Premiums For U.K. Regulated
Utility Assets Are Riding High,
But What Are The Means
For Payback?
April 3, 2017
Primary Credit Analyst:
Tania Tsoneva, CFA
London +44 20-7176-3489
[email protected]
Secondary Contacts:
Nazia Haider
London +44-20-7176-3056
[email protected]
Beatrice de Taisne, CFA
London +44-20-7176-3938
[email protected]
Renata Gottliebova
London +44-20-7176-1257
[email protected]
Gustav B Rydevik
London +44-20-7176-1282
[email protected]
standardandpoors.com/ratingsdirect
Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Overview
––U.K. regulated utility assets are achieving high premiums, reflecting their scarcity and
attractiveness to traditional pension fund and infrastructure investors.
––Given the generally low growth prospects for some of these assets, investors appear to
anticipate other methods for payback, such as financial or cost outperformance.
––Given that high valuations suggest increasing acquisition-related debt leverage, we anticipate
buyers will seek more complex financing solutions which provide ratings uplift or ring-fence
the operating company.
––We believe the drive for regulatory outperformance could create higher political and
regulatory scrutiny of profits in the U.K. regulated utility businesses.
S&P Global Ratings has witnessed another bout
of sale transactions in 2016 and early 2017,
implying high premiums for U.K. regulated utility
assets. Just very recently, National Grid agreed to
sell a 61% equity stake in its U.K. gas distribution
networks for £3.6 billion in cash to a consortium
of long-term infrastructure and pension
funds. The sale amount implies a premium of
approximately 50% of the regulated asset value
(RAV) as of March 31, 2017 (see “U.K. National
Grid Gas Distribution Downgraded To ‘BBB+’ From
‘A-’ On High Acquisition Debt On Sale; Outlook
Negative,” published on April 3, 2017). Australian
investment bank MacQuarie has also agreed to
sell 26% of its stake in the holding company of
Thames Water Ltd., while another U.K. utility,
Affinity Water Ltd., is on the market.
that investors anticipate alternative methods of
payback to the regulatory-approved tariffs such
as financing or operating outperformance. The
regulator’s cost of debt has reduced significantly
since the previous regulatory period, as
demonstrated in the latest cost of capital
decisions. That said, their allowance for the cost
of new debt is still higher compared to what we
have observed in the marketplace.
In simple terms, the achieved prices are a result
of the historically low cost of debt, unabated
demand for low-risk, inflation-linked assets
under well-established and mature regulation,
and regulatory incentives for operating
efficiencies. U.K. regulated utilities check all of
these boxes. At the same time, supply of these
assets is scarce and the gulf between regulated
and merchant utilities, in terms of relative risk
profiles, continues to widen. Asset base growth
could be a factor in pricing decisions, however,
in sectors such as gas distribution and for some
water utilities the regulatory asset base (RAB)
is set to remain flat or decline slightly in real
terms. Therefore, the premiums paid could imply
While we understand investors are prepared
to pay high premiums, we also see some
limitations.
April 3, 2017
Thanks to the mature and predictable
framework under which they operate, U.K.
regulated utilities are also excellent candidates
for more complex financing solutions, which
allow them to optimize their capital structures
while maintaining an investment-grade rating—
as required by some of their regulatory licenses.
Asset Base Growth Could Explain
Premiums Although It Is Subdued
In Some Sectors
Asset base growth could be a factor in pricing
decisions, as it leads to higher future profits and
cash flows. When investment requirements are
earmarked for enhancement, rather than just
replacing the assets, the RAV increases and
the rate of return is earned on a higher asset
base. In addition, the future cash flows of the
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
U.K. regulated utilities should cover not only
operating costs but also the higher depreciation
for past investments. That said, in sectors such
as gas distribution, the RAV is set to increase
only slightly in real terms (i.e. before indexation to
the retail price index [RPI]), which could limit the
opportunity for payback of the M&A premiums.
In the water sector, the regulator projects overall
industry growth in regulated capital value in
both wholesale water and wastewater segments,
although the investment requirements differ
significantly between companies.
Operational Efficiencies Could Help
Or Hinder Shareholder Returns
Regulated U.K. utilities are regulated under
frameworks which incentivize performance
and efficiency through rewards and penalties
mechanisms, as well as sharing budget
deviations with customers. One way of boosting
shareholder returns is through cost control
beyond the regulator-approved business plans
and good operating performance indicators
related to service. For example, in 2015-2016,
electricity distribution network operators (DNOs)
Table 1 – Gas Distribution Projected Closing RAV Balances During RIIO
Provisional closing RAV for year ending March 31 (2009/2010 prices – Mil. £)
2013
2014
2015
2016
2017
2018
2019
2020
2021
14,571
14,594
14,611
14,724
14,885
15,066
15,240
15,403
15,545
NGGD (total)
7,243
7,244
7,227
7,264
7,321
7,393
7,462
7,528
7,528
East of England
2,535
2,523
2,501
2,495
2,497
2,500
2,501
2,497
2,492
North of London
1,644
1,660
1,678
1,713
1,747
1,793
1,842
1,893
1,946
Industry
North West
1,743
1,747
1,738
1,741
1,753
1,764
1,772
1,780
1,782
West Midlands
1,321
1,314
1,310
1,315
1,324
1,336
1,347
1,358
1,365
NGN
1,577
1,584
1,598
1,624
1,655
1,682
1,707
1,732
1,753
Scotia GN (total)
4,141
4,148
4,155
4,193
4,252
4,314
4,372
4,419
4,455
Scotland Networks
1,277
1,282
1,287
1,300
1,320
1,340
1,357
1,368
1,375
Southern Networks
2,863
2,865
2,869
2,893
2,932
2,974
3,015
3,051
3,080
WWU
1,610
1,619
1,630
1,644
1,658
1,677
1,699
1,725
1,752
Source: Ofgem. RIIO = revenues + incentives + innovation + outputs. NGGD–National Grid Gas Distribution. NGN–Northern Gas Networks.
Scotia GN–Scotia Gas Networks. WWU–Wales & West Utilities.
Chart 1 – Water And Wastewater 2015-2016 Opening RCV Versus 2019-2020 Closing RCV
Opening RCV 2015-2016
Closing RCV 2019-2020
15000
(Mil. £)
12000
9000
6000
3000
0
Anglian
Water
Dwr
Cymru
Northumbrian
Severn
Trent
South
West
Southern
Water
Thames
Water
United
Utilities
Wessex
Water
Yorkshire
Water
Source: Ofwat 2016, S&P Global Ratings. RCV–Regulated capital value.
April 3, 2017
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Chart 2 – Water Only 2015-2016 Opening RCV Versus 2019-2020 Closing RCV
Opening RCV 2015-2016
Closing RCV 2019-2020
1500
(Mi. £)
1200
900
600
300
0
Affinity
Water
Bristol
Water
Dee
Valley
Portsmouth
Water
Bournemouth
Water
Sutton & East
Surrey
South East
South Staff
Source: Ofwat 2016, S&P Global Ratings. RCV–Regulated capital value.
collectively spent 9% less than their allowances
for the year. It is forecast that gas distribution
networks (GDNs) will spend £2.1 billion in total
over the eight-year period to 2021, which is 12.3%
less than the operators’ original plans. A certain
percentage of this underspend is returned
to customers depending on the quality of the
original business plans. However, more than 50%
is retained by the companies, contributing to
higher returns than assumed by the regulator.
It is too early to draw conclusions from the first
few years of the eight-year period (until 2021 for
GDNs and 2023 for DNOs) as it takes time for
companies to negotiate contracts and set up
partnerships. It is also unclear how much of the
lower spending is related to cost efficiencies or
non-delivery of work. Actual returns also differ
from notional ones assumed by the regulator, but
it seems that for some companies there is scope
to achieve double-digit returns, even after sharing
a percentage of the underspend with customers.
According to the regulator’s calculation, based on
an assumed capital structure, it seems that DNOs
will earn an average return on regulatory equity
of 9.03%, compared to the allowed cost of equity
of 6.4% for the fast-tracked companies (those
who agreed their tariffs first) and 6% for the
remainder. The average returns expected for GDNs
are 10.3% compared to an allowance of 6.7%.
April 3, 2017
The risks are symmetrical, however, some
network operators could see their returns
eroded due to higher-than-expected spending.
Various factors such as economic performance
and weather—which have both been supportive
for lower expenditure—could change in future
years and affect the overall returns.
The Historically Low Interest
Rate Environment Presents An
Opportunity
On the back of interest rate cuts and
oversubscribed debt issuance, we see an
increasing gap between what the regulator
allows in its cost of capital decisions and
what the U.K. regulated utilities achieve in the
marketplace. Some of the recent deals, such
as NGG (in August 2016: 1.125% coupon for a
five-year bond) and Northumbrian Water (in
October 2016: 1.625% for a 10 year bond), fare
well compared to Ofgem’s allowance of 2.42% for
2016-2017 and Ofwat’s assumption for new debt
of 2% per year. The regulators’ role is not easy as
they need to set a forward-looking cost of debt
over a five-year period for water utilities and
eight-year period for gas networks, and this cost
of debt should be appropriate to ensure that the
companies can finance their operations.
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Table 2 – Cost Of Capital Decisions – Extracts From UKRN’s Cost Of Capital Report
Recent cost of capital decisions
Decision year
Regulator
Sector
2014
2014
2015
CC
Ofwat
CMA
NI Electricity
Water
Water
RP5
PR 14
CMA - Bristol Water
Price control
Cost of embedded debt
3.20%
2.75%
2.95%
Cost of new debt
2.10%
2.00%
1.60%
Weighting of new to embedded debt
10:90
25:75
25:75
Cost of debt
3.10%
2.59%
2.61%
Risk free rate
1.50%
1.25%
1.25%
Equity risk premium
5.00%
5.50%
5.25%
Equity beta
Cost of equity (post tax)
Gearing
WACC (Vanilla)
Tax
WACC (full post tax)
Inflation assumption
0.70
0.80
0.85
5.00%
5.65%
5.73%
45.00%
62.50%
62.50%
4.10%
3.74%
3.78%
20.00%
20.00%
20.00%
3.90%
3.41%
3.46%
RPI
RPI
RPI
Source: UK Regulator’s Network (UKRN). CC–Competition Commission. CMA–Competition Market Authority.
RP5–Review period 5. PR 14–Price review 14. WACC–Weighted-average cost of capital.
In order to mitigate market uncertainties,
electricity regulator Ofgem is using trailing
average debt indices to set annual allowances
(2016-2017 allowances based on a 10-year trailing
average of the iBoxx index for ‘BBB+’ and ‘A-’ rated
corporates added up to 2.42%). We understand
that water regulator Ofwat has closed its
consultation on a possible transition to a market
index for new debt in the next regulatory period
starting April 1, 2020. As seen in the chart below,
tracking a market index means that the
companies see their cost of debt allowance
decline when interest rates are on a downward
trajectory. This decline is not as abrupt because
the allowed cost of debt captures market
dynamics over the past 10 years and, at present,
considers the effect of the financial crisis in
2007-2009. That said, regulated utilities have very
long-dated debt so this approach could bring
mismatches between the actual and assumed
cost of debt, depending on each issuer’s capital
structure and their cost of legacy debt.
Chart 3 – iBoxx Index Evolution Since April 1, 2015
(Evolution of low cost of debt indexation)
Real cost of debt
10-year trailing average
7%
6%
5%
4%
3%
2%
1%
0%
-1%
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: Ofgem 2016, S&P Global Ratings.
April 3, 2017
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Low Cost Of Debt And RPI Are A
Double Benefit For Our Cash Flow
Coverage Ratios
U.K. regulated utilities’ cash flow coverage ratios
have benefited significantly from the low interest
rate environment, owing to their frequent
participation in refinancing and funding capex
programs and dividends. In addition, they have
significant exposure to RPI-linked debt, whereby
we deduct the RPI component from funds from
operations (FFO) as part of the profit and loss
interest. The recently lower reported RPI and
the low cost of debt have led to double folded
benefits to our primary ratio of FFO to debt.
Over the last few years, RPI inflation (which is
used to index the utilities’ revenues and RAB)
has declined to 1% per year in 2015 from a peak
of 5% in 2011. We expect the RPI to reach 3.2% in
2017 and then stay broadly in the range of 3.0%3.5% until 2020, while the divergence between
the RPI and consumer price index (CPI) inflation
increases. This would likely arise from council
tax increases to finance social care and higher
mortgage costs—when the Bank of England
raises rates—but would only partly be offset by
lower housing depreciation.
Investors Are Adding Leverage
To Finance Acquisitions
Table 3 – S&P Global Ratings’ RPI and CPI Forecasts (% Year)
CPI
RPI
2015
0.1
1.0
2016
0.6
1.7
3.2
2017
2.6
2018
2.3
3.1
2019
1.8
2.8
2020
1.9
3.2
RPI–Retail price index. CPI–Consumer price index.
Chart 4 – Cash Flow To S&P Global Ratings-Adjusted Debt
(Weighted-average using adjusted debt)
Water utilities
4%
April 3, 2017
Free Operating
3%
2%
1%
0%
-1%
0%
2010-2011 2011-2012 2012-2013 2013-2014 2014-2015 2015-2016
Discretionary
-2%
-4%
-6%
-8%
In order to cover the acquisition bill, new
owners resort to higher financial leverage to
the extent that this does not compromise the
investment-grade ratings on the operating
subsidiaries. As one can expect from a defensive
sector such as regulated utilities, dividend
outflows have consistently led to strongly
negative discretionary cash flows (after capital
expenditure [capex] and dividends). That
said, the series of M&As between 2011-2013
exarcebated the cash flow deficit as new owners
executed capital restructurings and upstreamed
exceptional dividends. We observe that cash flow
generation after capex has improved for U.K.
water companies in the last couple of years and
remains positive for U.K. network utilities. For
networks, this is partly due to some belonging to
Network utilities
2010-2011 2011-2012 2012-2013 2013-2014 2014-2015 2015-2016
Source: Ofgem 2016, S&P Global Ratings.
vertically-integrated groups with a less intensive
retail business and conventional generation mix.
That said, the gas network operators have had
sustainably lower capex requirements compared
to both electricity transmission and distribution
networks, and water companies.
The balance sheet leverage in terms of adjusted
debt to RAB could indicate the scope for
increasing financial debt. Interestingly, this ratio
is consistently above the regulator’s assumption
of 62.5% on average for the water sector, and
is particularly elevated for the transactions
rated as structurally enhanced debt (SED). The
issue credit ratings on SED reflect their standstandardandpoors.com/ratingsdirect
6
Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Table 4 – Rated U.K. Water Utilities Credit Metrics For Financial Year As Of 2015-2016
Rated U.K. water utilities as of 2015-2016
FOCF/
Adj. Debt/ Adj.Debt
RAB (%)
(%)
DCF/
Adj. Debt
(%)
FFO cash
interest
coverage FFO/Debt
ratio (x)
(%)
Rated Entities
Long-term
corporate
credit rating
Outlook
Dee Valley Water PLC
BBB
Stable
71
8
3
5.4
15
Northumbrian Water Ltd.
BBB+
Stable
78
6
(1)
1.7
10
Portsmouth Water Ltd.
BBB
Stable
71
2
1
3.9
10
Severn Trent Water Ltd.*
BBB+
Stable
66
3
(1)
4.2
11
South Staffordshire Water PLC**
BBB+
Stable
--
6
(2)
6.3
17
United Utilities Water Ltd. ***
BBB+
Positive
60
1
(2)
5.2
13
Wessex Water Services Ltd.
BBB+
Stable
70
4
0
5.0
12
U.K. water utilities’ SED transactions-rating components
Financing group
Rating on
senior
secured debt
Rating on
subordinated
debt
Affinity Water Programme Finance Ltd
A-/Stable
BBB/Stable
77
3
(2)
3.6
11
Anglian Water Services Financing PLC
A-/Stable
BBB/Stable
83
3
0
2.7
6
Dwr Cymru (Financing) Ltd.
A/Stable
BBB+/Stable
57
1
1
3.2
10
South East Water (Finance) Ltd.
BBB/Stable
--
84
0
0
3.1
8
Southern Water Services (Finance) Ltd.
A-/Stable
BBB/Stable
86
3
1
3.7
9
Thames Water Utilities Cayman Finance Ltd.
A-/Negative
BBB/Negative
82
(3)
(4)
2.9
7
Yorkshire Water Services Finance Ltd.
A-/Stable
BBB/Stable
80
3
1
2.3
6
*Credit metrics based on Severn Trent PLC. **Credit metrics based on South Staffordshire PLC. ***Credit metrics based on United Utilities PLC.
RAB–Regulatory asset base. FOCF–Free operating cash flows. DCF–Discretionary cash flow. FFO–Funds from operations.
alone credit profiles as well as the benefit of
a package of structural enhancements for
senior creditors (see “A Comparison Of European
Regulated Utilities’ Structurally Enhanced Debt
Transactions,” published on March 21, 2016).
More Complex Financing Solutions
Optimize The Capital Structure
The U.K. regulator’s duty to ensure that utility
operations are financeable is linked to the
requirement—in many cases stated explicitly
in the companies’ licenses—to maintain an
investment-grade rating for the license holder
entity. The rating is therefore an important
consideration for new owners when deciding
on the post-sale capital structure and how to
refinance acquisition debt. We observe that
new owners often use shareholder loans to
downstream equity in order to benefit from the
tax shield on interest.
Another increasingly popular route is to
refinance at an intermediary holding company
April 3, 2017
(MidCo) level. This has at least two benefits: the
rating requirements and regulator’s duties do
not extend to companies outside of the license
holder (i.e. the operating company or regulated
utility) and there is no risk of a potential tax
clawback for the additional debt, if the regulator
has set a ceiling on actual debt at the operating
company for tax purposes. That said, creditors
at MidCos face material risks as they rely solely
on dividends from the regulated utility, and U.K.
regulators have the power to apply a cash-lock if
the investment-grade rating is under threat—i.e.
if we lowered the rating to ‘BBB-’ with a negative
outlook or placed it on CreditWatch negative.
In order to mitigate this risk, companies deploy
various structural and legal mitigants at the
operating company or MidCo level. In one of the
complex group ratings, Electricity North West
(ENW)—which we rated first in 2010—debt is
raised at the operating company ENW, the MidCo
(North West Electricity Networks; NWEN), and
the holding company (North West Electricity
Networks Holdings; HoldCo) level.
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
There are a number of structural features
present at the MidCo level, specifically:
––A liquidity reserve and facility covering 18
months of debt service at the MidCo level,
enhanced to some degree by a £50 million
intragroup loan between ENW and NWEN;
––An intercreditor agreement at NWEN, which
arranges for a 12-month minimum standstill
period at NWEN following an event of default,
possibly allowing for the resumption of
dividends from ENW in the meantime; and
––A favorable package of security (including the
pledge on the shares of ENW) and covenants at
the MidCo level.
ENW
NWEN MidCo
Dividend lock up
65% net
debt to RAB
85% net debt to
RAB, ICR <1.1x
Event of default
70% net
debt to RAB
92% net debt to
RAB; ICR <1.0x
In our view, NWEN’s transaction does not
qualify as SED as per our criteria “Rating
Structurally Enhanced Debt Issued By
Regulated Utilities And Regulated Infrastructure
Transportation Businesses,” published on Feb.
24, 2016. The key reasons include the presence
of significant unsecured debt at the operating
company, which is not part of the intercreditor
agreement, and the fact that the structural
features are available at the MidCo level,
which is structurally subordinated and not
the regulated license holder.
Therefore, we do not see sufficient ring-fencing
between MidCo creditors and the rest of the
group and we include all of the debt raised by
ENW, the MidCo, and the HoldCo in our analysis
of the consolidated group credit profile. The lower
ratings on the MidCo and HoldCo reflect their
restricted access to cash from the operating
company, ENW, which is their sole source of cash
generation. Given our views on the effectiveness
of regulatory ring-fencing in the U.K. and external
liquidity resources at the MidCo, we view the
credit quality of MidCo’s debt (‘BBB’) as only one
notch weaker than ENW’s debt (‘BBB+’). However,
we view the HoldCo’s speculative-grade debt
(‘BB+’) as two notches weaker than the MidCo
given the potential for further reduced cash flow
April 3, 2017
due to structural financial features at the MidCo,
which reinforce the regulatory protections
around ENW. Furthermore, should the credit
quality of ENW deteriorate, our view is that the
risk of regulatory ring-fencing could strengthen
further, implying a more rapid and severe
downgrade of the HoldCo and a lowering of the
ratings on MidCo’s debt.
Political And Regulatory Scrutiny
Is On The Rise
The drive for operational and financial
outperformance, in our view, could lead
politicians to exercise more scrutiny over the
regulatory decisions of Ofwat and Ofgem, as
evidenced in a 2016 report published by the Public
Accounts Committee (PAC) into the “windfall
gains” of U.K. water companies. The report
estimated that water companies have made
excessive profits of about £1.2 billion in 20102015 as a result of inflated financing and taxation
costs. It calls for increased accountability by
Ofwat in terms of its cost of capital methods and
the measures it plans to take.
That said, other stakeholders in the process
such as the decision maker of last resort, the
U.K. Competition Market Authority (CMA), found
no market evidence that the cost of capital and
its components are excessive. The CMA even
allowed Bristol Water PLC a small uplift for its
equity beta in the company’s latest referral of its
price review package in 2014.
We continue to monitor these developments
as overt political pressure could negatively
influence our view of the independence of both
Ofwat and Ofgem. On the other hand, we see
efforts by the U.K. regulators to become more
engaging, for example, the U.K. Regulator’s
Network has opted for a peer review process on
new cost of capital decisions. Extending the inbuilt checks and balances in the regulation and
consulting more stakeholders is positive for our
view of framework consistency. Extending the inbuilt checks and balances in the regulation and
consulting more stakeholders is positive for our
view of framework consistency.
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Premiums For U.K. Regulated Utility Assets Are Riding High, But What Are The Means For Payback?
Ratings On U.K. Regulated Utilities
Rated U.K. water utilities as of 2015-2016
Rated entities
Long-term corporate credit rating
Outlook
Dee Valley Water PLC
BBB
Stable
Northumbrian Water Ltd.
BBB+
Stable
Portsmouth Water Ltd.
BBB
Stable
Severn Trent Water Ltd.
BBB+
Stable
South Staffordshire Water PLC
BBB+
Stable
United Utilities Water Ltd.
BBB+
Positive
Wessex Water Services Ltd.
BBB+
Stable
Financing group
Rating on senior secured debt
Rating on subordinated debt
Affinity Water Programme Finance Ltd
A-/Stable
BBB/Stable
Anglian Water Services Financing PLC
A-/Stable
BBB/Stable
Dwr Cymru (Financing) Ltd.
A/Stable
BBB+/Stable
South East Water (Finance) Ltd.
BBB/Stable
--
Southern Water Services (Finance) Ltd.
A-/Stable
BBB/Stable
Thames Water Utilities Cayman Finance Ltd.
A-/Negative
BBB/Negative
Yorkshire Water Services Finance Ltd.
A-/Stable
BBB/Stable
Network entities
Long-term rating
Outlook
Electricity North West Ltd.
BBB+
Stable
National Grid Gas Distribution Plc
BBB+
Negative
National Grid PLC
A-
Stable
Northern Gas Networks Ltd.
BBB+
Stable
Northern Powergrid (Yorkshire) PLC
A
Stable
Scotland Gas Networks PLC
BBB+
Stable
Western Power Distribution PLC
A-
Stable
Scottish and Southern Energy PLC
A-
Negative
Scottish Power Ltd.
BBB+
Stable
London Power Networks PLC
BBB+
Stable
Financing group
Rating on senior secured debt
Rating on subordinated debt
Wales & West Utilities Finance PLC
A-/Stable
BBB/Stable
U.K. water utilities’ SED transactions – rating components
Rated utilities subject to RIIO Model as of 2015-2016
U.K. gas distribution companies’ SED transactions
Source: S&P Global Ratings.
Rating indicated is on one of the regulated operating subsidiaries in case of multiple networks.
The author would like to acknowledge the contribution of Lloyd Budd with research for this article.
Only a rating committee may determine a rating action and this report does not constitute a rating action.
April 3, 2017
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