Utility Week

Finance & Investment UTILITY WEEK | 1sT - 7Th AUgUsT 2014 | 23 W ith the privatisation and subsequent unbun- dling of the utilities and the introduction of competition in gas and electricity coming up to a 30-year anniversary, it is worth reflecting on the experience of the energy and water sectors in attracting and sustaining investment. A•er the original unbundling of the utilities, the private sector made a number of investments in a variety of non-regulated assets (from interconnection to LNG regasification terminals and generation) with no govern- ment support. The lesson is that once clear, stable and understandable market mechanisms are established, the private sector will invest in attractive opportunities. But over the past 30 years there has been a major change in the investor landscape. The vertically inte- grated energy utilities have now largely divested their net- work assets. Many of these still have balance sheets under pressure and are more likely to divest than invest. A new class of investors has stepped in, with investment capital from increasingly diverse sources and targeting a broader range of assets – from low-risk regulated assets to merchant assets that are completely exposed to the market. These points are important when considering the future and the next phase of investment. The strategic challenge for the government and the regulators is how best to meet the policy goals, incentivising the necessary private sector investment while retaining competition and getting a good deal for consumers. There is no shortage of investment capital – infra- structure funds from around the world continue to seek major opportunities, private equity is increasingly willing to take merchant risk provided there is a return commensurate with the risk, and the UK continues to be seen as a stable and attractive investment climate. So, what is the enduring challenge for policy makers? To set simple, sustainable market structures to ensure there is an appropriate balance of risk and return for the different types of asset – infrastructure assets should be made low risk to attract the lowest cost of capital, and merchant assets should have the potential to earn a market return without the need to protect investors from the commercial risks. Jayesh Parmar, partner, Baringa Partners "Once clear, stable and understandable market mechanisms are established, the private sector will invest in attractive opportunities." Investor view Jayesh Parmar "Over 30 years there has been a change in the investor landscape" such as Rolls-Royce, which can be priced out of overseas markets by an overly strong exchange rate. No UK utility, except National Grid, is affected significantly by exchange rate movements. Second, sector-related stories are also a share price driver. For example, Pfizer's £69 billion bid (now aborted) for AstraZen- eca has powered the pharmaceutical sector. In the utilities sector, the periodic review is crucial for all water companies, and Mili- band's energy price freeze pledge has been particularly targeted at Centrica and the other 'big six' energy companies. Energy companies also face various sector-related issues, ranging from the forthcoming Competition and Markets Authority's inquiry to fluctuating power prices and doubts about the durability – and level – of renewable energy subsidies. Third, individual company share prices are highly dependent on the latest results, with profit warnings producing the most notable downward movements. Previously, Cable & Wireless was notori- ous for issuing numerous profit warnings – a role now usurped by Carpetright. But the effect of profit warnings on share price, such as that from Tesco in January 2012, can be very damaging. Of the regulated utilities, Centrica is prob- ably the most exposed in this respect – as May's profit warning, arising from mild UK weather and extreme weather in the US, demonstrated. In fact, the five FTSE-100 utilities rep- resent a relatively small component of the total FTSE-100 value. Even if BT and Royal Mail – utilities in many investors' eyes – are included, the value of these seven stocks is currently just under £110 billion. Significantly, several European stock exchanges were dominated for many years by shares in banks, power companies and telecoms. However, failing banks, falling power prices and lacklustre telecoms returns have recently curbed this dominance. Given utilities' relatively low overall weighting, UK fund managers do not neces- sarily feel obliged to be heavily exposed to them; many, though, choose to do so, espe- cially in respect of National Grid. How the next two years will pan out in terms of the performance of the five FTSE-100 utilities compared with the FTSE-100 remains to be seen. In view of the many issues affect- ing the former, it is likely to be a rollercoaster ride – hardly matching the perception of the traditional boring utility. Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research

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