Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?

Transcription

1 Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback? Primary Credit Analyst: Tania Tsoneva, CFA London Secondary Contacts: Nazia Haider London Beatrice de Taisne, CFA London Renata Gottliebova London Gustav B Rydevik London gustav.rydevik@spglobal.com standardandpoors.com/ratingsdirect

2 Overview U.K. regulated utility assets are achieving high premiums, reflecting their scarcity and attractiveness to traditional pension fund and infrastructure investors. Given the generally low growth prospects for some of these assets, investors appear to anticipate other methods for payback, such as financial or cost outperformance. Given that high valuations suggest increasing acquisition-related debt leverage, we anticipate buyers will seek more complex financing solutions which provide ratings uplift or ring-fence the operating company. We believe the drive for regulatory outperformance could create higher political and regulatory scrutiny of profits in the U.K. regulated utility businesses. S&P Global Ratings has witnessed another bout of sale transactions in 2016 and early 2017, implying high premiums for U.K. regulated utility assets. Just very recently, National Grid agreed to sell a 61% equity stake in its U.K. gas distribution networks for 3.6 billion in cash to a consortium of long-term infrastructure and pension funds. The sale amount implies a premium of approximately 50% of the regulated asset value (RAV) as of March 31, 2017 (see U.K. National Grid Gas Distribution Downgraded To BBB+ From A- On High Acquisition Debt On Sale; Outlook Negative, published on ). Australian investment bank MacQuarie has also agreed to sell 26% of its stake in the holding company of Thames Ltd., while another U.K. utility, Affinity Ltd., is on the market. that investors anticipate alternative methods of payback to the regulatory-approved tariffs such as financing or operating outperformance. The regulator s cost of debt has reduced significantly since the previous regulatory period, as demonstrated in the latest cost of capital decisions. That said, their allowance for the cost of new debt is still higher compared to what we have observed in the marketplace. Thanks to the mature and predictable framework under which they operate, U.K. regulated utilities are also excellent candidates for more complex financing solutions, which allow them to optimize their capital structures while maintaining an investment-grade rating as required by some of their regulatory licenses. In simple terms, the achieved prices are a result of the historically low cost of debt, unabated demand for low-risk, inflation-linked assets under well-established and mature regulation, and regulatory incentives for operating efficiencies. U.K. regulated utilities check all of these boxes. At the same time, supply of these assets is scarce and the gulf between regulated and merchant utilities, in terms of relative risk profiles, continues to widen. Asset base growth could be a factor in pricing decisions, however, in sectors such as gas distribution and for some water utilities the regulatory asset base (RAB) is set to remain flat or decline slightly in real terms. Therefore, the premiums paid could imply While we understand investors are prepared to pay high premiums, we also see some limitations. Asset Base Growth Could Explain Premiums Although It Is Subdued In Some Sectors Asset base growth could be a factor in pricing decisions, as it leads to higher future profits and cash flows. When investment requirements are earmarked for enhancement, rather than just replacing the assets, the RAV increases and the rate of return is earned on a higher asset base. In addition, the future cash flows of the standardandpoors.com/ratingsdirect 2

3 U.K. regulated utilities should cover not only operating costs but also the higher depreciation for past investments. That said, in sectors such as gas distribution, the RAV is set to increase only slightly in real terms (i.e. before indexation to the retail price index [RPI]), which could limit the opportunity for payback of the M&A premiums. In the water sector, the regulator projects overall industry growth in regulated capital value in both wholesale water and wastewater segments, although the investment requirements differ significantly between companies. Operational Efficiencies Could Help Or Hinder Shareholder Returns Regulated U.K. utilities are regulated under frameworks which incentivize performance and efficiency through rewards and penalties mechanisms, as well as sharing budget deviations with customers. One way of boosting shareholder returns is through cost control beyond the regulator-approved business plans and good operating performance indicators related to service. For example, in , electricity distribution network operators (DNOs) Table 1 Gas Distribution Projected Closing RAV Balances During RIIO Provisional closing RAV for year ending March 31 (2009/2010 prices Mil. ) Industry 14,571 14,594 14,611 14,724 14,885 15,066 15,240 15,403 15,545 NGGD (total) 7,243 7,244 7,227 7,264 7,321 7,393 7,462 7,528 7,528 East of England 2,535 2,523 2,501 2,495 2,497 2,500 2,501 2,497 2,492 North of London 1,644 1,660 1,678 1,713 1,747 1,793 1,842 1,893 1,946 North West 1,743 1,747 1,738 1,741 1,753 1,764 1,772 1,780 1,782 West Midlands 1,321 1,314 1,310 1,315 1,324 1,336 1,347 1,358 1,365 NGN 1,577 1,584 1,598 1,624 1,655 1,682 1,707 1,732 1,753 Scotia GN (total) 4,141 4,148 4,155 4,193 4,252 4,314 4,372 4,419 4,455 Scotland Networks 1,277 1,282 1,287 1,300 1,320 1,340 1,357 1,368 1,375 Southern Networks 2,863 2,865 2,869 2,893 2,932 2,974 3,015 3,051 3,080 WWU 1,610 1,619 1,630 1,644 1,658 1,677 1,699 1,725 1,752 Source: Ofgem. RIIO = revenues + incentives + innovation + outputs. NGGD National Grid Gas Distribution. NGN Northern Gas Networks. Scotia GN Scotia Gas Networks. WWU Wales & West Utilities. Chart 1 And Wastewater Opening RCV Versus Closing RCV Opening RCV Closing RCV (Mil. ) Anglian Dwr Cymru Northumbrian Severn Trent South West Southern Thames United Utilities Wessex Yorkshire Source: Ofwat 2016, S&P Global Ratings. RCV Regulated capital value. standardandpoors.com/ratingsdirect 3

4 Chart 2 Only Opening RCV Versus Closing RCV Opening RCV Closing RCV (Mi. ) Affinity Bristol Dee Valley Portsmouth Bournemouth Sutton & East Surrey South East South Staff Source: Ofwat 2016, S&P Global Ratings. RCV Regulated capital value. collectively spent 9% less than their allowances for the year. It is forecast that gas distribution networks (GDNs) will spend 2.1 billion in total over the eight-year period to 2021, which is 12.3% less than the operators original plans. A certain percentage of this underspend is returned to customers depending on the quality of the original business plans. However, more than 50% is retained by the companies, contributing to higher returns than assumed by the regulator. It is too early to draw conclusions from the first few years of the eight-year period (until 2021 for GDNs and 2023 for DNOs) as it takes time for companies to negotiate contracts and set up partnerships. It is also unclear how much of the lower spending is related to cost efficiencies or non-delivery of work. Actual returns also differ from notional ones assumed by the regulator, but it seems that for some companies there is scope to achieve double-digit returns, even after sharing a percentage of the underspend with customers. According to the regulator s calculation, based on an assumed capital structure, it seems that DNOs will earn an average return on regulatory equity of 9.03%, compared to the allowed cost of equity of 6.4% for the fast-tracked companies (those who agreed their tariffs first) and 6% for the remainder. The average returns expected for GDNs are 10.3% compared to an allowance of 6.7%. The risks are symmetrical, however, some network operators could see their returns eroded due to higher-than-expected spending. Various factors such as economic performance and weather which have both been supportive for lower expenditure could change in future years and affect the overall returns. The Historically Low Interest Rate Environment Presents An Opportunity On the back of interest rate cuts and oversubscribed debt issuance, we see an increasing gap between what the regulator allows in its cost of capital decisions and what the U.K. regulated utilities achieve in the marketplace. Some of the recent deals, such as NGG (in August 2016: 1.125% coupon for a five-year bond) and Northumbrian (in October 2016: 1.625% for a 10 year bond), fare well compared to Ofgem s allowance of 2.42% for and Ofwat s assumption for new debt of 2% per year. The regulators role is not easy as they need to set a forward-looking cost of debt over a five-year period for water utilities and eight-year period for gas networks, and this cost of debt should be appropriate to ensure that the companies can finance their operations. standardandpoors.com/ratingsdirect 4

5 Table 2 Cost Of Capital Decisions Extracts From UKRN s Cost Of Capital Report Recent cost of capital decisions Decision year Regulator CC Ofwat CMA Sector NI Electricity Price control RP5 PR 14 CMA - Bristol Cost of embedded debt 3.20% 2.75% 2.95% Cost of new debt 2.10% 2.00% 1.60% Weighting of new to embedded debt 10:90 25:75 25:75 Cost of debt 3.10% 2.59% 2.61% Risk free rate 1.50% 1.25% 1.25% Equity risk premium 5.00% 5.50% 5.25% Equity beta Cost of equity (post tax) 5.00% 5.65% 5.73% Gearing 45.00% 62.50% 62.50% WACC (Vanilla) 4.10% 3.74% 3.78% Tax 20.00% 20.00% 20.00% WACC (full post tax) 3.90% 3.41% 3.46% Inflation assumption RPI RPI RPI Source: UK Regulator s Network (UKRN). CC Competition Commission. CMA Competition Market Authority. RP5 Review period 5. PR 14 Price review 14. WACC Weighted-average cost of capital. In order to mitigate market uncertainties, electricity regulator Ofgem is using trailing average debt indices to set annual allowances ( allowances based on a 10-year trailing average of the iboxx index for BBB+ and A- rated corporates added up to 2.42%). We understand that water regulator Ofwat has closed its consultation on a possible transition to a market index for new debt in the next regulatory period starting April 1, As seen in the chart below, tracking a market index means that the companies see their cost of debt allowance decline when interest rates are on a downward trajectory. This decline is not as abrupt because the allowed cost of debt captures market dynamics over the past 10 years and, at present, considers the effect of the financial crisis in That said, regulated utilities have very long-dated debt so this approach could bring mismatches between the actual and assumed cost of debt, depending on each issuer s capital structure and their cost of legacy debt. Chart 3 iboxx Index Evolution Since April 1, 2015 (Evolution of low cost of debt indexation) Real cost of debt 10-year trailing average 7% 6% 5% 4% 3% 2% 1% 0% -1% Source: Ofgem 2016, S&P Global Ratings. standardandpoors.com/ratingsdirect 5

6 Low Cost Of Debt And RPI Are A Double Benefit For Our Cash Flow Coverage Ratios U.K. regulated utilities cash flow coverage ratios have benefited significantly from the low interest rate environment, owing to their frequent participation in refinancing and funding capex programs and dividends. In addition, they have significant exposure to RPI-linked debt, whereby we deduct the RPI component from funds from operations (FFO) as part of the profit and loss interest. The recently lower reported RPI and the low cost of debt have led to double folded benefits to our primary ratio of FFO to debt. Table 3 S&P Global Ratings RPI and CPI Forecasts (% Year) CPI RPI RPI Retail price index. CPI Consumer price index. Chart 4 Cash Flow To S&P Global Ratings-Adjusted Debt (Weighted-average using adjusted debt) utilities Network utilities 4% Free Operating 3% Over the last few years, RPI inflation (which is 2% used to index the utilities revenues and RAB) has declined to 1% per year in 2015 from a peak 1% of 5% in We expect the RPI to reach 3.2% in 0% 2017 and then stay broadly in the range of 3.0%- 3.5% until 2020, while the divergence between the RPI and consumer price index (CPI) inflation increases. This would likely arise from council -1% 0% Discretionary tax increases to finance social care and higher mortgage costs when the Bank of England -2% raises rates but would only partly be offset by lower housing depreciation. -4% Investors Are Adding Leverage To Finance Acquisitions -6% In order to cover the acquisition bill, new owners resort to higher financial leverage to -8% Source: Ofgem 2016, S&P Global Ratings the extent that this does not compromise the investment-grade ratings on the operating subsidiaries. As one can expect from a defensive sector such as regulated utilities, dividend outflows have consistently led to strongly negative discretionary cash flows (after capital expenditure [capex] and dividends). That vertically-integrated groups with a less intensive retail business and conventional generation mix. That said, the gas network operators have had sustainably lower capex requirements compared to both electricity transmission and distribution networks, and water companies. said, the series of M&As between exarcebated the cash flow deficit as new owners executed capital restructurings and upstreamed exceptional dividends. We observe that cash flow generation after capex has improved for U.K. water companies in the last couple of years and remains positive for U.K. network utilities. For networks, this is partly due to some belonging to The balance sheet leverage in terms of adjusted debt to RAB could indicate the scope for increasing financial debt. Interestingly, this ratio is consistently above the regulator s assumption of 62.5% on average for the water sector, and is particularly elevated for the transactions rated as structurally enhanced debt (SED). The issue credit ratings on SED reflect their stand- standardandpoors.com/ratingsdirect 6

7 Table 4 Rated U.K. Utilities Credit Metrics For Financial Year As Of Rated U.K. water utilities as of Rated Entities Long-term corporate credit rating Outlook Adj. Debt/ RAB (%) FOCF/ Adj.Debt (%) DCF/ Adj. Debt (%) FFO cash interest coverage ratio (x) FFO/Debt (%) Dee Valley PLC BBB Stable Northumbrian Ltd. BBB+ Stable 78 6 (1) Portsmouth Ltd. BBB Stable Severn Trent Ltd.* BBB+ Stable 66 3 (1) South Staffordshire PLC** BBB+ Stable -- 6 (2) United Utilities Ltd. *** BBB+ Positive 60 1 (2) Wessex Services Ltd. BBB+ Stable U.K. water utilities SED transactions-rating components Financing group Rating on senior secured debt Rating on subordinated debt Affinity Programme Finance Ltd A-/Stable BBB/Stable 77 3 (2) Anglian Services Financing PLC A-/Stable BBB/Stable Dwr Cymru (Financing) Ltd. A/Stable BBB+/Stable South East (Finance) Ltd. BBB/Stable Southern Services (Finance) Ltd. A-/Stable BBB/Stable Thames Utilities Cayman Finance Ltd. A-/Negative BBB/Negative 82 (3) (4) Yorkshire Services Finance Ltd. A-/Stable BBB/Stable *Credit metrics based on Severn Trent PLC. **Credit metrics based on South Staffordshire PLC. ***Credit metrics based on United Utilities PLC. RAB Regulatory asset base. FOCF Free operating cash flows. DCF Discretionary cash flow. FFO Funds from operations. alone credit profiles as well as the benefit of a package of structural enhancements for senior creditors (see A Comparison Of European Regulated Utilities Structurally Enhanced Debt Transactions, published on March 21, 2016). More Complex Financing Solutions Optimize The Capital Structure The U.K. regulator s duty to ensure that utility operations are financeable is linked to the requirement in many cases stated explicitly in the companies licenses to maintain an investment-grade rating for the license holder entity. The rating is therefore an important consideration for new owners when deciding on the post-sale capital structure and how to refinance acquisition debt. We observe that new owners often use shareholder loans to downstream equity in order to benefit from the tax shield on interest. Another increasingly popular route is to refinance at an intermediary holding company (MidCo) level. This has at least two benefits: the rating requirements and regulator s duties do not extend to companies outside of the license holder (i.e. the operating company or regulated utility) and there is no risk of a potential tax clawback for the additional debt, if the regulator has set a ceiling on actual debt at the operating company for tax purposes. That said, creditors at MidCos face material risks as they rely solely on dividends from the regulated utility, and U.K. regulators have the power to apply a cash-lock if the investment-grade rating is under threat i.e. if we lowered the rating to BBB- with a negative outlook or placed it on CreditWatch negative. In order to mitigate this risk, companies deploy various structural and legal mitigants at the operating company or MidCo level. In one of the complex group ratings, Electricity North West (ENW) which we rated first in 2010 debt is raised at the operating company ENW, the MidCo (North West Electricity Networks; NWEN), and the holding company (North West Electricity Networks Holdings; HoldCo) level. standardandpoors.com/ratingsdirect 7

8 There are a number of structural features present at the MidCo level, specifically: A liquidity reserve and facility covering 18 months of debt service at the MidCo level, enhanced to some degree by a 50 million intragroup loan between ENW and NWEN; An intercreditor agreement at NWEN, which arranges for a 12-month minimum standstill period at NWEN following an event of default, possibly allowing for the resumption of dividends from ENW in the meantime; and A favorable package of security (including the pledge on the shares of ENW) and covenants at the MidCo level. Dividend lock up Event of default ENW 65% net debt to RAB 70% net debt to RAB NWEN MidCo 85% net debt to RAB, ICR <1.1x 92% net debt to RAB; ICR <1.0x In our view, NWEN s transaction does not qualify as SED as per our criteria Rating Structurally Enhanced Debt Issued By Regulated Utilities And Regulated Infrastructure Transportation Businesses, published on Feb. 24, The key reasons include the presence of significant unsecured debt at the operating company, which is not part of the intercreditor agreement, and the fact that the structural features are available at the MidCo level, which is structurally subordinated and not the regulated license holder. Therefore, we do not see sufficient ring-fencing between MidCo creditors and the rest of the group and we include all of the debt raised by ENW, the MidCo, and the HoldCo in our analysis of the consolidated group credit profile. The lower ratings on the MidCo and HoldCo reflect their restricted access to cash from the operating company, ENW, which is their sole source of cash generation. Given our views on the effectiveness of regulatory ring-fencing in the U.K. and external liquidity resources at the MidCo, we view the credit quality of MidCo s debt ( BBB ) as only one notch weaker than ENW s debt ( BBB+ ). However, we view the HoldCo s speculative-grade debt ( BB+ ) as two notches weaker than the MidCo given the potential for further reduced cash flow due to structural financial features at the MidCo, which reinforce the regulatory protections around ENW. Furthermore, should the credit quality of ENW deteriorate, our view is that the risk of regulatory ring-fencing could strengthen further, implying a more rapid and severe downgrade of the HoldCo and a lowering of the ratings on MidCo s debt. Political And Regulatory Scrutiny Is On The Rise The drive for operational and financial outperformance, in our view, could lead politicians to exercise more scrutiny over the regulatory decisions of Ofwat and Ofgem, as evidenced in a 2016 report published by the Public Accounts Committee (PAC) into the windfall gains of U.K. water companies. The report estimated that water companies have made excessive profits of about 1.2 billion in as a result of inflated financing and taxation costs. It calls for increased accountability by Ofwat in terms of its cost of capital methods and the measures it plans to take. That said, other stakeholders in the process such as the decision maker of last resort, the U.K. Competition Market Authority (CMA), found no market evidence that the cost of capital and its components are excessive. The CMA even allowed Bristol PLC a small uplift for its equity beta in the company s latest referral of its price review package in We continue to monitor these developments as overt political pressure could negatively influence our view of the independence of both Ofwat and Ofgem. On the other hand, we see efforts by the U.K. regulators to become more engaging, for example, the U.K. Regulator s Network has opted for a peer review process on new cost of capital decisions. Extending the inbuilt checks and balances in the regulation and consulting more stakeholders is positive for our view of framework consistency. Extending the inbuilt checks and balances in the regulation and consulting more stakeholders is positive for our view of framework consistency. standardandpoors.com/ratingsdirect 8

9 Ratings On U.K. Regulated Utilities Rated U.K. water utilities as of Rated entities Long-term corporate credit rating Outlook Dee Valley PLC BBB Stable Northumbrian Ltd. BBB+ Stable Portsmouth Ltd. BBB Stable Severn Trent Ltd. BBB+ Stable South Staffordshire PLC BBB+ Stable United Utilities Ltd. BBB+ Positive Wessex Services Ltd. BBB+ Stable U.K. water utilities SED transactions rating components Financing group Rating on senior secured debt Rating on subordinated debt Affinity Programme Finance Ltd A-/Stable BBB/Stable Anglian Services Financing PLC A-/Stable BBB/Stable Dwr Cymru (Financing) Ltd. A/Stable BBB+/Stable South East (Finance) Ltd. BBB/Stable -- Southern Services (Finance) Ltd. A-/Stable BBB/Stable Thames Utilities Cayman Finance Ltd. A-/Negative BBB/Negative Yorkshire Services Finance Ltd. A-/Stable BBB/Stable Rated utilities subject to RIIO Model as of Network entities Long-term rating Outlook Electricity North West Ltd. BBB+ Stable National Grid Gas Distribution Plc BBB+ Negative National Grid PLC A- Stable Northern Gas Networks Ltd. BBB+ Stable Northern Powergrid (Yorkshire) PLC A Stable Scotland Gas Networks PLC BBB+ Stable Western Power Distribution PLC A- Stable Scottish and Southern Energy PLC A- Negative Scottish Power Ltd. BBB+ Stable London Power Networks PLC BBB+ Stable U.K. gas distribution companies SED transactions Financing group Rating on senior secured debt Rating on subordinated debt Wales & West Utilities Finance PLC A-/Stable BBB/Stable Source: S&P Global Ratings. Rating indicated is on one of the regulated operating subsidiaries in case of multiple networks. The author would like to acknowledge the contribution of Lloyd Budd with research for this article. Only a rating committee may determine a rating action and this report does not constitute a rating action. standardandpoors.com/ratingsdirect 9

10 No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an as is basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P s public ratings and analyses are made available on its Web sites, (free of charge), and and (subscription) and (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www. standardandpoors.com/usratingsfees. Copyright 2017 by Standard & Poor s Financial Services LLC. All rights reserved. STANDARD & POOR S, S&P and RATINGSDIRECT are registered trademarks of Standard & Poor s Financial Services LLC. spglobal.com/ratings