The deep, dark waters of utility renationalisation

Any attempt to bring the public utilities back into state ownership will be a fiendishly complex affair.

In recent months, utility stocks have suffered despite their proven ability to deliver decent dividends. Both National Grid and Severn Trent have seen their shares fall by around 10 per cent over the past year.

Within the water sector, the ongoing periodic review – along with the aggressive proposed 2.4 per cent weighted average cost of capital (WACC) figure – has weighed heavy on the share price. The Labour Party’s renationalisation proposals are undoubtedly a further negative, especially for overseas investors wary of assuming significant political risk.

Currently, the seemingly endless Brexit debate – and its many shenanigans – dominate UK politics; and, in the opinion polls, the two leading parties are level-pegging. However, unless the Conservative Party runs up a decent lead in the opinion polls, it is difficult to see how under current legislation an early general election could be called. Nevertheless there will be an election by 2022 at the latest – something that the discerning investor will be taking into account.

In its 2017 manifesto, the Labour Party pledged to “bring key utilities back into public ownership to deliver lower prices, more accountability and a more sustainable economy”. Aside from its radical railways policy, the Labour Party is also focusing on “regaining control of energy supply networks … and transition to a publicly owned decentralised energy system”, and has a commitment to “replace our dysfunctional water system with a network of regional publicly owned water companies”.

Also on the Labour Party’s hit list is Royal Mail, whose shares have plunged recently following a savage profit warning. Little, though, has been said about British Tele­com, where a future Labour government’s priority would be to bring about a nationwide rollout of fibre-optic cable.

Compensation

While these pledges may seem clear-cut, they inevitably raise a raft of questions about how any renationalisation strategy would be undertaken and to what extent existing shareholders would receive appropriate compensation.

Designing an effective compensation regime would be a complex affair. In the lead-up to any general election, the share prices of utility stocks would be volatile – and would surely fall further if the Labour Party secured a decent working majority.

Then there is the issue of the unquoted utility companies. Many are either subsumed within larger organisations or are private equity-owned.

But, in terms of shareholder compensation, there are some precedents worth considering. The credit crisis of 2008/09 saw Royal Bank of Scotland (RBS) receive an unbelievably vast injection of £45.5 billion of taxpayers’ money whereby the government secured close to an 80 per cent equity stake in the bank, most of which it still holds. Non-government RBS shareholders simply saw the value of their shareholding plummet as RBS’s share price collapsed.

A more relevant precedent may be Railtrack, the predecessor of Network Rail, which the Labour government hastily nationalised in 2001 once it had become clear that Railtrack had grossly underestimated the costs of ongoing asset maintenance requirements. After lengthy wrangling, Railtrack shareholders eventually received 262.5p per share, compared with the issue price of 380p when the company launched in 1994. In the interim, the share price had gone past the £17 mark.

Prior to that, the bitter debate over nationalising the shipbuilding yards in the late 1970s saw the industry become part of the public sector. The Aircraft and Shipbuilding Industries Act 1977 set a valuation precedent in that compensation to shareholders was based on the average share price leading up to the preceding general election in 1974.

Significantly, renationalisation compensation has often been paid for by the issuance of government bonds – a policy that the shadow chancellor, John McDonnell, has proposed to implement to fund renationalisation projects if the Labour Party were to win the next general election.

Currently the yield on 10-year Treasury stock is under 2 per cent, well below the cost of equity finance. As such, new bond finance would lower the average WACC – and theoretically could help cut utility bills.

Alternatively, a compensation formula based on prevailing regulatory asset values (RAVs) could be used.

Whatever formula were adopted, though, would be very complicated given the very diverse ownership arrangements in the utility sector. Many utilities, especially the water companies, are private equity-owned, while others are controlled by overseas owners; importantly, National Grid holds assets worth many billions of pounds in the US.

Legality

Legality is a further renationalisation issue. It is something that leading City law firm Clifford Chance has addressed in its detailed publication UK Nationalisation: The Law and the Cost. Clifford Chance expressed doubt that the Human Rights Act 1998, which incorporated the European Convention on Human Rights into UK law, would prevent the implementation of a utility renationalisation policy.

However, the European Court of Human Rights has set down two basic rules, relating to the payment of reasonable compensation and to the adoption of a reasonable valuation method to assess that level of compensation; neither are clear-cut figures.

The most recent challenge to renationalisation in the UK courts was made by Northern Rock shareholders. Zero compensation was awarded. However, Northern Rock, through its reckless overnight funding policy, was clearly bust – a scenario that would not apply to the UK’s utility companies.

A more promising route for oppressed shareholders could lie through bilateral investment treaties (BITs). Most UK BITs have been concluded with emerging economies, such as China (including Hong Kong) and India; neither the US nor western EU countries are party to BITs with the UK. Under BITs, compensation for expropriated assets must be “prompt, adequate and effective”, which is a higher hurdle than that set by the European Convention on Human Rights.

Hence, it could mean that shareholders in the Hong Kong-owned Wales and West Utilities, a gas distribution company with 22,000 miles of pipelines covering one-sixth of the UK’s area, are better protected than conventional UK pension fund-holders. In the case of Hong Kong, which is part of Communist-ruled China, this seems particularly ironic given the Communist doctrine on private property ownership.

Going down the utility renationalisation route would certainly be a tortuous path for an incoming Labour government, which would need a decent parliamentary majority to deliver such a policy.

Nonetheless, back in 1997, a near £5 billion windfall tax was imposed shortly after Labour began its last period in office.

The cost

Quantifying the potential cost of the Labour Party’s utility renationalisation policy is very complex. Under various questionable assumptions, the Centre for Policy Studies has calculated a total of £176 billion.

But before such a policy could be implemented, utility share prices would inevitably have fallen very sharply.

By way of example, the water sector has a current RAV of £72 billion. Severn Trent accounts for £8.7 billion of that total, and its shares are presently trading at a 12 per cent premium to its RAV.

If an incoming Labour government were to pay compensation amounting to, say, 80 per cent of RAV, this would cost £57.6 billion, with the Severn Trent element amounting to £6.9 billion. If just 50 per cent of RAV were paid, the figures would be £36 billion and £4.3 billion respectively.

Nor should it be forgotten in all this that the Labour Party has expensive proposals for the railways and may also need funds to tackle the UK’s low penetration levels of fibre-optic connections as well as scrapping the notoriously poor value private finance initiative (PFI).

As the legendary fictional detective Sherlock Homes said, “these are very deep waters, Watson,” although in the case of the Labour Party, it is the leader, Jeremy Corbyn, and the shadow chancellor who are promulgating the utility renationalisation policy rather than the deputy leader, Tom Watson.