After a heady cocktail of regulatory change and uncertainty for UK energy companies during the past two years, 2017 should be calmer. Famous last words, perhaps, but bosses at energy giants Centrica (CNA) and SSE (SSE) were surely relieved at the relatively benign outcome of the Competition and Markets Authority’s (CMA) investigation into the energy supply market. Energy suppliers swerved a cap on the price level of their default tariffs, with the regulator instead recommending a transitional price cap for the 4m customers on pre-payment meters.
That’s not to say that UK energy companies are not still feeling the effects of the regulatory changes ushered in under the previous government. Renewables policy has been a particular source of upheaval following the government’s decision to scrap some companies’ climate change levy exemption certificates (LEC), effective last year. This has caused particular pain for Drax (DRX), which has converted half of its generation units to burn biomass. During the six months to the end of June, the decision contributed to a £50m reduction in adjusted cash profits.
There was better news in December after the European Commission approved state aid funding, through a contract for difference (CFD), for the conversion of the company’s third biomass unit – removing some uncertainty for would-be investors, and directors. This approval was a condition of management’s decision to push ahead with its £340m acquisition of small business energy supplier Opus Energy.
Despite the previous government’s removal of LECs, renewable energy generation is only set to become more important. SSE has set aside a record £1.85bn for capital and investment expenditure this year and renewables will play a significant role in this. In fact, around £5bn of its target £6bn capital expenditure between March 2016 and 2020 has been committed predominately to government-mandated renewable projects. Management also intends to direct £100m of the proceeds of its sale of a 16.7 per cent stake in its Scotia Gas Networks business to the construction of the 225MW Stronelairg wind farm. The importance of renewable generation was evident as a reduction in the production of this type of power weighed on wholesale profits during the first half of the financial year.
Meanwhile Centrica will continue to shift its gaze from energy generation towards its consumer-facing businesses. Management is targeting annual savings of £750m by 2020, and operating cash flow growth of between 3 per cent and 5 per cent. The British Gas owner is making good progress against these targets, with management recently announcing it expects to exceed its cash flow and adjusted earnings per share targets.
While National Grid (NG.) has generally managed to escape political interference, last year some MPs called for a break-up of the group on the grounds of a conflict of interest in it both owning and operating the country’s energy infrastructure. However, Ofgem recently decided against breaking up the group. Instead it will establish an independent systems operator, which will sit within the group structure but have a separate licence, offices and staff.
For the UK-listed water companies, 2017 looks likely to be more of the same. Pennon's (PNN) waste management business, Viridor, is continuing its investment in energy recovery facilities (ERF), which extract energy from non-recyclable residual waste, committing to its 12th facility at Avonmouth last year. The group will invest £252m in the site, which will be completed by 2021. The shift from landfill to ERF has turned around the previously underperforming business and management expects the company to make £100m in cash profits in the year ending March 2017.
We are now a year into the AMP 6 regulatory period, which runs until 2020. Severn Trent (SVT) has so far secured £540m of the £670m operational efficiencies targeted in its business plan to be captured by the end of this period. What’s more, management expects to generate £15m in regulatory rewards for the year ending March 2017, as a result of outperforming its incentive targets. United Utilities (UU.) is also making good progress against its AMP 6 targets. It achieved its best ever score on Ofwat’s service incentive mechanism, which bodes well for delivering against its regulatory incentives and gaining outperformance rewards.
| Price (p) | Market value (£m) | PE (x) | Yield (%) | 1-year change (%) | Last IC view | |
| Centrica | 229 | 12,580 | 15.1 | 5.3 | 11.7 | Buy, 229p, 15 Dec 2016 |
| Drax | 377 | 1,531 | 71.3 | 0.7 | 81.4 | Hold, 365p, 28 Dec 2016 |
| National Grid | 949 | 35,656 | 15 | 4.6 | 2.5 | Buy 920p, 14 Dec 2016 |
| Pennon | 791 | 3,274 | 21.4 | 4.3 | -8.3 | Buy, 822p, 28 Nov 2016 |
| Severn Trent | 2,236 | 5,270 | 19.3 | 3.6 | 8.0 | Hold, 2,209p, 15 Nov 2016 |
| SSE | 1,557 | 15,758 | 21.1 | 5.8 | 10.2 | Hold, 1,546p, 09 Nov 2016 |
| United Utilities | 898 | 6,120 | 14.3 | 4.3 | -0.9 | Buy, 901p, 24 Nov 2016 |
Favourites: National Grid remains our top pick among the utilities. As well as offering stable, index-linked returns in the UK via its transmission and distribution businesses, there are more pronounced growth opportunities in the US. There, it is focused on updating its regulatory agreements with the US authorities, increasing the level of capital investment and returns the company is allowed to make. As a result, around 40 per cent of its US business is operating under new frameworks. During the first half of the year, capital investment stateside increased by £39m to £1bn.
Outsiders: We are more favourable on Drax following the recent European Commission decision. Management’s plans to make the group an entirely renewable energy generator make sense, given the government’s aim to make coal generation obsolete by 2025. However, the fact that the CFD award was later than expected is likely to drag on cash profits. If the delay in the contract award has hurt earnings, the dividend could also suffer.
