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Should investors worry about National Grid ‘breakup’ threat?

The government and regulator Ofgem are considering whether National Grid’s role in balancing the UK’s supply and demand of electricity should be transferred to an independent body
Should investors worry about National Grid ‘breakup’ threat?
  • National Grid’s role as ‘Electricity System Operator’ (ESO) could be transferred to an independent body to avoid potential conflicts of interest.
  • The ESO was hived off into a separate legal entity in 2019 although currently remains part of the wider group.
IC TIP: Hold at 947p

The energy industry breathed a collective sigh of relief in December as the election of a majority Conservative government banished the spectre of nationalisation. But it appears that the trouble is not quite over for National Grid (NG.). According to a report from The Telegraph over the weekend, the government is mulling a potential breakup of the group to guard against any conflicts of interest in the push to achieve net zero carbon emissions.

What exactly would a ‘breakup’ entail?

The ‘breakup’ debate centres around National Grid’s role as ‘Electricity Systems Operator’ (ESO) – this means that it balances the supply and demand for electricity across Great Britain in real-time. MPs questioned more than four years ago whether the group could faithfully undertake these responsibilities without being influenced by the commercial interests of the rest of its UK business – as well as being the ESO, National Grid earns money from owning and operating the high voltage transmission network in England and Wales and is also developing subsea interconnector cables to import power from abroad.

Regulator Ofgem conducted a review of the ESO in 2017 and National Grid avoided a breakup by agreeing to make the ESO a legally separate entity with distinct employees, board and offices. The move was completed in 2019 and the ESO remains a part of the wider National Grid group.

Yet Ofgem is currently re-examining the setup and according to The Telegraph, support is growing to go a step further and take away National Grid’s ESO role completely. This comes as the UK has ramped up its commitment to decarbonisation and shift towards renewable power – as part of its ambition to reach net zero emissions by 2050, the government is aiming to have 40 gigawatts (GW) of offshore wind capacity by 2030.

Should investors be concerned?

The framing of this as a potential ‘breakup’ of National Grid seems to overstate the significance of what could happen. National Grid does not disclose how much revenue or profit its ESO activities bring in, but analysts at Jefferies estimate that they account for just 4 per cent of underlying operating profit and less than one per cent of the group’s regulated asset value. The broker therefore believes that any decision to separate the ESO would have “limited financial impact”. It does, however, caution that National Grid would have less visibility over the direction of net zero policy.

In response to the latest rumours, National Grid says that it “continues to work closely with the government, regulator and industry to explore what changes will be needed to achieve net zero, and the role of the ESO is an important part of that discussion”.

It remains unclear what structure a new systems operator would adopt or how National Grid shareholders would be compensated for the loss of the ESO. No final decisions have been made. “Ofgem is reviewing whether existing system operation arrangements can meet the challenge of delivering net zero in the gas and electricity network sector at the lowest cost to consumers,” a spokesperson for the Department of Business, Energy and Industrial Strategy (BEIS) said. “We will consider Ofgem’s findings when they are presented.” The regulator says that it expects to publish its advice “soon” – it is waiting for the government to release its white paper on energy policy.

Rather than being stripped of the ESO, we think that the bigger threat to National Grid is Ofgem’s plans to almost halve the allowed returns that energy companies will be permitted to make from 2021 to 2026. A squeeze on profits could potentially feed through to a smaller dividend, undermining the income case for investors.

Yet as we await the regulator’s final plans which are due in December, there is comfort to be drawn from recent developments in the water industry. In September, the Competition and Markets Authority (CMA) provisionally ruled in favour of four private water companies that had challenged Ofwat’s latest five-year price controls, believing that the level of allowed returns should be increased. The prospect of a similar CMA challenge by energy companies could therefore prompt Ofgem to soften its stance.  

In the meantime, National Grid is due to unveil its half year results on Thursday. Back in June, the group warned of a £400m hit to underlying operating profit this year on the back of Covid-19-driven customer bad debts in the US, higher costs and the deferral of a rate increase. Given how the pandemic has since unfolded, it will be interesting to see if they stick to this guidance, although the regulatory framework means that revenue shortfalls can be recovered in future years. Despite the Covid-19 blow, National Grid increased its full year dividend and analysts are pencilling in a higher interim payout as well. So, while there is uncertainty ahead, the shares are still worth holding onto in this challenged income landscape. Hold at 947p.