RAV premia and implications for the price control RAV premia and - - PowerPoint PPT Presentation

RAV premia and implications for the price control RAV premia and implications for the price control

Ken Linge Finance Director Finance Director

CE Electric UK

Introduction

L b i b bj l h i l

• Long-term businesses, but subj ect to regular short-interval

economic regulation.

• We understand that this is an important issue as it is all too

easy to erroneously explain the existence of a RAV premium as the result of generally slack regulation particularly in respect the result of generally slack regulation, particularly in respect

• f the cost of capital.
• Important that we don’ t force a thin-equity model on the

whole sector.

Panel 2

CE Electric UK

Components of RAV premium

• Cost of capital.
• Expectation of regulatory out-performance.

Economic conditions

• Economic conditions.
• S

ynergies with other businesses.

• Value of other assets or liabilities being acquired.
• Balancing risks as part of a portfolio
• Balancing risks as part of a portfolio.
• Market entry.
• A “ must-have” trophy for the collection.

Panel 3

Expect that something is left for the buyer

CE Electric UK

Issues with RAV premium

• Represents a snap-shot of a negotiated price of one transaction

hi h b i h ll f h ifi f h i d which brings together all of the specifics of the time and

• place. As such it is not an indicator of the “ right” answer for a

whole sector.

• Quoted premium often varies between buyer and seller.
• Often problematic as they rely on estimates to disaggregate the

worth of a quoted company worth of a quoted company.

Panel 4

CE Electric UK

RAV premium and implied WACC

b d DPCR4 d t based on DPCR4 data

100.0% 75.0% 50 0% rem ium 25 0% 50.0% RAV pr 0 0% 25.0% 0.0% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% Vanilla WACC

Panel 5

CE Electric UK

Investor returns haven’ t fallen

7,000 5.5 6.0 5,000 6,000 3 5 4.0 4.5 5.0 5.5

Dividend Yield and Index P f L t 5 Y

3,000 4,000 2.0 2.5 3.0 3.5

9‐Feb‐03 2‐Apr‐03 ‐May‐03 1‐Jul‐03 2‐Aug‐03 4‐Sep‐03 5‐Nov‐03 7‐Dec‐03 2‐Feb‐04 5‐Mar‐04 8‐Apr‐04 1‐Jun‐04 3‐Jul‐04 6‐Sep‐04 8‐Oct‐04 9‐Nov‐04 3‐Jan‐05 4‐Feb‐05 1‐Apr‐05 ‐May‐05 6‐Jul‐05 7‐Aug‐05 9‐Sep‐05 0‐Nov‐05 2‐Dec‐05 7‐Feb‐06 1‐Mar‐06 ‐May‐06 9‐Jun‐06 1‐Jul‐06 2‐Sep‐06 4‐Oct‐06 5‐Dec‐06 9‐Jan‐07 2‐Mar‐07 7‐Apr‐07 ‐May‐07 2‐Jul‐07 3‐Aug‐07 5‐Oct‐07 6‐Nov‐07 2‐Jan‐08 3‐Feb‐08

Performance Last 5 Y ears

19 02 19 12 24 05 17 02 15 28 11 2 06 18 29 13 24 11 24 17 29 10 22 07 21 05 19 3 12 24 05 19 02 17 31 1 23 05 16 02 13

FTSE 100 Dividend Yield (Left Axis) FTSE 100 Index (Right Axis)

P/ E ratios FTS E 100 US + S &P 500 Europe + DJ Euro S toxx

Panel 6

CE Electric UK

Investor expectations haven’ t fallen

• Public information we have seen does not indicate that the

ultimate equity investors in the thin-equity model expect lower equity returns. I titi ti f t j d t d i

• In a competitive auction for assets, j udgments made in

modelling are subj ect to significant uncertainty – making the assumptions deliver a forecast value that wins an auction is easier than making those assumptions come true easier than making those assumptions come true.

• The most likely outcome is that the investment ultimately fails

to yield the forecast benefits Danger that impetus will be to to yield the forecast benefits. Danger that impetus will be to achieve cost savings “ at all costs” irrespective of long-term impacts on the asset base or customers.

• Holding company problems have to be isolated. The cost of

capital has to relate to the investment grade operating company.

Panel 7

company.

CE Electric UK

Other factors

• Have some acquisitions been based on flawed and optimistic

i ? assumptions?

• Use of high leverage and index-linked debt to bring down

WACC and enhance equity returns. WACC and enhance equity returns.

• Expectations of long-term out-performance against

regulatory targets regulatory targets.

• Rising RAV to protect against refinancing risk.
• Belief in an implicit government guarantee.
• Interesting that existing asset owners don’ t seem to be
• Interesting that existing asset owners don t seem to be

participating in these transactions.

Panel 8

Are we storing trouble for the years ahead?

CE Electric UK

Rating agencies

• Ofgem has consistently taken the view that an investment

grade credit rating provides sufficient evidence of an i fi i d h i i i h h appropriate financing structure and that its concern is with the ring-fenced entity only. Ratings are a snapshot and are s bj ect to change The

• Ratings are a snapshot and are subj ect to change. They

measure the probability of a short to medium term default on debt, not an assessment of whether a company can finance its activities They are not perfect as a long term predictor of

• activities. They are not perfect as a long-term predictor of

financial stability.

• Need to look at different ratios to capture the profile issues
• Need to look at different ratios to capture the profile issues

relating to index-linked debt. Cash based ratios may not be the most appropriate.

• Limitations on their effectiveness in measuring stress requires
• ther monitoring.

Panel 9

CE Electric UK

Failure is a possibility (1)

• There are some striking similarities to some of the important

f f h b i i features of the sub-prime scenario.

• Financial engineering is being brought to bear to introduce

margins to asset backed sec rities that are nlikel to be margins to asset -backed securities that are unlikely to be sustainable in the long-term. Assumptions are effectively made that the future will take

• Assumptions are effectively made that the future will take

care of itself – but the valuations either accept, or worse ignore, very credible risks that, if realised, can lead to extremely damaging situations extremely damaging situations.

• Ultimately, the customers will have to be served and

protected – and that will inevitably fall to the government in protected and that will inevitably fall to the government in the absence of a promptly available, viable solution.

Panel 10

CE Electric UK

Failure is a possibility (2)

• In the case of sub-prime and its impact, the concerns were

i d b i k b i d recognised but action was not taken because it was assumed that the existing arrangements would work out and that the market would deal with the fall-out.

• Within the regulated sector we might think that as long as

regulated assets have a worth there will be a range of willing buyers Therefore the “ lights will stay on” and any financial

• buyers. Therefore the lights will stay on

and any financial turmoil will be experienced elsewhere.

• But at what price and over what time?
• But at what price and over what time?
• The UK example shows that the market, or a regulator, does

not necessarily deal with all of the results of such inactivity. not necessarily deal with all of the results of such inactivity.

Are we entering a period of more intrusive regulation?

Panel 11

g p f g

CE Electric UK

C l i Conclusions

Panel 12

CE Electric UK

Conclusions (1)

• One-size does not fit all.

A hi h i i lik l b i di i f i i i

• A high premium is likely to be an indication of over-optimistic

assumptions, and the upfront cash flow of index-linked bonds, rather than evidencing a decline in required equity returns.

• We believe that companies with a more traditional equity

structure are essential to the long-term sustainability of the sector It is critical that Ofgem avoids an approach that places

• sector. It is critical that Ofgem avoids an approach that places

an incentive on such companies to dilute their equity holding or to exit the sector.

• Underlying risks have only increased.
• Recent operational experiences, e.g. floods, and changing

Recent operational experiences, e.g. floods, and changing

• bligations, demonstrate the need for immediately available

cash reserves.

Panel 13

• Cost of equity hasn’ t changed – it certainly hasn’ t reduced.

CE Electric UK

Conclusions (2)

• Leveraged financial structures in regulated networks have

much in common with the sub-prime and financial sectors.

• Rapidly increasing leverage.
• Reliance on tranched debt and credit ratings.
• Underestimation of refinancing risks.

g

• Optimistic assumptions on efficiency – out-performance assumed in

perpetuity.

• S

cope for imprudent or abusive treatment of some financing. p p g

• Inherently less resilient to financial shocks.
• The most likely outcome is a sequence of events in which:
• The most likely outcome is a sequence of events in which:
• The fund managers take their fees.
• The incentives created put significant pressure on management to talk up and

d d underspend.

• The investment never realises the expected returns.
• The asset is eventually sold at a mark down, if sold to a rational investor,

Panel 14

y , ,

• therwise the obligation has to be assumed by the government.

CE Electric UK

CE Electric

• Whatever other investors assume, in the real world CE Electric

is experiencing:

• S

ustained rises in commodity/ raw material costs driven by an expanded global market place and supplier consolidation.

• Increased lead times and inability to fix prices.
• Increases in contract rates due to a more competitive market place for service

provision.

• Marked increase in faults and site security costs (copper theft).

Marked increase in faults and site security costs (copper theft).

• Volatility in weather patterns leading to increased fault costs from storms and

negative impact on income.

• CE Electric needs to work with Ofgem to ensure that the price

control settlement:

Gives proper incentives to long term investors and operators

• Gives proper incentives to long-term investors and operators.
• Allows the appropriate funding for the long-term investment needs of the

company.

Panel 15

• Doesn’ t encourage properly capitalised organisations to adopt higher risk

structures.

CE Electric UK

Impact on DPCR5

Ofgem must: C id h l k f f i f

• Consider the usual key components of cost of equity, cost of

debt and gearing. In addition consider the rob stness of the financing

• In addition, consider the robustness of the financing

arrangements in the context of:

• the credit crunch;

the credit crunch;

• the application of index-linked bonds;
• high gearing; and
• credit ratings.
• Discourage further thin-capitalisation.
• Balance the scope of regulation between:
• Balance the scope of regulation between:
• A focus on the regulated business; and
• An overview of holding company structures.

Panel 16