Rising interest rates leave debt-laden utilities exposed

Analyst Nigel Hawkins examines the impact of the current macroeconomic environment on major utilities and warns of tough decisions ahead for a highly-geared sector.

The last month has seen major turbulence in both the UK political and financial arenas. With the government’s economic policy in serious disarray, the focus is moving to the pronounced downside of far higher inflation and rising interest rates – and their impact on mortgage payments.

More specifically, financial markets are watching the pivotal 10-year gilt yield – regarded by top Treasury officials as sacrosanct – like a hawk. Its yield has more than doubled in just two months from below 2% to 4%.

And, even if the impact of Einstein’s eighth wonder of the world (compound interest) is disregarded, this very sharp increase has a pronounced impact for UK companies, including highly geared utilities.

Over the same two-month period, utility yields have risen noticeably. In the case of National Grid, its prospective yield in early August was 4.4%; at the time of writing, it is 5.7%.

Alarmingly, too, its share price has fallen by over 17% in the past month – an unprecedented decline since its flotation in the mid-1990s. The fact that it is currently carrying net debt of almost £43 billion is surely very  relevant.

Recent market movements suggest there will be renewed efforts by utilities to lower their debt levels, especially with further interest rate increases anticipated.

After all, going back to the original privatisation model in the late 1980s and early 1990s, low debt was very much to the fore. In recent decades, gearing up came into vogue, especially after the financial crisis of 2008/09 when ultra-low interest rates became the norm.

In the case of Thames Water, for example, its latest gearing figure – based on net debt divided by its Regulatory Capital Value (RCV) – exceeds 80%; this figure is well above Ofwat’s assumed ratio.

Furthermore, higher borrowing costs are bound to have a negative impact on dividend growth – although less so in Thames’ case, since it has not paid a dividend to its external investors for over five years.

After all, higher interest costs will reduce a utility’s earnings per share and therefore lower dividend growth prospects. More specifically, shares in leading power stocks have fallen of late. In National Grid’s case, its recent share price plunge means that cutting its near £43 billion net debt will assuredly become a priority.

By contrast, SSE’s latest net debt figure is below £9 billion – its market capitalisation is currently around half that of National Grid. Furthermore, while SSE has an annual £2.5+billion capex programme, it is due to be partly funded by the planned sale of a 25% stake in its electricity networks division.

Importantly, SSE is facing a key pricing review of its electricity distribution business, which accounts for around a fifth of its operating profit: the eagerly awaited final determination is expected near the year end.

SSE’s R110-ED2 determination, along with those for other electricity distribution companies, will be scrutinised well beyond the walls of its head office since Ofgem’s pivotal Weighted Average Cost of Capital (Wacc) figure should take full account of the latest upward movements in interest rates.

Elsewhere in the electricity sector, it seems inevitable that further cost increases, including the impact of higher interest rates, will push the projected bill for Hinkley Point C to well above the latest £25-26 billion estimate.

Raising equity

Given the undoubted pressure on balance sheets, questions are bound to be asked about future rights issues, which historically have been quite rare, especially among the water companies.

In fact, in the electricity sector, it has been the smaller quoted Renewable Energy Infrastructure Funds (REIFs), of which there are now 22, which have been prolific in regularly raising new equity.

Since January 2020, just before the start of the Covid-19 pandemic, REIFs have raised £7 billion of new equity, the vast majority of which has been earmarked for investment in renewable energy projects, including wind and solar generation, as well as in battery storage schemes.

On the water front, somewhat different criteria apply.  As always, most focus will be on the next periodic review, which is due to apply as from April 2025. The recent rise in interest rates – unless they are reversed – will presumably be reflected in the Wacc that Ofwat assumes for the review.

For the 2020/21-2024/25 period, Ofwat’s final determination was based on a (RPI-stripped) Wacc of 1.96%, calculated on the basis of an allowed debt return of just 1.15% and an allowed equity return of 3.18%.

Water companies will certainly expect a higher figure for the former, which – due to an assumed gearing ratio of 60% – is the more important determinant of consumer prices. As things stand, the much-vaunted efforts to reduce water charges from 2025 seem unlikely, especially with increasing political pressure to tackle leakage levels and to cut the seemingly routine storm overflow discharges into inland waters.

The challenges facing the water sector are illustrated by the unquoted Thames, which boasts 15 million customers. Its private equity ownership model has resulted in a massive gearing-up exercise, with net debt now reaching £12.9 billion – a very chunky number in an era of rising interest rates.

In 2021/22, Thames reported a £230 million increase in the RPI accretion on its borrowings – a period when inflation had barely taken off. This year’s figure seems set to be appreciably higher. After all, Thames has a sizeable portfolio of inflation-linked bonds, whose financing costs will presumably have risen sharply of late.

While Thames’ finances are complex, especially with regard to the various swaps and hedging arrangements, it seems clear that materially higher interest rates will lower its returns: Thames’ financial expenses in 2021/22, increased by the RPI accretion, were £384 million (net).

In its 2021/22 annual report, Thames confirmed that: “If we are unable to adapt our cost base to rising inflation or interest rates, this could result in a re-prioritisation of investment and reduced service levels, impacting customer services and operational performance.” Not a message that politicians, Ofwat and Thames’ customers want to hear.

Floating debt

United Utilities, whose shares have plunged by 18% over the past month, is also exposed to materially higher interest costs, due partly to its disproportionate reliance on floating debt, which accounts for almost 60% of its total net debt.

The company recently confirmed it had bonds of £4.3 billion, which are linked either to movements in the RPI or the CPI. Its recent pre-close statement acknowledged that there was an adverse impact from this exposure.

The UK’s top gas player, Centrica (now a shadow of its former self), has suffered many setbacks in recent years: its shares are now worth just £4.2 billion, which is less than one-fifth of their 2013 value.

And while there are no certainties in today’s utility world, it can be safely assumed that Centrica will not be acquired by Russia’s Gazprom, which was widely mooted some years ago.

In fact, on the debt front, Centrica is now very well positioned, with a net cash balance of £316 million at June 2022.

Over the past two decades, private equity has unquestionably figured very prominently in the UK market: rising interest rates will not be conducive to the continuation of this trend. While it is premature to sound the death knell of private equity, some recent deals, such as the acquisition of the Morrisons grocery business, have attracted strong criticism.

In fact, many privatised utilities are owned by private equity consortia, who may well be faced with markedly lower financial returns and, in some cases, with demands for further equity injections: Thames is believed to be seeking substantial additional funds from private sources.

As such, fewer highly geared private equity bids are likely, because projected returns may fall while raising the necessary finance to complete such deals may become progressively harder.

Challenging times indeed for all utilities – watery or otherwise.

As the legendary singer, Billy Ocean, concluded – when the going gets tough, the tough get going.

Nigel Hawkins is the utilities analyst at Hardman and Co, which undertakes investment research