Fog lifts from UK utilities

With the renationalisation debate kicked into the long grass and investors unexpectedly contemplating political certainty in the UK, what is 2020 likely to bring for the utilities sector? Nigel Hawkins gives his view.

While the nation digests the general election result on 12 December and its Brexit consequences, the decisive majority won by the Conservative party has undoubtedly been good news for the utilities sector.

Not surprisingly, share prices have responded positively – with much of the uncertainty removed.

After all, the very real threat of re-nationalisation had hung over much of the quoted utilities sector, like the Sword of Damocles. Several utilities had even taken action to transfer some of their assets offshore to make it that much harder for an incoming Labour government to acquire them.

Of course, the Labour party needed a big majority to implement their wide-ranging renationalisation programme. The fact that the Conservatives secured an 80-seat majority means that renationalisation has been kicked into the very long grass – at least for the utilities sector, if not for the hapless rail sector.

Undoubtedly, many utility executives had been really concerned about the utility policies of an incoming Corbyn government.

After all, its predecessors had fought many renationalisation battles in the past, going right back to the bitter shipbuilding disputes of the 1970s.

More recently, RBS was nationalised by the previous Labour government – not on ideological grounds – but simply on the basis that RBS was heading to the bankruptcy courts. Eventually, it received over £45 billion of taxpayers’ money to keep it afloat.

The most relevant precedent was Railtrack, which crashed almost 20 years ago. Many utility investors were aware that the then Labour government had given – after very considerable pressure – a modest c260p per share as compensation: at their peak, Railtrack shares had been worth over £17.

Against that background, it was hardly surprising that utility shares were weak prior to 12 December, especially those that were on Labour’s hit list. These included National Grid, the electricity distribution companies and the privatised water companies.

Interestingly, BT’s key Openreach division was added to the renationalisation list, almost as an after-thought. In effect, Openreach is the guardian of much of the UK’s internet connections.

Although it has escaped renationalisation – and apparently free charging, another Labour manifesto commitment – Openreach still has a massive investment programme. And, despite numerous Ofcom proposals of late, it is still not clear how the planned nationwide roll-out of a full fibre broadband network will actually be undertaken – and financed.

Apart from the fog being lifted on utility renationalisation, several price reviews have moved forward.

For the water companies, PR19 remains pivotal, especially since Ofwat’s tough talking now seems to be backed up in the final determinations that were issued shortly after the general election.

Despite the various conditional cost allowances benefiting Thames, the three quoted water companies – all of whom were Ofwat fast-trackers – saw no major changes. None of this trio, Severn Trent, United Utilities and South West – the latter is part of the Pennon Group – is likely to appeal.

All three are set to announce new dividend policies, now that their financial outlook is far clearer.

Indeed, both Severn Trent and United Utilities have already convened Capital Market days to explain to analysts and investors how they plan to operate during the next five years – no Competition and Markets Authority (CMA) appeals there presumably.

In Pennon’s case, it has reputedly appointed bankers to undertake the sale of its Viridor waste business, which could also be a candidate for an IPO. However, the £4 billion price muted in the press for this business seems distinctly racy, with a figure nearer £3 billion being more feasible.

Having waited for South West’s final determination, Pennon will be re-examining its finances – and will seek to reward its shareholders accordingly.

For other water companies, the grass is far less green. Some, and especially those with high debts, may end up appealing to the CMA. In some cases, the gap between what these water companies are prepared to offer and what Ofwat is seeking is wide.

Major compromises or a CMA referral are the only effective way out of breaking these deadlocks; it will shortly become clear which companies have chosen the former route and which the latter.

Whilst the outlook for the water sector is now far clearer, the regulated electricity sector still faces real uncertainty. Although it escaped the possibility of being renationalised, National Grid is facing a very market-sensitive pricing review of most of its UK business, which will impact in April 2021.

Last May’s downward spike in its share price was mainly attributable to Ofgem’s proposal to cut the allowed returns for the equity component of its regulated UK operations.

It seems certain that, during 2020, National Grid’s periodic review will remain the utility sector’s biggest game in town – unless widespread M and A activity is undertaken.

The eight gas distribution companies are also the subject of periodic reviews on the same timeline as National Grid, which – based on other regulatory reviews – seem likely to squeeze their returns.

More generally, there are several issues that impact investment in UK utilities.

As has been claimed after previous elections, there is a ‘wall of money’ awaiting investment into the UK.

This time round, it might actually be true. After all, this is the first time for over 22 years that a Conservative party administration is in power with a substantial parliamentary majority.

Political risk is now quite low – and certainly compared with pre-12 December.

Of course, the UK must still negotiate an acceptable trading agreement with the EU assuming that Brexit is indeed delivered at 11pm on 31 January.

In fact, with a few exceptions, the mainland EU market – unlike say for many engineering businesses – is of comparatively little interest for most UK utilities. National Grid’s expanding electricity and gas Interconnectors division is one exception, whilst ScottishPower is owned by Spain’s Iberdrola.

Although Centrica’s overseas focus is primarily in the US, it does have a decent gas business in Ireland, where SSE also operates.

And, on the electricity front, France’s EDF is building Hinkley Point C, whilst both Eon and RWE have been major UK investors for a generation, although their enthusiasm has seriously waned of late. A relationship with mainland EU countries that fractured further would, though, create significant challenges for the utilities sector.

Most potential overseas investors will have noticed that political risk in other leading EU countries is rising.

For US investors, who generally try and avoid overt political risk, the UK now looks like a haven of calm.

By contrast, in Germany, the CDU/SPD coalition is hanging on by a thread and may disintegrate even before the planned retirement of long-serving Chancellor, Angela Merkel. It seems likely that the Green Party will become even more influential.

While the latter’s participation would undoubtedly boost renewable energy, the risk of some recently built coal-fired power stations – lacking CO2 abatement equipment – being closed down would rise.

Having an elected President firmly in place, means that France’s politics should be less volatile. Yet, deep unrest is identifiable, whilst leading French utilities, such as EDF and Engie, are facing serious challenges.

Within the last few weeks, the forming of a left-wing coalition in Spain, including Podemos, has undoubtedly scared many potential investors.

The proposal for a single national electricity company could see yet further upheavals in a market, where structural change has become endemic.

And, as always, Italy’s politics look unfathomable – and continue to act as a serious deterrent to long-term overseas investment: the shambles of Telecom Italia being an obvious example.

Politics aside, UK utilities generally offer good dividends, with some utilities yielding close to 5% – a veritable harvest compared with the current derisory yields on UK gilts. Water companies, like Severn Trent, will be aiming to offer sustainable dividends until March 2025.

Such a scenario may also re-invigorate M&A activity, although the recent rise in the £sterling means that UK utilities are less cheap than previously.

Buying stakes in water companies may well resume as private equity investors analyse the post PR19 numbers: in the past, Severn Trent, amongst others, has attracted private equity interest.

Centrica, too, must be in the frame. With its share price down by almost two-thirds over the last five years and a dividend cut of 58 per cent, it has not exactly delivered value to its long-suffering shareholders.

With the fog of uncertainty now lifting, UK utilities could be in for an interesting year.