Investing in Regulated Utilities (part II, Energy)

And Centrica PLC

The visible hand of the regulator, courtesy Wikipedia

The previous article discussed the water utility companies, which are subject to the price controls, capital expenditure and performance targets of the regulator Ofwat. The regulations for energy companies are more complex than for the water utilities.

Government policy towards the energy companies is complicated because:

1. The UK has agreed to meet reduced carbon emission targets. And this is expensive:

·         The UK must move away from fossil fuels. The cost of renewable energy sources are, with the exception of hydroelectric power, higher than for fossil fuels - gas, coal or oil.

·         Energy saving is costly in the short term. For example, subsidies for building insulation take years to payback.

2. The UK is a major producer of fossil fuels.

3. The Government burnt its fingers with nuclear power. The cost of decommissioning all the nuclear plants in the UK was estimated by the Public Accounts committee, in February 2013, at 100 billion pounds. The government has indemnified British Energy for the vast majority of this decommissioning cost.

4. Unlike water, energy prices fluctuate wildly and are determined at the international level.

5. The energy business is nearly 9 times the size of the water business by revenue. The cost to the householder of gas and electricity far exceeds the cost of water and sewage.

The government offloaded these concerns onto the energy regulator the Office of Gas and Electricity Markets (Ofgem). With 593 staff, Ofgem monitors and controls 10 energy companies. The energy sector is split between activities which are economically regulated (energy distribution networks) and activities which are market-based (energy production and retailing). The latter are still subject to Ofgem's service and social objectives. And Ofgem is not reluctant to impose heavy fines.

As the present price controls for energy distribution end in March 2015, the regulator published in 2013 a new model to set pricing and controls for the 2015-2023 period. In Ofgem's words ( Strategy decision for the RIIO-ED1 electricity distribution price control):

" RIIO-ED1 is the first electricity distribution price control to reflect the new RIIO (Revenue = Incentives + Innovation + Outputs) model. RIIO is designed to drive real benefits for consumers. It will provide the companies with strong incentives to step up and meet the challenges of delivering a low carbon, sustainable energy sector at a better value for money than would have been the case under our previous approach."

More explicitly, Ofgem defines the 'challenges' as

1. Ensuring that the networks can connect and manage the new low carbon technologies and generation required for GB to meet its carbon targets

2.The need to manage their own environmental impact

3.Social issues, notably the need to address fuel poverty and the treatment of vulnerable customers.

It is, perhaps, not surprising that, with so many staff to work on the price and service controls for 2015-2023, Ofgem's proposals are complex and, to an outsider, incredibly bureaucratic and imprecise. About the only solid data in the 58-page document is the proposed return on equity for the industry, which will be set between 6 and 7.2%. This is low. By controlling the return on equity, instead of return on regulated asset values, the regulator intends to control directly shareholder returns.

This complexity is illustrated by Ofgem's chart on price controls for energy distribution:

The four UK quoted energy companies are engaged in the following energy businesses:

	Exploitation	Production*	Distribution**	Retail*	Other
Centrica	Gas	Gas, nuclear, wind	No	Yes	N.America
Drax	No	Coal, biomass	No	Yes	No
National Grid	No	No	Yes	Yes	USA
SSE	Gas	Coal, gas, water, wind, biomass	Yes	Yes	Ireland

*Subject to quality, service and social controls by Ofgem. **Subject to price controls too by Ofgem.

The wise investor will:

1. Review energy companies' annual reports for their abundant references to Ofgem.

2. Want to separate the business of distribution, which is subject to strict price controls, from the rest of the energy business (exploitation, production, retail and other), which is not.

3. Recognise that the new pricing structure and service regime, which is due to be announced in 2014 to begin in 2015, could have a serious impact on returns for companies engaged in distribution. By far the largest is National Grid.

4. Keep a weather eye on the statements of politicians and the Department of Energy and Climate Change.

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Centrica PLC

Centrica sidesteps Ofgem's economic controls imposed on energy distribution by not having a distribution business. The company's business is split between:

1. UK retail gas and electricity (British Gas), which is subject to Ofgem's control via promoting market competition and setting service standards. Ofgem does not set prices. This business accounted for 40% of Centrica's operating profit in 2012. Centrica, according to the 2012 Annual Report, is concerned about the "regulatory creep" in this business. Operating profits are stagnant.

2. Centrica Energy's exploitation of energy sources that include gas, nuclear and wind. This is not subject to Ofgem and the business accounts for 45% of operating profit. Nuclear and wind have proved to be very poor investments (see below). Gas is very profitable and comes from secure sources, mainly in the North Sea. This is the main source of growth.

3. A UK storage business that relies for its profit on buying gas in the summer, when prices are low, and selling gas in the winter, when prices are higher. This accounts for 3% of Centrica's operating profit. Given shrinking summer-winter margins, Centrica will not invest in this business without 'government intervention'. Operating profits are declining.

4. A North American retail gas and electricity business subject to US and Canadian regulators. This accounts for 12% of operating profits. Centrica is aiming to increase its investment by add-on acquisitions. Operating profits are slowly improving.

Centrica is a profitable and financially strong company.

1. The company's net debt is a manageable 68% of equity, and Moody's gives Centrica's long-term debt an A3 credit rating.

2. Five years' operating cash flow (including capital expenditure) of 6.5 billion pounds paid for equity dividends of 3.4 pounds leaving 3.1 billion for acquisitions and buying back 500 million stock, announced in February this year.

3. Return on equity these last 5 years (2008-12) averages a healthy 18%.

4. Dividend per shares has increased by 8% per annum these last seven years.

Earnings per share, however, show a disturbingly uneven flow:

	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012
Earnings per Share-actual*	12	38	27	(4)	41	(3)	17	38	8	25
Adjusted Earnings per Share**	17	18	18	19	31	22	22	25	26	27

*As reported in the accounts. **Management figure adjusting for a large number of items.

In 2006, Centrica's management laid out four priorities for the business.

"1. Transform British Gas. 2. Sharpen the organization and reduce costs. 3. Reduce risk through increased integration. 4. Build on our growth platforms." (From Centrica's 2009 Annual Report).

Shareholders do not seem to have benefited from this plan. Centrica's share price (in blue) has underperformed the Gas and Water 350 utility index (in green), in recent years.

Courtesy Yahoo, click to enlarge.

A big part of this plan led Centrica to spend 2.3 billion pounds, financed by a mammoth rights issue, to buy 20% of British Energy in 2008. The other 80% is owned by EDF (Electricité de France). British Energy owns the nuclear power stations in the UK with 4 new plants envisaged. This investment accounts for 40% of Centrica's net assets. And Centrica does not control it. In the 4 years that have elapsed since buying 20% of British Energy, the business has produced a net loss of 37 million pounds (including a 231 million pound impairment in 2012). The impairment wrote off Centrica's investment in new nuclear plants whose cost had risen alarmingly. By pulling out of the new plants, Centrica is left with its investment in the nuclear plants currently operating.

Centrica's investment in wind farms has fared little better. It has made profit of 23 million pounds in the last 4 years on an investment of 533 million pounds. This is a return on wind farm investments of 1% per annum.

In 2012, Centrica acquired a stake in the Norwegian sector of North Sea gas for $1.6 billion.  In all, Centrica raised 5.8 billion pounds in equity and borrowings between 2008 and 2012 to acquire upstream assets in gas, nuclear and wind.

Centrica's policy of acquiring upstream assets with which to feed its retail operations makes sense. However, the enormous misuse of capital in nuclear and wind farms has dragged down earnings per share, diluted existing shareholders and increased debt. As the responsible Chairman and CEO are still in office, it is hard to know what they will do in the future.

At the present share price of 374p, Centrica is on an historical price earnings ratio of 16 and the stock yields 4.4%. Investors would do better to look at the better-managed SSE PLC in this sector - see http://thejoyfulinvestor.blogspot.co.uk/2013_01_20_archive.html