It’s an option that has never been available to investors in past inflationary periods—investing in energy companies to protect their portfolios.

The main reason was that vertically integrated utilities in monopoly service territories had large power generation fleets that were exposed to rising input commodity costs during inflationary periods that sometimes regulators would not pass through to ratepayers. As a result, they have in the past been terrible inflation hedges.

But since the advent of global power deregulation that began during the 1990s, companies have had the option (or in most cases were mandated by government) to vertically unbundle, which created unregulated generation-only, wires-only or distribution-only companies.

The competitive generation-only companies (known as independent power producers) and the wires-only firms (in charge of electric, gas transmission and distribution) offer new opportunities for protecting against inflation.

The generation-only firms unencumbered by regulation (those that participate in competitive markets) more easily can pass through costs—while the wires-only firms are not subject to the wild commodity price increases in their cost structures that would be characteristic of a vertically integrated utility that owns generation.

Enter National Grid (NTSE: NGG). Created in the mid-1990s when the United Kingdom (UK) unbundled its vertically integrated utilities to create electric competition, National Grid owns the high-voltage electricity transmission system in England and Wales and operates the system across Great Britain. It also owns transmission lines in parts of Europe.

In addition, the network utility owns and operates the high-pressure gas transmission system in Britain, as well as electricity transmission systems in the northeastern US.

Although wires-only companies already exist in the US and elsewhere, as an inflation hedge National Grid has superior attributes that few other network utilities can match:

Economies of Scale and International Diversification

With a market capitalization of $46.63 billion (US), National Grid is nearly the size of America’s largest utility (Duke Energy: NYSE: DUK), and is one of the world’s largest utility network firms, which bolsters the sustainability and dependability of the firm’s earnings.

In fact, the firm has stated it aims “to grow the ordinary dividend at least in line with the rate of RPI (retail price index) inflation for the foreseeable future.” Further, with 65 percent of its operations in the UK and 35 percent in the US, based on 2012/13 operating profits, the firm offers economic diversification.

Moreover, the UK regulatory environment allows National Grid to earn in excess of its allowed return if the network utility meets certain performance benchmarks. The firm has received around $40 billion (US)/£25 billion (UK) in investment allowance for essential infrastructure over 8 years.

Immune from Commodity Prices

National Grid does own some power generation in the US, in the form of 50 fossil fuel powered stations on Long Island and 4.6 megawatts of solar generation in Massachusetts, but the firm has a 100 percent commodity pass-through in all of its contracts.

What’s more, all of its network businesses are decoupled from the commodity. Decoupling refers to the disassociation of a utility’s profits from its sales of the energy commodity. Instead, a rate of return is aligned with meeting revenue targets, and rates are trued up or down to meet the target at the end of the adjustment period. This makes the utility indifferent to selling less product and improves the ability of energy efficiency and distributed generation to operate within the utility environment.

The low price of natural gas in the US is a result of recent shale discoveries that have created an unprecedented supply. This trend is translating into growth for National Grid, as its network expands to meet new demand. If natural gas prices reversed as a result of inflation, National Grid’s management has stated this would not impact network expansion opportunities. Indeed, expansions have gone uninterrupted even when gas and oil prices were on par.

National Grid Delivers Consistent 2012/2013 Earnings


A Solid Growth Story

Earlier this year, the UK’s Labour party threatened a windfall profits tax on generators in response to increasing energy prices, seemingly creating a headwind for what otherwise has been a solid company with a solid earnings growth profile. But as Steve Holiday, CEO of National Grid explained last week at the Edison Electric Institute Finance conference, National Grid has no generation that would be impacted by such a tax. Regardless, the transmission part of the bill is only 3 percent to 4 percent. Further, the UK has approved the firm’s rates for the next 8 years.

To put investors at ease, National Grid hired a legal team to see how such a tax could be imposed. The firm found that this would necessitate a change to the firm’s charter, which would take nothing less than an act of Parliament.

National Grid in the last year has generated a return on equity of 43.4 percent. The firm also sports a dividend of 6.4 percent that it intends to continue to increase at the rate of 2 percent to 3 percent in line with inflation, after receiving favorable regulatory outcomes in the US and UK.

National Grid is a low-risk company focused on generating shareholder value through both dividends and asset/equity growth. The company fuels this growth by investing in essential assets under predominantly regulated market conditions to service long-term sustainable consumer led demands.

This focus will not only continue to deliver shareholder value, but it also offers an ideal inflation hedge. National Grid is a buy up to 72.