Industry overload

The UK’s electricity utilities, by and large, have not had a happy time of it over the past 18 months. Overcapacity and wholesale power prices that are below the long-run costs of generation have made life very difficult for the sector’s FDs. The name of the game has been to lose as little as possible on the generation side while making as much as you can from your retail base – assuming, of course, that you have both generation and retail assets.

This may not sound terribly exciting, but figuring out a coherent strategy for increasing shareholder value that does not sound desperate, overly cautious or totally boring is a huge challenge in today’s power market.

Not that boring is altogether bad. In fact, quite the reverse. The one thing that utilities have going for them right now is the fact that, in a perpetually tumbling stock market, a stock that lacks real pizzazz can strike institutional investors as a very good thing. “Steady as she goes” can look very attractive indeed. As Scottish and Southern Energy FD Gregor Alexander points out, focusing on dividend growth and holding steady is a strategy that has brought his company plenty of plaudits from analysts. “We were the seventh best performing stock on the FTSE-100 for the year to 31 December 2002,” he notes.

Scottish and Southern is famous for the assets it has not bought over the past two years. Its decision to retain a strong balance sheet and not to indulge in wrongly priced bids has won it friends and admirers in the City. Similarly, Scottish Power’s recently found “aggressive conservatism” which now eschews adventures outside its areas of core competence, is also winning it friends. Andrew Wright, utilities analyst at UBS Warburg, points out that his firm expects Scottish Power’s share price, long bogged down below 380p, to reach 475p over the next 12 months.

The US utilities, which have had their share of woes, thought they had a magic formula for making utilities excitingly different. It was called energy trading and was the fastest game in town. Enron demonstrated how you could go from being a nonentity local pipeline operator to a global player at near light speed on the back of brilliant trading. Unfortunately, they also demonstrated how vapid such a strategy could ultimately be, once they’d dealt themselves to destruction.

As Ross Hunter, head of energy trading at PricewaterhouseCoopers observes, since the Enron implosion, the idea that a trading operation can generate super profits for a utility has taken a severe knock. “In the UK trading is not where you look for massive value creation. The game here is to use trading to achieve more balance to your portfolio and to carry out effective risk management. UK utilities do not see their trading arms as aggressive profit centres.”

So with no super-trader dealing wizardry to add spice to the game, that leaves just generation and retail sales as the twin “weapons” in a utility company’s armoury. A third option, of course, is overseas expansion in either or both North America and Europe. Still another is diversification, but again, outside of Centrica, after some dabbling, this route has gone out of fashion for all the good reasons that generally weigh in against a conglomerate approach.

With generation struggling, given the long-term nature of the UK’s overcapacity, we are down to retail as the only promising area for UK-related organic growth. Here, it has to be said, if one takes Centrica as the sector’s acknowledged star of retail management and cross selling, everyone else looks a little grey.

Wright notes scale and skill are the twin factors that make retail yield above average profits. Centrica, with a starting position of all British Gas’s UK customers, has vastly more scale than anyone else in the UK sector.

As Wright comments: “This gives it the ability to spread the fixed costs of establishing new products and services, over many more customers.”

Scottish Power, with 3.5m UK customers, would not find it as easy to recover the kinds of outlays that, say, Centrica has had to make with its telecoms venture, which has been losing tens of millions of pounds a quarter for a while now. To put that kind of loss in perspective, Centrica’s total profit from retail electricity sales was £40m in the last published set of accounts.

With nothing much to be done to add startling new value dimensions to the existing retail base, the plan has to be to hold on to what one has by improving levels of service for these products that you know the customer absolutely has to have, ie, power and gas. This strategy does not prevent utilities from buying additional chunks of the retail customer pie as and when they become available at a decent price.

Once they do this, however, they have to match the new retail acquisition with either the purchase of further generating assets or by striking deals with generators. It has to be said that despite the present low wholesale price the history of such deals is not particularly encouraging. TXU Europe’s downfall was caused, at least in part, by long contracts at too high a price and the secrecy surrounding third-party deals in this sector seems to make it very difficult for utilities to sign sensible deals.

Hence, any player with a substantial retail base now looks to buy itself some generating assets. Even Centrica, which specialises in doing deals with generators to meet its retail commitments, has been buying generating plants for the past two years. It now owns three.

The one big compensatory factor that utility FDs with both generating and retail arms have going for them, as Scottish Power FD David Nish emphasises, is that low wholesale prices make for good retail profits, since customer pricing has stayed steady.

Analysts call this “the failure to switch” – it’s customer churn that allows low pricing to come through. The more inertia there is in the market, the more stable the retail price.

“What you lose on the swings, you gain on the roundabout,” says Nish.

This is the beauty of running a balanced portfolio. As he explains, if you can match your generation capabilities against the demands of your retail base, that keeps things “in the family” and keeps you out of the spot market. This is crucial, since the spot market is where the laws of supply and demand operate.

It’s important to realise just how fierce the spot market can be because it throws a stark, clear light on the nature of the electricity generation game. It also serves as a warning of what can happen if the government and the players that make up the sector, get things badly wrong. As Californian consumers and businesses recently found to their sorrow, in a free market electricity costs can spiral way out of control if supply fails to match demand. If the balance does tilt badly, stabilising the market takes time – possible years if the sector loses too much capacity.

As Graham Bartlett, FD of Powergen (now owned by E.ON) observes: “This entire sector is shaped by the fact that no one knows how to store electricity.

If we could package it like cornflakes and stack it on the shelves, this would be a very different market.”

The need for the spot market arises, Bartlett points out, because forecasting demand is difficult. A sudden cold snap can leave retail suppliers struggling to meet the needs of their customers. If a supplier needs to rapidly buy additional capacity and doesn’t have sufficient cover from its secondary or fall back arrangements with alternative suppliers, then it has to go to the spot market and pay whatever price the market demands. As Bartlett notes, this could easily be anywhere between £200 and £300, as against the current wholesale price of between £13 and £17 per megawatt hour.

In an ideal world, a power supplier would have generating assets standing idle until the price spiked, at which point they would fire up those idle assets and generate as much power as the spot market could stand. Unfortunately, in real life, generating assets do not quite work like this. In fact there are some severe engineering challenges facing any generator who thinks that the spot market, with its inflated prices, represents a good way of turning wholesale price losses into a sizeable profit.

To start with, there’s the difficulty and cost of running a generating plant, which was meant to run at full tilt, on a stop-start basis. “It takes four hours to fire up a gas generating plant to bring it online to take advantage of a sudden two hour peak. This means you have to keep a sharp eye on the cost of what you are doing, together with the likely maintenance costs associated with the stress on the plant, and you have to have good reason to believe that the price is going to peak in four hours’ time before you fire things up,” Bartlett says.

Much of the expenditure that Powergen has gone in for in the past few years has been to add flexibility to its generating plant, so that it has assets that are better able to stand the stop-start spot market game.

The other strategy available is to mothball a plant in an attempt to drive up prices by taking capacity out of the market. However, as Hywel Ball, head of Ernst & Young’s energy and utilities team observes, markets don’t work like this. “Every supplier has an incentive to keep running its plant while minimising its loss, in the hope that every other supplier is in worse shape and making a greater loss. Long term that puts you in a stronger market position since you will have killed off a number of your competitors.”

Philip Green, senior utilities analyst with Merrill Lynch, points out that this tendency is tempered by the fact that if the electricity price falls too low then you’re better off selling gas instead of going to the expense of turning it into electricity. More expensive legacy coal-fired plants become candidates for deep mothballing very rapidly under such conditions. Oil plant, at £40 a megawatt hour in costs, is already either mothballed or out.

However, Green points out that so far the market has been dogged by suppliers mothballing plants to varying degrees, rather than actually decommissioning and closing them.

Powergen’s Graham Bartlett agrees. “The game here is the same as in any other industry that suffers from overcapacity. You take a plant out until the price recovers, then you want it put back again. There are various levels of mothballing and there are ongoing maintenance costs associated with each level. The more lightly you mothball a plant, the more maintenance costs you have to bear,” he says.

What is certain is that as the wholesale price stands, the only new plant that anyone is interested in building is renewable energy. The government has mandated that every generator has to derive at least 10% of its energy from renewable resources by 2010, or it will face a £30 penalty on each megawatt hour that it produces short of the 10%. There are, however, problems with renewable sources.

“The bigger the percentage of renewables we have the more uncertain our generation output levels become. Wind is its own master. You can end up producing x, half-x or 2-x,” Bartlett says. Other alternatives such as a biomass plant, (for example, willow-burning stations) are also under consideration.

What is clear is that the renewables issue shows the importance of the political dimension in the power game. Everyone in the sector is waiting to see what the new government White Paper for the sector, promised for February 2003, comes up with. The well publicised difficulties of British Energy, a nuclear generator with high fixed costs and no flexibility, are a case in point.

As E&Y’s Ball observes, the government could transform the UK’s capacity issue overnight by letting British Energy go to the wall. However, nuclear, on one reading, is “green”. Its waste might poison the planet for several million years, but nuclear doesn’t generate greenhouse gasses. Besides, folding up the country’s nuclear stations would precipitate gigantic closure costs for the taxpayer.

There’s no doubt that government has some tough issues to solve. “The current fragmented nature of this industry is part of what makes things difficult for the sector and for government,” says Philip Green. “With a fragmented industry you get disingenuous behaviour. You lose cohesiveness and when the government says you need to think about “a” or “b”, there are too many diverse strategies to get anything working coherently.”

The solution, it seems, is more pain and more consolidation. What the White Paper will do to encourage this will be revealed soon.

POSITIVES AND NEGATIVES FOR CORPORATES

Overcapacity is good news in the short term for both residential and corporate buyers of electricity. Prices are cheaper and users don’t much care if the supplier’s name on the bill changes, as distressed suppliers sell their customer base to stronger players. However, as Merrill Lynch analyst Philip Green observes, “most customers don’t get the price they could get because there’s a reluctance to switch suppliers”. About 65% of UK buyers have not switched their supplier in the past three years.

Sound advice to any corporate is to hire a professional utilities buyer.

They can nearly always beat whatever price you can negotiate for yourself because they aggregate the demands of all their clients. This is then sold as a package to a supplier for a substantial discount, some of which the utility buyer passes on to their customers. Generators favour the big utility buyers because they can sell a chunk of their capacity at one go.

Utility buyers also understand the niceties of the electricity market, which has two buying seasons a year, during which the best prices can be had. After that, much like budget airlines with premium pricing for seats bought on the day, the generators, having achieved their comfort level sales, may charge a premium price for those who seek to buy electricity at the last moment.

However, there’s a real long-term danger in the current unbalanced market.

If too much capacity is actually taken out (as opposed to being lightly mothballed), then we could drift into the Californian situation of brown-outs and wild price spikes. Again, corporates who buy through experienced utility buyers will benefit from their market knowledge if the UK starts edging towards these kinds of conditions.