Reading the omens for re-nationalisation – Peter Atherton

It is perfectly feasible that there will be a General Election in 2018 or 2019. Opinion polls suggest that a Labour government under Mr Corbyn is a 50/50 possibility. Therefore, Labour’s policy of re-nationalising the utility sector is now being taken very seriously by the companies and those who invest in them.

Indeed, since the last General Election, where Labour out-performed expectations, the share prices in the listed utility companies have significantly underperformed the market. In the case of National Grid for example, its share price is down 34% since May 2017, with the political risk caused by Labour’s policy a key factor in this decline.

So, what are the key questions that investors must ask themselves, and what actions should the companies take?

The first question is whether the Labour party can be persuaded to change tack and not re-nationalise. The answer to this is no unless there is a change in the leadership, which looks highly unlikely. With the current leadership team of Mr Corbyn and Shadow Chancellor John McDonnell it is very likely that the policy to re-nationalise will form a flagship part of Labour’s election manifesto.

Investors need to understand that for Mr Corbyn and his team the re-nationalisation of the utility sector is a matter of high principle. What’s more, they see this as an opportunity to reverse a key economic reform made by the hated Thatcher government in the 1980s – reforms that they bitterly opposed at the time. They are therefore highly unlikely to be persuaded against this policy by arguments on the relative economic merits of different ownership structures. If the Labour Party wins the next election with their current leadership, then re-nationalisation is highly likely to happen in some form.

But what is Labour’s policy, and what do they mean by re-nationalisation? Whilst Labour’s policy statements have been short on detail, the broad thrust is clear. A future Labour government would take into public ownership key assets across the power, gas and water sectors. The purpose would be to enable the state to make the key economic decisions for these industries and to significantly limit (and maybe eliminate) private profit from the sectors. Labour is clear that this must be achieved by the state taking ownership of assets rather than through regulation – although regulation is also likely to be used as a secondary tool to achieve their overall goals.

Precisely which assets would be acquired is un-clear and Labour probably haven’t decided yet themselves. But from statements made by key Labour figures it would appear that the national transmission networks (gas and power) and the 10 major water and sewage companies would be priorities. The gas and electricity distribution networks are also likely to be targets. But, as yet, they have been less clear about their attitude to the electricity generation and energy supply businesses. So far, there has been no suggestion that upstream oil and gas assets would be targeted, although the logic of the policy would suggest that key assets such as interconnectors and LNG terminals might also be considered at some point.

So, faced with Labour’s policy, what should investors and the companies do? For investors, two immediate actions are appropriate. Firstly, they need to apply a significant risk discount to the equity of the companies. Indeed, this has already happened with, for example, the dividend yield on National Grid rising by over 200bps in the last eight months. Secondly, investors need to make it clear to management teams that their sole priority in this process is to preserve bond and shareholder value.

How can management teams protect value? Firstly they need to recognise that they are extremely unlikely to dissuade the current leadership of Labour from this policy. They also need to accept that, if Labour is elected with re-nationalisation as a manifesto commitment, then they would have every right to pursue that policy. So focusing their energies on the policy debate is likely to be futile. Instead, their efforts must be focused on ensuring that a future Labour government pays a proper price.

A number of steps should be taken by management teams. Firstly, they must develop a robust legal case on valuation. For the network companies the valuation debate is very likely to centre around the Regulatory Asset Base (RAB). There are protections in UK and international law against the expropriation of assets, and the network companies should develop the strongest possible legal case that RAB forms the baseline valuation for their assets. Arguing for a “market value” would be dangerous, as this can be easily manipulated through regulation. RAB valuation is different as it is a creation of regulation.

Secondly, companies must examine all other legal methods to protect value – note the aim here is to ensure a fair price is paid, not to thwart the policy. Such measures might include moving corporate domicile, the re-issuing of debt under US jurisdiction, and placing corporate funds overseas.

Thirdly, management need to protect the rest of their business. Most utilities have wider business interests than just their UK regulated assets. Management teams must act to protect the value of their other activities. Corporate, legal, tax and capital structures should be arranged so that a re-nationalisation of the UK-regulated assets does not impair the value of their other assets.

Fourthly, capital allocation decisions need to take account of the clear rise in the discount rate of UK-regulated investment. Capital allocated to the UK regulatory business must be treated as high risk.

Finally, investors, both UK and international, need to make it clear that any expropriation of assets will come with a very high price to a future Labour government. Many of the network utilities are now owned by overseas sovereign wealth, infrastructure, and pension funds. These investors should combine with their governments and British investor colleagues to spell out the impact across all sectors, not just the utilities, will be less investment and what investment is forthcoming will be at a significantly higher price.

Focusing on valuation and ensuring a proper price is paid for their assets may also provide companies the best overall defence as it is as yet unclear how Labour plans to finance re-nationalisation. With the combined RAB of water, gas and power at around £120bn, Labour would be looking at a cost three times the annual defence budget. The public may well question whether this is a worthwhile use of taxpayer cash.

Whilst I believe it is futile to try and convince the current Labour leadership that re-nationalisation is the wrong policy, it is worth noting that they would not be so keen on it if the policy was not popular with the public. But it is. Looking beyond the current issue with Labour, those who favour private ownership must think hard as to why the public – after 30 years of largely successful private ownership – back re-nationalisation by 2:1 according to recent polls. I will write on this in a future article.

Cornwall Insight Associate Peter Atherton is a well-known equity analyst having headed utility research at several eminent City institutions, most recently Jefferies, and is a respected energy commentator.

For a free trial of Energy Spectrum please contact us on enquiries@cornwall-insight.com

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