Utility Week

UTILITY WEEK | 27TH MARCH - 2ND APRIL 2020 | 21 Finance & Investment ESG and "capitals thinking" The rise of Environmental Social Governance (ESG) approaches to com- pany performance reporting and the development of "capitals thinking" provided a rich seam for discussion at Utility Week's Investor Summit and a dedicated pre-conference workshop. Some significant scepticism among some participants, however, showed that these perspectives on performance management and valuation are still relatively fresh to many utilities – and their regulators. The following, taken from presentations, give insight into the pro-ESG and "capitals-thinking" arguments put forward by speakers. Mark Gough, chief executive, Capitals Coalition, opened a pre-con- ference workshop on ESG and laid a heavy emphasis on the importance of structured "capitals-thinking". He provided a useful definition of what constituted "capital". Produced capital: All man-made assets , such as buildings, factories, machinery, physical infrastructure (roads, water systems) as well as all financial assets. Natural capital: Stock of renewable and non-renewable natural resources , (e.g. plants, animals, air water, soils, minerals) that combine to yield a flow of benefits to people. Social capital: Networks together with shared norms, values and under- standing that facilitate cooperation within and among groups. Human capital: The knowledge, skills, competencies and attributes embodied in individuals that facilitate the creation of personal, social and economic well being. Oxera's Sahar Shamsi provided a thought-provoking keynote on the regulatory response to the legitimacy challenge in the UK utilities sector, including an analysis of measures to drive down returns. She assessed how these measures are impacting the balance of affordabil- ity and financeability in the sector and considered how capitals-thinking could help achieve better balance in an environment with increasingly "pluralist interests". Brought to you in association with The panel: John Lynch, managing director principal investments at JP Morgan Infra- structure Investment Fund. The fund has around £15 billion under investment, of which 15 to 25 per cent at any one time is in the UK. Richard Nourse, former Merrill Lynch executive who founded renewable energy investor, Greencoat Capital in 2009. It now has £5 billion of assets. Peter Antolik, who has worked across the UK utilities sector and is now a partner at Arjun Infrastructure Partners, which invests directly in 12 different businesses at the moment, with a portfolio valued at £2 billion. Move towards greater cost pass -through mechanisms (e.g. true-ups and more indexation) to reduce outperformance and windfall gains (or losses) 9 Higher-powered incentives to reward only the top-performing networks could also reduce outperformance Less reliance on incentives? More reliance on incentives? In the current regulatory cycles (e.g. water PR19, energy RIIO -2, air traffic control RP3), regulators have arguably demonstrated higher levels of risk aversion in reducing the scope for both ex ante and ex post outperformance of the price controls. • the reduction in the strength of the profit impetus can lead to a deterioration in incentives for delivering innovation and efficiency Increased focus in current price control processes? Spectrum of possible regulatory response to concerns regarding outperformance Cost pass -through High -powered incentives Regulatory response to the legitimacy challenge? (II) Focus on reducing the scope for outperformance 0% 2% 4% 6% GT and GD 2012 GD 2017 E&G, T&D 2013 E&G, T&D 2016 ET 2013 ET 2016 ET 2014 ET 2017 Ireland Netherlands France Portugal 0% 2% 4% 6% RIIO-T1 - 2012 RIIO-ED1 - 2014 RIIO-2 (SSMD) - 2019 PR09 - 2009 PR14 - 2014 PR19 - 2019 Openreach - 2014 Openreach - 2018 Openreach - 2019 Openreach - 2020 NATS - 2014 NATS - 2019 Electricity & Gas Water Telecoms Transport 8 Real vanilla WACC (UK) Real vanilla WACC (selected European examples) Source: Oxera analysis, based on various regulatory determinations. Regulated utility returns face similar downward pressure internationally, e.g. in the USA and Australia Regulatory response to the legitimacy challenge? (I) Lower cost of capital allowances Source: Oxera Deal or no deal? N ow that the fog of nationalisation has lied, M&A activity in the UK utilities sector may be unleashed but "a hangover" remains about the direction of travel. This was the view of a panel of heavyweight investors who fielded questions at the summit. The panel discussed the key questions investors are cur- rently asking about UK utilities and how they weigh up the balance of risk and reward. They were clear that regulated utilities in the UK are seen as ripe for deals, and that while investors have care- fully watched the Brexit and nationalisation debates, the real levers are longer-term clarity on policy and regulation (it must be noted here that they were speaking before news of the coronavirus crisis broke). Nourse pointed to huge swathes of opportunity in the energy transition and decarbonisation of heat processes, stressing the hunger for investors to be involved. But, he insisted a roadmap was needed from the government. The panel also agreed that a decision needed to be taken on who would carry the risk for the massive investment needed to hit net zero emissions by 2050. If investors are expected to shoulder a lot of this burden, they can reason- ably expect higher short-term returns. Regulation will also have to be flexible to allow the fund- ing of projects vital to achieving decarbonisation and freeing up innovation, they said. The panel agreed that investors were willing to take a very long-term view of investments and that there was a discern- able move towards lower or non-levered investments that allow investors a better view of the yield over the long term. As new opportunities open up, investors are expecting much greater transparency on a number of issues. Antolik said the desire for direct investments came from that need to be close to the management teams and to understand the process. Lynch said more and more was being expected of the independent chairs of its various funds. The issues being raised by investors range from environ- mental, social, and governance (ESG) to diversity and increas- ingly social contracts. However, they admitted that too oen these were still "box-ticking" exercise and there was a lack of standardisation on how these impacts are measured. Antolik summed up by saying: "You have to remember the UK is still very investable. It's seen as one of the best countries in the world to invest in for infrastructure. There's always a lot of noise in price control periods. When you step back from it, utilities offer a reasonable return for the risk you take. "Investors will remain wary but deals will be done." James Wallin, editor, Utility Week digital

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