The curse of energy retail

Energy retail margins are tiny, but being in retail makes the big six fair game for angry politicians. Might the big energy companies be better off simply exiting the retail sector? Nigel Hawkins reports.

The big six energy companies, and especially UK-based Centrica and SSE, are currently taking a lot of political flak. It is a scenario that seems unlikely to change as the general election approaches in a year’s time.

Given their large retail base, both companies are vulnerable as politicians, especially Labour leader Ed Miliband, take aim at the unpopular utilities. Undoubtedly, the promise of cheaper energy bills from an elected Labour government will ring true to many disillusioned voters.

Utilities are now replacing bankers as public enemy number one. Since the 2008 financial crisis, banks, such as the hapless RBS, have been hammered in the court of public opinion. Worryingly for investors, utility share prices are now being adversely affected, most notably that of Centrica, which has just announced a profit warning due to mild weather in the UK and some dreadful weather in the US.

Importantly, too, it has put up for sale three gas-fired power stations. Its recent generation returns from these plants were profoundly disappointing.

However, it is Miliband’s pledge to freeze energy prices for the first 18 months of a Labour government that has depressed Centrica’s share price as analysts slash profit forecasts on the basis of reduced margins. This analysis is being replicated throughout the food retail sector.

While SSE is also vulnerable, it has substantial generation earnings. However, it also faces September’s independence referendum, which raises very different issues, most of which are unprecedented, although the establishment of the Irish Free State in 1922 provides a precedent of a sort.

Undoubtedly, recent political intervention is closely related to the fact that utility customers are also voters. Given this apparent curse of retail exposure, it begs the question as to whether Centrica and others should reduce their retail activities, or indeed exit the market completely.

In the latter scenario, complex legal issues would no doubt arise.

Discerning investors will have noticed how National Grid – without a retail base – has escaped virtually all political criticism. Its share price performance has been impressively robust, especially with its
UK regulated revenues effectively locked in until 2021.

Outside the energy utilities, the oil sector provides probably the closest analogy to the branding issues currently affecting retail-facing utilities.

Shell’s activities rarely become high profile, unless petrol prices are involved. In fact, Shell makes minimal profit from petrol forecourt sales, perhaps 2p per litre. Similar comments apply to BP, or at least did prior to the disastrous blow-out in the Gulf of Mexico.

If both companies sold or closed all their petrol stations, would their finances and share price suffer significantly?

For UK utilities, this issue most affects Centrica. Back in 1997, when the then British Gas was split up, Centrica was allocated the retail customer base – and, crucially, the legal right to use the British Gas name in the UK. Given the deep-seated safety concerns of millions of gas users, this name undoubtedly conveys a potent symbol of trust, which is heavily endorsed on television.

To bolster its balance sheet, the compnay also got both major Morecambe Bay gas fields.

Today, the branding benefits of being British Gas are being progressively eroded by aggressive hard-nosed politics.

Of course, Centrica could seek to change the British Gas name, but given its embedded technical reputation, this is unlikely to work. Recent name changes, such as Consignia for Royal Mail, did the latter few favours.

On the financial front, Centrica’s profit margins will come under real scrutiny if a Labour government is elected, and an eighteen-month price freeze could be extremely damaging, especially if gas input prices, for whatever reason, were to rise.

Aside from Norway and the US, where Centrica has signed up to long-term contracts, the largest overseas gas suppliers are the Middle East, North Africa and Russia, none of which are known for political stability.

Interestingly, though, Drax Power provides a template of sorts as a generator operating purely on a B2B basis. Drax itself has not escaped political controversy of late due to its questionable – and very expensive – biomass conversion policy.

In any event, having recently confirmed that three of its gas-fired stations are up for sale, Centrica does not seem disposed to rely on improved UK generation returns.

In its 2013 full-year figures, Centrica confirmed an underlying operating profit of almost £2.7 billion, of which £571 million – 21 per cent – was attributable to its UK residential energy operations. But its highly rated energy business, despite a £133 million loss on gas-fired generation, contributed over £1.3 billion. On its own, this latter division would presumably attract an enhanced price/earnings rating.

Nonetheless, Centrica still needs the cashflow from its UK retail operations. However, this does not mean that the status quo will necessarily endure, especially if margins are slashed following the general election.

Moreover, Centrica is expected to lose market share, either voluntarily or compulsorily, depending on the Competition and Market Authority’s (CMA) conclusions. It could pre-empt these likely recommendations by selling parts of its UK retail operations.

For SSE, generation remains the key driver. This division faces major uncertainties, not least September’s referendum. However, the company is the target of less political flak than Centrica and is better placed to ride out sustained criticism or adverse CMA recommendations.

The four other big six members are foreign-based, so they are less financially exposed to major reverses in the UK. Nonetheless, some are clearly disenchanted with the seemingly endless political intervention – a fact shown by the current modest level of generation investment in the UK.

Selling its energy supply business would clearly be an option for each big six company, but becoming more reliant on UK generation may not seem a particularly attractive option at present.

The “nuclear option” would, quite simply, be full market exit and tacit admission that the UK utility kitchen has become too hot in which to operate. RWE, which is facing fundamental strategic challenges in Germany, is the most likely of the big six to adopt one of these radical options.

Where all this leaves the paramount need to invest more than £100 billion in the UK electricity sector by the early 2020s is anyone’s guess.