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FTSE350: Regulatory change looms over utilities

What happens in 2019 will set the stage for the utility sector's returns for years to come
January 24, 2019

Many of the utilities hold a somewhat monopolistic position in their markets, making regulation an essential determinant of their fortunes. Significant regulatory changes are on the cards for both the water and energy companies, and while the main shifts will not come into effect until the next decade, 2019 will be a pivotal year for dictating the sector's outlook.

Pennon (PNN), United Utilities (UU.) and Severn Trent (SVT) presented their business plans to Ofwat in late 2018, and are now waiting for them to be classified. For the companies, the sooner the response, the better. The UK's water regulator will publish initial assessments in January, followed in March and April by early draft determinations for plans it deems ‘exceptional’ or ‘fast track’, which have higher allowed returns. Companies whose plans are graded ‘slow-track’ or ‘significant scrutiny’ will have to submit revisions in April ahead of determinations in July.

Energy regulator Ofgem is also currently consulting on RIIO-2, a piece of price control regulation that will affect distributors such as National Grid (NG.) and SSE (SSE). Shares in both companies were hit in late 2018 when the regulator proposed capping returns at 3 per cent in RPI terms – the bottom of the range it had suggested earlier in the year. Such a rate would mean a cut of about 50 per cent in baseline returns from their current levels. This prompted fears over the sustainability of National Grid’s dividend, although the group said its payout policy remained unchanged and noted the regulator’s consultation is still in the early stages. RIIO-2 does not come into effect until 2021.

Elsewhere, Centrica (CNA) has taken up arms and is mounting a legal challenge against Ofgem’s decision to change the period within which wholesale prices were used to set the cap, which resulted in the cap being set at a lower level. The group has long been vocal in its opposition to the threshold, and chief executive Ian Conn has previously questioned whether the Conservative government believes in free markets. Such ire is understandable, given Centrica is more exposed to the UK consumer market than many of its listed rivals, although it's unlikely many voters will share Mr Conn's views.

Where Centrica is seeking to oppose the government, rival SSE had been attempting to move out of the market by combining its household business with that of Npower to create a new household supplier. However, the deal fell apart in late 2018 after management concluded the new company would be unable to meet collateral requirements. The group is now looking at other options.

The cap is part of a two-pronged attempt to improve the energy market for customers, the other prong being increasing competition, which has contributed to an alarming rise in small supplier failures in recent months. Eight small suppliers failed in 2018, and already in 2019 Economy Energy has ceased trading. In response, the regulator is planning to tighten entry requirements for suppliers entering the market, which could breathe some relief into the incumbents. There is also growing pressure on government and regulators to make a competitive market solution work for customers and providers, especially while the Labour opposition continues to loudly advocate for nationalisation of energy, water, rail and the Royal Mail Group (RMG).

 

NamePrice (p)Market cap (£m)12-month change (%)Trailing PEForward PEDividend Yield (%)Last IC View
Centrica134.757,676.21-5.3711.311.18.91Sell, 133p, 23 Nov 2018
ContourGlobal183.81,232.77-34.8216.510.31.68Buy, 234p, 07 Aug 2018
Drax4101,613.1141.4839.513.93.17Buy, 357p, 03 Jan 2019
National Grid795.127,113.4-5.7514.113.65.85Hold, 796p, 24 Dec 2018
Pennon755.43,175.981.4814.113.15.22Buy, 765p, 27 Nov 2018
Severn Trent1,9294,574.91-4.614.313.94.63Buy, 1,897p, 23 Nov 2018
SSE1,12611,558.81-16.115.511.48.49Hold, 1,169p, 14 Nov 2018
United Utilities 8085,509.664.3715.514.54.98Hold, 754p, 21 Nov 2018