Re-awakening utilities: the great energy transition
- Reaching net zero requires utility companies to shift their attention towards renewable energy sources
- Climate change will also bring challenges such as flooding, so spending will be required to futureproof the network
- There is no longer room for complacency - we must invest in the companies best placed to adapt to change and generate returns
The value of any investment can fall as well as rise and investors may not get back the amount invested.
Historically, the utilities sector has been viewed as one of stability and predictability, with companies typically benefiting from highly regulated revenues and business models that rarely change. Our credit team often refer to investments in this sector as “sleep tight” credits, allowing us to focus our research efforts on other parts of the portfolio. However, as the world moves towards net zero and begins to feel the effects of climate change, the implications for the sector are profound. Much more care is required to separate the winners from the losers, and while a few restless nights might ensue, opportunities to generate attractive returns by lending to certain utility companies are emerging.
The move towards renewable energy generation is undoubtedly one of the most important shifts of our generation, but it inspires a genuine sense of optimism in us. Given energy is used by every company, the utilities providing that energy must make the shift to net zero so the wider economy can deliver the UK’s now legally-mandated net zero pledge.
Therefore, it is heartening to see high levels of ambition from many of the utilities that we speak to. Enel, an Italian utility company we lend to on behalf of our clients, is an example of a company with stretching targets that we believe puts it in the ‘winners’ camp. Its goal is to have an electricity generation mix entirely derived from zero-emission sources by 2040. By 2025 it expects to add a further 21GW of renewable capacity to reach around 83 per cent generated from clean sources. Enel has issued large amounts of debt to help fund this transition, for which bond investors demand a premium relative to its peers, providing a higher return for our clients if our faith in its long-term progress is repaid.
Beneath this basic energy electrification story, there is complexity. A crucial area for the transition to net zero is still in its infancy: the shift away from gas for domestic heating. Indeed, this shift is so immature that there is much debate in the sector about how the move to net zero will happen. One key battle is the argument for heat pumps versus green hydrogen. While there are several aspects to the debate, cutting through the various self-interests of the parties involved, it is apparent that, in most cases, the best heating solution from a pure physics standpoint is heat pumps. The energy efficiency advantage of heat pumps over hydrogen is vast. Hydrogen is also likely to be necessary for making steel production (among other things) more eco-friendly and should, therefore, be reserved for these industries. The UK Government’s current target is to install 600,000 heat pumps per year by 2028. One company we believe is well placed to take advantage of this shift is Centrica. Traditionally the largest installer of boilers around the UK through its British Gas brand, it is in the process of retraining its employees to install heat pumps. By leveraging its existing strong customer base it has the potential to become the market leader in this area.
Looking beyond energy, the actual impact of climate change is set to create challenges in the years ahead. As an early example of this, the last decade has seen a 16 per cent increase in the number of days of heavy rainfall annually in the UK compared to 1960-1990, with the Met Office scenario for high emissions climate change leading to extreme rainfall events rising by 3.5x in Glasgow and 2.5x in London by 2070. Given the water network is already struggling with intense rainfall, the capital expenditure that will be required to futureproof the network is going to be substantial. We have recently invested in Severn Trent bonds, which we view as an industry leader in this field. We are hopeful of further similar opportunities in the water sector in the years ahead.
With utility companies facing extraordinary challenges, such as the electrification of energy, decarbonisation of heating and flooding risks, it is clear the sector can no longer be easily described as “sleep tight”. As bond investors, it is our role to find the companies best placed to succeed in the face of these challenges. We want our clients to sleep tight in the knowledge that their investments are resilient, and that we are investing their capital with the intention of creating a more robust version of the world. If that means a few more restless nights covering the utilities sector, then so be it.
look to the future.
Not the past.
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This communication was produced and approved in February 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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