We recently held our annual European Utilities Roundtable – assessing sector fundamentals against the economic, regulatory, and political backdrop. We improved the sector fundamental score from Neutral to Positive.
After Covid, facilitating the Energy Transition from fossil fuel dependence to renewables in line with Net Zero targets was to be the backbone of economic growth in the European Union (EU). Following the invasion of Ukraine and the consequent gas crisis in Europe in 2022, we found the sector’s already defensive characteristics underpinned further by higher political and regulatory support. Why? Because the EU is keen to ensure the security of energy supplies, with concerns over gas shortages, affordability and systemic risk moving front and centre.
Gas prices moderating
New levels of government intervention are unprecedented. The EU has loosened restrictions on State Aid rules leading to direct government support in the form of either equity injection or more State ownership of critical infrastructure, notably in the Netherlands and Germany. The EU is also forcing local authorities to find ways to reduce the planning permission process for renewables developments from 6-10 years to 2-3 years. Additional major initiatives are in play on both sides of the Atlantic in a bid to attract investments and secure supply chains. In Europe for example, RePowerEU is a European Commission proposal to end reliance on Russian fossil fuels by 2030; the EU Power Market Reform seeks to reduce energy price volatility as well as create favourable conditions for investment in low-carbon energy. The US’s Inflation Reduction Act has also forced the EU to re-consider ways to encourage European Utilities to invest in Europe rather than taking advantage of attractive returns in the US, potentially through the Net Zero Industrial Act.
Electricity networks are increasing in strategic importance to facilitate the security of supply and decarbonisation targets. Regulatory mechanisms continue to work as expected, with regulated utilities being allowed to pass through inflation in rates and costs to end-users. Inflation is positive for the growth in value of networks assets and higher allowed returns on investments, ie better remuneration. Regulators are also adopting a more flexible approach, so electricity network operators will be incentivised to connect renewables sources to the grids sooner than before.
Capital expenditure is therefore increasing but financial strength is mitigated by future earnings before interest, taxes, depreciation, and amortization (EBITDA) growth and conservative balance sheet targets.
In terms of energy supply, the EU has now good gas storage ahead of Winter 2023 potentially hitting a target of 90% this Autumn, all things being equal. This has been attributed to a warm winter, lower demand and higher LNG imports replacing Russian gas. Commodity price volatility is therefore falling but electricity prices remain elevated versus historic levels. This is positive for utilities with merchant generation exposure.
Whilst we see plenty of reasons to be positive, we are also cognisant of risks to our thesis. Continued fall-out from military conflict remains an obvious one, and the extent of this together with the rapid pace of structural reform across the European Union has the potential to create uncertainty; unintended consequences need to be monitored. Weather-related risks will be ongoing and there is scope for project costs to be impacted by supply chain constraints. We are already seeing multi-year lead times for the delivery of transformers, shortages of skilled labour and squeezed supply of raw materials like copper and lithium.
Clean energy supply chains dominated by China
Source: JP Morgan, European Utilities, Mid-Year 2023 Credit outlook
On balance, we continue to like the defensive characteristics of the utilities sector, and within it prefer regulated electricity transmission and distribution names. The gas crisis in 2022 forced the EU into making faster decisions around energy-related infrastructure and their efforts have been focused further with competition for investments from the US’s Inflation Reduction Act.