Kempen: Investing in utilities, high dividends without high environmental costs

September 21, 2020

At Kempen, integrating ESG criteria is an integral part of all our investment processes. This can manifest itself in what are on the face of it some surprising ways. Our high-dividend equity strategies, for example, have significant exposure to high-dividend payers in the utilities sector, which have long been major polluters.

But this is no longer a fair assessment of the sector. Many utilities firms are changing rapidly, embracing cleaner technologies and becoming crucial players in the energy transition. In short, with a selective approach, and by engaging to urge further improvements, dividend investing and minimising climate change can go hand-in-hand.

An important component of any high-dividend portfolio

If you’re an investor looking for an attractive dividend, we feel it’s hard to ignore the utilities sector. People always need power whatever’s going on in the economy, which means utilities companies enjoy much more predictable revenues than most other firms. What’s the result? Consistently attractive dividends for their shareholders.

Utilities firms form a significant part of our high-dividend strategies at Kempen – typically around 10%. This has been beneficial for our portfolios over the years as they have performed very strongly in recent years, especially in the US.

Important players in the energy transition

Is investing in utilities compatible with a responsible investment approach to investment? When people think about electric utilities, power stations burning dirty coal and huge chimneys belching out black smoke into the atmosphere typically spring to mind. But this is no longer a fair representation of what they’re all about.

The reality is that electric utilities are playing a vital role in the world’s transition towards clean energy. Of course burning coal still forms a part of their energy mix, as it’s impossible to change entirely overnight, but people typically underestimate the improvements that firms have made in recent years.

Utilities still have a relatively high carbon footprint, but by investing in those transitioning towards clean energy and engaging with them to improve further we can help the move towards a more sustainable world.

The importance of being selective

Of course, not all utilities are the same: it’s important to choose which ones to invest in carefully. While utilities have performed well overall in recent years, there has been considerable performance dispersion within the sector.

There are also considerable differences in the extent to which individual firms have embraced the energy transition and, therefore, their carbon footprint. Some firms began the transition towards renewable energy before others, and therefore benefited from early-mover advantage. Some utilities embraced the shift later on, while others have barely moved away from fossil fuels. We also see differences in the approach towards renewables taken depending on a utility’s country of origin and size.

This is important from an ESG perspective if we wish to avoid the most polluting companies. The energy transition is probably the most critical issue facing companies in the utilities sector: if they are not well prepared for it, they are unlikely to represent attractive long-term investments.

And it’s important to remember that the utilities sector isn’t all about power generation. For example, network companies, which build and operate the power lines that transport electricity from power stations to businesses and people’s homes, can make good investment opportunities. These firms are going to benefit from increased investment in distribution networks as the world undergoes a process of electrification. A good example of a high-quality firm paying an attractive dividend in this field is National Grid in the UK.[1]

The energy transition won’t mean lower dividends

We feel the move towards renewables does not affect utilities’ ability to pay an attractive dividend. The projects they have been involved in have always required considerable investment, so the costs involved in the energy transition are nothing new to them. What’s more, many utilities are increasingly allowing other investors, such as infrastructure funds or pension schemes, to come on board early on to share the costs of a project and crystallise some of the value up front. This enables them, in our view, to get involved in more projects as well as pay their dividends.

The importance of engagement

At Kempen, we integrate ESG throughout our entire investment process, and this extends to engagements with companies that we’ve already invested with. We always discuss ESG matters with the companies we’re considering investing in, and with utilities we typically spend a large percentage of our time together talking about the energy transition – what the firm’s plans are, how it intends to participate, and how the firm is likely to change over time as a result.

Application to other sectors

There’s a similar story to be told in the energy sector: even some oil & gas firms are transitioning towards clean sources of energy, so could be good investments from both a dividend and ESG perspective.

A great example is  Repsol, the Spanish energy company. Having long been involved primarily in oil and gas exploration and production, the firm is now making big investments in renewables. As the first oil company, it announced its goal of becoming a net-zero emitter by 2050 with specific reduction targets for 2025, 2030, and 2040. These sustainability targets are incorporated into executive pay, with 40% of the long-term pay of its top managers tied to achieving the targets.[2]

Dividend investing at Kempen

At Kempen we’ve been running high-dividend strategies for close to 20 years, following a highly disciplined approach. We’ve got a strict list of requirements that any firm we’re considering investing in must meet to enter our portfolios:

• they need to have good capital discipline, only investing in the best projects
• they need to be cash-generative so that they can pay attractive, sustainable dividends
• they need to have an attractive valuation that provides a good margin of safety.

And as we have a long-term investment horizon, we require our holdings to be well positioned from an ESG perspective. This means we won’t invest in a utility with an unnecessarily high carbon footprint regardless of its valuation or dividend, because in the coming years it could be hit by punitive carbon taxes.

We follow a disciplined process and our team has been working together for the past two decades. The members of the team also invest their own money in their strategies, ensuring that their interests are aligned with those of our clients.