Utility Week

UTILITY WEEK | 9TH - 15TH MARCH 2018 | 13 Policy & Regulation Market view E uropean integrated utilities have been under pressure for some time: at the turn of the decade, the sector's average rating resided in "A" territory; this has since fallen to "mid-BBB". Supported by a broadly unchanged and favourable regulatory envi- ronment – as well as improving prices and macroeconomic conditions – regulated and unregulated utilities are now mostly stable from a ratings perspective. Looking ahead, risks and opportunities may appear in equal measure. In the shorter term, most at risk is the UK's regulated water sector as it navigates PR19, which out- lines the next regulatory period from 2020. In the longer term, attention may turn to how energy utilities adapt to technological disruption. Among the key trends this year is likely to be increasing merger and acquisition (M&A) activity. Last year, for instance, National Grid's disposal of its 61 per cent equity stake in its UK-based gas distribution networks fetched £3.6 billion – a 50 per cent premium on the asset value, as of March 2017. Such a price reflects both the historically low cost of debt and the enduring demand for low risk, inflation-linked assets that enjoy a well- established regulatory tradition. The times of cheap money are not yet over, and investor appetite from infrastruc- ture and pension funds for regulated assets could accelerate as a result. We foresee fur- ther disposals this year. To fuel growth, regu- lated operators of more mature networks may look to acquire either international or midstream assets. All things considered, M&A activity could be among the key ration- ales for rating actions. Burgeoning financing activity is noted in the unregulated market too. Spurred by the potential upsides from lower costs of debt and inflation rates, refinancing and bond activity is flourishing. Notably, we foresee more refinancings on hybrid bonds because many instruments issued in 2013 and 2014 will soon reach their first call date. Utilities refinancing upcoming maturities with markedly less expensive instruments could enjoy sizeable cashflow savings. A recent example is Engie's €1 billion hybrid bond (with a 1.375 per cent coupon), which will replace the two pre-existing instru- ments, comprising coupons of 3.875 per cent and 4.625 per cent. Coupled with the rise of green bond issuance, we expect the already active bond market to continue on its course. Investment opportunities are also signifi- cant for existing portfolios. Europe's grids not only require additional lines and substa- tions to connect new assets but also network upgrades to manage the increased intermit- tency that renewable generation entails. And network modernisation is costly across many sectors. Regulatory changes Also presenting both risks and opportu- nities to Europe's utilities are regulatory changes, and particularly their focus on efficiency. Regulators are encouraging utili- ties to ensure affordable network access to customers. With energy efficiency gains being delivered at pace, regulators are set- ting increasingly ambitious cost-efficiency targets. Though achievable at present, such targets may offer less headroom for outper- formance in the future. What's more, regula- tors' increasing application of benchmarking indicators, whereby performance targets are set according to the sector's average, may trouble the weaker or less-efficient operators. Regulatory resets in Germany, France, Italy and Ireland have exerted additional (yet manageable) downward pressure by lower- ing allowed returns. As a consequence, many utilities in these markets will likely begin their regulatory periods suffering a fall in revenues. Decreased revenues, however, will be partly mitigated by other remuneration schemes in place – notably incentives to bol- ster the efficiency of operations and invest- ments, while also reducing costs. All things considered, the most at-risk sector from regulatory change is the UK's water industry. Elements of the upcoming PR19 could stretch water companies. Ofwat has reduced the allowed cost of capital to 2.4 per cent, from 3.6 per cent, and while this reflects the lower market cost of debt – and Europe's utilities recovering Over the past decade, European utility credit ratings have declined as commercial and regulatory risks have risen. Pierre Georges assesses whether they are likely to regain their financial strength. also partially protects companies at a time when interest rate rises are anticipated – the protection it offers largely depends on each company's capital structure and the duration of existing debt. We predict that this meas- ure could prompt a 1-5 per cent decline in companies' revenues between 2020 and 2025. Further, the potential introduction of a revised cost baseline mechanism may also challenge water utilities. The benchmark will now encompass an econometric model, which considers the performance of com- panies both within and outside the water industry. To gain rewards, companies may need to outperform not only their own his- torical costs but also those of their peers. That said, PR19 is still in its nascent stages, and may yet offer companies greater flexibil- ity in mitigating the negative effects. Here, we expect companies to modify their finan- cial policies and to implement further effi- ciency measures. Looking ahead, business models remain a challenge for European utilities. Regulatory changes are not the only factor that could lead to business model revisions: technologi- cal disruption too is among the most press- ing sector challenges. This is certainly the case for energy com- panies, operating in a market where techno- logical disruption is evident. Renewables are now commanding around a fiªh of Europe's unregulated players' earnings before inter- est, taxes, depreciation and amortisation (Ebitda). This raises questions about the existing liberalised baseload generation model – with fossil fuel and nuclear assets the energy transition's most likely casualties. Further disruption will likely arise once elec- tric and automated vehicles are part of eve- ryday life, and once battery storage solutions are closely integrated on the grid. So, while European utilities are firmly on the road to recovery, they cannot rest on their laurels. How they de-risk and ensure more defensive portfolios now will likely be crucial to their sound financial performances hereaªer. Pierre Georges, senior director, EMEA utilities, S&P Global Ratings

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