Whatever dish National Grid finally picked from Ofgem’s regulatory menu, it seems to have been a mighty fine choice. Indeed, ever since the company confirmed its acceptance of Ofgem’s unprecedented eight-year regulatory package on 28 February 2013, its share price has boomed.
In fact, the key driver was its eagerly awaited dividend policy announcement, which was disclosed a month later.
The statement, which will have been painstakingly drafted and scrutinised by lawyers, states baldly that National Grid has “agreed a new dividend policy to apply from 1st April 2013. The new policy will aim to grow the ordinary dividend at least in line with the rate of RPI inflation each year for the foreseeable future”.
Of course, there is some wiggle room in this commitment, notably over the use of the word “aim” and that delightfully imprecise term “the foreseeable future”, which may – or may not – endure until the end of the regulatory period in March 2021.
Nevertheless, the market “bears” anticipating a sharp dividend cut were routed. Instead, in just a few weeks, National Grid’s shares advanced by around 20 per cent as long-term investors moved in (notwithstanding a pronounced US investor-led correction as Utility Week went to press). Its market valuation now makes it the 21st biggest in the FTSE-100, way ahead of its nearest comparators, Centrica and SSE.
National Grid’s 2012/13 full-year results were announced earlier this month and the overall figures were in line with expectations. Earnings per share were up by a reassuring 12 per cent. The impressive return from its UK gas transmission operations was the standout feature. To be sure, net debt rose to £21.4 billion, mainly due to the continuing high capital expenditure figure – £2.7 billion was invested last year. The split between the UK and the US showed a 70/30 per cent ratio in favour of the former, as based on the respective 2012/13 operating profit.
That split reveals why the regulatory review has been so crucial for shareholders, especially in the context of its eight-year duration.
In effect, this recently concluded process gives its UK electricity transmission, gas transmission and gas distribution businesses virtually assured revenues streams until March 2021. It is a scenario that almost any other major UK company would envy in today’s fragile economy.
National Grid’s future capital expenditure programme was a key factor in driving the regulatory settlement. Over the next eight years, total UK capital expenditure is estimated at around £25 billion, although there is material uncertainty about investment levels at the back end of the regulatory period.
As ever for regulated utilities, the allowed weighted average cost of capital (Wacc) has been a pivotal factor in the regulatory settlement. In this case, National Grid decided to do business with Ofgem on Wacc numbers, which ranged from 4.55 per cent for the electricity transmission business to 4.24 per cent for the gas distribution business.
No doubt the water companies will be studying these Wacc assumptions with diligence as their next review period looms. In fact, Ofgem’s Wacc assumptions are in the same ballpark as those of Ofwat back in 2009.
More recently, the Civil Aviation Authority (CAA) published some initial thoughts in setting price limits for the UK’s leading airports, including Heathrow. Despite the polarised views between Heathrow’s owners and its airline customers, the eventual ruling will be relevant for future utility Wacc assumptions.
Looking forward, National Grid has declared three priorities.
First, it seeks to deliver its investment programme as efficiently as possible. Given its vast size – notwithstanding the many uncertainties – this will present a formidable challenge.
Second, it will be driving its performance to meet UK regulatory targets and assumptions, and presumably aiming to outperform them.
Third, the company is determined to build on its US plans in various eastern seaboard states, with the raising of customer service being a particular priority.
National Grid has received various brickbats for the unimpressive returns from its US operations, where the regulatory regimes vary from state to state. The duration periods are generally far shorter, and with more consumer input. There have been some suggestions that either National Grid will sell its US operations or partially demerge them.
The reality, though, is that its US operations have recovered over the past two years and the paramount issue for National Grid has been to secure good numbers for the all-important UK review. Job done.
For a company whose share price is seldom a major mover – stable returns and lack of takeover speculation being obvious reasons – the recent share price surge has been unusual. However, many discerning investors will have worked out that there is latent demand for stocks that embody National Grid’s characteristics.
After all, ten-year gilts are currently yielding a measly c2 per cent, which is welcome news for the UK’s debt office charged with financing annual public deficits in excess of £100 billion. For investors, though, unless you are highly risk-adverse, such yields are hardly tempting, especially now that National Grid’s reaffirmed dividend policy promises far higher running yields.
In fact, there are very few suitable investment opportunities, with low construction and operational risk, which can draw in investors seeking to offset their deferred pension liabilities with long-term, low risk dividend flows that are comfortably above those from gilts. But it would be wrong to conclude that everything is rosy in National Grid’s garden.
Political risk is a feature, although an incoming Labour government is very unlikely to re-run National Grid’s regulatory settlement prior to 2021 even if it scraps Ofgem. In any event, National Grid’s impact on consumer electricity prices is modest when set against rising gas prices. Furthermore, it is widely accepted that National Grid’s UK electricity transmission business is crucial to rolling out green energy projects. These are already struggling due to political and regulatory uncertainty, which makes fundraising challenging.
In the US, the company has unfinished regulatory business and reverses there would not be unexpected.
At the operational level, National Grid will need to work hard to control its operation cost base, along with assiduous management of its net debt. The latter, at over £21 billion, is indisputably high but is heavily underpinned by future revenues. Interest rates may rise at some time, and almost certainly well before March 2021.
Other unexpected events – tornados, hurricanes and a prolonged bout of snow – can readily occur, which may cause National Grid short-term concerns. Currently, though, the company is really relishing the “meal deal” that Ofgem has served up.
Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research
This article first appeared in Utility Week’s print edition of 7th June 2013.
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