Premium on WPD sale is ‘big help’ to Ofgem

The “significant premium” National Grid has agreed to pay for Western Power Distribution will be a “big help” to Ofgem as the regulator defends its proposed cost of equity for transmission and gas distribution networks against appeals to the Competition and Markets Authority (CMA), an industry analyst has suggested.

Last week, National Grid announced it had agreed to acquire electricity distribution network Western Power Distribution (WPD) for an equity value of £7.8 billion as part of a strategic “pivot” towards power that will also see the group sell a majority stake in its gas transmission business.

The announcement came just a day after the CMA issued its final decision in the appeal of four water companies against their settlements for PR19, setting the weighted average cost of capital at 3.2 per cent in real terms – 0.3 percentage points lower than its provisional figure in September but still 0.24 percentage points higher than Ofwat’s final determinations.

All of the transmission and gas distribution networks are seeking to appeal their final determinations for the RIIO2 price controls starting next month to the CMA, with the main point of contention being Ofgem’s proposed cost of equity of 4.55 per cent and the subsequent reduction of 0.25 percentage point to account for the expected outperformance of networks – the so-called outperformance wedge – giving an allowed return on equity of 4.3 per cent.

Speaking to Utility Week, Investec senior analyst Martin Young said National Grid’s argument that the cost of equity being offered by Ofgem is insufficient to attract the required investment will be somewhat undermined by the agreed £7.8 billion purchase price for WPD.

National Grid said WPD’s net debts stood at £6.4 billion as of February, suggesting an underlying enterprise value of £14.2 billion. Young said this represents a “significant premium” of at least 60 per cent over its regulatory asset value (RAV), depending on which figure you take for the latter.

Young said if the regulator got the cost of capital “absolutely spot on” and networks achieved no gains through incentives or underspending their allowances, then their enterprise value would be the same as their RAV: “If you’ve got a premium, it means you are able to outperform the regulatory construct on the financing side, you are able to deliver incentives and you able to outperform on totex.”

He continued: “I would expect things to generally trade at a premium to RAV. I believe that if we’ve got an incentive-based form of regulation, then you want the opportunity for companies to outperform and retain some of the benefit.”

But he added: “That is a completely different thing to saying you can do it to the extent that you can justify a 60 per cent premium to the regulatory asset value.”

He said: “Given the magnitude of that premium and the stance that Ofgem has hitherto taken, you’ve either got to be extremely bullish that the CMA will come out with something markedly different to what Ofgem has done, or actually you believe your own cost of capital is at such a level that you can beat what Ofgem is offering”.

‘Everything is entwined’

In a call with investors following the announcement, National Grid chief executive John Pettigrew downplayed the significance of the premium and justified the price on the basis of WPD’s past performance, expected growth and potential synergies with the rest of the group. He reiterated that National Grid’s appeal to the CMA was technical in nature and said he was confident the appeals body would “look at the fundamentals” when examining the case.

“They hold the view that you can compartmentalise everything,” said Young. “My view would be that everything is massively entwined at this juncture: what’s happened in water, where we are with the appeal processes in gas and electricity transmission and where we are with RIIO ED2.”

Earlier this month, Ofgem published indicative figures for the cost of equity for the RIIO ED2 price controls, which begin two years later than the rest in April 2023. Although Ofgem’s rates for the cost of equity and allowed returns on equity were 0.1 percentage points higher than for the other sectors at 4.65 per cent and 4.4 per cent, Young said they were derived from the same methodology, only with updated market values.

“If I was Ofgem,” Young posited, “I would probably think: Well, hang on a minute. One of the things that I’ve been doing is cross-checks from the CAPM [capital asset pricing model]. The problem with some of those cross-checks is they were disappearing into the dim and distant past because they were a while back before the narrative toughened.

“And now somebody pays a significant premium, so if I’m sitting in Ofgem, I’m probably thinking: Thank you very much. This a big, big help in terms of the arguments that we will be putting down… when the CMA starts the evidence gathering process.

“It’s got to be 100 per cent nailed that Ofgem is going to use what National Grid has offered to pay for WPD in the evidence it submits to support its view of the cost of equity.”

Young said it was partly for this reason that he was surprised National Grid made the offer for WPD: “It makes it more difficult to try and push your claims around the cost of equity.”

Nevertheless, Young said he does see the logic in pivoting towards power: “If you think about decarbonisation and the road to net zero, you by and large know how you’re going to do the power side of things. You know what you’re going to do with small scale transportation – electric cars, electric vans etc. Cars and vans are a significant proportion of the CO2 emissions from road transportation.”

“The bit where there’s a bit less visibility is around heat, but in the here and now what are the alternatives to gas heating? It’s air-source heat pumps and ground-source heat pumps, so electrification of heat.

“That might not be all heat in the future, but you know there’s going to be a reasonable amount of electrification of heat so putting your bets down on electrification and wanting to shift your focus away from gas and onto electricity is a sensible strategic thing to do.”

Putting a price on gas transmission

As part of the deal announced last week, National Grid will also sell the Rhode Island based Narragansett Electric Company to WPD’s US owner PPL Corporation for $3.8 billion (£2.7 billion). National Grid said it planned to cover the remaining £5.1 billion for WPD using bridging loans that would be repaid following the sale of a majority stake in its gas transmission business.

National Grid did not give a more precise figure for what proportion of the business it intends to offload and Pettigrew denied that it marked a full withdrawal from the sector, stating that the group is still interested in the potential to develop hydrogen and carbon capture and storage networks.

However, Young said: “Given the equation that they’ve presented whereby it was swapping two assets for one asset; that equation as a swap only really works if you do 100 per cent.”

He estimated that National Grid could expect to command a 29 per cent premium over the forecast £6.5 billion regulatory asset value (RAV) of its gas transmission business in March 2022, selling the company for an equity value of £4.5 billion: “If they sold the lot, the whole thing, give or take, pretty much washes its face in terms of money in, money out.”

“Now, that might not be the way to maximise the value of what you are trying to sell because of all of the uncertainties about the future of gas in this country,” he added. “You probably want to keep a bit to effectively hedge your bets, so to speak, until such time that we get better clarity around exactly what are these opportunities and the optionality for a gas business.”