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Finance & Investment Investor view Bruce Huber and Gerard Reid "Utilities cannot buy renewable assets at prices that enable them to generate sufficient returns to keep their shareholders happy" O ne of the greatest challenges facing utilities is the rising cost of capital, as highlighted in Alexa Capital's recent report: UK Energy Perspective – Is there a Better Way Forward? Higher costs compound pressures on management at a time when utilities are facing imperatives to lower prices and move towards cleaner fuel sources. The pressures are becoming extreme in Europe where policy change has been significant and we are seeing most of the major European utilities cost-cutting and restructuring, leading to asset sales and portfolio repositioning. On the positive side, feed-in tariffs (FITs) and increasingly prevalent long-term power purchase offtake contracts are revolutionising the power landscape. These offtake structures are facilitating massive capital investment into the energy sector, especially in renewables which, with their zero marginal costs and priority grid access, have pushed down wholesale prices across the region. In the case of Germany, the vast majority of the 70GW renewable capacity developed over the past decade has been financed by private individuals or institutional investors (either directly or indirectly through funds), with less than 10 per cent owned by Germany's "big four" utilities. How did this come about? The answer is simple and gets to the core of the "FIT revolution". Utilities could not buy renewable assets at prices that enabled them to generate sufficient returns to keep their shareholders happy. These returns are around 10 per cent, while the average FIT investor will take 7 per cent or less. Currently, there are pension funds and investment trusts buying German, French and UK assets at equity return levels of between 4 and 7 per cent. Meanwhile, utilities across Europe are required to pay dividends often above these levels to retain shareholder support. What does this mean? If a megawatt of power capacity costs €1 million, a pension fund requires only €40,000 a year in returns, while the utility requires €100,000. So why should the public pay a utility so much to invest in generation, and is there a solution? A few months ago NRG Energy, the largest independent generator in the US, took a notable step by spinning out certain assets into a unit called NRG Yield. NGR Yield comprises 2.5GW of generation assets (including 414MW of solar and wind) supported by long-term power purchase agreements. Investor demand drove a 20 per cent share price increase, implying that new investors will receive a yield below 4 per cent. And what does NRG get out of the transaction? Capital, plus continued control and management fees. The maths are compelling. Bruce Huber and Gerard Reid, Alexa Capital LLP 20 | 15th - 21st November 2013 | UTILITY WEEK Analysis UBS's alternative manifesto Forget price freezes if you want to reduce energy prices, says Swiss bank UBS. By Connor McGlone. E veryone's an energy policy expert these days, but some have stronger credentials than others when it comes to judging whether or not they should be listened to. Among that number is the prestigious Swiss bank UBS, which this week became the latest to offer an alternative manifesto to Labour's popular but investor- spooking 20-month price freeze plan. While its analysts agree with Labour's diagnosis up to a point, their proposed cure will appeal more to climatesceptic Conservative instincts. Soaring energy prices are a threat, according to UBS models. If current "gold-plated" policies are maintained, they say UK household energy bills will have seen a rise of around 260 per cent by 2020 from 2004's levels. Attacking profits is not the answer, the banks experts argue in their report Freezing Energy Tariffs Without the Gimmicks". The report says: "Criticising retailers may be politically popular, but we believe retail margins, at under 5 per cent, are the wrong target if sustained consumer benefit is the aim. "Even if retail margins were cut to zero, this would be more than offset by just a single year of rises in government and network charges. Also, we believe tariff freezes and other punitive measures could actually raise energy bills longer term." The report's author, Stephen Hunt, says there are solutions which could cut retail tariffs to 2020 by 5 per cent in real terms while still attracting the required investment. A policy framework to do this would include extending the deadline for the Energy Company Obligation energy efficiency programme, with no consumer-funded follow-on and focusing on additional biomass conversion capacity instead of offshore wind. UBS also suggests trimming the 2020 renewable energy target from 30 per cent to 27.5 per cent and using the revenues raised from the carbon price floor to subsidise domestic tariffs. UBS has also made forecasts based on Labour's proposed policies if the party was elected in 2015. Of the two largest energy companies, UBS estimates Centrica's value would drop by 13p a share and SSE's value would be cut by 54p a share. However, UBS prefers SSE to Centrica because it believes the former is oversold compared with the latter when valuing the Labour freeze. "Although not riskless, we believe SSE remains attractive relative to Centrica and its European peers, and in absolute terms. We reiterate our 'buy' rating on SSE and our 'neutral' call on Centrica," said the bank.