Never a dull moment for these energy suppliers

Rising political risk

Discontent over rising energy bills has been brewing for some time, and Labour leader Ed Miliband provided the lightning rod recently with his pledge to freeze energy prices if he wins the next election. Shortly after, five of the so-called Big Six - Centrica's British Gas, EDF, RWE's npower, Iberdrola's Scottish Power and SSE - announced winter price hikes. E.ON is certain to follow. Bosses were hauled in front of MPs to justify the increases, and the political storm intensified when former Prime Minister John Major called for a windfall tax on energy company profits.

It's not hard to understand why when British Gas made an annual operating profit of £1.1bn. But it isn't that straightforward. Parent company Centrica took a £1.2bn tax charge last year and there was a net cash outflow from investing activities of £2.6bn, reflecting the acquisition of North Sea gas and oil assets. Just this month, Centrica confirmed a £4.4bn deal with Qatar to bring liquefied natural gas (LNG) into the UK. It has to service a net debt pile of over £4bn, too. All in all, Centrica reported a net increase in cash of £452m last year. Not bad, but how much of that can you lose before the company's creditworthiness and dividend paying ability take a hit?

The Big Six argue that price rises are driven by factors mostly beyond their control such as wholesale energy costs and environmental and social levies. And many City analysts believe targeting energy company profits is the wrong approach. "Criticising retailers may be politically popular, but we believe retail margins at under 5 per cent are the wrong target if sustained consumer benefit is the aim," say utilities analysts at UBS.

Indeed, British Gas, the UK's largest residential energy supplier, was losing money before it put up prices. Last year, only 4 per cent of a British Gas customer's energy bill was profit for the company. If that is not a politically acceptable margin, then is it even a business anyone would want to be in? E.ON UK chief executive Tony Cocker took the unusual step of actually asking for a Competition Commission enquiry into his own industry in an attempt to demonstrate the price rises are fair.

Green taxes may take the heat off for now

Until the next election, at least, the coalition is in control of energy policy. And it has clearly settled on a more dovish approach than Mr Major's proposal. Remember, the government needed to keep one of the Big Six - EDF - on side, given its pivotal role as just about the only company willing to build the UK's new fleet of nuclear power stations. Having just agreed to pay the French utility double the current electricity price for energy it produces at Hinkley Point C, the UK government seems unlikely to want to jeopardise the deal with a punitive windfall tax. And EDF applied direct political pressure this week, with its smaller-than-expected price rise accompanied by a warning that further increases would be necessary if the government failed to cut green taxes.

And it does appear that the current government's real target is green energy taxes, rather than energy company profits. Green levies, which the Big Six pass on to customers, help pay for investment in low carbon energy generation and energy efficiency improvements to homes. In fact, environmental and social policies accounted for 9 per cent of every British Gas bill last year, and these levies are expected to grow rapidly over the next few years, putting further upward pressure on energy prices.

Another prong in the Tory attack is an ambitious attempt to cut the time taken to switch energy suppliers from around five weeks currently to just a day. If they pull it off, that should benefit the likes of First Utility, the UK's largest independent energy company. It's promise of no winter price rises has already attracted thousands of new customers, including one Mr Miliband. At present, First Utility's market share is about 2 per cent, but faster switching could create a serious challenger to the Big Six.

Share prices off the boil

Fair or not, the political storm over energy bills shows every sign of becoming a defining issue at the next election. It has already had a detrimental impact on Centrica and SSE's share prices (see table), and rising political risk may have other unintended consequences, too. "Market perception of political interference will have already pushed up the cost of capital of the sector," warns Angelos Anastasiou, utilities analyst at Whitman Howard. Ironically, this could lead to the very thing that the politicians say they are trying to avoid - higher energy bills. That is because energy companies need to raise money to invest in new generation assets, and with talk of price controls and windfall taxes, lenders to energy companies will want a higher return to balance the risks.

And the critical question here is what does all this mean for dividends? Politicians have so far failed to address the question, but if, as they claim, the Big Six are not making excess profits, paying for windfall taxes or price caps would surely threaten those juicy payouts. Any attack on dividends could have unpalatable consequences for the pension funds that own these core income stocks.

For now, at least, the dividends keep coming. SSE's main financial objective this year is to increase the dividend by more than inflation, and first-half results this week made that more likely. SSE's first-half dividend rose 3 per cent despite a 12 per cent drop in adjusted pre-tax profit and losses at the retail business driven by higher costs.

Centrica, meanwhile, increased its interim dividend by 6 per cent in July. The company is due to update on trading as we go to print, but first-half adjusted profit after tax rose 2 per cent to £767m - British Gas profits were roughly flat as higher costs broadly offset the positive impact of increased gas consumption and prices. But the oil and gas production arm, Centrica Energy, which accounts for roughly half of group profits, did far better with 16 per cent growth in adjusted cash profits.