25 September 2013
Nik Stanojevic, Equity Analyst at Brewin Dolphin
Labour announced that if it won the general election it would break up the six large vertically integrated energy suppliers and freeze retail energy tariffs. We highlight the following points:
- A breakup alone is quite likely to increase retail tariffs, not reduce them
- Any solution to keep prices low is likely to be very expensive for the government (e.g. nationalisation, regulation and huge subsidies)
- Retail distribution margins are in fact very low (2012: £49 of the average bill energy bill of £1,188)
- The UK Energy market is one of the most liberal and competitive globally.
- Bills have risen due to commodity prices, increases in regulated transportation and distribution charges, and environmental costs and taxes.
Centrica, SSE and Drax, Labour Party proposes radical energy market reform
At its annual conference yesterday, the Labour Party announced that if it won the general election in 2015 it would make two radical changes to the UK energy market; namely break up the six large vertically integrated energy suppliers and freeze retail energy tariffs to the start of 2017. Unsurprisingly the energy utilities are trading down this morning with SSE and Centrica off 3.3% and Drax down 1.9% as we write this.
Looking at the two proposals, neither makes sense to us and both look very difficult to implement. Right now the UK energy market is one of the most liberal and competitive globally with independent players operating both in the generation space and the retail space.
On the wholesale/generation side, as a free market no company today has an obligation to provide any energy in the UK, and would be unlikely to do so if prices fell below costs. Given the planned closures in the UK generation fleet, there is a strong argument that the generation market will tighten through the middle of the decade, just as any proposals get implemented.
In Centrica’s press release today in response to the comments, it correctly makes the point that energy prices have risen due to higher commodity costs, increases in regulated transportation and distribution charges (which are regulated) and environmental costs and taxes. Centrica’s retail distribution margin was only 4.1% in 2012 (£49 on an average bill of £1,188), which is broadly in line with industry average.
How could the proposals be implemented? There are some taxes and environmental charges for the government to play with – according to Centrica these were around 15% of the average bill last year (environmental and social policies were £112 and taxes were £72 of the average £1,188 bill). The removal of these would amount to the state absorbing any increase in upstream costs.
The simple separation of wholesale and retail alone would likely have the opposite effect and actually increase retail prices. There have been times in the recent past when retail margins have been negative and utilities have absorbed the losses into their wholesale businesses. If these businesses were separated then this would no longer be possible and the separate retail companies would need to hedge their future requirements, so as not to be exposed to the volatile wholesale energy price. The cost of these hedges would increase the retail price of energy.
One option could be to nationalise the utilities and for the government to absorb the any losses resulting from a price control. This is fiscally irresponsible in the extreme and would require a dramatic shift to the left in Labour policy, perhaps making it unelectable. Labour could regulate and effectively subsidise the wholesale market, but again, this would also be extremely expensive.
Could Labour be counting on lower commodity prices? This seems unlikely. Locally produced shale gas probably won’t have an impact on gas prices by 2015 due to planning constraints. Even if projects get off the ground, volumes are unlikely to be enough to displace all gas in the UK. The marginal supplier, which would probably be global LNG, would therefore continue to set the wholesale price.
In all these scenarios lower energy prices could mean higher consumption and exacerbate the issues. One positive of higher energy prices from a policy perspective has been the increased focus on energy efficiency which has been a headwind for volumes in recent years. Would the government trying to re-establish its left wing credentials wish to undo this trend?
What to do with the shares? News flow could be negative in coming months. The UK energy suppliers may soon announce retail price increase (to cover the costs of government policies) and political rhetoric could become more populist and heated. However, any policies look very difficult to implement and are likely to stifle investment at a time when this is badly needed in UK generation, which would ultimately be positive for sector profitability. The Labour Party looks quite difficult to elect right now, with Ed Miliband as leader, but it may be helped by UKIP which could draw votes away from the Conservatives if it can convert its success in European elections to the general election. Overall our feeling right now would be to buy on any weakness resulting from this uncertainty (We rate Centrica, SSE and Drax).
The value of investments can fall and you may get back less than you invested.
No investment is suitable in all cases and if you have any doubts as to an investment’s suitability then you should contact us.
Past performance is not a guide to future performance.
Any tax allowances or thresholds mentioned are based on personal circumstances and current legislation which is subject to change.
The opinions expressed in this article are not necessarily the views held throughout Brewin Dolphin Ltd. No Director, representative or employee of Brewin Dolphin Ltd accepts liability for any direct or consequential loss arising from the use of this document or its contents.
For further information please contact Nik Stanojevic on 020 3201 3357 or the press office on 020 3201 3206