A Utility Regulation Own Goal?

Editors’ Note: MarketMinder Europe favours no politician nor any party, assessing political, regulatory and legislative developments solely for their potential market and economic impact.

The energy crisis continues hitting UK households and energy suppliers alike, with more than 20 of the latter having collapsed in the last three months.^[i] That includes Bulb Energy, which the government has agreed to provide a £1.7 billion bailout in order to keep its 1.7 million customers’ lights on and homes heated.^[ii] This saga earned the chief executive of energy market regulator Ofgem an invitation to a hearing in the House of Lords, where peers grilled him on the industry’s seeming inability to handle a shock. In the hearing, he signalled that Ofgem will overhaul its regulations to include stricter stress tests (in which regulators use models and hypothetical scenarios to assess a company’s ability to withstand a financial shock) and capital requirements—echoing global regulators’ response to the 2007 – 2009 global financial crisis. In our view, this solution ignores the problems’ real cause. Furthermore, whilst it might give customers more insight into suppliers’ finances, it likely won’t make UK Utilities companies more attractive holdings for stock investors.

Much of the analysis on UK energy suppliers’ woes focuses on how their costs have changed as wholesale energy prices have spiked this autumn (meaning, the price suppliers pay for natural gas and other sources of power). The largest, most established companies have overall managed to weather the storm thus far, as they tend to build winter inventories much earlier in the year. As a result, they didn’t need to buy as much when prices spiked, helping keep their costs in check. However, the newer, so-called challenger companies, which tend to have more limited financial resources, keep much smaller inventories. As The Guardian reports: “Many challenger companies buy energy from the wholesale markets just three to six months in advance, which left them exposed to record energy markets prices after a rapid surge earlier this year.”^[iii]

Whilst costs do matter greatly, in our view, they would be far less likely to bring these companies’ collapse if the suppliers were allowed to raise the prices they charge customers accordingly. But following legislation passed in 2017, Ofgem caps prices on the default energy tariff, which generally applies to households that don’t regularly shop around to find the best deal on a fixed-rate tariff. The government estimates this includes around 11 million households.^[iv] Accordingly, suppliers have a very limited ability to pass their higher costs to customers, which has forced many to operate at a loss this autumn, dooming many challenger companies to administration.

In our view, whilst price controls seem appealing from a sociological standpoint—especially when the potential beneficiaries are the elderly and financially vulnerable, which is frequently the case for households on the default tariff—they often end up being an own goal for this very reason. We aren’t in the business of advocating for or against policies, but we do think it is worth noting that if the price caps weren’t in place, then it is far less likely that Ofgem would now be scrambling to prevent firms from going bust. Toughening stress tests and raising capital requirements strikes us as an attempt to solve a problem inflicted by politicians—one politicians could easily fix by removing the price caps, however politically contentious that would be.

But politicians aren’t considering that, leaving investors to discern how the added requirements will affect stocks in the UK’s Utilities sector. When regulators applied similar rules to banks a decade ago, our research found it caused financial institutions to focus on building their balance sheets rather than increase their market share, which perhaps weighed on their growth and returns. Additionally, the mere possibility of new regulations raised uncertainty—banks and investors knew the rules were going to change, but it took a few years to discover exactly what those new rules would be. Now, we do think the lengthy period of rule writing and discussion helped markets price in the eventual changes before they occurred, mitigating the risk of a sudden disruption. But we have also found that regulatory uncertainty can weigh on returns until resolved, and we think that was the case with Financials globally in the years after the financial crisis.^[v]

Yet we think there is something else to keep in mind as it pertains to Utilities stocks. According to our research, Utilities tend to trail broader markets considerably during economic expansions, as their revenues don’t much fluctuate with the economic cycle. This helps them do relatively better during recessions, as their revenues tend to hold up better than companies in industries that are more sensitive to the belt-tightening that usually accompanies an economic downturn. So new regulations or no, we don’t think UK Utilities would be likely to lead broader markets in the foreseeable future, as the global economy is growing and stocks remain in a bull market (a long period of generally rising equity prices). But if you own some Utilities for diversification, the pending regulatory changes might be reason to consider diversifying with Utilities firms outside the UK—finding those with less looming uncertainty.