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Utility Week 18th April

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UTILITY WEEK | 18Th - 24Th AprIL 2014 | 7 Comment "There is real concern that parts of the UK utility sector are faced with so many risks that they will seriously affect much-needed investment" Utility Week expert view Nigel Hawkins I n the wake of the 2008 financial crisis, there was a widely held view that the UK banking sector had become uninvestable. Many fund managers, espe- cially those running overseas funds, saw so many risks – many of them vast and unquantifiable – that invest- ment in the sector was quite simply too dangerous. Of course, out of the UK high street quartet, the behe- moth that is HSBC stood alone. While Barclays tottered, it did not need a major injection of equity investment from the government, unlike Lloyds. The RBS case is very different as a monumental £45.5 billion of taxpayers' money was used to prop up the hapless bank. Almost six years later, it remains on its uppers, with a current share price about 40 per cent below the government's average purchase price – major private sector investors remain elusive. While the banking sector collapse has attracted unprecedented bile, the politicians' new whipping boys are the utilities – a sector, incidentally, that the govern- ment is relying on for record investment levels. More than £100 billion of electricity investment is needed by the early 2020s, much of it in new generation plant. Yet currently, very few major projects are under construction; few seem set to proceed over the next two years. Furthermore, there are real fears that RWE and Eon, as well as EDF – should the EU curb the infamous 35-year £92.50/MWh Hinkley C strike price – may scale back their UK operations. In today's turbulent political climate, Centrica, through its British Gas domestic business, is particularly exposed; SSE, too, has received trenchant criticism. By contrast, the more valuable National Grid is virtu- ally exempt from such attacks since it does not operate in the retail – and therefore voting – market: its share price remains impressively robust. But utilities such as Centrica now face real challenges. Imagine its chief executive, Sam Laidlaw, visiting US fund managers. "Hiya Sam; we like utilities – solid cash flow, good dividends, decent yields and low risk. Any nasty clouds on the horizon we should be aware of?" Laidlaw would have to admit to a highly uncertain general election result in just over a year, with a Labour Party that has pledged an 18-month price freeze that would slash Centrica's gas margins. Aside from the many Energy Act 2013 uncer- tainties, he would also mention the Compe- tition and Markets Authority (CMA) enquiry that could eventually result in major divest- ments of Centrica's UK customer base. Don't forget, too, that sharply falling gas prices, per- haps driven by the US shale boom, would seriously dent Centrica's earnings. SSE's chief executive Alistair Phillips-Davies is in an equally tight spot. While a price freeze until January 2016 has recently been announced and the potential downside of the CMA enquiry is less serious, SSE has to address the impact of the historic Scottish referendum in September. To date, SSE, unlike Standard Life, has remained stu- diously neutral. But if Scotland voted for independence, SSE's base would then be in a foreign country. At the macro-economic level, fundamental decisions, such as the apportioning of the national debt, need to be taken. More specifically, SSE investors will be very con- cerned about the durability and value of renewable sub- sidies post any secession; there is also unfinished busi- ness on the future of SSE's coal-fired plant. Furthermore, an ongoing review of network prices, a major earner for SSE, is under way; the outcome remains uncertain. Both of these UK-based big six energy companies face a ra of risks. For some investors seeking solid utility- like returns, they may be uninvestable. Within the water sector, there are also real risks as the periodic review proceeds to Ofwat's final determina- tion later on this year. But the regulatory veil of uncertainty is gradually liing. First, Ofwat's indicative 3.85 per cent Weighted Average Cost of Capital (Wacc) has established a financial base. Second, Pennon's now confirmed deal provides solid guidance for potential investors. While some allowance needs to be made for the ben- efits that Pennon will receive for being an early settler, its deal provides a firm indication for the likes of North- umbrian, Southern and Wessex – if not for Thames. More generally, UK utilities are being effectively re- categorised depending on their risk components – a fact reflected in recent share price movements. National Grid and Pennon are now unquestionably in the low-risk category. At the higher end lie Centrica, despite its strong balance sheet, SSE and Thames. In time, some of these risks may diminish. The Scottish referendum may result in the status quo and the next gen- eral election may produce an outright Conservative victory. And some new baseload plants may actually be built. For the moment, though, there is real concern that parts of the UK utility sector are faced with so many risks that they will seriously affect much-needed investment. Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research

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