EURELECTRIC ANNUAL CONFERENCE 2005:
"POWER FOR EUROPE: CAN WE SHAPE THE FUTURE?"

SESSION I: THE FUTURE FINANCIAL SHAPE OF THE ELECTRICITY INDUSTRY

Given the 16 trillion dollars worth of investment in energy that would be needed worldwide in the coming decades, 62% of which would be in electricity – 50-50 in power generation and transmission, Omar Abbosh, Global Utilities Managing Partner at Conference sponsor Accenture, told the Conference that the key question was “how to ensure that the right amount of capital gets to the right assets at the right time?” If this was to be possible, then governments and regulators must “set a platform for incentives”, and the financial community must come up with “creative ideas and approaches to ensure efficient allocation of capital”, underlined Mr. Abbosh in his introductory remarks to Session I of the Conference, in which speakers focussed on the need to ensure investment in the electricity industry.

“Value creation is the only factor that guarantees long term sustainability” for any company, Gerardo Hermo Blanco, Chairman of EURELECTRIC network of experts on Finance and Economics, reminded the audience. Taking as a comparison the economic assessment contained in the European Commission’s recent 4th Benchmarking Report, which looks at market performance on the basis of market structure, price performance and employment and productivity, Mr Hermo offered delegates an “alternative benchmarking report”. He pointed out that electricity revenue is today at the same level as in 1998, just before the liberalisation provisions began to take effect, which means around 10% lower in real terms. However, although Europe’s electricity companies have improved labour productivity by some 1.5% over the period examined, and fewer companies are destroying value than was the case in 1998, still only 13 out of the top 31 electricity groups are today creating value and both average capital productivity and productivity on primary energy and intermediate inputs have fallen, so that on average the industry is posting an annual loss in total factor productivity. Looking at electricity distribution activity, which is a regulated segment of the electricity business, 50% of the companies analysed are destroying rather than creating value and, on average, distribution companies are spending 80% of their operating cash-flow on new capital expenditure. Mr Hermo explained that value destruction in the sector is linked to the remuneration on capital expenditure allowed by the regulatory regime.

Mr Hermo quoted forecasts that necessary capital expenditure required to finance requirements in power generation and networks would amount to €665 bn from 2003 to 2020. He then estimated that to cover all likely costs and provide a margin for further investment, EU electricity industry revenue would need to rise from the current €179 bn to just over €317 bn in the year 2020. This would equate to a year-on-year price increase of 2.1%, Mr Hermo estimated.

Looking at the topic of how regulatory uncertainty is affecting investment, Wynne Jones, Director at Frontier Economics, told delegates that the main problem lies not with networks but with power generation, which raises the question as to whether the European electricity markets can deliver new generation capacity, given that while the US for example favours capacity markets, Europe does not. Examining various parts of Europe, Mr Jones explained how regulation in the post-liberalisation era had favoured entry into the generation market by the regional electricity companies that had distribution monopoly in their own area and had led to a “sub-optimal dash for gas”. Meanwhile in Northern Europe there has been an “explosion” in renewable energy sources “driven not by the market but by intervention from the authorities”. Mr Jones explained that the current market situation tended to result in long periods when the electricity price stood below the long-term marginal cost of production, interspersed with very short periods where the price would be far above the marginal cost. Hence “consumers have been getting a very good deal in recent years”, but “when the squeeze arrives, people are not happy and it is not clear whether regulators - and politicians - will be prepared to allow the very high prices necessary to ensure investment, if political strains appear”, warned Mr Jones.

Looking for solutions, Mr Jones stressed the need to “educate regulators and politicians”, adding that improving the demand-side response - which could “take out the price spikes and make price fluctuations more acceptable” - and setting up an explicit capacity market could also provide useful results. “Thinking the unthinkable”, Mr Jones suggested that oligopoly - which would promote advance build of plant, may not be such a bad thing as this could lead to smoother prices and help avoid load-shedding. This is “not good competitive economics”, conceded Mr Jones, and would lead to average higher prices but would avoid customers getting “stuck in the lift” when prices shoot up suddenly, he argued.

Utility sector equities - including the shares of electricity companies - are “a compulsive buy” for European equity investors given the “scale and strength of the industry” and the steady dividends consistently in excess of average market yields being paid to shareholders by the sector’s companies, Rupert Hume-Kendall Co-Head of Equity Capital Markets at Merrill Lynch , told the conference. Mr Hume-Kendall conceded that it was not easy to draw firm conclusions right across the electricity sector, given that the sector is very large, with large companies very diverse in terms of their balance-sheet composition, regulatory framework and type of ownership structure, but he pointed out that in general the utilities sector is highly resilient and is a “significant component” of the equity index, and that private equity investors tend to prefer low-growth, high-yielding stocks to high-growth segments with poor dividend yield. While utility stocks outperformed the Euro600 index over the last 12 months, they have underperformed the market over the last four. However, Mr Hume-Kendall reminded his audience that US Fed Chairman Alan Greenspan had “rattled” the markets with interest-rate warnings at that time and that utilities, like bonds, are particularly interest-rate sensitive.

“Recent years have seen the emergence of a new class of specialised infrastructure investors, who value infrastructure assets substantially higher than do the integrated energy companies and their shareholders”, Dirk Brouwer, Managing Director at the Benelux arm of SEQUOIA, told the audience. These investment funds, whose ultimate investors are pension funds and insurance companies, with some banks also jumping on the bandwagon, are attracted by the stable, index-linked regulated cash streams, long-term interest rates of 3-4%, cash yields of 9-10% and internal rates of return on capital of 14-16% enjoyed by these network businesses, explained Mr Brouwer. Recent transactions include three gas distribution network deals which saw the UK National Grid Transco sell off part of its infrastructure and a “mini earthquake” involving four such sell-offs in a single week. Mergers and acquisitions in this segment are showing premiums of 20-25% on the stock market valuations, which might put pressure on integrated energy companies to spin off their regulated network activities, he predicted. Where governments were planning to privatise incumbent energy majors, it would now be “difficult to do the privatisation any other way” than by splitting off the regulated business, he told delegates.

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PANEL DEBATE

Omar Abbosh, Global Utilities Managing Partner at Conference sponsor Accenture, Gerardo Hermo Blanco, Chairman of EURELECTRIC network of experts on Finance and Economics, Wynne Jones, Director at Frontier Economics, Rupert Hume-Kendall, Co-Head of Equity Capital Markets at Merrill Lynch, Alistair Buchanan, Chief Executive of UK regulator Ofgem, Fulvio Conti, newly-appointed CEO of Italian major ENEL

For the panel debate, the speakers were joined by Alistair Buchanan, Chief Executive of UK regulator Ofgem, and Fulvio Conti, newly-appointed CEO of Italian major ENEL.

Mr Brouwer stressed that “investments will be dependant on the regulatory environment that a company operates in”. Investors must accept regulation and political realities, but there must consistency in the approach and forewarning of any new regulatory concepts. “Investors don’t like sudden changes”, he warned.

Mr Buchanan underlined his belief that “markets work if politicians allow them to”. Moreover, “I don’t think regulators should fiddle with markets” or get involved in “political issues”, he said, refusing to take a position in response to a question from the floor on nuclear power, as “this is a political issue”. However, “when parties misbehave, regulators should enforce the rules vigorously”. Where a national regulator is fully equipped to act on the basis of European treaty Articles 81 and 82, they should look at overall “behaviour” of companies – especially any tendency towards “oligopolistic behaviour”, argued Mr Buchanan. Nevertheless, “we can’t squeeze companies too hard, otherwise there would be a reverse effect from liberalisation”.

Based on his pre-regulator days as a consultant, Mr Buchanan asserted that “the most important quality that investors look for is a good management team”.

Responding to a question from the floor, Mr Jones said that long term contracts do not have much of a future as “for a lot of major consumers, opportunity costs of energy are what matter” and they just want to be sure that “their competitors are not getting it cheaper”. He also expressed his belief that the power industry “is not a natural monopoly but is a natural oligopoly” and that in time the trend will be towards the sort of structure shown by the oil industry.

Mr Conti stressed the need for a stable regulatory environment, and called for “continual investment in order to get the price down”. However it is not easy to reduce prices while at the same time meeting the commitments of the Kyoto Protocol, he warned, adding that sensible policy for a power generation company must be based on “having the right mix in a balanced portfolio” and “not putting all your eggs in one basket”. At all events, “the best policy of a successful company” consists in “having a good attitude toward customers”, he underlined.