February 19, 2013 3:03 pm
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Ofgem’s uncompromising stance toward National Grid’s [NG LN: Baa1/A-] 2013-2021 business plan reflects the regulator’s previous “over generous” cost-of-debt assumptions and political pressure to keep consumer bills down, industry sources told dealReporter.
The tough stance on the new eight-year price control framework could have implications for National Grid’s balance sheet, which analysts believe will come under pressure, requiring asset sales, a dividend growth cut or capital raise. The new performance-based review effectively determines National Grid’s ability to deliver returns above its cost of capital on its UK electricity and gas transmission and gas distribution businesses, which account for 60% of the group’s operating profits.
Political pressure on Ofgem has been highlighted by the regulator’s decision to introduce an indexed allowance for the cost of debt under its new review known as RIIO (Revenue = Incentives + Innovation +Outputs). In the previous price determination periods, Ofgem set a fixed allowance in the belief this would protect companies against cost rises. But the cost of market debt fell over the period leaving consumers to bear the brunt of an “over generous” debt allowance that enabled National Grid to consistently deliver a high return on equity, said a former advisor to National Grid and a legal source.
National Grid has been able to maintain an attractive 5% dividend yield since 2008 while at the same time seeing its share price grow strongly since a GBP 3.2bn rights issue in 2010. “National Grid has been very shareholder friendly. The yield should have come down but it didn’t and that is causing the regulator grief especially as that dividend is coming from the customer,” said a utility sector buy-side analyst. “If [the cost of debt] now gets squeezed it will naturally have implications for the dividend,” added a second analyst.
Under the new price controls, Ofgem has cut energy companies’ spending plans through to 2021 to GBP 38bn from a proposed GBP 45bn. National Grid has particular concerns with Ofgem’s cost-of-capital allowances on its gas transmission and distribution businesses and said the financing package for the former is not consistent with it achieving a comfortable investment-grade rating. The utility also complained that the 7% cost-of-equity allowance and 60% notional gearing level for electricity transmission – its single biggest business – is unlikely to attract the equity needed to fund investments.
Febrile political atmosphere
Industry sources said Ofgem’s uncompromising stance reflects the government’s increased focus on energy policy in the past few years, as steep increases in gas and electricity bills have hit consumers. The febrile atmosphere has seen Labour call for Ofgem to be abolished for failing to act in consumer interests. “The main focus is very much on keeping bills down,” said a spokesperson for the Department of Energy and Climate Change (DECC). This is a key aspect of two recent flagship reforms: the Energy Bill and Green Deal, said the spokesperson.
National Grid’s costs only account for a small proportion of consumers’ energy bills, but it’s an area the government has some influence over, said a person directly involved in Ofgem’s RIIO review process. “The treasury is desperately trying to kick the pressure to someone else and is all over DECC and Ofgem like a rash,” said a lawyer.
National Grid now has until midnight on 1 March to accept or refer Ofgem’s decision to the Competition Commission for an appeal, which would trigger a potential seven month review.
Disagreement between regulators and the companies they oversee is common during price control setting periods. The first lawyer said companies like National Grid have to fight hard during price determination periods as everything around such hard-wired businesses is quite heavily ring-fenced and it is constrained in what it can do later in terms of selling businesses and creating financial flexibility. An infrastructure banker explained that the loss of earnings from such assets risked being credit dilutive.
During the final months of the previous gas distribution price control in 2007 National Grid was able to persuade Ofgem to “move in all areas” from its initial proposals. “But Ofgem hasn’t been so amenable this time around,” said the analyst. Ofgem knows there is a lot of appetite for UK infrastructure and on that basis it obviously feels it can be tough with the return assumptions, he added.
National Grid, like most energy companies, has historically avoided going to the Competition Commission and one of the utility’s top-ten investors said a CC appeal would be “unattractive”.
Appeal risks “pyrrhic” victory
Ofgem’s departing CEO, Alistair Buchanan, publicly suggested last July that National Grid should go to the Competition Commission if it objected to the price control plans. But that comment was made before the commission overruled a decision by Ofgem’s equivalent in Northern Ireland (NI) relating to an appeal by Terra Firma-owned Phoenix Gas. The commission stressed the onus was on encouraging investment in the network and its final decision allowed customer bills to go up substantially more than under the NI regulator’s proposals.
Because RIIO is a new system, National Grid may think it can pick holes in Ofgem’s argument but they’ll need to assess whether this would result in a pyrrhic victory, said the second lawyer. A third lawyer also warned the CC could disagree with and make changes to other points in the price control framework that Ofgem and National Grid had actually agreed on.
The UK utility has said it will announce its future long term dividend policy at the latest by its full-year results in May and after it has reached a final agreement with Ofgem. A National Grid spokesperson said: “Clearly the board will wish to have a sustainable dividend policy that meets the needs of current and future investors and any decision will reflect the capability of all its businesses to meet or exceed their regulatory price control frameworks.”
National Grid is following a one-year dividend policy for FY2012/13, under which it plans to increase the dividend by 4% in nominal terms. If it does appeal, National Grid could come out with another one year temporary dividend policy, a second top-20 investor said. But the first lawyer emphasised that this could upset some investors as National Grid’s income seeking pension fund shareholder base seeks “certainty over return”.
The top-20 investor expected the dividend to rise a few percent each year in line with RPI. “It won’t be as generous as the [policy set in 2008],” said the investor. The top-ten investor predicted National Grid would maintain its annual increase at 4%. “The RIIO final proposals still leave room for manoeuvre,” claimed the investor.
But analysts at JP Morgan Cazenove said a 4% per year nominal dividend increase will be unsustainable without balance sheet strengthening. The analysts also pointed out that six of National Grid’s 13-strong board, including the chairman and finance director, were not involved in setting the previous long-term policy and would have no allegiance to it.
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