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Specter of nationalization raises risks for UK utility shareholders, creditors

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Specter of nationalization raises risks for UK utility shareholders, creditors

The possible nationalization of Britain's energy networks and water utilities, proposed by the opposition Labour Party, is raising considerable risks for both equity and bond investors in the sector.

Labour outlined the first details of its proposal to take the country's gas and electricity networks back into public ownership in May, showing it would plan to potentially pay less than market value to shareholders of companies owned by National Grid PLC, SSE PLC, Iberdrola SA and PPL Corp., among others.

Compensation would be awarded through bonds but could be trimmed to account for pension fund deficits, asset stripping since privatization, stranded assets, the state of repair of assets and state subsidies given to the energy companies since privatization, according to the party.

The plans have put investors, including a large number of public and private pension funds, on edge, and parent companies of the regulated utilities have warned that they will accept nothing less than the assets' fair market value — although how exactly to calculate that will be up for debate.

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National Grid owns Britain's gas and power transmission operators, while U.S.-headquartered PPL owns four regional electricity distribution operators through Western Power Distribution PLC.

Berkshire Hathaway Energy, a unit of Warren Buffett's Berkshire Hathaway Inc., owns two regulated utilities through Northern Powergrid Holdings Co., and several others, including the subsidiaries of UK Power Networks Holdings Ltd., are ultimately owned by Hong Kong-based CK Hutchison Holdings Ltd. and affiliated companies.

Some analysts expect Labour would use the regulated operating companies' book value of equity, or the sum of their assets and liabilities, as a starting point for a purchase price.

That would potentially peg compensation below the companies' regulated asset values. Analysts at Alliance Bernstein calculate a possible downside of up to 18% for shareholders in SSE as a result, while National Grid would be much less exposed due to its highly valued U.S. business.

Bondholders also have reason to worry. Labour has said debts in the regulated utilities would be carried over and honored in full, but experts say creditors of the networks' intermediate holding companies could be left in the lurch depending on how exactly the utilities would be valued.

Such companies include Berkshire Hathaway's Northern Powergrid Holdings and PPL's Western Power Distribution, as well as CK's UK Power Networks Holdings.

"It's likely that the Labour party is only interested in the license holders, rather than any entities up the corporate structure," Maria Fassakhova, a senior director at Fitch Ratings, said in an interview.

But it is common in the industry to raise additional debt outside of the regulatory ring-fence of those operating companies, she said. That could become a problem if the government pays substantially less than the regulatory asset value, since the intermediate holding companies rank below the regulated operating companies when it comes to servicing debts.

"If there is no buffer left, there is nothing for the [creditors of] holding companies," Fassakhova said.

Water utilities like United Utilities Group PLC, Severn Trent PLC and Pennon Group PLC would carry even greater risk for creditors due to the water sector's higher gearing levels. Jonathan Constable, a senior credit analyst at Legal & General Investment Management, has said that the uncertainty around nationalization has likely already weighed on bonds issued by U.K. water holding companies.

As the U.K. remains in a political deadlock over Brexit, the specter of a specter of nationalization will continue to hang over utilities. Recent voting intention polls show Labour several points ahead of the governing Conservatives around outgoing Prime Minister Theresa May in the case of a general election, although the party would face an uphill battle to secure a majority in parliament.

Shares in National Grid, SSE and PPL dropped when Labour announced its plans on May 15, although they have since recovered and are up slightly since the start of the year.

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Although investors in the affected utilities are expected to challenge any compensation perceived to be below fair market value in court, their legal avenues are limited.

Jurisdictions like Singapore or Hong Kong have bilateral investment treaties with the U.K. that enable retroactive claims for fair compensation, and European and Australian investors can launch proceedings under the Energy Charter Treaty. But U.S. investors, for example, don't have similar protection.

To prepare for the eventuality of a nationalization, foreign pension and investment funds have already been shifting their stakes abroad, according to Dan Neidle, a partner at law firm Clifford Chance.

"We're aware of a number of very significant investors who have moved their investment holdings to Hong Kong," he said in an interview, although he was unaware of any U.S.-based funds moving their investments. "I think we're going to see more investors, including European ones, putting structures like this in place in the next few months," he added.

Neidle said that it would be extraordinary if the government would not pay fair market value, given precedents in the U.K. and abroad. S&P Global Ratings said last year that nationalizing the U.K. water and power sectors would cost around £160 billion if based on the regulated asset value of the companies.

In any case, a nationalization would take years to materialize. "That means there will be uncertainty for quite some time," Neidle said.

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