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Energy price cap threat to earnings re-emerges

The impact of a cap on prices would place energy groups' margins under pressure
April 27, 2017

Just when energy suppliers thought they had escaped the prospect of a price cap on bills, along came the general election. Speculation the Conservative manifesto would include a price cap on standard variable tariffs (SVT) was confirmed by secretary of state for work and pensions Damian Green in a Sunday television interview. "There will be a lot about energy prices in the manifesto. People feel that some of the energy companies have taken advantage of them," he said.

IC TIP: Hold at 201p

Energy market regulator Ofgem would set the limits of the cap, making it more flexible, Mr Green said. "It would be able to reflect market conditions so the market would still have an influence," he added. A spokesperson for Ofgem declined to comment.

The Conservative manifesto is expected to be published next month. A spokesperson for the party said: "Our manifesto will be announced in due course - but you can expect us to be introducing new policies in this area. We are prepared to intervene when markets are not working for ordinary working families and that is certainly true for expensive and unfair standard energy tariffs." The announcement sent shares in energy giants Centrica (CNA) and SSE (SSE) down 5 and 4 per cent respectively during the first day of trading following the announcement.

Action on prices looked less likely following the release of the Competition and Markets Authority's (CMA) review of the energy Market. The CMA made fairly benign proposals compared with the regulation of supply margins some feared. However, political pressure has been mounting as five of the 'big six' energy suppliers raised prices this year. Centrica is the only one that hasn't, imposing a price freeze until August. The Department for Business, Energy and Industrial Strategy is expected to publish a green paper in coming months on protecting consumers, which is thought could include an energy price cap.

A spokesperson for Centrica said: "We do not believe price regulation is in consumers' interests. With over 50 suppliers and huge choice, the energy market is now highly competitive. Price regulation will result in reduced competition and choice, stifle innovation and potentially impact customer service." He added average dual-fuel bills increased by 3 per cent a year over the past decade, a total of £273. This consisted of a transmission, distribution and metering cost of around £150 and environmental and social policy costs of £100. Energy costs have not risen.

The spokesperson continued: "Our profits have been flat to slightly falling. Increases have been because of the costs of changing the energy system and policy costs, not profiteering from suppliers."

 

Significant risk to companies

With large exposure to SVTs, the potential impact on Centrica and SSE would be material. Assuming a reduction in average SVT bills of around £100 - as has been suggested in media reports - analysts at RBC Capital Markets estimate a potential 30 per cent full-year 2018 drop in EPS for Centrica and 20 per cent for SSE. This in turn would push dividend payout ratios to around 100 per cent, potentially threatening payout levels. However, they admit this is a basic estimate assuming a worst-case scenario. Sharepad puts Centrica's dividend cover at 2.6 times at the end of 2016, with SSE at 1.6 times at the end of September.

The average pre-tax profit margin of a big six supplier was 4.04 per cent in 2015, according to Ofgem (see chart below). This results in a pre-tax profit of £47 on a dual fuel bill of £1,165 annually. On that basis, a £100 drop could push some energy groups into losses. However, Berenberg analysts noted reports that said a cap on SVTs would be relative to the lower-priced tariff on offer. This would likely lead to the lower tariffs rising.

The potential impact of a cap on energy prices is large, but very little is known about how the policy would work and - in any case - it would take time to be implemented. Nevertheless, the risks to the earnings of energy suppliers has increased. This is particularly the case for Centrica, which has been increasing investment on its customer-facing businesses since 2015. We move buy tip (226p, 23 Mar 2016) Centrica to hold, as we await policy details.

 

The average dual fuel bill contains many costs