Regulatory review: Spanish regulatory risk overdone; Italian risks overlooked

Transcription

1 September 14, 2010 Europe: Utilities Regulatory review: Spanish regulatory risk overdone; Italian risks overlooked Market overly cautious on Spanish risk... REE and Enagas face regulatory reviews in the coming 18 months. We estimate that the market is discounting cuts to revenues of 15%-25% for both stocks, despite the fact that this implies allowed returns below WACC. We believe this is overly conservative. Our forecasts reflect a 5% cut to regulatory revenues in these reviews and further cuts in 2016: despite this there is c.40% potential upside for both stocks....but Italian risk unappreciated Terna also faces a review in 2011 and, in our view, the market expects current rates of return to remain broadly unchanged. However, we expect a cut to returns, reflecting the fall in interest costs in Italy and we see absolute downside. REE and Enagas trading close to all-time lows on multiples; Terna in top quartile On our estimates, REE and Enagas are close to alltime lows relative to the sector: we upgrade both to Buy. Terna is in the top quartile relative to history: we add it to our Conviction Sell List. Regulated utilities high multiples, high gearing, risks not reflected except in Spain With the exception of REE and Enagas, regulated utilities trade on higher multiples and are more highly geared than the utility sector average. The comparison of regulation across Europe is complicated: we prefer IRRs, which suggest returns are currently highest in Spain although we assume IRRs everywhere will be cut to WACC by Historically, the performance of regulated utilities has been inversely correlated to bond yields, interest rates and inflation; this relationship has weakened recently but it could suggest downside for these stocks if bond yields and interest rates start to rise. Valuations now include short-term element and M&A for UK water stocks; PTs up 9% We have adjusted our price target methodology to include a short-term P/E based component, as well as including M&A for the UK water stocks. The net effect is to increase valuations for the regulated stocks by an average of 9%, with the biggest change at Pennon, which we upgrade to Neutral. RATING AND 12-MONTH PRICE TARGET CHANGES New Old Share New Old Conviction List Changes PT PT Price rating rating Terna ( ) Sell* Sell Rating Changes Red Electrica ( ) Buy Neutral Enagas ( ) Buy Neutral Pennon (p) Neutral Sell Price Target Changes Severn Trent (p) Neutral Neutral Snam RG ( ) Sell Sell United Utilities (p) Sell Sell Northumbrian Water (p) Sell Sell National Grid (p) Sell* Sell* * denotes Conviction List membership RELATED RESEARCH Opportunities from stock picking: Buy low, sell high; Terna added to Conviction Sell List, September 14, COVERAGE VIEW: CAUTIOUS With this report Fred Barasi assumes primary coverage of Red Electrica, Enagas, Terna and Snam, Fred Barasi +44(20) fred.barasi@gs.com Goldman Sachs International Matija Gergolet +44(20) matija.gergolet@gs.com Goldman Sachs International Deborah Wilkens +44(20) deborah.wilkens@gs.com Goldman Sachs International Andrew Mead +44(20) andrew.mead@gs.com Goldman Sachs International The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC certification, or go to Analysts employed by non-us affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research

2 Table of contents Regulatory reviews in 2011/12: Spanish risks overdone; Italian risks overlooked 2 Inverse correlation between regulated utilities and bonds, base rates and inflation has broken down since Revising price targets to capture short- as well as long-term valuation opportunities 15 Italy: Low bond yields to lead to lower returns; Terna Conviction Sell, Snam RG Sell 22 Terna (TRN.MI): Unappealing valuation, unappreciated risk: Adding to Conviction Sell 25 Spain: Market over-discounting the pain? REE and Enagas both upgraded to Buy 29 Red Electrica (REE.MC): Significant discount to history reflects overly cautious scenario; up to Buy 35 Enagas (ENAG.MC): Discounted multiples with premium yield and low gearing, up to Buy 36 National Grid (NG.L): Disposals and delivery all priced in leaving only downside risks 39 UK Water: Reflecting higher M&A potential in valuations; upgrading Pennon to Neutral 45 Pennon (PNN.L): Up to Neutral owing to M&A risk, well positioned for sustainable growth 47 Prices in this report based on market close as of September 9, 2010 unless otherwise stated. Goldman Sachs Global Investment Research 2

3 Regulatory reviews in 2011/12: Spanish risks overdone; Italian risks overlooked We see significant valuation discrepancies within the subsector of regulated utilities. While both Spain and Italy face regulatory reviews in the next months (REE and Enagas in Spain, Terna in Italy), on our estimates the market is currently discounting very different outcomes. We have applied what we consider to be conservative but consistent approaches to valuing regulated stocks, and see potential upside to our price targets of 40% for REE and 37% for Enagas, with absolute downside in Terna. As a result, we upgrade both REE and Enagas to Buy from Neutral, and add Terna to our Conviction Sell List, with forthcoming reviews as a potential catalyst in both cases. We have also adjusted our price target valuation methodology for European utilities to include a short-term valuation component, as well as reflecting a greater likelihood of M&A across the sector. The addition of Terna (Sell) to the Conviction List is the only change to that list, which includes National Grid as a Conviction Sell as well as RWE (Conviction Sell, 53.53) and EDF ( 32.87) as a Conviction Buy. Exhibit 1: Upgrading Spanish and UK target prices, downgrading Italian ones All price targets have a 12-month time horizon. Changes of more than 10% to price target highlighted, share price upside/downside highlighted according to quartiles, rating changes highlighted according to upgrades and downgrades Price target components P/E Valuation SOTP** M&A New PT Old PT Change to PT Upside to new PT New rating Old rating Conviction List Changes Terna ( ) % -9% Sell * Sell Rating Changes Red Electrica ( ) % 40% Buy Neutral Enagas ( ) % 37% Buy Neutral Pennon (p) % 10% Neutral Sell Price Target Changes Severn Trent (p) % 6% Neutral Neutral Snam RG ( ) % -3% Sell Sell National Grid (p) % -4% Sell * Sell * United Utilities (p) % -5% Sell Sell Northumbrian Water (p) % -6% Sell Sell * Denotes Conviction List membership, ** SOTP or DCF Source: Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 3

4 Exhibit 2: Sector upside downside to our price targets: wide range in regulated utilities 80% 70% 60% 50% 40% 30% 20% 10% 0% 10% 20% EDF CEZ Shanks Veolia Gas Nat EDPR EDP Acciona REE Enagas Edison Verbund Suez Env Fortum Centrica Drax E.ON Endesa IBR Iberdrola PPC Pennon EDF EN PGE SVT A2A SSE Snam NG UU RWE NWG Terna For the risks and methodology associated with our price targets, please see previously published research. Source: Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 4

5 Comparing regulation across Europe provides stock specific opportunities... In this report, we look at the differences in regulation across Europe. So as to make it more comparable, we have analyzed the effective IRRs and used consistent assumptions for future returns. Our forecasts and valuations for the regulated utilities are based on our assumption that IRRs converge across Europe to a level just marginally above the cost of capital (on average c. 30bp above) by 2016 for new assets (as well as on existing assets in certain cases). This approach provides a strong basis to identify valuation opportunities among the regulated stocks....we add Terna to the Conviction Sell List and upgrade both REE and Enagas to the Buy List Based on our revised valuation approach, there is over 40% potential upside to our price targets for both REE and Enagas, and we upgrade both stocks to Buy. We see absolute downside at Terna with a potential negative catalyst in the form of the 2011 regulatory review, and add the stock to our Conviction Sell List. We also reiterate the Conviction Sell on National Grid. Terna and National Grid both screen as having bottom quartile downside relative to the sector, Q4 growth and Q4 EV/EBITDA (Terna also has a Q4 P/E and CROCI). On the other hand, REE and Enagas offer above utilities sector average potential upside, low P/Es and Q1 CROCIs, with gearing in line or better than the regulated average. Market expectations differ significantly for regulatory reviews in 2011/12 in Spain and Italy Both Spanish utilities (REE and Enagas) and Terna face regulatory reviews in the next 6-18 months (while for Snam RG the first review will be in 2012). We estimate that the market is discounting significantly different degrees of regulatory risk in each country. In Spain, we estimate that current share prices imply cuts to revenue of 15% for Enagas and 25% for REE, which would correspond to IRRs of 6% and 5%, respectively (which would be less than WACC). In Italy, Reuters consensus earnings and the current share price suggest that market expectations for Terna s forthcoming regulatory review are for the current rate of return to remain broadly unchanged. Our forecasts reflect a 5% cut to revenues for both REE and Enagas, which corresponds to a cut in the allowed IRR of 80-90bps, and a cut in Terna s allowed rate of return of 1.0% to 5.9% real pre-tax (which represents a 70bp cut to the IRR), resulting in a yoy fall in EPS of c.15% for 2012E. While the Spanish government has recently called for a review of the energy regulated system, which poses an additional potential risk to the regular regulatory reviews, it has also stressed its commitment to more investments particularly in interconnectors and in the development of gas storage: this should mitigate regulatory risk as it implies the need for more investments (and growth) for Enagas and Red Electrica. 12-month price targets now include P/E valuations for UK water companies and M&A; average increase 9% To capture some of the mean reversion dynamic of the utilities share prices, we adapt our 12-month price targets to include a shorter-term valuation multiple component. For more details, see the accompanying report, Opportunities from stock picking: Buy low, sell high; Terna added to Conviction Sell List. Our price targets now equally reflect a shorter-term valuation based upon mean reversion and also our longer-term values, which incorporate our structural views of the sector such as power price recovery and higher CO2 emission costs. Where we consider an M&A premium valuation to be appropriate, we have included it at 50% with the remaining 50% split between short-term and long-term valuations. We include M&A valuations for the four listed UK water companies, reflecting recent deals for similar assets (most recently the sale of EDF s regulated electricity distribution network in London), and a falling cost of debt. We upgrade Pennon to Neutral from Sell, but generally continue to see limited value in the UK water stocks, as we believe that a high probability of M&A is already in the price in many cases, eg, Northumbrian Water (NWG) trading at an 18% premium to March 2011E RAB, United Utilities (UU) at a 12% premium. We retain a Neutral rating on Severn Trent (SVT), and Sell ratings on NWG and UU. Goldman Sachs Global Investment Research 5

6 We reiterate our Conviction Sell on National Grid On our estimates, National Grid s share price reflects an M&A premium for its UK and US assets and implied superior earnings growth. We forecast minimal earnings growth, which would be undermined if the company did not deliver on improving US returns over the next few years. Short-term mean reversion on a sector P/E basis would still imply 6% potential downside in the shares relative to the sector. Reflecting our longer-term power price upside and the impact on other stocks in the sector, longer-term valuations imply material relative downside in National Grid s shares. We reiterate our Conviction Sell rating on the shares. Macro backdrop highlights future risks for sector relative performance of regulated stocks We have also looked at the relationship between the sector relative performance of regulated utilities and bond yields, interest rates and inflation. This relationship, which has weakened recently, historically has implied a strong inverse correlation particularly in Italy which would suggest underperformance of the subsector should bond yields and interest rates begin to rise. Regulated stocks also appear less attractive when compared with utilities average Exhibit 3 provides an overview of the regulated stocks and compares average metrics with the sector averages for pan-european utilities. On the whole, we see less valuation upside for regulated stocks (14% vs. 23%). We see multiples as less attractive (regulated trading on P/E of 12.9x vs. sector average of 12.5x and EV/EBITDA of 9.5x vs. sector average of 7.7x) and the gearing is also higher (Net Debt to EBITDA of 4.3x vs. the sector average of 3.1x) as compared to the sector average. Growth for regulated stocks is also lower over the medium term, although better on a very short-term basis: we forecast regulated stocks to grow EPS 7% 2011E vs. 2010E vs. sector average of 2%. For , we forecast regulated stocks to deliver an EPS CAGR of 5% vs. the sector average of 11%. Renewable stocks, which are also partly regulated, also show high gearing levels, comparable to regulated names, yet with higher forecast growth rates. Exhibit 3: European regulated stocks are generally unattractive on valuation, gearing and returns measures compared to the wider utilities sector average and renewable stocks Valuation, gearing and return measures for European regulated utilities vs. utilities sector and renewables average. Shading shows Q1 (blue) and Q4 (black) stocks for each category, compared with regulated subsector for returns and gearing and wider utilities sector for valuation. National Grid P/E adjusted for repex and CTC 2011E Terna NWG UU NG SRG SVT PNN Enag REE Reg average Utils average Renewables Valuation Upside/downside -9% -6% -5% -5% -2% 6% 9% 36% 42% 14% 23% 28% P/E EV/EBITDA EPS CAGR (11-14E) -1% 6% 10% 6% 2% 6% 7% 5% 4% 5% 11% 25% EBITDA CAGR (11-14E) 3% 4% 5% 6% 5% 3% 3% 8% 6% 5% -6% -100% Yield 6.1% 4.4% 5.3% 7.0% 5.9% 5.0% 4.2% 5.9% 5.5% 5.6% 5.2% 2.3% RAB premium 8% 18% 12% 7% 5% 10% 7% N/A N/A Gearing ND/EBITDA Returns CROCI 6.4% 7.2% 6.6% 7.2% 6.9% 5.6% 7.3% 8.7% 8.1% 7.3% 7.5% 6.8% Source: Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 6

7 Regulation is key earnings driver: discrepancies in market views create opportunities The most significant revenue (and earnings) driver for the regulated stocks is the return allowed by the regulator and our assumptions for regulated returns have a direct impact on our earnings forecasts and valuations. Regulators in Italy, Spain and the UK take a different approach to assessing Regulated Asset Bases (RABs) gross or net and have different incentive mechanisms and different depreciation assumptions. We provide an overview of country and asset based regulation (Exhibit 4). As different regulatory approaches result in different cash flow profiles, we believe the allowed return over the life of the asset is a more meaningful measure of the regulation. Hence, we analyze and compare the effective IRRs across different regulatory regimes. Exhibit 4: Different regulatory regimes across Europe result in significant variation in cash flow profiles. Cash flow by year of operation following an initial nominal 100 mn investment. Stars show average stage in regulation of current assets Cash flow from 100mn investment in year 0 ( mn) Spain wind Italy wind REE old T REE/Enag new T UK water Snam, TRN Enag storage Enag old T 2 Enag regas Year of operation Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 7

8 The regulation for utilities varies from country to country. In Exhibit 4 we have focused on the major regulatory frameworks of the listed utilities (as well as Spanish and Italian wind, to provide a comparison with the partly regulated renewable sector). While the UK and the Italian cash flow profile are broadly similar (with Terna and Snam receiving a boost in the initial years thanks to incentive regulation), the cash flow profile in Spanish regulation is quite different. Enagas returns on gas storage and regassification are high in the short term but fall away sooner than REE s returns on transmission, which are sustainably higher for longer. Red Electrica s old assets (pre-2008) receive a lower remuneration initially, yet this is allowed to grow with inflation indefinitely. Perhaps an easier way to compare regulations is by looking at the IRR (Exhibit 5). The next reviews in Europe are in 2010 (effective from January 2011) for Enagas s gas storage and regassification assets, and 2011 for gas and electricity transmission in Spain and electricity transmission in Italy. National Grid also faces reviews for gas and electricity assets in Massachusetts and New York over the next six months. Our forecasts are based on a convergence of IRRs to close to WACC by 2016 We estimate that allowed regulatory returns are higher than WACC across Europe. We do not believe this is sustainable and we assume that allowed IRRs will be cut to close to WACC in all cases by 2016 as regulators trim the spread allowed to regulated businesses. We estimate the average spread between WACC and allowed returns to be 120bp; we forecast that this will be cut to less than 30bp for new assets by Exhibit 5: Returns are most easily summarised in IRRs total cuts largest in Spain IRR for existing regulation (current) and under GSf cuts to regulation in 2011 or 2012 and 2016, based on 40-year asset life 40 yr IRR: Current 2011/ Total cut Snam* 7.3% 7.3% 0.0% Old assets 7.3% 7.3% 0.0% New assets 7.3% 6.0% 1.3% Terna 7.5% 6.8% 7.5% 0.0% Old assets 7.5% 6.8% 7.5% 0.0% New assets 7.5% 6.8% 6.1% 1.4% UK Water 5.7% 5.7% 0.0% REE* 8.0% 7.1% 6.5% 1.5% New transport 7.7% 7.1% 6.5% 1.2% Old transport 8.0% 7.1% 6.5% 1.5% Enagas* 7.7% 7.2% 6.7% 1.0% New transport 7.7% 7.1% 6.5% 1.2% Old transport 7.8% 7.3% 6.7% 1.1% Regas 6.5% 6.1% 5.7% 0.9% Storage 9.2% 8.8% 8.5% 0.7% Spanish wind** 7.7% 7.1% 7.1% 0.6% Italian wind** 12.3% 10.3% 10.3% 2.0% Exhibit 6: We assume that IRRs are cut to levels close to WACC for all companies by 2016 Company average achieved IRR under GS assumptions IRR (%) 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% Spanish wind (GS assumption) Snam Terna UK water REE Enagas * weighted average return across different businesses ** Spanish wind based on 25% load factor, Italian 20% Source: Company data, Goldman Sachs Research estimates. Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 8

9 We assume cuts to the IRR will be effective for all assets (i.e. new and old) in the UK and Spain, leading to immediate cuts in the average IRRs for the companies. In Italy we assume that old assets will continue to receive higher returns owing to legacy incentive payments, while new assets will no longer receive incentives after 2016, leading to a gradual decline in the weighted average IRR for Snam and Terna after For REE and Enagas, we assume a first cut in regulatory revenues in 2011/12 and another in 2015, resulting in an IRR for Enagas and REE of c.6.5% in 2016, compared to IRRs above 7% for Snam and Terna. For Terna, we reflect a cut to returns in , reflecting the current low cost of debt. From 2016, we normalise the underlying return back to the current level, but assume new assets no longer receive incentive payments in Italy. We include renewables for comparison, as the returns are (partly or fully) regulated in many European countries. We expect cuts to allowed returns for renewables in Italy and Spain in 2012 (as for regulated stocks). By 2016, we assume that IRRs on new investments for each company s core business (i.e. gas and electricity transmission, and UK water) are all between 5.7% and 6.5%, and within 30bp of our assumed WACC in all cases. We update forecasts to reflect more cautious regulatory assumptions in Spain and Italy We have revised our regulatory assumptions for Enagas, REE and Terna to reflect cuts in 2011 or This change is based on recent regulatory decisions (e.g. the Italian regulator cut the return for gas storage to 6.7% from 7.1% real, pre-tax in August 2010) and to reflect the current low interest rate environment. We have updated our forecasts to reflect these revised regulatory expectations, and for UU to reflect the sale of the majority of its remaining non-regulated business. We now forecast that the outcome of the regulatory reviews in Spain in 2011 and 2012 will be a 5% cut to revenues, which results in a 10% cut to EPS in 2012 for Enagas. At REE, the underlying cut to revenues is more than offset by higher earnings from the 1.6 bn acquisition of grids in Spain (announced in July 2010) and a lower cost of debt than previously assumed. For Terna, we assume that the rate of return is cut from the current 6.9% (pre-tax, real) to 5.9% in 2012, reflecting the current low risk-free rate and the passing on of the benefit of the 2008 reduction of c.6% in Italian corporate taxes to final consumers (which the Italian Regulator has already implemented for Snam RG and which on its own should lead to c.50bp cut to allowed rates of return for Terna). The lower allowed rate of return results in a 14% cut to our 2012 EPS forecast for Terna. For United Utilities, we reflect lower earnings from the sale of the majority of the non-regulated business (announced in July 2010), resulting in cuts to our EPS forecasts of 9%-10% in Exhibit 7: Cuts to forecasts reflect more conservative regulatory assumptions in Spain and Italy and disposals for UU Changes to EPS and EBITDA forecasts, EPS EBITDA 2010E 2011E 2012E 2013E 2010E 2011E 2012E 2013E Enagas 2% 2% 10% 7% 0% 2% 4% 2% REE 2% 7% 5% 4% 4% 12% 7% 6% Terna 0% 6% 14% 8% 0% 1% 8% 8% UU 4% 10% 9% 9% 6% 6% 6% 6% Source: Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 9

10 Looking at the European regulated utilities, National Grid stands out as the largest of the group, followed, at some distance by Snam RG. Terna, Red Electrica, United Utilities, Severn Trent and Enagas all have similar EBITDA, while Pennon and Northumbrian are the smallest of the group. Despite similar EBITDA, REE and Enagas are able to convert a higher share of EBITDA into net income owing to lower debt levels and lower cost of debt (see Exhibit 3). Exhibit 8: P&L highlights for regulated utilities UK companies have March year-end EUROPE [EUR mn] Stock EBITDA EBIT Clean Net Income E 2011E 2012E 2013E E 2011E 2012E 2013E E 2011E 2012E 2013E Snam RG 1,886 2,446 2,576 2,734 2,814 2,991 1,274 1,781 1,882 2,017 2, ,021 1,028 1,060 1,038 Terna 1,003 1,139 1,219 1,173 1,247 1, Enagas , REE ,124 1,164 1,254 1, UK [GBP mn] National Grid 4,444 4,723 4,791 5,098 5,465 5,705 3,489 3,680 3,669 3,883 4,154 1,638 1,663 1,689 1,762 1,848 Northumbrian Water Pennon Severn Trent , United Utilities 1, ,030 1,094 1,144 1, Source: Company data, Goldman Sachs Research estimates. Another key difference for Enagas and REE is their relatively low payout ratio, of c.60% compared to an average 73% payout for the regulated sub-sector (2011E). Terna and United Utilities have particularly high payout ratios (above 90% in 2011E, with Terna close to 100%, reflecting a top-up from the capital gain on the sale of its Brazilian business in 2009). Exhibit 9: EPS, DPS and payout ratios for regulated utilities EUROPE [EUR] Stock EPS (Clean) DPS Payout ratio E 2011E 2012E 2013E E 2011E 2012E 2013E E 2011E 2012E 2013E Snam RG % 69% 72% 73% 75% Terna % 96% 96% 96% 96% Enagas % 60% 60% 60% 60% REE % 61% 61% 61% 61% UK [GBp] National Grid % 72% 81% 83% 86% Northumbrian Water % 64% 56% 52% 53% Pennon % 65% 65% 61% 62% Severn Trent % 82% 75% 68% 71% United Utilities % 89% 93% 87% 85% Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 10

11 Italy and Spain to face the next regulatory review in 2010, 2011 Exhibit 10: Next European regulatory reviews are in Spain and Italy in 2010 and 2011 Overview of current regulation in UK, Italy and Spain Country Main cos affected Regulation Return (pre-tax, real) IRR (40 years) Started Expires? Revenues reflect inflation? Sensitive to demand Spain Enagas Gas storage 10 yr govt bond + 350bps on net RAB 9.2% No growth in returns Limited Spain Enagas Regasification 10 yr govt bond + 350bps on net RAB 6.5% No growth in returns N Spain REE Elec transmission - post yr govt bond + 375bps on net RAB 7.7% No - 2.5% growth p.a. assumed N Spain Enagas Gas transmission - post yr govt bond + 375bps on net RAB 7.7% No - 2.5% growth p.a. assumed N Spain REE Elec transmission - pre yr govt. bond + Yes - CPI reflected in revenues and 8.0% 2008 N/A 150bps on gross RAB RAB growth N Spain Enagas Gas transmission - pre yr govt. bond + Yes - CPI reflected in revenues and 7.8% 2008 N/A 150bps on gross RAB RAB growth N Italy Terna Elec transmission 6.9% 7.5% Yes - CPI reflected in revenues; RAB grows with GDP deflator Protected (capped at +/- 0.5%) Italy Enel, A2A Elec distribution 7.0% " Y Italy Snam Gas distribution 7.6% " N Italy Snam Gas transmission 6.4% 7.1% " c.15% of revenues Italy Snam Gas storage 6.7% " N UK National Grid Elec transmission 6.1% Yes - regulation set on real basis, RAB grows with inflation (RPI) N UK National Grid Gas transmission 6.1% " N UK National Grid Gas distribution 5.8% " Limited UK UK SSE, E.ON, Iberdrola Pennon, NWG, UU, SVT Elec distribution 5.6% " Limited exposure - capped Water 6.3% 5.7% " Only within 5yr regulatory period - corrected at end of period Source: Company data, Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 11

12 Inverse correlation between regulated utilities and bonds, base rates and inflation has broken down since 2008 Up to 2008, regulated stock performance relative to the utilities sector was inversely correlated with macro indicators. However, since 2008, the performance of the regulated utilities relative to the rest of the utilities sector has shown little correlation with bond yields, base rates and inflation, as regulated stocks have outperformed despite flat or rising macro indicators. In our view, this outperformance reflects a change in the commodity price outlook, as gas, oil and power prices have fallen significantly from 2008 peaks (all currently trading at less than 50% of 2008 peak levels). Exhibit 11: Recent rally in UK regulated stocks, driven by M&A speculation on UK waters, has led to breakdown in historical correlations UK regulated stocks performance relative to utilities sector vs. 12-month LIBOR, 10-year gilt yields and RPI (all inverted) % /12/01 10/12/02 10/12/03 10/12/04 10/12/05 10/12/06 10/12/07 10/12/08 10/12/ m LIBOR (inverted) UK bonds (inverted) UK RPI (inverted) UK regulated utils (RH axis) Source: Datastream, Eurostat. Goldman Sachs Global Investment Research 12

13 Exhibit 12: Similarly, strong historical (inverse) correlations between European regulated stocks and macro indicators have weakened in last 2 years Spanish and Italian regulated utilities relative performance vs. 12-month EURIBOR, European government bonds and Euro core CPI % /12/01 10/12/02 10/12/03 10/12/04 10/12/05 10/12/06 10/12/07 10/12/08 10/12/ m EURIBOR (inverted) Euro bonds (inverted) Euro core CPI (inverted) Spain regulated utils (RH axis) Italy regulated axis (RH axis) Source: Datastream, Eurostat. Goldman Sachs Global Investment Research 13

14 Exhibit 13: Strong inverse historical relationships have weakened significantly in last two years only Terna remains correlated R squared data for correlation between regulated utilities performance relative to wider sector vs. macro indicators, 2005 to date, shading pertains to levels of over 50% R squared since 2005 Pennon SVT UU NWG NG Enagas REE Snam Terna LIBOR/EURIBOR (3m) 55% 34% 0% 52% 62% 55% 31% 70% 71% LIBOR/EURIBOR (12m) 51% 32% 1% 51% 63% 55% 27% 70% 68% Bond yields 43% 44% 5% 53% 62% 61% 7% 48% 41% Base rates 63% 34% 0% 56% 68% 57% 32% 72% 71% RPI/CPI 13% 23% 5% 18% 32% 21% 55% 55% 67% R squared since 2009 Pennon SVT UU NWG NG Enagas REE Snam Terna LIBOR/EURIBOR (3m) 8% 2% 19% 7% 17% 14% 16% 2% 31% LIBOR/EURIBOR (12m) 2% 7% 30% 2% 19% 10% 14% 1% 26% Bond yields 8% 23% 27% 14% 2% 17% 6% 36% 63% Base rates 4% 0% 5% 6% 14% 4% 6% 0% 21% RPI/CPI 16% 1% 5% 19% 4% 32% 30% 0% 46% Source: Datastream, Eurostat. Snam and Terna have historically been the most strongly correlated with macro indicators; Terna retains some correlation Over the past five years, Snam and Terna have had very strong inverse correlations with base rates, interest rates and inflation. Although this relationship has weakened for these stocks since 2008, Terna retains some correlation, with a 63% R-squared statistic for its correlation with bond yields since the start of 2009 (with an associated correlation coefficient of -79%, indicating a strong inverse relationship). Our macro expectations are that interest rates and bond yields will increase in Europe over the next year, on which basis this relationship would suggest that Terna may underperform the wider sector. Goldman Sachs Global Investment Research 14

15 Revising price targets to capture short- as well as long-term valuation opportunities To capture some of the mean reversion dynamic of the utilities share prices, we adapt our 12-month price targets to include a shorter-term valuation multiple component. We have done this across our European utilities sector coverage as highlighted in Opportunities from stock picking: Buy low, sell high; Terna added to Conviction Sell List, September 14, Our price targets now equally reflect a shorter-term valuation based upon mean reversion and a longer-term valuation, which incorporates our structural views of the sector such as power price recovery and higher emission costs. Where an M&A valuation is appropriate, we have included it with a 50% weighting, with the remaining 50% split between short-term and long-term valuations. Exhibit 14: Updated 12-month price targets based on P/E and SOTP valuations, adjusted for M&A for the UK water companies Components of new price targets (per share data pence for UK stocks and for remaining stocks) P/E Change to Upside to SOTP M&A New PT Old PT Valuation PT new PT Terna % 9% Snam % 3% United Utilities % 5% Enagas % 37% National Grid % 4% Severn Trent % 6% Red Electrica % 40% Northumbrian Water % 6% Pennon % 10% Source: Goldman Sachs Research estimates. Key risks for Severn Trent, United Utilities and Northumbrian Water are a bid from private equity/infrastructure fund or inflation higher/lower than expected. Key risks for Snam are faster demand growth, lower interest rates, or financing and regulatory reviews better than forecast. Goldman Sachs Global Investment Research 15

16 Exhibit 15: Overview of how we derive our valuations Assumptions behind our P/E, SOTP and M&A valuations Terna Snam United Utilities Enagas National Grid SOTP assumptions P/E assumptions M&A assumptions Unchanged (assume incentives remain for one further regulatory period) Unchanged (assume incentives remain for one further regulatory period) Updated for debt MtM moves, disposals in nonregulated business ( 11%) SOTP reduced by 10% to reflect front end loaded regulation; reflects cut to tariffs of 5% in 2012 and 2015, WACC 6.5%. Unchanged 15% discount applied reflecting weak SUSTAIN score 20% discount applied based on average historical discount for low growth 15% discount applied reflecting low EPS growth, based on historical average 15% premium applied, based on historical average premium reflecting strong, stable EPS growth 15% discount based on historical average, EPS overstated due to stranded costs and repex N/A N/A 20% premium to RAB N/A N/A Severn Trent Updated for debt MtM moves ( 6%) No premium/discount applied 20% premium to RAB Red Electrica Source: Goldman Sachs Research estimates. SOTP increased by 9% to reflect acquisition of grids for 1.6bn and back end loaded regulation, reflects cut to tariffs of 5% in 2012 and 2015, WACC 6.5%. Northumbrian Water Updated for debt MtM moves ( 6%) Pennon Updated for debt MtM moves (+1%) 20% premium applied, based on historical average premium reflecting strong, stable EPS growth No premium/discount applied historically traded at discount (15%) but offest by strong SUSTAIN score 30% premium, reflecting strong SUSTAIN score and historical average premium of 15% N/A 20% premium to RAB 25% premium to RAB, reflecting embedded value of low cost debt Goldman Sachs Global Investment Research 16

17 Short-term valuation calculated highlighting the cheap and expensive stocks near term For most of the stocks, we apply a simple P/E valuation using mean reversion to a sector average (14x), but adjusted for historical precedent and the future sustainability of earnings. Exhibit 16: P/E premia applied to Enagas, Pennon and REE; discounts applied to NG, Snam, Terna and UU. Premia/discounts are based on historical data and GS SUSTAIN positioning Derivation of P/E premia/discounts used in calculating P/E valuations Historical average Premium/ discount for GS Applied premium/ ESG Quartile Ind. Pos. Quartile CROCI Quartile premium/ discount SUSTAIN outliers discount Comment Enagas 15% % Historical premium reflects strong, stable historical growth rates National Grid -15% % Historical discount reflects underlying EPS lower due to accounting effects Northumbrian Water -15% % Pennon 15% % 30% Strong GS SUSTAIN positioning due to exposure to waste industry, strong ESG score and high cash returns Red Electrica 20% % Historical premium reflects strong, stable historical growth rates Severn Trent Snam RG -20% % Historical discount reflects low EPS growth Terna % -15% Poor structural position, low returns and low ESG score United Utilities -15% % Historical discount reflects low EPS growth Source: Goldman Sachs Research estimates. Taking into account history to forecast the future We factor in whether the utility has consistently traded at a premium or discount to the sector over the past five years (so as to avoid selling stocks that always trade at a premium and buying stocks that always trade at a discount). As set out in Exhibit 16, this adjustment affects seven regulated stocks, although we apply a sector premium or discount of more than 15% to only three of them. Capturing future sustainability in earnings Given the focus on the short term EPS (12 months rolling forecast), we also reflect an adjustment to capture the potential sustainability of the earnings and/or the ability to grow the earnings (and vice versa for the negatives). We use our GS SUSTAIN analysis to reflect the support for the earnings outlook and confidence. GS SUSTAIN is the firm s investment framework for identifying structural sector leadership. The GS SUSTAIN scoring reflects general management quality and operational health of the company (ESG ratings), the company s industry position (and hence the likely ability to sustain return on capital, grow it or risk declines) and the level of cash returns (reflecting the ability to generate profitability from one s asset base). Overall, the SUSTAINbased adjustment to the P/E valuation only impacts three regulated stocks. We have applied a premium or discount of 15% in line with the historical level of top and bottom quartile P/E relatives in the sector over the last five years. Exhibit 16 provides the detail for NWG, Pennon and Terna, which are the stocks for which there is an impact. Generally, regulated stocks have strong ESG scores compared with the rest of the European utilities sector, with six of the nine stocks recording Q1 ESG scores, typically owing to strong scores in social and governance areas. However, they do tend to score less well on industry positioning compared to global peers, owing to relatively low regulatory returns in Europe (although the regulation scores well for its stability), and lower growth in European markets. Cash returns are mixed, with the Spanish stocks and Pennon achieving Q1 CROCI, but Terna and Severn Trent below average. We reflect SUSTAIN leadership through an uplift to Goldman Sachs Global Investment Research 17

18 historical P/E premia/discounts for NWG and Pennon, and factor a discount into our P/E valuation for Terna owing to its low GS SUSTAIN score. Short-term valuations captured by P/E The valuations and adjustments for the target P/E multiple are shown in Exhibit 17. Valuations for Pennon, Red Electrica and Enagas imply premium P/E multiples are justified on clean EPS reflecting historical premia and in Pennon s case the prospect of sustainably high earnings. Valuations for National Grid, United Utilities, Terna and Snam imply discounts to P/E multiples are justified on clean EPS reflecting historical discounts and in Terna s case, the risk of a comparably low sustainability of earnings. Compared to hybrids, the regulated EPS does not need any adjustment for CO2 subsidies through Exhibit 17: P/E valuations reflecting 14x adjusted EPS and adjustments for historical precedent and future sustainability Pennon at a premium reflects quality of earnings and higher multiples for the waste business Companies (ranked by resulting P/E premium/ discount to sector average P/E) Currency * 12-month rolling EPS, ** 1-year forward EPS (e.g. 2011E) Source: Goldman Sachs Research estimates Unadjusted P/E (x) Plus NPV of free CO2 permits (x) Additional P/E premia or discounts Additional P/E premia or discounts (x) P/E used for valuation (x) EPS (adjusted for CO2) (currency)* P/E valuation (currency/ share) Clean EPS (no CO2 adj.) (currency)** P/E on clean EPS at short term valuation P/E premium/ discount on clean EPS Pennon p % % Historical premium for stable high EPS CAGR (waste business) Verbund % % Historical premium due to nature of assets EDF % % Historical premium to the sector - tariff option and long lived assets Red Electrica % % Historical premium reflecting superior earnings growth and low volatility Enagas % % Historical premium reflecting superior earnings growth and low volatility Fortum % % Premium for long-lived assets Centrica p % % Premium for growth and sustainable earnings CEZ Kc % Edison % % PGE PLN % EDP % Severn Trent p % Northumbrian Water p % Iberdrola % Gas Natural % Recent (historical) discount supported by low GS SUSTAIN score National Grid p % % Discount reflecting EPS overstated relative to cashflow Terna % % Historical discount due to low EPS CAGR EON % % Historical discount to the sector, weak industry positioning United Utilities p % % Historical discount due to low EPS CAGR Snam RG % % Historical discount due to low EPS CAGR Endesa % % Historical discount reflecting high proportion of Latin America earnings SSE p % % CO2 adjustment A2A % CO2 adjustment indicates large discount RWE % % CO2 adjustment indicates large discount Drax p % % CO2 adjusted and historical discount Comments Goldman Sachs Global Investment Research 18

19 Short-term valuations would imply most upside for Enagas, REE and most downside for UU This approach highlights the value in several of the defensive utilities that are trading out of line relative to the sector and their history such as Enagas and REE, both of which we upgrade to Buy from Neutral mainly owing to their discount to the sector on valuation multiples. In contrast to the UK and Italian stocks, United Utilities and Terna appear expensive relative to the sector owing to the potential deterioration in earnings due to historical precedent. Exhibit 18 shows the current P/E valuation and sector relative for all the companies on rolling 12-month clean EPS (25% 2010E and 75% 2011E EPS). It also shows the P/E and sector P/E relative for the companies at the targeted short-term valuation. On this basis, Enagas currently trades on a P/E relative to the sector of 84 (84% of the sector median P/E), but on our short-term valuation, it should be trading on a P/E relative of 117 therefore some of the upside is mean reversion to 100 and then a further premium is warranted given the historical premium to the sector on which Enagas has traded. From the Exhibit, it can be seen that Enagas and Red Electrica have some of the greatest share price upside to short-term valuations, which reflects the current discounts to the sector and the historical premiums on which they have traded. Terna (Conviction Sell) appears to be on a high P/E rating relative to the sector compared to its history and given the potentially unsustainable nature of the current earnings. National Grid (Conviction Sell) looks better on short-term valuations and would only have 3% relative downside to the sector median multiple. Its current P/E discount to the sector is smaller than it has been historically, implying modest downside. Goldman Sachs Global Investment Research 19

20 Exhibit 18: P/E valuation multiple mean reversion plus a few adjustments give targeted short term valuations and implied multiples Current P/E valuation Components of short term valuation target Target P/E valuation Company Currency Share price Rolling 12 month clean EPS Current P/E (x) Current P/E relative to the sector plus: Underlying mean reversion plus: Historical premia/ discount plus: GS SUSTAIN outlier plus: Free plus: Other CO2 adjustments adjustment Target P/E Relative to the sector Target P/E (x) Short-term valuation (currency/s hare) Upside/ downside on short-term valuation Ranked in order of upside/downside to short term valuation 09/09/ % 2010E plus On rolling Sector median (ex 75% 2011E EPS 12 mth EPS renewables) = 100 Relative to sector median EPS ex free CO2 permits but adjusted for NPV of permits (Renewables EBITDA or waste cos GDP valuations or rounding) Sector median (ex renewables) = 100 Sector median based upon historical average of 14x underlying P/E, EV/EBITDA to growth or P/E adjusted for GDP Enagas % EDP % Red Electrica % Shanks p % CEZ Kc % Gas Natural % EDF % Veolia Environnement % EDP Renovaveis % Acciona % Fortum % Verbund % Suez Environnement % Centrica p % E.ON % Iberdrola % Pennon p % Endesa % Iberdrola Renovables % PGE PLN % National Grid p % SSE p % Northumbrian Water p % Snam RG % RWE % EDF Energies Nouvelles % Severn Trent p % Terna % A2A % United Utilities p % Edison % Drax p % Sector median (ex renewables) % Relative to sector median valuation Source: Goldman Sachs Research estimates. Goldman Sachs Global Investment Research 20

21 Incorporating M&A valuations into our price targets for the UK water companies We expect M&A to be a factor in valuations, reflecting the trend in the general market (see Tactical Research: Screening for alpha: capitalizing on an acceleration in M&A, March 17, 2010) and also recent evidence in the sector. Using our GS Takeover Index for utilities, we have extended the list of companies that have M&A valuation as part of their price target to include the UK Water companies, all of which have upside potential to our M&A valuation. Despite using a 50% weighting for the M&A valuation, we continue to see limited upside for UK regulated names. We derive our M&A valuation for the UK water stocks using a 20% premium to RAB (25% for Pennon) see UK water section for more details. We see limited risk of M&A for the other regulated stocks. The Spanish and Italian regulated stocks all have a blocking shareholder(s), which we believe would make a takeover difficult or impossible. National Grid s shareholder structure presents no particular barriers to M&A, but we consider a purchase of the UK assets may be politically difficult (as the national transmission grid is an important asset for the UK government) and the sale of the US businesses would face significant regulatory hurdles. Exhibit 19: GS takeover index highlights UK water stocks as potential takeover candidates; we reflect M&A valuations in our 12- month price targets for these stocks GS takeover index; scores 1-5 where 5=high probability of takeover Source: Goldman Sachs Research estimates. Average takeover potential score Shareholding Scale Valuation Regulatory/political situation SVT % NWG % Pennon % UU % NG % Enagas % REE % Terna % Snam % M&A weight in price target Goldman Sachs Global Investment Research 21

22 Italy: Low bond yields to lead to lower returns; Terna Conviction Sell, Snam RG Sell While the Italian regulated utilities have outperformed this year thanks to their high dividends (and defensive nature) in an environment of low (and falling) bond yields, we believe this environment could present negative surprises for the names. In fact, in an environment of low interest rates, the Italian regulator is likely to reduce the allowed rates of returns for Terna and Snam RG in order to pass on the benefit of the low interest rate environment to consumers. While companies have been quicker to exploit such an environment, managing to reduce their cost of debt to c.3%, we believe that there is little room left for them to reduce such costs further, while the regulator is now likely to start passing on such cost benefits to consumers at the next reviews. This should start with the 2011 review process for Terna (for the period), which we believe will lead to significantly lower rates of return for it and which we believe the market has not yet anticipated. Considering the unattractive valuation relative to the wider utilities sector, we add Terna to Conviction Sell and reiterate Snam RG as Sell. Regulation: low yields lead to lower returns When the Italian regulator reviews the rates of return for the regulated assets (transmission, distribution, storage) it resets the return for both existing and new assets. While this is similar to the UK, it is different to Spain, where the return is maintained for the whole life of the asset (see for example Spanish RD326/2008, article 4) and the review (which is due every four years) only affects new assets. While Snam has already gone through regulatory reviews, Terna is facing one in 2011 While Snam RG has had review for both its transmission and storage assets over the last 12 months, representing almost 80% of its RAB, Terna is facing its next one over the next 12 months. Considering the current methodology consistently used by the Italian regulator for determining the rates of return, we expect the regulator to take into account the average Italian 10-year government bond yield observed between July 2010 and June 2011 for the regulatory period. In our new forecasts, we assume an a average risk-free of 4.0% and 44% debt-56% equity gearing (in line with the last review) to derive a 5.9% real pre-tax rate of return, which still implies a 14% fall in 2012 earnings. Based on the current 3.8% yield on Italian government bonds and Terna s gearing of around 50% debt-50% equity, we estimate that the real pre-tax rate of return would fall to 5.4% real pre-tax, compared with the current 6.9%, with a 153 mn impact on EBITDA and 99 mn impact on net income (or 22% of 2011E earnings). Market consensus currently assumes only a 2% net income fall in 2012 versus Our 2012 estimates are 9% below consensus for Terna. In addition, as in the last two Snam RG reviews, we expect Terna s returns are likely to be cut to take into account the lower Italian corporate tax rate since 2008, which has resulted in it having a c.6% lower corporate tax rate. The Italian regulator has already taken this into account in the last two reviews for Snam RG, leading to a reduction of returns for transmission (from 6.7% to 6.4%) and storage (from 7.1% to 6.7%, all real pre-tax). We estimate that the lower corporate tax rate should have a 50-60bp negative impact on Terna s allowed rate of return, with the lower risk free rate leading to c.60bp reduction and a potential 20bp benefit from lower assumed inflation by the regulator. Goldman Sachs Global Investment Research 22