Utility Week

10 | NOVEMBER 2022 | UTILITY WEEK Finance Analysis Rising interest rates leave debt-laden utilities exposed Analyst Nigel Hawkins examines the impact of the current macroeconomic environment on major utilities and warns of tough decisions ahead for a highly-geared sector. T he last month has seen major turbu- lence in both the UK political and financial arenas. With the govern- ment's economic policy in serious disar- ray, the focus is moving to the pronounced downside of far higher inflation and rising interest rates – and their impact on mortgage payments. More specifically, financial markets are watching the pivotal 10-year gilt yield – regarded by top Treasury officials as sacro- sanct – like a hawk. Its yield has more than doubled in just two months from below 2% to 4%. And, even if the impact of Einstein's eighth wonder of the world (compound inter- est) is disregarded, this very sharp increase has a pronounced impact for UK companies, including highly geared utilities. Over the same two-month period, utility yields have risen noticeably. In the case of National Grid, its prospective yield in early August was 4.4%; at the time of writing, it is 5.7%. Alarmingly, too, its share price has fallen by over 17% in the past month – an unprec- edented decline since its flotation in the mid-1990s. The fact that it is currently car- rying net debt of almost £43 billion is surely very relevant. Recent market movements suggest there will be renewed efforts by utilities to lower their debt levels, especially with further interest rate increases anticipated. A˜er all, going back to the original pri- vatisation model in the late 1980s and early 1990s, low debt was very much to the fore. In recent decades, gearing up came into vogue, especially a˜er the financial crisis of 2008/09 when ultra-low interest rates became the norm. In the case of Thames Water, for example, its latest gearing figure – based on net debt divided by its Regulatory Capital Value (RCV) – exceeds 80%; this figure is well above Ofwat's assumed ratio. Furthermore, higher borrowing costs are bound to have a negative impact on dividend growth – although less so in Thames' case, since it has not paid a dividend to its exter- nal investors for over five years. A˜er all, higher interest costs will reduce a utility's earnings per share and therefore lower dividend growth prospects. More spe- cifically, shares in leading power stocks have fallen of late. In National Grid's case, its recent share price plunge means that cutting its near £43 billion net debt will assuredly become a priority. By contrast, SSE's latest net debt figure is below £9 billion – its market capitalisa- tion is currently around half that of National Grid. Furthermore, while SSE has an annual £2.5+billion capex programme, it is due to be partly funded by the planned sale of a 25% stake in its electricity networks division. Importantly, SSE is facing a key pricing review of its electricity distribution business, which accounts for around a fi˜h of its oper- ating profit: the eagerly awaited final deter- mination is expected near the year end. SSE's R110-ED2 determination, along with those for other electricity distribution companies, will be scrutinised well beyond the walls of its head office since Ofgem's piv- otal Weighted Average Cost of Capital (Wacc) figure should take full account of the latest upward movements in interest rates. Elsewhere in the electricity sector, it seems inevitable that further cost increases, including the impact of higher interest rates, will push the projected bill for Hinkley Point C to well above the latest £25-26 billion estimate. Raising equity Given the undoubted pressure on balance sheets, questions are bound to be asked about future rights issues, which historically have been quite rare, especially among the water companies. In fact, in the electricity sector, it has been the smaller quoted Renewable Energy Infrastructure Funds (REIFs), of which there are now 22, which have been prolific in regu- larly raising new equity. Since January 2020, just before the start of the Covid-19 pandemic, REIFs have raised £7 billion of new equity, the vast majority of which has been earmarked for investment in renewable energy projects, including wind and solar generation, as well as in battery storage schemes. On the water front, somewhat different criteria apply. As always, most focus will be on the next periodic review, which is due to apply as from April 2025. The recent rise in interest rates – unless they are reversed – will presumably be reflected in the Wacc that Ofwat assumes for the review. For the 2020/21-2024/25 period, Ofwat's final determination was based on a (RPI- stripped) Wacc of 1.96%, calculated on the basis of an allowed debt return of just 1.15% and an allowed equity return of 3.18%. Water companies will certainly expect a higher figure for the former, which – due to an assumed gearing ratio of 60% – is the more important determinant of consumer prices. As things stand, the much-vaunted efforts to reduce water charges from 2025 seem unlikely, especially with increasing political pressure to tackle leakage levels and to cut the seemingly routine storm over- flow discharges into inland waters. The challenges facing the water sector are illustrated by the unquoted Thames, which boasts 15 million customers. Its pri- vate equity ownership model has resulted in a massive gearing-up exercise, with net debt now reaching £12.9 billion – a very chunky number in an era of rising interest rates.

• Cover