Utility Week - authoritative, impartial and essential reading for senior people within utilities, regulators and government
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20 | 21sT - 27Th FEbrUarY 2014 | UTILITY WEEK Finance & Investment Market view I n the past six months a combination of factors has created a challenging environ- ment for utilities and placed the sector firmly in the public spotlight. The public outcry against energy price rises, heightened parliamentary scrutiny of regulated network companies, and the severe storms and floods have all brought considerable attention to the sector. For a sector that has transformed itself in terms of efficiency, environmental compli- ance, innovation and customer service over this period, it remains doggedly vulnerable to the caprices of pub- lic sentiment. The need to maintain con- fidence is now acute for the water sector, as it charts a course through some distinctly choppy waters. From a financing perspec- tive, the main question is, will this sector be riskier as a consequence of regulatory change? Early signals from ratings agencies and analysts are not too optimistic. Regulators are keen to stress that their approach as one of evo- lution rather than revolution, and they would not be doing their job if they did not champion and pro- tect the interests of consumers, or question the workings of the industry. However, in what is now a minefield of financial complexity on a mas- sive scale (£120 billion of debt in the water sector alone), the prospect of regulatory change can have far-reaching consequences. Given the size and financial complexity of the large utility providers, many of whom have debt obligations amounting to several billion pounds, it would be impossible to refinance or restructure these liabilities in a few months to align with new metrics for the next regulatory period. Compared with companies operating in most other sectors, utilities make predict- able returns from long-term assets and can therefore sustain much higher levels of debt. Some have adopted securitised structures, where lender protections are strengthened, and so benefit from strong credit ratings, notwithstanding their higher gearing. Companies with higher leverage have lower capital buffers and should be able to operate with a lower weighted average cost of capital, since they hold smaller amounts of expensive equity and a greater proportion of cheaper debt. However, there appears to be little room for manoeuvre in the forthcom- ing water price review. Ofwat has increased its notional gearing ratio from 57.5 per cent to 62.5 per cent and made it clear that the higher leverage levels reached by securitised compa- nies have overstepped the mark. The regulator is pushing for water firms to accept lower real rates of return on equity (5.6-5.8 per cent) and capital (3.85 per cent) in PR14. These are real figures (stripping out inflation) but due to the ingrained nature of inflation (RPI specifically) in the regulatory model, there is no escape from the binary outcome of this assumption. If outturn inflation is higher than the assumption this is good for the companies, if it is lower, this is bad. It is a blunt measure taken at a fixed time in the cycle. Recent changes in approach from regulators also raise questions about the optimum length of time to fund assets. Traditionally, the sector has invested in long-term assets and secured funding on a similarly long-term basis. How- ever, with periodic price controls, companies are exposed to the risk that revised cost of debt assumptions may not fully take account of historic debt costs and may never be fully recovered. In the electricity and gas markets, the RIIO cost of debt mechanism provides an evolving figure based on a trailing average of debt indices. Paradoxically, with interest rates likely to rise in the next year or two, companies' current borrowing costs are set to increase at a time when the trailing aver- age will progressively reflect the unprec- edented and sustained period of low interest rates that we have witnessed in recent years. From an investment perspective the UK's regulated utilities market has traditionally been viewed as attractive. The combination of a stable political structure, an economic outlook that is more positive than the euro- zone and a supportive regulatory framework, has captured the attention of investment funds seeking a safe haven for their capital. Given the pitfalls and complexity of keep- ing asset-heavy firms financially afloat on a sustainable basis, it is all the more important for regulators to ensure that debt investors retain their confidence in the sector. At present there has been limited investor reaction in the debt markets to recent devel- opments. Credit spreads have eased with general market movements, but no more than 2-3 basis points (0.02-0.03 per cent) can be attributed to sector concerns. However, the impact of a ratings downgrade could typically see the cost of new bond issuance increase by as much as 0.25 per cent per annum for a one notch downgrade. Looking ahead, the water sector looks set for a period of change, with the expectation of declining equity returns and declining lev- erage, which is not particularly attractive for investors. Given the prevalence of companies that are now owned by private investment consortia, some with debt-heavy structures, the reaction of the rating agencies to these potential changes will be highly influential. From a debt-investor perspective, it remains to be seen whether the effects of declining credit ratings and rising funding costs will be restricted to reducing share- holder returns, or whether it means that companies will face genuine challenges in raising debt finance. The sector has achieved enormous pro- gress in the past three decades. It is now likely to face a period of consumer, political and regulatory headwinds. So far there has been little discussion regarding the future attraction of the sector for investors. It is the strength of regulatory commitment to "financeability" that will ultimately determine their future appetite. Nick Walker, head of regulated utilities, Lloyds Bank Commercial Banking It's a confidence thing Network companies are facing a shifting regulatory and political environment. Nick Walker assesses the likely impact of this uncertainty on investors' appetite for financing UK utilities. "The need to maintain confidence is now acute for the water sector"