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FTSE 350: Regulatory screws to tighten on utilities

The prospect of price controls has weighed heavily on energy companies for the past few years, but 2018 could be the year these become a reality
January 25, 2018

The story of the energy sector over the past few years has been driven by two themes: regulation and competition. Complaints about the cost of energy and a decline in the wholesale costs of electricity and gas have translated into political pressure to reduce bills, which is frequently met with efforts to increase competition. As a result, the number of suppliers providing gas, electricity or both has grown sharply from 11 at the end of 2007 to 60 in mid 2017, while political pressure to introduce some form of price cap has been growing – albeit with brief breaks – since before the 2015 general election.

Last year saw the proposal of a draft cap on energy prices, a temporary measure lasting until 2020, with the possibility of an extension until 2023, in the wake of a government review into energy prices. 2018 looks likely to bring yet more push-back from the energy providers against the proposals, in attempts to moderate or waylay entirely any further pricing regulations.

We have already seen a little of this, with SSE (SSE) and RWE proposing spinning out their household consumer-facing businesses into a separate entity and Centrica’s (CNA) policy proposals to scrap the standard variable tariff – the default plan for customers that is causing so much consternation. These moves should be seen merely as opening salvos, as groups operating in the sector are unlikely to take market reforms lying down.

Alongside this, energy companies are likely to continue to explore other avenues of growth. Centrica has been investing heavily in its distributed generation and power division, while SSE is investing in wind farms and other renewable assets, while also trialling demand management technology to allow it to manage its networks more effectively.

The big difference in 2018 will be an extension of the regulatory and competitive pressures suffered by the energy sector to the water companies. September 2018 is the deadline for water utilities to submit their business plans for the next regulatory period – known as AMP 7 – which will begin in 2020. As is often the case, there has been loud demand in the media for tighter regulation of the water sector. With high-profile failings on leakage and damning research on the failings of the sector since privatisation released during 2017, regulator Ofwat appears more eager to take action.

This has culminated in Ofwat adopting the toughest ever weighted average cost of capital in its methodology for the next period. The tougher methodology will force companies to pass more savings on to consumers. However, it also allows for higher rewards for ‘exceptional’ or ‘fast-tracked’ business plans in the form of higher returns on regulated equity, making the success of companies’ plans – and similarly their performance this year – pivotal for their returns over the coming cycle.

Taking a longer-term view, it is worth noting that the methodology also indexes consumer bills against CPIH – a measure of consumer price inflation that accounts for housing costs, and is typically lower and less volatile than the retail prices index (RPI). As it stands, all three of the major listed water utilities have dividend policies that aim to grow payments by RPI, or RPI plus 4 per cent in the case of Severn Trent (SVT) and Pennon (PNN). If their earnings are no longer growing in line with RPI, it may become difficult to drive dividend increases at the same level.

In a further parallel with the energy sector, water companies are facing greater competition in the form of new suppliers entering their markets. Early last year the non-household water supply market was liberalised, allowing it to operate in much the same way as retail electricity and gas. As the number of suppliers grows, the big players may find themselves losing customers just as the energy suppliers did. So far, however, this has not been the case, with Pennon even growing its customer numbers. It also bears mentioning that non-household supply accounts for a relatively small part of the water companies’ operations.

Future growth for the water companies may come from the waste sector. As landfill capacity falls, companies and individuals will come under increasing pressure to recycle or reuse much more of their waste. Pennon and Severn Trent both have divisions working on areas such as waste management, anaerobic digestion and renewable energy. These seem likely to become much more important in future.

CompanyPrice (p)Market value (£m)PE ratioYield (%)1-year change (%)Last IC view
Centrica1427,9248.58.5-34.8Sell, 138p, 29 Nov 2017
Drax Group2691,09450.92.0-12.8Hold, 318p, 24 July 2017
National Grid87929,72212.76.0-3.3Buy, 912p, 10 Nov 2017
Pennon Group7623,19620.64.8-3.8Buy, 768p, 28 December 2017
Severn Trent2,0854,926183.9-2.9Hold, 2,125p, 27 Nov 2017
SSE1,31913,37917.87.0-11.6Buy, 1,393p, 08 Nov 2017
United Utilities Group8155,557134.8-8.7Buy, 783, 23 Nov 2017