National Grid and SSE, two of the UK’s largest utilities, have announced that they are planning to sell all or part of their gas distribution businesses. Prices discussed are well above the regulated asset value of the properties and the total dollar sale value could exceed $15 billion. These gas properties, we are told, have slower growth prospects than the electric distribution businesses. Disposing of these underperforming, although still valuable, gas distribution assets leaves the remaining electric business with a faster growth rate, one not hampered by the sluggish gas sector.
Remember though, the peculiar nature of British utility regulation. This has evolved over the years into a familiar (for U.S. analysts) version of rate of return regulation - albeit on steroids. As a result, business growth is incentivized and achieved by new, often costly, investments in the utility's rate base (its assets), rather than from growth in sales. The regulator's slogan here might be, "If you build it, they (the custom-ers) will pay for it". The "and like it" is perhaps an implied part of the bargain.
However, electric sales have been heading south for some time. This trend of declining kwh sales coupled with ever rising prices is what makes certain industries ripe for disruption. Paying more while using less is an odd value proposition from the customer's perspective.
Who would buy these gas utility properties at above the value set by regulators and why? The apparent answer? Lots of investors with a realistic idea of cost of capital. This apparently includes investors needing a steady return to meet predictable future cash needs as well as Chinese state corporations seeking global presence. In the case of UK properties, one Hong Kong-based conglomerate, CK Hutchison, an operator of utilities and other infrastructure properties has been a big buyer in the past and could continue to do so in the future. At the passive ownership level, buyers have included sovereign wealth funds and Canadian pen-sion funds. The latter pursuing global infrastructure activities on a significant scale. Stable, regulated earn-ings and cash flow streams of utilities also would fit the needs of insurance companies as well, but they have not shown the same interest to date.
These utility asset sales, if they take place as contemplated, indicate rather clearly there are investors for modest growth infrastructure projects who are willing to accept relatively low, stable returns. This begs a related question. If money is relatively cheap, why is it so difficult for Western political entities to launch infrastructure projects, Hinkley Point notwithstanding? And, should American pension funds, optimistically assuming 7-8 percent annual returns and which seem poised to disappoint a generation of retirees, consid-er the safe, predictable returns in utility and other infrastructure investments that actually help the country as a whole?
But those are questions of public policy. For utility investors the issue here is more one of self-interest or perhaps even self-preservation. If outside investors willingly accept lower returns on utility properties (as evidenced by high asset sale prices), will regulators notice and lower the equity returns granted? Capital after all does at some level compete in a global market.
The proposed British asset sales are big and not just by way of dollar amount or size. They are also infor-mationally "big". Even though UK gas and electricity markets are highly regulated, holding an auction for some of these assets does provide what we call "price discovery". Parenthetically, these UK assets are rel-atively low risk and being pursued by numerous sophisticated bidders. Auctions of this sort also tell us clearly about availability of capital and its cost. Our concern here is a potential discrepancy between what regulator's view as the appropriate cost of capital and a potentially far lower cost revealed by these up-coming asset auctions. What regulators do with this information remains to be seen.
By Leonard Hyman and William Tilles
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