Investing In Water Stocks In The UK

Considering investing in water stocks? Look no further! Here, we list the top UK water shares and examine the regulatory environment in which they operate.

Investing in Water Stocks in the UK

Water is the most basic of natural resources, sustaining all life on Earth. However, it is no exaggeration to say that it is a commodity mostly taken for granted. As demand for water continues to increase, driven by projections that see the UK population increasing 6% by 2045 to stand at 71 million, then now could be the perfect time to consider investing in this most basic of necessities. If so, then you have come to the right place for your one-stop shop for everything to do with investing in UK water stocks!

What are water shares?

A water stock simply refers to shares of a company whose business is closely tied to the water industry.

Supplying fresh water to homes and businesses is only part of the equation. There is also the issue of removal and treatment of wastewater.

Understanding what water stocks are all about is effectively understanding the water cycle.

Each water company pays the Environment Agency (in England) and Natural Resources Wales to collect water from reservoirs, rivers and underground aquifers in their locale. Groundwater and surface water treatment works clean the raw water, making it safe to drink. A network of pipes and enclosed storage reservoirs ensure clean water is available on demand. A network of sewers and pumping stations collect waste water, which is cleaned at sewage treatment works. Finally, the treated water is recycled back into the water system (for which a consent fee is payable to the regulator).

UK regulatory framework for water stocks

If you are serious about investing in water shares, then an outline understanding of the regulatory environment will make you a smarter investor.

The water industry was privatised back in 1989. Today, a complex body of governmental agencies manage or influence the 11 water and sewerage undertakers in England and Wales (a separate company exists in Scotland).

The table below sets out the key regulators together with a brief resume of their role:

OrganisationDescription
Department for Environment, Food & Rural Affairs (in England) and Welsh GovernmentProvides strategic and policy direction for the industry
OfwatEconomic regulator for England and Wales. Its function is to protect the consumer. For each five-year period (known as ‘price review periods’) it sets the price, service and incentive package that each water company must deliver. At the moment, the industry is in the seventh Asset Management Plan Period (AMP7, 2020-2025)
Drinking Water InspectorateIndependently checks that water supplies in England and Wales are safe to drink
Environment AgencyIssues licences to water companies allowing them to collect water from reservoirs and rivers and, once used, return it to the environment following treatment

Top water stocks in the UK

Of the 11 regulated companies providing water and waste services in England and Wales, three are listed on the London Stock Exchange:

CompanyMarket capDescription
Severn Trent (LSE: SVT)£7.4bnProvides water services to 4.6m customers under the businesses Severn Trent Water and Hafren Dyfrdwy. Its region stretches across the heart of the UK, from the Bristol Channel to the Humber, and from North and mid-Wales to the East Midlands.
United Utilities (LSE: UU)£7.4bnServes 7.3m customers throughout the North West of England. Its customer base stretches from Crewe in the south to Carlisle in the north, and includes the major cities of Liverpool and Manchester.
Pennon (LSE: PNN)£2.8bnOwns three regulated water companies serving 2.3m customers: Bournemouth Water, South West Water and Bristol Water. It also owns Pennon Water Services, which is a business-only provider.

Severn Trent

Severn Trent has two business divisions. For the year ending 31 March 2021, its core regulated business earned revenues of £1.7bn. The vast majority of that revenue (98%) came from Severn Trent Water, with the remaining coming from Hafren Dyfrdwy. Profit before tax came in at £452m.

Outside of its two regulated water businesses, the company also runs a Business Services division. Operating throughout the UK, it generates renewable energy from various sources, including anaerobic digestion, crop, hydropower, wind turbines and solar technology. This much smaller business generated revenues of £135m and profit before tax of £24m for the same period.

Like all water companies, Severn Trent saw water usage being severely impacted by the Covid lockdowns. It saw a significant decline in non-household consumption, which was partially offset by higher domestic usage. Consequently, profit before tax was 17.1% lower than the previous year.

However, in its half-year results to November 2021, the company reported that consumption patterns have begun to return to pre-Covid levels. Consequently, revenues for this period were up 8% and profit before tax 10%.

Severn Trent’s dividend policy is to grow it year-on-year by at least CPIH (the ONS’s preferred measure of inflation) through to 2025. This is less generous than its previous policy of inflation plus 4%.

United Utilities

For similar reasons to Severn Trent, United Utilities’ revenue and profit were down 2.7% and 45% respectively for year ending 31 March 2021.

Throughout AMP7, the company is intending to accelerate its investment strategy to become a digital utility. Through its systems thinking approach, it wants to make better use of technology, automation and machine intelligence to drive operational and environmental performance. For example, it intends to install a total of 20,000 state-of-the-art sensors to its assets by summer 2022. This will enable it to improve, among other things, flood performance as well as gain greater insight into the whole-life of its assets.

As it has so far exceeded Ofwat’s customer outcome delivery incentives (ODIs), it has earned a bonus of £21m. This reward will be reflected in FY 2022/23. It has earmarked a cumulative outperformance payment of around £150m through to 2025.

United Utilities’ dividend policy is identical to that of Severn Trent.

Pennon

As the smallest of the three companies, Pennon is listed on the FTSE 250. However, it still faces similar challenges and opportunities to its two larger peers.

Two key milestones need to be mentioned in relation to this firm. Firstly, in 2020 it sold Viridor (a UK-wide waste management company) for £3.7bn to a private equity consortium. The £1.7bn profit it made from this sale was distributed to shareholders by way of a special dividend together with a share buyback programme.

Secondly, in June 2021 it bought all the issued share capital of Bristol Water for £400m. The deal is expected to add 16% to its regulatory capital value (a key metric used by Ofwat for setting price limits for every price review period) going forward.

Like its peers, Pennon has a progressive dividend policy, which will grow in line with CPIH plus 2% per annum through to 2025.

Are water stocks right for you?

In return for being a monopoly business, each water company is heavily regulated. Consequently, they each face similar challenges. It is important that you are aware of these before making any investment decision.

  • Large debt on the balance sheet – The water industry involves huge capital outlays, often requiring planning decades in advance. Whilst interest rates have remained low, servicing the debt was not a problem. But with rising inflation, interest rates are starting to creep up. With some of this debt index-linked, that is likely to put a strain on their balance sheets in the following years.
  • A tougher regulatory environment – Through 2020-25, Ofwat has rebased the tariffs each can charge under the price review and raised the bar with regard to performance targets. In their latest annual reports, each company highlighted that turnover had been impacted as a result.
  • Bad debt – The Water Industry Act 1991 (as amended by the Water Industry Act 1999) prohibits the disconnection of a water supply and the limiting of supply as a means of enforcing the payment of an outstanding bill. This is a unique challenge for the industry. Although each company has a robust debt management strategy in place, with an unfolding cost of living crisis hitting many households, revenues could get squeezed in the following years.

To summarise, water shares are the classic defensive stock. During the Covid-19 crash of 2020, their share prices fell nowhere near as heavily as the wider index. They have reliable, highly visible income streams with a progressive dividend policy (although, of course, no dividend is ever guaranteed). As with any stock, water shares can be volatile. But as demand for water continues to increase, water stocks remain one of the most favoured shares amongst pension funds and income chasers alike.

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