U.K. and U.S. energy transmission and distribution company, National Grid (NYSE: NGG), has much at stake over the pending Brexit decisions. While many stakeholders continue to watch the saga between the U.K. and European Union play out, National Grid has been busy making preparations for whatever the outcome.
The gas and electric utility's business includes four segments: transmission and distribution of U.S. regulated networks; U.K. electricity transmission; U.K. gas transmission; and National Grid Ventures and other activities, which include interests and investments separate from the core regulated businesses. The final Brexit plans will likely have implications for segments tied to both the state of the British economy as well as its energy trades with mainland Europe. But there are other factors in the U.K. electricity transmissions segment, which comprises more than one-third of the company's asset base, that should concern shareholders even more.
How much exposure?
The U.K. regulated segments contributed 44% of operating profit in fiscal year 2018. While that was down from the 50%-plus in prior years, mid-year results for the current period once again showed a 50% contribution.
So any impact on the U.K. portion of the utility would be quite meaningful to the overall performance of the company. These impacts can range from how the U.K. economy itself responds, to how the flow of electricity is managed to and from the continent and its effects on network reliability.
National Grid describes how it makes money this way: "Our regulators in the U.K. and U.S. set the type and level of charges we are allowed to pass on to our customers to simulate market competition. We also make money from businesses that operate in markets outside our core regulated businesses."
National Grid Ventures operates in the realm outside those core regulated businesses. These include the interconnectors between the U.K. and Europe. It currently has six interconnectivity projects operating, under construction, or in development with the European continent.
This additional supply and trade of energy contributes to the energy security that the company maintains as one of the four themes that make up its business environment. But while it is a growth area, the company's Ventures segment isn't the real driver for operating profit as you can see below:
The annual report describes how the company sees the impact of Brexit on its operations:
We believe U.K.-E.U. cooperation on energy is positive for U.K. and E.U. consumers in terms of energy security, affordability and decarbonisation. We continue to keep the implications of Brexit under review, especially regarding our access to energy markets and the impacts on interconnectors' revenues and costs. Our interconnector partners share a financial interest in the ownership and profits from their operation. For the past 12 months, we have been assessing these issues and have devised scenarios to cover the majority of likely outcomes. Based on the worst case scenario ("no deal" on free trade), we have determined that the risk of increased costs of tariffs and any possibility that our partners might be compelled to "switch off" the interconnectors is low. Throughout the year, we have been engaging with our customers and stakeholders, especially with our regulators, as we seek to inform them of the Brexit outcome we believe would be in the best interests of consumers.
With that said, National Grid has been working on contingency plans no matter the Brexit decision. In a presentation made at their Annual Customer Forum in March, the company spelled out the details. In the case of a No Deal Brexit, after a transition period, the U.K. would no longer be part of the Internal Energy Market (IEM), under which the E.U. operates. The company feels confident that with some commercial changes and modifications related to daily electricity capacity auctions, there wouldn't be any interruption to the interconnectors, and no trade tariffs would be implemented.
Uncertainty as an investment
Customers and investors should feel good about all the work that has gone into preparing for the potential Brexit outcomes. If that were the only uncertainty, it shouldn't be a reason to avoid the stock. The plans, however, can't help predict what indirect impact Brexit might have on the company through the British economic response.
On top of that, the company is in the midst of a changing regulatory environment in Britain. U.K. energy regulator Ofgem (Office of Gas and Electricity Markets) has proposed a new framework that would cut baseline returns almost in half beginning in 2021, to drive savings for consumers. National Grid has expressed their disagreement with the scope of the reduction and countered this proposal. In the long run, this could have more of an impact on investors than even the Brexit outcome, adding to the uncertainty.
In Dec. 2018, Ofgem proposed RIIO-2, to take effect in 2021, when the U.K. gas and electricity price controls from RIIO-1 expire. RIIO stands for setting Revenues Using Incentives to Deliver Innovation and Outputs. Ofgem initiated this price control methodology in 2013 to help protect consumers and limit what the energy network monopoly can charge.
RIIO-2 effectively proposes cutting allowable investor returns to 4% from 7% to 8% under RIIO-1. The company's initial reaction was "disappoint[ment] with the proposed financial package, in particular the cost of equity range as we do not believe it appropriately reflects the level of risk borne by transmission networks." In Mar. 2019, the company submitted an official response it feels "fairly reflects the risk-return balance for consumers and investors alike." The response suggests an allowable return of 5.5%, beginning in 2021.
Investors would be wise to pay more attention to the finalized regulation framework and its impact on an investment in National Grid, rather than focus on how Brexit ultimately plays out.
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