Below the radar: gas distribution companies

In the UK, there are eight gas distribution businesses, whose role is to move gas from the National Transmission System (NTS) to the end-user.

Following the privatisation of British Gas in 1986, gas transportation and distribution became the exclusive purview of Transco. After years of anguished debate about Transco’s regulation, the business eventually became part of the expanding National Grid.

Back in 2005, National Grid sold four of its regional gas distribution businesses – Northern, Scotland and Southern, along with Wales and West. It still owns four gas distribution businesses, East of England, North London, North West and West Midlands; they have a combined customer base of almost 11 million.

However, with its high net debt of £24.6 billion, National Grid recently announced that majority stakes would be sold in these businesses, with completion due early in 2017.

Despite gas distribution being National Grid’s second most profitable UK business, this policy was justified by outgoing chief executive, Steve Holliday, who confirmed that ‘gas distribution in the UK is now a mature business with low growth of around 2 per cent a year’. Low growth maybe, but gas distribution companies are highly valued by the market for their long-term, low-risk returns.

National Grid’s four gas distribution businesses have a Regulatory Asset Value (RAV) of £8.5 billion. If a premium of say 30 per cent were applied – not out of line with recent deals in the utilities sector – a valuation north of £11 billion would be reached; that would be equivalent to almost half of National Grid’s net debt.

The second largest gas distribution business is run by Scotia Gas Networks (SGN), which is an Anglo-Scottish undertaking; it includes the large Southern gas region. SGN’s owners are split between FTSE-100 stock, SSE, and the Canadian-based Borealis, which has taken stakes in other UK utilities.

Its 2014/15 figures show that SGN is a strong business. Operating profits were £372 million, slightly up on the £359 million of the previous year. Total capital and replacement expenditure was a formidable £369 million as priority was given to modernising gas pipe-lines.

SGN’s RAV is just below £5 billion so – once its net debt of £3.4 billion is stripped out – a book value of c£1.5 billion remains: and a 30 per cent implied premium over RAV would give a figure of almost £2 billion. And on a non-financial note, SGN deservedly won two awards at the Utility Week Awards last month.

The two other UK gas distribution businesses are rather smaller undertakings.

Northern Gas Networks (NGN) is based in the North East of England, although it is also present in parts of Cumbria and Yorkshire. It supplies around 2.7 million homes/businesses. Its ownership is dominated by Hong Kong/Chinese undertakings. The lead shareholder is Cheung Kong Infrastructure (CKI), which owns various UK utilities, including both Northumbrian Water and UK Power Networks.

CKI’s focus is very much on long-term cash flow, with out-performance of the regulatory settlement being key. CKI also owns Wales and West Utilities (WWU), which is based in Newport.

WWU operates c2.5 million gas supply points in its wide area and supplies some 7.5 million people. WWU’s assets include c35,000 kilometres of gas pipes, covering the equivalent of one-sixth of the UK by area.

In terms of regulation, the periodic review of 2013 – the first to adopt the RIIO outputs-based methodology – has been crucial.

Between April 2013 and March 2021, Ofgem has projected total expenditure (totex) of £16.8 billion, which illustrates the priority being accorded to replacing old gas pipes and providing new gas connections. Given that just a third of the regulatory period has passed, it is still premature to assess the likely out-performance.

However, Ofgem did publish an annual report covering 2013/14, the first year of the eight-year period. It concluded that, even in year 1, the variance from Ofgem’s expected costs and the actual outcome averaged 16 per cent.

Whilst highlighting the back-ending of some investment schemes, Ofgem did comment that the combination of a mild winter – which was kind to gas pipes – lower than expected economic growth and planning delays as being key factors for this substantial variance.

Of course, in subsequent years, the actual out-performance figures for the gas distribution companies may look less good.

Most crucially, of course, Ofgem also addressed the gas safety issue and pronounced itself generally satisfied with what the gas distribution companies were doing.

Over the next few months, as National Grid begins selling majority stakes in its remaining four gas distribution companies, the market will keep an eagle eye on the prices being paid.

With last year’s general election producing a working majority for the Conservative Party, the political risk now is rather lower than would have been the case a year ago. But if aggressive bidding is the order of the day, expect not only National Grid’s share price to respond favourably but also those of other regulated businesses, most notably the three quoted water companies.

With the current vogue for long-term solid investments, this sale may even set new valuation parameters – in terms of the RAV premium – for utility businesses.

Nigel Hawkins (nigelhawkins1010@aol.com) is a Director of Nigel Hawkins Associates which undertakes investment and policy research