Debt-ridden governments see them as cash cows and Fukushima has destroyed the nuclear consensus. Emma Cusworth wonders, are utilities still defensive, or are they now sitting ducks?

Utilities, a stable, regulated sector offering low-beta, inflation-linked returns, have traditionally been a safe haven for long-term investors. However, against a backdrop of increasingly cash-strapped euro-zone governments and a resurgent anti-nuclear movement, utilities have proven anything but defensive: investors suffered significant capital losses and underperformance during 2011.

The Stoxx Europe 600 Utilities index finished 2011 down 17.7%. Since January 2009, it has fallen almost 25%, a 40-plus percentage point underperformance versus the broad Stoxx Europe 600 index. This partly reflects the unwinding of output sold on an 18 to 24-month forward basis, which held utilities up during the crisis: between 1 August 2007 and 31 December 2008, Stoxx Europe 600 Utilities outperformed Stoxx Europe 600 by 17.64 percentage points.

Meanwhile, mounting political risk and a strong post-Fukushima anti-nuclear backlash have put significant pressure on margins. "Consistent sector underperformance in 2009-11 reflects financial strain, uninspiring European pricing and risks of politically-motivated revenue grabs," according to Adam Dickens, European utilities analyst at HSBC.

Sitting ducks
As the chart below shows, European natural gas and coal prices have risen by over 138% and 47% in the two years to 30 November 2011. "This has been driven by increasing demand from South East Asia, particularly since Fukushima, which has not only diverted supply from Europe, but those European countries currently moving away from nuclear are replacing it with natural gas," says Jean-Hugues De Lamaze, European utilities portfolio manager at Ecofin.

And while the costs of production have increased, utilities companies have been squeezed by highly regulated retail prices, increased taxes and falling industrial demand - the only source of non-regulated tariffs which companies can use to pass on higher costs. Forecasts for a recession in Europe should lead to flat or lower demand in most countries, which would be negative for the sector.

"Power providers make most of their money from industrial clients," says Jerome Le Page, senior analyst of ESG research, utilities, at MSCI. "Economic slowdown, therefore, has a big impact."

But things do not look great for companies with greater exposure to retail markets either, as they face intervention from vote-hungry governments anxious to freeze or minimise price increases.

Having initially refused to unfreeze natural gas tariffs in 2012 - a presidential election
year - the French government announced in December that prices would increase by 4.4% on 1 January 2012 after the highest administrative court suspended the freeze. Instead, the government introduced a new formula for calculating retail prices from 2012. While this was welcomed by GDF Suez, which said the increase would allow it to cover costs in the long term, it falls far short of the 10% increase proposed under the old formula. GDF Suez generates 51% of its power from natural gas and was down 23% over 2011.

Spanish utilities sell conventional electricity at ‘pool' (or market) prices. However, the Spanish government has been either freezing prices, or limiting increases below the new pool prices, creating a ‘tariff deficit' - money the government owes the utilities. By the end of 2011 this deficit amounted to €20bn, according to Khiem Le, fund manager at Axa Investment Management.

He says that €9bn has been securitised and paid to the utilities, but the government still owes €11bn. "This deficit will keep growing by €3-4bn a year for 2012 to 2014, and there is a risk the utilities will not get paid in full."

Utilities have also been raided by cash-strapped governments through new taxes. Shares in Finland's Fortum fell 12% from €22 on 17 June to €19.40 on 22 June after a tax on utilities' windfall profits from emissions trading was announced.

In Germany, the government has not abolished its controversial nuclear fuel tax, imposed in exchange for extending the life of the country's 17 operational reactors, despite its abrupt u-turn on the extensions earlier this year.

Italy has also announced a ‘Robin Hood' tax and the Belgian government is planning to increase a tax on nuclear electricity next year to reduce its budget deficit - a move that will cost GDF Suez about $252m, according to CEO Gerard Mestrallet.

"The regulatory environment is much more negative" says Le. "Cash-strapped governments need money and utilities companies are sitting ducks because they can't delocalise."

Nuclear impact
A more fundamental shift has also occurred in the European utilities sector. Since the disaster at Japan's Fukushima nuclear power plant in March 2011, anti-nuclear sentiment has increased dramatically.

EU regulators have agreed on a framework for a new safety test for nuclear power plants. In Italy a referendum on restarting its nuclear programme met with over 90% opposition. Reducing France's reliance on nuclear power from 75% to 50% by shutting 24 reactors by 2025 has become a key election issue. The Swiss government announced that its five reactors, which supply around 40% of the country's power, would not be replaced. The last one goes off-line in 2034. Germany, which before the Fukushima disaster relied on nuclear for around 23% of its power, permanently closed seven plants and reversed its position on extending plant life-spans, targeting an accelerated phase-out by 2022.

"Fukishima triggered a new era for utilities companies," says De Lamaze. "It caused the biggest political decision for a while, which came as a big surprise in Germany. Its u-turn has massive implications."

In a time when margins are already squeezed, utilities are having to revise their long-term strategies and absorb the (higher-than-forecast) costs of decommissioning plants before their previously planned retirement dates.

"Companies have not made provisions for shutting plants this early and governments are also more thorough in designing the clean-up process - which has increased the cost versus 20 years ago," Le says.

Electricity generation companies have been among the worst performers. Switzerland's Alpiq and BKW were down 53% and 54% respectively during 2011, and Germany's RWE fell 41%. France's EDF, whose generation is four-fifths nuclear, was also down 41%.

Still defensive?
Unlike other classic defensive sectors such as healthcare, telecoms and consumer staples, utilities have underperformed a falling equity market. HSBC equity analyst, Peter Sullivan, says that is because investors no longer view it as defensive.

"We believe much of the sector value lost in 2011 will prove to be permanent," says Virginia Sanz De Madrid Grosse, research analyst at Deutsche Bank.

As a whole, the sector has not proven defensive during the crisis, but utilities is an increasingly diverse sector and some elements remain defensive.

"The problem is the definition of utilities," says De Lamaze. "Ten years ago the majority of companies were regulated and had great visibility of future returns and cash-flows, but many national monopolies have since been privatised. Within the sector, some segments are proving very defensive, such as UK water."

UK water is generally considered one of the best value spots within European utilities, offering a defensive play given the visibility and five-year term of the regulatory regime, which is perceived to be among the fairest and most reliable.

"We believe there is better value in UK water companies for 2012, with real revenue security to 2015, defensive earnings and low regulatory risk," Sanz De Madrid Grosse says. "The current environment is highly supportive for the sector, with low bond yields making nominal returns lifted by high RPI appear more attractive."

The link to inflation offered by regulated utilities in stable regimes such as the UK should also remain attractive to long-term investors. As Christian Seymour, head of European infrastructure at Industry Funds Management, explains: "The whole thesis for pension funds investing in utilities is they get a long-term annuity from the asset class and a strong link to inflation protection. Pension funds want liability matching and investing in utilities is core to an inflation protection strategy."

While political risk and the fall-out from Fukushima continue to plague European utilities with little hope of margin pressure easing, utilities, on the whole, no longer represent a defensive, inflation-linked play. Investors will have to be more selective within the sector to root out stocks that retain those attributes.