European 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 environment – 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 the 2019 price review (PR19), which outlines the next regulatory period from 2020. In the longer term, attention may turn to how energy utilities adapt to technological disruption, particularly once battery storage solutions and the energy transition truly take hold.
Investors retain their interest
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 infrastructure and pension funds for regulated assets could accelerate, as a result. We foresee further disposals this year. To fuel growth, regulated 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 rationales for rating actions: take Fortum’s recent €3.76 billion purchase of the 46.65 per cent stake in Uniper’s shares (owned by Eon), which resulted in a downgrade.
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 re-financings 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 cash-flow 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 instruments, comprising coupons of 3.875 per cent and 4.625 per cent. Coupled with the rise of green bond issuance, which is aiding the continent’s energy transition, we expect the already-active bond market to continue on its course.
Investment opportunities are also significant for existing portfolios. Europe’s grids not only require additional lines and substations to connect new assets but also network upgrades to manage the increased intermittency that renewable generation entails. And network modernisation is costly across many sectors: installing buried lines in the power sector is one example; replacing old gas lines with plastic ones is another.
Regulatory resets and opportunities ahead
Also presenting both risks and opportunities to Europe’s utilities are regulatory changes, and particularly their focus on efficiency. Regulators, we note, are encouraging utilities to ensure affordable network access to customers. With energy efficiency gains being delivered at pace, regulators are setting increasingly ambitious cost-efficiency targets. Though very achievable at present, such targets may offer less headroom for outperformance in the future. What’s more, regulators’ 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 on utilities, as allowed returns are lowered. As a consequence, many utilities in these markets will likely begin their regulatory periods suffering a fall in revenues (compared to previous ones). Decreased revenues in these markets, however, are partly mitigated by other remuneration schemes in place – notably incentives to bolster the efficiency of utilities’ operations and investments, 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 in England and Wales. Water regulator, Ofwat, has reduced water companies’ allowed cost of capital to 2.8 per cent, from the incumbent level of 3.6 per cent. While this reflects the lower market cost of debt – and 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 its existing debts. As such, we predict that this measure 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 companies both within and outside the water industry. To gain rewards, companies may need to outperform not only their own historical costs but also those of their peers. That said, PR19 is still in its nascent stages, and may yet offer water companies greater flexibility in mitigating the negative effects. Here, we expect companies to modify their financial policies and to implement further efficiency measures.
Adapting to disruption: the longer-term goal
Looking ahead, business models remain a challenge for European utilities. Regulatory changes are not the only factor that could lead to business model revisions: technological disruption, too, is among the most pressing sector challenges – and will likely drive strategic decisions.
This is certainly the case for energy companies, operating in a market where technological disruption is evident. Renewables are now commanding around a fifth of Europe’s unregulated players’ earnings before interest, 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 electric and automated vehicles are part of everyday 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 hereafter.