National Grid (LSE:NG) shares. But there’s a lot more to the company than meets the eye.
The firm’s status as a regulated monopoly protects it from competition in an industry where demand is unlikely to go away. This, however, is just one part of a more complicated picture.
Regulated returns
National Grid operates in both the gas and electricity industries but its largest division is its UK electricity transmission business. And this is regulated by Ofgem.
The FTSE 100 firm builds and maintains transmission infrastructure, which is expensive. As well as restrictions on competitors, it’s allowed to earn a regulated return on its investments.
The return factors in Ofgem’s estimates of financing costs (via debt or equity) and allows a specified return on top of this. Importantly, there’s also an additional uplift to offset inflation.
The allowed rate is reviewed every five years and Ofgem’s proposal for the period between 2026 and 2031 is just under 4.5%. National is arguing for a higher rate, but we’ll see what happens.
Balance sheet
National Grid’s status as a regulated monopoly should influence how investors think about its balance sheet. The firm’s long-term debt has been rising consistently and looks set to keep doing so.
With other companies, this might be an issue. But in this case I think investors should not only be relaxed – they should be actively encouraged by seeing the number going up.
Borrowing allows National Grid to make investments. And as long as the cost of the debt is below the allowed return on those investments, the result should be higher profits for shareholders.
For most companies, taking in debt is risky. But a firm that can earn a specified return in a vital industry that’s protected by regulation is in a much stronger position than most other businesses.
Outlook
National Grid aims to deploy £60bn across its divisions by 2029. And by comparing the firm’s financing costs with its allowed return, investors can get an idea of the likely effect on profits.
However, there are complications. Ofgem can disallow inefficient expenditures, adjust valuations, or refuse to count investments in the allowed return until projects are completed.
This isn’t just theoretical. National Grid’s maintenance practices are currently the subject of an independent audit after a fire broke out at a substation near Heathrow in July.
If the investigation finds the firm has mismanaged its asset, it could be disallowed from future return calculations. It’s too early to say how likely this is, but it’s a risk that can’t be ruled out.
Safe dividends?
Being a regulated monopoly can be a double-edged sword. It keeps competition at bay, but this is no guarantee of outsize returns – or even any returns at all.
From a passive income perspective, this means dividends are – as always – not guaranteed. And investors should think carefully about both sides of the equation.
In terms of dividend safety, a number of FTSE 100 companies have built strong competitive positions. They might not be regulated monopolies, but they’re extremely hard to disrupt.
With my own investing I’m focusing on these opportunities. For a business where supply is limited and demand is reliable, I think there’s a surprising amount of risk with National Grid shares.
