Utility Week

UTILITY Week 11th July 2014

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UTILITY WEEK | 11Th - 17Th JULY 2014 | 21 Finance & Investment C onventional and renewable generators in the US have been creating new listed subsidiaries, or YieldCos, to take ownership of some existing oper- ating assets and use their cashflows exclusively to pay dividends, rather than to build new generation. The attractions to investors are clear – in a world of zero real interest rates, yields on bonds are compressed and even "high yield" debt no longer gives high returns. Investors like the relatively secure cashflows that exist- ing utility assets typically have, in the knowledge that these cashflows will come back to them directly rather than being used to fund uncertain future investment. The YieldCo structures and dividends oen have tax advantages too. The attractions to the parent companies also seem clear at first glance, though YieldCos may prove to be a double-edged sword. While debt is cheap, financial ratios and credit ratings may prevent highly lever- aged structures. Hybrid capital has become popular to supplement conventional debt, but equity credit on hybrids has its limits. Partially list- ing a YieldCo can drive a re-rating of the value of the existing operating assets, release a lump sum of cash to be used for new investment, and potentially provide a vehicle for refinancing new assets when they are commissioned. The risk of creating a YieldCo is that the parent com- pany's new investment plans are likely to face increased scrutiny. In the past, investors looking for dividends from operating utility assets had to buy the whole pack- age, including the plans for new investment. Companies with a dubious track record on new investment were partly cushioned by the revaluation of existing assets in a world of low returns. In the future, how many investors will be willing to buy shares in the development company if they can access the secure YieldCo dividends directly? The answer will depend on whether company managements can present a compelling picture of the returns available from risky new projects. Martin Brough, utilities equity analyst, Deutsche Bank "In a world of zero real interest rates, investors like the relatively secure cashflows that existing utility assets typically have." Analyst view Martin Brough "Will investors buy shares in the utility if they can access the YieldCo dividends directly?" with obligations consistent with its Devel- opment Consent Order application; engage effectively with the infrastructure provider both in terms of integration and assurance; comply with the relevant project compensa- tion policies; and limit the extent of delays on the overall programme timeline. That said, the project carries high lev- els of ongoing uncertainty, which Thames describes as "above and beyond anything faced by the rest of the industry". Conse- quently, its plan also proposes a package of special uncertainty mechanisms, including "a change mechanism to deal with transfers of scope between us and the infrastructure provider on a consistent basis and to deal with overall changes in the scope of the programme". So while the SIP regulations in theory prohibit an incumbent undertaking an infra- structure project once it has been "speci- fied", exactly where the line between the allowed preparatory work and the actual delivery work lies is more hazy – and clearly subject to practical as well as theoretical considerations. Karma Ockenden is a freelance journalist Why the Tideway Tunnel qualifies as an SIP Under the SIP regulations, the secretary of state may only "specify" an infra- structure project if he or she is of the opinion that a) it is of a size or complexity that threatens the incumbent undertaker's ability to provide services for its customers; and b) specifying the infrastructure project is likely to result in better value for money than if it was delivered by the incumbent. The Tideway Tunnel is the government's preferred route to ensuring compli- ance with the Urban Wastewater Treatment Directive. It will run 25km along the River Thames between Acton and Abbey Mills and intercept 34 combined sewer overflows, diverting their surface water and sewage contents to treatment rather than allowing it to discharge into the river. Regarding part a), the secretary of state considered four types of risk: scale risk, construction risk, management risk, and regulatory risk. He determined the Tideway would form 30 per cent of Thames's £11 billion 2015 regulatory capital value should it undertake the project, and that peak annual expenditure would be between £500 million and £900 million. Such a concentration of risk in a single project would increase Thames Water's risk profile compared with its normal undertaker role. Moreover, the construction risk profile of the tunnel would be far higher than the company's normal construction works; the project would straddle nor- mal five-yearly regulatory cycles; and it would put significant stress on Thames Water's management and governance arrangements. Consequently, the Department for Environment, Food and Rural Affairs says: "The scale and risk profile of the project make it likely that if it were undertaken by [Thames Water] without government intervention, [Thames] would have its credit rating downgraded, probably to sub-investment grade, and would be unlikely to be able to raise sufficient finance to remedy this and meet its licence conditions at a cost that would be acceptable to customers." Regarding part b), the secretary of state concluded that allowing an infra- structure provider to deliver the project would likely lead to better value for money for customers; the project's higher than usual risks would affect the entirety of Thames Water's business and so would increase the cost of financ- ing for all of the company's investments.

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