National Grid charges up with £7.8bn electricity acquisition

National Grid (NG.) is betting big on an electric future. The group has agreed to acquire Western Power Distribution (WPD) – the UK’s largest electricity distribution business – from US utility PPL (US:PPL) for an equity value of £7.8bn.

At the same time, it has struck an agreement to sell its US Rhode Island-based electricity and gas business, The Narragansett Electric Company (NECO), to PPL for an equity value of £2.7bn.

Hailed as “transformational” by chief executive John Pettigrew, these transactions reflect a strategic pivot of National Grid’s UK portfolio towards electricity. The group says that “electricity distribution is expected to see a high level of asset growth as a result of the ongoing energy transition” and indeed, the government’s independent advisers at the Climate Change Committee estimate that UK electricity demand could more than double by 2050.

Power play

At present, National Grid owns the transmission network in Great Britain, transporting electricity from where it is produced at high voltages across long distances in England and Wales. Scottish Power and SSE (SSE) conduct these activities in Scotland.

But National Grid is not yet involved in the local distribution of electricity at lower voltages to homes and businesses. Six companies – including WPD – currently operate the distribution networks in England, Scotland and Wales, carrying electricity from the grid to end users.

As such, Pettigrew says that “the acquisition of WPD is a one-off opportunity to acquire a significant scale position in UK electricity distribution.” WPD serves around 7.9m customers across south west England, south Wales and the Midlands.

Underscoring the shift towards electricity, National is also looking to offload a majority stake in its UK gas transmission business, National Grid Gas (NGG), and will kick off the sales process in the second half of this year.

“Given the strategic nature of [this] business coupled with its central position in a transition towards a hydrogen economy…we expect strong interest when the sales process begins,” says Pettigrew.

While the price tag remains unclear, the group will likely be looking for a generous premium to NGG’s regulated asset value (RAV) of £6.3bn. It anticipates that the disposal will be completed in the second half of 2022.

National Grid has been reducing its exposure to gas, exiting gas distribution in the UK just under two years ago. Having initially sold 61 per cent of its Cadent gas business to a consortium of private equity players in 2017, it offloaded the remaining 39 per cent stake to them in 2019.

Now, the group is moving a step closer to pulling out of gas in the UK completely, which would leave it with just its gas distribution networks across the north eastern US.

Following the NGG sale and asset swap with PPL, the proportion of National Grid’s assets in electricity will rise from 60 per cent to 70 per cent. Analysts at broker Jefferies say that “given the energy transition shift to electricity, [this] is a strategically positive move in our view.”

Positioning for a greener future

As the UK looks to fulfil its ambition of net zero carbon emissions by 2050, natural gas is increasingly been viewed as a transition fuel. Hydrogen is being considered as a potential replacement, and by 2023 the government is aiming to be ready to blend up to 20 per cent of hydrogen into the gas distribution grid.

On the same day as announcing its strategic pivot, National Grid also said that it is exploring the creation of a “hydrogen backbone”, connecting the industrial clusters around the UK where hydrogen is expected to be produced. This could see around a quarter of the current gas transmission pipelines – around 2,000 kilometres – be repurposed to carry hydrogen.

But more so than hydrogen, what National Grid is trying to do is capitalise on rising electrification amid the shift to renewable energy and the anticipated electric vehicle (EV) revolution. Electricity distribution networks will be critical in ensuring there is significant capacity for EV charging, and WPD is preparing for more than 200,000 EV charging points to be installed across its network by 2023.

What about the all-important dividend?

The WPD acquisition – which requires the greenlight from shareholders and is expected to conclude within the next four months – should have little impact on National Grid’s balance sheet in the long-term. It will be funded by an £8.25bn bridge loan that will also go towards refinancing some of WPD’s debt, and this will be repaid using the proceeds from the NECO and NGG sales, as well as the issue of new bonds.

The NECO sale is conditional upon the WPD purchase going ahead and is guided to close by early 2022. It is also subject to regulatory approval.

National Grid says that the deals will “significantly” boost earnings from year one, and alongside the NGG sale, will continue to be accretive in the long-term. Jefferies is pencilling in a 6 per cent boost to EPS in 2023.

The group says that this will support its updated policy of growing the annual dividend in line with CPIH inflation from its 2022 financial year, versus at least in line with RPI inflation previously.

Analysts are anticipating continued dividend growth despite the prospect of lower allowed returns during the next five-year regulatory period – known as RIIO-2 – which commences in April. Ofgem has slashed the allowed return on equity from 7-8 per cent presently, to 4 per cent and 4.3 per cent for electricity and gas network operators, respectively.

While National Grid has decided to largely accept the regulator’s final determination for RIIO-2, it is lodging an appeal with the Competition and Markets Authority (CMA) over the proposed cost of equity and so-called ‘outperformance wedge’. SSE is also following suit. If the CMA decides to hear their case, a review will begin in April and take around six months to complete.

Both companies can draw comfort from the fact that the CMA has increased the allowed returns and cost of equity for four private water companies after they appealed regulator Ofwat’s final determination. On this basis, RBC Capital Markets analyst John Musk “continue[s] to see upside risk to returns in RIIO2”.

Musk also views National Grid leaning into electricity as “a positive step”, but says that investors will “first need to digest the high headline multiples on WPD” – the group is paying a 61 per cent premium to WPD’s projected RAV for the year ending 31 March 2022. As the market ruminated on the latest news, National Grid’s shares remained flat at 830p. While there is still some regulatory uncertainty, with a dividend yield of 5.9 per cent, the shares are worth holding onto.