The dramatic victory of the Brexit campaign in the European Union referendum has caused the pound to plummet. Moreover, shortly after the unexpected result, shares fell sharply, with the bank and housebuilding sectors particularly weak. But most shares have now rallied.
As expected, defensive stocks, in particular utilities such as National Grid and Severn Trent, weathered the latest financial storms comfortably. Their shares have risen sharply since the vote to leave the EU as investors sought secure dividend streams.
In the aftermath of the referendum, City in interest rates to stimulate the economy; some additional quantitative easing may also be prescribed.
But if the pound continues to plunge on the foreign exchange markets, action might be needed – namely a rise in interest rates.
Such a policy seems unlikely in the short term, although further increases in US interest rates have been flagged for some time, assuming that world’s financial markets settle down.
If such a scenario does come to pass, what would be the impact on UK utilities?
First of all, the ability of utility companies to outperform their regulatory settlements, particularly in the period following the credit crisis in 2008, has been partly due to the accessibility of cheap funding.
This scenario has been very evident with the water companies. The share prices of the three quoted water stocks have risen consistently as their core business earnings exceeded Ofwat’s expectations, as set out by the assumed weighted average cost of capital (Wacc).
Consequently, their dividend payment profiles have been boosted along with their share price.
Earlier this year, the Public Accounts Committee examined increases in water charges and concluded that “Ofwat has consistently overestimated water companies’ financing and taxation costs when setting price limits”.
In the 2014/15 price review, the regulator set a far tighter 3.6 per cent Wacc assumption that fully reflected the low interest rates of recent years.
By March 2020, it will become apparent whether this prescribed Wacc figure was a prudent judgment or whether it was genuinely tough.
Similar principles apply within the electricity sector, particularly to the distribution companies, whose pricing formulas are also based on Wacc assumptions.
In the case of National Grid’s full-year results for 2015/16, the benefits of borrowing at lower levels than assumed by Ofgem were very apparent.
In a rather convoluted explanation, National Grid confirmed that “net financing costs (for 2015/16) were £1,013 million, £20 million lower than 2014/15 at actual exchange rates and £64 million lower than 2014/15 at constant currency, benefiting from continued refinancing of debt at lower prevailing interest rates, strong Treasury management and lower accretions on index-linked borrowing”.
Looking forward, these variables could reverse if interest rates were to rise – and indeed return to the more normal levels associated with the period prior to the 2008 credit crisis.
Virtually all major utilities – in addition to their shareholders’ equity – have a debt portfolio, with varying redemption periods; in some cases, bonds are index-linked rather than paying a defined coupon.
While there is a minimal threat of a sharp rise in interest rates for the present, the cost of money could creep up over the next few years – with the yield on the government’s ten-year Treasury bond being the key benchmark.
If interest rates rise, that yield should move up to reflect higher borrowing costs. In time, this would increase the Wacc for private sector companies and make it more difficult for them to achieve a decent return on capital. All utilities are exposed to this scenario, but some more than others.
SSE, for example, with adjusted net debt (including hybrid capital) of £8.4 billion, is vulnerable if it suffers revenue shortfalls on several fronts, namely low generation prices, adverse price-setting rulings and cuts in renewable subsidies.
In anticipation of this trend, some companies may undertake bond issues, with the aim of locking in cheaper borrowing if the term structure of interest rates is moving upwards.
Such a scenario could result in utilities claiming – near the end of the regulatory period – that the Wacc was actually set too low, thereby preventing any outperformance of the regulatory parameters.
Aside from the years of attrition between Ofgas and British Gas regarding the appropriate Wacc for Transco, almost no utility has complained about the Wacc assumption near the end of a regulatory period; however, this could change.
Importantly, though, if higher borrowing costs do give rise to a resurgence of inflation, water companies will continue to enjoy considerable protection, because high inflation – presumably measured by the consumer price index – boosts their operating margins.
In reality, recurring inflation is a medium-term risk.
More immediately though, the dramatic Brexit vote has taken UK politics into uncharted waters.
Disregarding Greenland’s exit from the EEC in 1985 following its separation from Denmark in 1979, no country has ever left the EU, so resolving the many trade-related issues, in the absence of relevant precedents, is likely to take years.
The vote to leave the EU has also seriously depressed the pound’s value and raised many political and financial questions, one of which is the medium-term and long-term direction of UK interest rates.