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FTSE 350: Electricity providers battle political headwinds

The big electricity producers are trying to negotiate political and regulatory uncertainty as the general election approaches.
January 29, 2015

The debate around the cost of living and rising energy prices rumbled on in 2014. When Labour leader Ed Miliband promised to freeze energy prices in 2013, bosses at Centrica (CNA) and SSE (SSE) were not best pleased. Yet just six months later the latter announced it would freeze prices until at least January 2016, warning that its profit margin in domestic energy supply would suffer as a result.

As wholesale energy prices have started to fall, Mr Miliband has rebranded his freeze a "cap" and argued for regulatory powers to force providers to cut bills. Shares in Centrica and SSE duly took another knock. Yet Angelos Anastasiou, utilities analyst at Whitman Howard, believes Centrica's underlying financials are still sound, while SSE's spread of business between renewables, wires and pipelines as well as supply "provides safety but also upside".

It is not just political meddling that Centrica and SSE had to battle last year: milder than expected weather also hit the companies' numbers. In September SSE's management admitted adjusted EPS for 2014-15 would be towards the bottom of the range set out in March, which effectively pegs it back to the level seen in the previous year. This casts in some doubt the sustainability of the group's target range for dividend cover of 1.5 times earnings. Shortly after, Centrica announced that full-year adjusted EPS would be 19-20p rather than 21-22p as hoped at the time of its interim results, due to warmer conditions during the second half - the company's third profit warning during the year.

Even beyond the domestic energy market, political uncertainty was a recurring theme within the sector last year. In December, the Department for Energy and Climate Change announced it would consult on whether to remove subsidy guarantees from certain types of biomass projects. The news sent shares in Drax Group (DRX) plummeting. The group is in the process of converting three of its six units from coal to biomass-burn. These are unaffected by the consultation, but the announcement has cast doubt on a potential fourth conversion.

In another party-political move, the prime minister pledged to end subsidies for new onshore wind farms, should the Conservatives gain a majority in May's general election. During the following month, shares in wind, hydro and landfill gas (LFG) producer Infinis Energy (INFI) dropped 12 per cent. However, the group posted half-year pre-tax profit growth of just over 150 per cent, largely driven by the strong performance of its LFG business. But this business is in decline, and if Cameron wins a mandate to make good on his promise, it could cast a shadow over Infinis' long-term strategy to diversify away from LFG.

National Grid (NG) had a good year. It pushed on with its agreement with Norwegian grid operator Statnett to build a subsea power line, which would allow the UK to import hydroelectric power. The project could also be used to send excess wind power produced by UK turbines to Norway, which Statnett would sell on to other European countries.

The grid operator rounded off the year by hosting the first capacity market auction. Companies running the existing capacity of nuclear, gas and coal-fired power stations bid for annual subsidies in return for guarantees that they will make their stations available during peak periods of demand. The market will be operational for the first time during 2018-19. However, analysts predicted that the lower-than-expected clearing price of £19.40 per kW would end up having a negative impact on some providers' earnings.

Prospects for dividends depend partly on the outcome of the Competition and Markets Authority's (CMA) investigation into the supply sector. The CMA is expected to deliver its initial findings at the end of January or beginning of February, with its final report to be published at the close of the year. That should bring investors some clarity on the future path of a sector that has long been more popular with investors than consumers. But it's hard to envisage the companies making any real strategic progress until the general election is out of the way.

CompanyPriceMarket ValuePERDividend yield1-year performance (%)Last IC view
Drax Group358.11449.6713.33.8-55.4Sell, 462p, 17 Dec 2014
Infinis Energy190.5571.5114.86.68-27.29Buy, 228p, 18 Nov 2014
SSE 150414853.8640.35.812.24Sell, 1,544p, 12 Nov 2014
Centrica269.413385.7612.16.38-16.44Hold, 286p, 26 Nov 2014
National Grid932.835075.5316.34.5317.78Buy, 919p, 10 Nov 2014

Favourites

With no energy supply business, National Grid is unaffected by the volatile political climate. The company's numbers were also running ahead of consensus estimates at the half-year mark, when it turned in adjusted pre-tax profits of £1.14bn - up 16 per cent on the previous year. Beyond the FTSE 350, Aim-listed Indian renewable energy producer Greenko (GKO), which has benefited from the country's thirst for greater energy capacity and prime minister Narendra Modi's reforms, also looks a good bet. Having lost a fifth of their value since October, the shares now trade at 10 times 2016 earnings.

Outsiders

Shares in Drax Group are now down 37 per cent since the government's initial announcement on biomass. There is still too much uncertainty around the government's stance on biomass, which could affect future conversions, for us to call a recovery. The company's coal business also has to deal with the rising cost of carbon taxes, which trebled during the first half.