Utility Week

UTILITY WEEK | 28Th March - 3rd aprIL 2014 | 19 Finance & Investment A s the FTSE 100 remains within spitting distance of its all-time record high in December 1999 of 6,930, City experts are asking why there is so little corporate activity. A-er all, despite the long economic downturn, corporate balances are bulging, but – with a few exceptions – investment levels remain sluggish. For the utilities sector, which in the late 1990s hummed with corporate activity, there are various explanations. With a general election now less than 18 months away, not forgetting the radical utility policies being peddled by the Labour Party, any bidder would probably face flak on several fronts. In the water sector, the ongoing periodic review con- stitutes an extra risk for potential bidders. Now that Pen- non has provisionally secured "fast-track" status from Ofwat, it is – due to reduced regulatory risk – more in play. Significantly, its shares have responded positively to Ofwat's announcement, unlike those of Severn Trent, which turned down a £22 per share bid last summer: Severn Trent was not fast-tracked. Once the water review is done and dusted, expect renewed takeover activity. As energy firms grapple with low generation returns and political meddling, it is fanciful to suggest a swathe of bids will hit the sector. But once the electricity distribution review is concluded, further private equity involvement may be attracted: the new eight-year duration period will be of particular interest to funds with a long time horizon. In terms of companies, National Grid seems too large to become a credible bid target, short of a complex break-up strategy. Some years ago, SSE was widely seen as an obvious target. More recently, it has attracted its fair share of tricky issues, the forthcoming Scottish refer- endum among them. Drax Group could come into play. However, its valua- tion is based primarily on its biomass strategy, which is dependent on subsidies – these may be cut by the EU. Despite its problems, Centrica remains an unlikely target. Years ago, there was a persuasive case for Gazprom to bid for it. With the latter facing production and financial challenges, this is now improbable, all the more so in the light of Russia's latest Crimean initiative. While there is no realistic prospect of a repeat of the takeover fever of the mid-1990s, utilities' share prices would no doubt respond positively if bidders returned. Nigel Hawkins, director, Nigel Hawkins Associates "As energy firms grapple with low generation returns and political meddling, it is fanciful to suggest a swathe of bids will hit the sector." Analyst view Nigel Hawkins "Utilities' share prices would undoubtedly respond positively if bidders returned" consultants, and the associated internal time costs. These costs can be traded-off against the benefits of securing higher returns from the CMA. In relation to the direct cost of going to the CMA, the government (as part of its consultation on streamlining the process for regulatory and competition law appeals) published an impact assessment in which it estimated the average cost of appealing a price control to be £320,000, with a high esti- mate of £800,000. At face value, the low direct costs of appealing (relative to the potential benefit) might appear to give a strong incentive to appeal. However, in practice the trade-off is more complex, because issues such as the strength of the regulatory relationship and perceived external credibility – though more subjective – are also of importance. Our analysis suggests Ofwat has broadly got the balance right in relation to the finan- cial benefits from securing enhanced sta- tus in relation to South West and Affinity. In each case shareholders would need to be pretty confident of success at the CMA for the rejection of enhanced status to be commercially rational – and a single basis point increase in the wholesale Wacc would almost certainly be value-destroying even if they succeeded. As this is the first time the RBR framework has been applied, there will almost be some lessons learned on both sides a-er PR14 has been concluded. For now, based on what is publicly known at least, Ofwat's calibration of these incentives seems to be appropriate – as does the decision of South West and Affin- ity to accept the risk and reward guidance. Sam Williams, director and co-founder, Economic Insight ExpEctEd nEt prEsEnt valuE of gEtting highEr Wacc at thE cMa Source: Economic Insight Analysis out of Wacc? The weighted average cost of capital is a vital number for water companies, so at what point would it be worth risking a cMa challenge in the hope of getting more? 3.7% The wholesale vanilla Wacc Ofwat has set 3.9% It would be rational for enhanced companies to risk a challenge in the hope of getting a 3.9 per cent Wacc if the probability of success was 60 per cent or more 4.1% It would be rational for enhanced companies to risk a challenge in the hope of getting a 4.1 per cent Wacc if the probability of success was just 30 per cent or more thE storY BY nuMBErs Expected benefit of higher Wacc (£m NPV) £40 £30 £20 £10 £0 -£10 -£20 -£30 3.8% 10% 20% 30% 50% 60% 70% -£11 -£9 -£7 3.9% 4.0% 4.1% Wholesale vanilla Wacc Probability of success at the CMA -£1 £3 £8 £10 £16 £22 £20 £28 £37

• Cover