The UK is desperate for investment to renew its utility infrastructure – £100 billion is needed in the power sector by 2020, while the water companies have plans to spend £44 billion over the same period.
The politicians blame each other for the situation. The Conservatives blame Labour for “chronic underinvestment” in the Blair/Brown era, while Miliband accuses Cameron and Osborne of only attracting “half the level needed”.
Away from the politicking, it is clear that UK utilities are largely relying on infrastructure decades old. Past glories are powering the present, but the sweated assets will not cope with the growing and increasingly more complex demands of the future.
Historically, the UK has been a happy home for investors’ cash, with political and regulatory stability providing predictable, steady returns. But things are less certain now. Mixed policy messages, the threat of significant political intervention, tighter regulation and a crackdown on the rate of return have chipped away at confidence. The country is still attractive compared with its rivals, but risk is growing.
Utility investors play the long game. Assets last decades, so they deliver long-term returns. But profit has almost become a dirty word. Some Labour politicians ask why the big corporations and investors should be allowed to make so much money when hardworking families are struggling?
Their answer appears to be to tax the big corporations more. As a bonus, taxing the multinational corporations more also helps fill some of the £90 billion budget deficit.
Labour has also set its stall out for a crackdown on the water companies and the tax they pay. Shadow environment secretary Maria Eagle highlighted in her 2014 conference speech that from £2 billion profit in 2013, the water companies paid only £74 million in tax, and £1.8 billion in dividends “to foreign hedge funds and anonymous private owners – the privileged few”.
She stated Labour would stop the water companies “siphoning off” money, and ensure they paid a fair share of tax.
All of this uncertainty is being introduced at a time when it is least welcome. Concerns of an investment hiatus continue to grow; some say we’re already suffering.
The election will, hopefully, return a stable and secure government, with clear objectives and an acknowledgement that investors need a stable fiscal, policy and taxation regime. This money will then not only generate them a return, but allow gas, water and electrons to continue to flow.
A last chance to impress
By the decade’s end, energy needs £100 billion; water needs £44 billion. The money has to come from somewhere. By Mathew Beech.
The shift to a privatised model was meant to remove the need for state intervention, allowing the market to decide what investment, and in what generation technologies.
“New priorities are the reason why the state is back big time,” says Dieter Helm, professor of energy policy at the University of Oxford. “Decarbonisation necessitates state intervention.”
Helm says this shift to a low-carbon economy, which the then energy secretary Ed Miliband signed up to in the 2008 Climate Change Act, could have been achieved under regular market conditions. However, with the carbon price as “ineffective” as it is – currently €7 per tonne as the market struggles with chronic oversupply – investors are not being driven towards low-carbon investments.
This, coupled with the high upfront cost and low running costs for renewable technologies, is why energy secretary Ed Davey said last month “we have to intervene”. He added that a technology-neutral solution, led by the carbon price, would be the ideal solution, “the second best solution for the UK is contracts for difference ”. Electricity Market Reform (EMR), the legislation tasked with delivering reliable, low-carbon energy at as small a cost as possible to consumers, introduced CfDs, as well as the capacity market.But this latest intervention, coming on top of several others – or as Helm puts it, the Miliband-Huhne-Davey energy policy – has created its own problems.
Bloomberg New Energy Finance founder Michael Liebreich told a conference in London in March that the UK and Europe have “probably chosen the stupidest ways” of trying to encourage investment by “imposing enormous amounts of policy uncertainty and instability”.
He highlighted the retroactive changes made in southern Europe, and the “permanent reviews and complexities” in the policy regime, such as the changes the government made to the solar subsidy regime, scaling back the support for large-scale solar.
What investors crave is stability and clarity. But the constant changes to policy, plus the impending impact of the election – one where energy policy could be significantly overhauled should Miliband enter Number 10 – has hit the attractiveness of the UK for investors.
March’s EY renewable energy country attractiveness index revealed the UK slumped to a 12-year low of eighth after being leapfrogged by France.
The key reasons, according to EY’s energy corporate finance lead Ben Warren, are the “slow passage of market reform” and the “policy hiatus” created by the election.
“We can expect an effective moratorium on energy policy,” he added.
Not that Davey would agree with that. EMR, which is bedding in and starting to deliver new capacity and low-carbon technologies via the capacity market, has been designed to give investors a guaranteed return. Something to give them certainty.
Networks are the traditional energy home for investors, with the price control setting out an eight-year window of how much the returns on investment will be. But there is a slight bump in the road, as the Competition and Markets Authority (CMA) has accepted calls from British Gas Trading and Northern Powergrid to appeal against Ofgem’s RIIO-ED1 price control decision for the eight-year period from 1 April 2015 to 31 March 2023.
The CMA is also in the midst of its inquiry into the energy market and starting an investigation into Bristol Water’s rejection of the PR14 final determination. The outcomes of these will be watched keenly by investors.
The water sector, fresh from the bruising PR14 price control, is also crying out for investment. The companies have set out plans to plough £44 billion of investment into the sector over the next five years.
Here, with the top investor worry of regulatory risk settled for the next period, the next major concern, according to the Water UK investor survey, is political risk. Something, as EY says with energy, which is only exacerbated with an election on the horizon.
Another potential area of concern is the “difficult issue” of indexation. Ofwat chair Jonson Cox has indicated a determination to break the industry link to RPI. He accepts doing this would be difficult and controversial, but says: “Financial markets are nothing if not adaptable, but we realise that change may take some time.”
Despite all these concerns, the regulated utilities still represent a secure investment, with predictable and steady long-term returns. The election result will provide clarity for investors, and that will allow much-needed investment to flow into the UK.
Viewpoint
Domicile, tax and ownership – a troubling policy trinity
Whether it’s Premiership football, the attempted takeover of a “British” pharmaceutical company or the claim “vampire kangaroos” operate the capital’s water supply, attitudes to ownership have changed in British politics and this causes turbulence, uncertainty and risk for business.
The dominance of private equity ownership in the water sector has meant significant attention has been paid to this sector and companies have found themselves placed on the wrong side of a moral argument in what they consider to be a legal and compliance matter.
The water regulator has been careful not to comment on tax policy and has been clear the regulated companies, and their customers, can benefit from capital allowances associated with their investment.
These concerns reverberate across the political divide. In its business manifesto, Labour states: “We will support incentives for long-term investment, examining the case for changes to redress the systemic bias in favour of debt finance.”
The chancellor is unequivocal, stating: “We like multinational companies being based here. We like them creating jobs here and they should pay their taxes here as well.” He has implemented the Diverted Profits Tax, designed to make sure they do.
Whoever is in power after 7 May will have to balance being seen to act on these matters while reassuring inward investors of the stability of UK politics, taxes and regulation. But the outrage is loud, remedies are not apparent, and prolonged scrutiny will keep utility companies at the centre of this storm.
Michelle Lewis, director, McQuillan
Talking point
“Water companies, especially, are in the firing line over tax”
Politicians are increasingly focused on tackling tax avoidance and highly complex tax reduction schemes employed by some well-known companies. The recent budget built on this trend with the so-called Google Tax.
The big six energy companies have complex tax arrangements. Four of the big six are overseas-owned and pay corporate taxes under various jurisdictions, offsetting their gross liabilities with various capital allowance concessions.
As for Centrica, virtually no-one fully understands its tax liabilities, partly because of the many North Sea oil and gas taxes that are levied concurrently.
In fact, much of the ongoing tax criticism of utilities is focused on the water companies. In Thames’s case, it reported an operating profit of £549 million in 2012/13 and of £655 million in 2013/14. Yet, for both these years, tax credits were recorded, partly due to one-off capital allowance treatment changes.
Importantly, most utilities have high net debt levels and benefit from offsetting interest payments against their taxable profit.
Furthermore, the UK’s long-established system of capital allowances enables companies with high investment levels to derive further financial benefit. Hence, ultra-low rates of tax rates are often applicable.
While the current corporation tax regime may be anomalous and even unfair, it is the duty of parliament – and not of regulatory bodies – to prescribe utility taxation policy.
Tackling tax avoidance and limiting schemes to minimise a company’s corporation tax liability are moving rapidly up the Treasury’s agenda.
Nigel Hawkins, director, Nigel Hawkins Associates
M&A: Water sector ready to get it together?
The water sector is on the cusp of a revolution – not only in terms of politics. Ofwat chairman Jonson Cox opened the door for “radical” mergers and acquisitions (M&A) when he called for “dynamic and differentiated” approaches to any mergers.
Plus, the time following the completion of any price review is typically the time when investors eye up potential new homes for their money. South West Water parent company Pennon, according to RBC Capital Markets equity research analyst Maurice Choy, is the most likely target for M&A.
“Pennon offers the best investment value and balance among its publicly listed peers,” Choy said. This is due to its attractive RPI+4 per cent dividend policy until 2020, plus discussions have been reignited by the resignation of Pennon chair Ken Harvey.
The other water companies also represent potential targets. As Cox said, the way M&A could work in the post-PR14 and post-election world is set to move away from the assumption that “bigger is better”.
Cox said that the “logic of vertical integration no longer works”, and suggested that M&A could see wastewater businesses merge as some companies sell their wholesale water supply business.
Whitman Howard utilities analyst Angelos Anastasiou told Utility Week that, despite what appears to be a favourable environment for M&A, and a regulator willing to approve “creative” takeovers, the election will be a barrier for some.
All eyes will be on the election.
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