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An ill wind

29 January 2013

Back in the boom times, Europe set itself ambitious green targets for 2020, but since then there has been a financial meltdown and those targets now look fanciful. Ellen Bennett reports

Remember 2007? Those were heady days. The financial crisis had barely begun to unravel. Northern Rock hadn't collapsed, Lehman Brothers was going strong, state rescues of major banks were still years away. And well-meaning Eurocrats in Brussels published the 20-20-20 package of energy targets. An ambitious bid to bring energy policy in line with the sustainability agenda, it proposed slashing the European Union's greenhouse gas emissions by 20 per cent, increasing its proportion of final energy consumption from renewable sources to 20 per cent, and increasing energy efficiency by 20 per cent. All the targets were slated for 2020.

Six years later, with the euro barely hanging on to life, those targets look precarious. The unprecedented changes in the European financial landscape have played havoc with utilities' ability to raise investment. The UK energy sector alone needs £200 billion by 2020. With European governments, including the UK's, under pressure to keep the lights on, those green targets are beginning to look less important. A decarbonisation target for 2030 was dropped from November's Energy Bill - a strong sign that the coalition government believes it is no longer possible.

The challenging investment climate is partly to blame for the slow progress being made towards meeting the targets in a number of leading European states - including the UK, Germany and France (see map). The following advice, issued late last year by broker Nomura to potential utilities investors, should strike fear into the heart of any European utilities executive: "There is no let-up in what we consider to be the dire outlook for utilities and we believe that the outlook for generation remains unattractive... We see very few attractions for a sector that trades at a 7 per cent discount to the broader market."

Why so negative? According to trade body Eurelectric, investors are running scared from a toxic cycle of volatile regulation and deferred investment. The broader context is a tightened financial framework and tough new regulations such as Basel III, meaning both that less investment is available overall, and that investors are far more cautious where they place it.

Meanwhile, energy companies themselves are becoming less attractive because the recession is reducing demand, so they are making less money. Analysts are consequently downgrading their ratings of the sector. In November, Moody's downgraded Italian energy company Enel to Baa2, with a negative outlook, citing macroeconomic, political and regulatory challenges in Italy and Spain. Earlier this month, Spanish power company Iberdrola, owner of Scottish Power, announced the sale of its French windfarm business to US giant General Electric in a bid to cut debt and maintain an investment grade rating. Moody's rated the company Baa1 in November with a negative outlook.

The degree to which the sectors are regulated obviously makes a significant difference. Heavily regulated sectors give a guaranteed return - a very attractive prospect for investors in the current climate. Chinese investors, for example, have been cherry-picking such investments (see box page 17). In the UK, National Grid has been a safe haven for investors, offering an impressive 8 per cent year-on-year dividend growth. However, investors have been warned that this dividend could be slashed by as much as half this year, following publication of Ofgem's price determination for the eight-year period running from April 2013. National Grid has a few months to accept or reject the proposals.

What does this bleak outlook mean for energy companies? According to Eurelectric, it means they will not be able to fulfil their investment plans. In a survey carried out by the organisation in the fourth quarter of last year, Powering Investments,

44 out of 45 energy leaders said the investment needed to secure the transition of energy to renewable sources would not occur. They believed, on average, that only half the required investment would be forthcoming.

The Renewable Energy Association (REA) is the UK representative on the Keep on Track initiative, a European body monitoring progress towards meeting the 2020 targets. Six member states, including the UK, are currently behind target (see chart on facing page). REA head of policy Paul Thompson points to the complexity of the policies and political uncertainty inhibiting investment and adds: "The financial crisis is making it even less enticing for investors to invest in the industry."

It's not just the financial crisis blocking investment in utilities. The uncertainty surrounding regulation and policy changes over the next few years is arguably even more of a problem for investors. According to Susanne Neis, head of the energy policy and generation unit at Eurelectic and author of Powering Investments, said: "The most important obstacle seen by utilities and investors is policy risk: contradictory policies setting targets on everything, retroactive changes to existing schemes and windfall taxes have weakened precisely the sector which is meant to raise the needed huge sums for our energy future... In order to make Europe competitive, and an attractive place, European and national policymakers have to be aware of their responsibility: set the framework coherently and in such a way that the needed investments take place in the most cost efficient way. Only then will 202020 become a reality."

Energy leaders across Europe are already quietly accepting that the 2020 targets will not be met. Angela Knight, chief executive of Energy UK, says: "Some countries will have considerable difficulties in now meeting those targets. We need to reconsider the policies in light of these ongoing factors. We're not saying we should throw these targets out of the window, but a boom time policy operating in a very difficult period needs to be thought through - and that includes the timescale."

MEP for South West England and Gibraltar, Giles Chichester, who sits on the European Parliament's energy committee, says it would be "common sense" for the EU to revisit the 202020 targets. "We have a great record in the EU of setting targets and failing to achieve them," he says.

There are currently no official moves afoot to change the 202020 targets. However, news last week that Europe has given the banks a four-year reprieve on Basel III targets, delaying their implementation until 2019, suggests that policymakers are willing to be pragmatic. Given the rocky investment climate coupled with the uncertainty over regulation and public policy, they will have little choice. The world has changed since 2007.

What about UK water?

Water companies have less to fear from the financial crisis than their counterparts in energy. Indeed, some may benefit from other investments losing their allure, as they remain a stable and relatively high-return investment class. However, there are practical considerations for water companies as they seek to raise investment from Europe.

The industry is currently seeking to fill a significant funding gap with private investment and the European bond market is an obvious place to start. In a worst case scenario, if the euro collapses, that source of funding would, at least temporarily, dry up. Even if that's not the case, UK water companies seeking to raise investment on the Continent could struggle with the technicalities around currency fluctuations as banking regulations are tightened up.

Finally, new regulations for investors such as pension funds and life assurance companies are likely to force them to favour short-term investments over long-term investment, which could change the way water companies raise debt and force them into more frequent refinancing. This could create extra cost and uncertainty.

Severn Trent finance director Mike McKeon acknowledges these possibilities, but adds: "If there were to be a crisis in the eurozone or elsewhere, which hit bond market access for corporates, the water industry is likely to be down the list of those who would be first impacted. In this situation the industry should continue to access markets and the needed funding. There would, however, be increased uncertainty in this environment and with this increased risk."

Opportunities from challenges

They say every cloud has silver lining - and true to form, the eurozone crisis has thrown up opportunities as well as challenges in the European utilities sector. One of the conditions of the EU and IMF support packages that have been put in place for Portugal, Greece and Ireland is that they reduce their deficits. Selling assets is the obvious way to do this. According to a report published by law firm Slaughter & May last year:

· Portugal plans to sell assets including airports, airlines and interests in the energy, communications and insurance sectors. It sold a 21 per cent stake in electricity company Energias de Portugal to China's Three Gorges Corp and a 40 per cent stake in power grid operator Redes Energetica Nacionais.

· Greece has a €50 billion package of assets to sell over the next five years, including ex-Olympic properties, ports, airports and utilities. Natural gas grid operator Desfa, gas company Depa and a 35 per cent stake in refiner Hellenic Petroleum are on the market.

· Ireland is selling a number of state assets including a minority stake in its electricity board.

Given the uncertainty surrounding these nations, investments in or partnerships with them are not for the fainthearted. However, there are likely to be some buyers - particularly the Chinese and other Asian nations. The Chinese have already demonstrated their willingness to invest in European utilities: China Investment Corporate acquired a stake in Thames Water's parent company, Kemble Water, for a sum believed to be at least £500 million in January 2012. This followed a visit from chancellor George Osborne to China in the same month, where he was later joined by prime minister David Cameron. In December 2011, the Abu Dhabi Investment Authority bought 9.9 per cent of Kemble for an undisclosed price. Utilities analyst Nigel Hawkins suggests Chinese investors are able to take an unusually long-term view, allowing them to cherry-pick investments that may be too risky for other investors.

This article first appeared in Utility Week's print edition of 18th January 2013.

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Source: Utility Week

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