Electricity firms face a shock to the system

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The Independent Online
ARE THE regional electricity companies seizing their last chance to reward loyal shareholders, or waving a red rag at a bull? As the interim reporting season gets under way, it shows all the signs of the usual dividend race - just months before the RECs' monopoly distribution business is due to come under the scrutiny of Stephen Littlechild, director-general of Offer, the industry regulator.

Last week, Eastern Electricity set a cracking pace with a 20 per cent surge in its payout, from 5.5p to 6.6p. Part of this increase resulted from its decision to rebalance the dividend, with 30 per cent payable at the interim stage, rather than the 28 per cent it paid out last year. Even so, the size of the rise took the City by surprise.

It also put pressure on the rest of the RECs, which tend to follow each other. Nick Pink, utilities analyst at SG Warburg, expects that at least three and maybe seven will decide to rebalance their dividends in line with Eastern. But they may also be forced to drive up the overall level of those dividends.

'I doubt whether any company will give a less than 12 per cent increase for the full year,' said Angelos Anastasiou at Panmure Gordon. Fellow analysts agree, with predictions that the RECs will show year- on-year rises of between 12.7 and 15 per cent.

Yet yields on the RECs are already well above the market average, as is the typical 2.9 times dividend cover. So any further rise in the payout will fuel the argument that their earnings should be curbed.

The RECs do not seem unduly nervous about this prospect; they have clearly accepted that some squeezing is inevitable. The question is, how much? In July, Mr Littlechild completed a review of the supply price regime. The price controls he imposed were much less harsh than had initially been feared, but he is expected to take a more critical view of the distribution business when it comes up for review this April.

Distribution accounts for the lion's share of the RECs' operating profits - between 85 and 97 per cent. Under the generous price-capping formula laid down by the Government when they were first privatised, they can raise prices annually by an average of 1.1 per cent above inflation. Yet unlike the privatised water firms, they do not have to fund large capital expenditure programmes.

In this respect, they are much more akin to BT and British Gas, both of which have had their formulae revised sharply downwards recently. BT now operates under inflation minus 7.5 and British Gas under inflation minus 5 per cent. The RECs also enjoy far better rates of return on their assets, in some cases twice the 5-7 per cent enjoyed by British Gas and the water companies.

None the less, some in the City feel they have little to fear. All have improved the quality of their customer services, and many have also reduced prices voluntarily. At Midlands Electricity, bills have dropped by 4 per cent this year, according to Vernon Andrews, director of planning and external affairs. Eastern has also cut prices and announced a minimum pounds 5 rebate for all domestic customers - the second of the year - when it reported last week.

Others argue that Mr Littlechild has shown himself to be level-headed. 'He's been very consistent and, from an investor's point of view, a good regulator,' said one analyst, suggesting that Mr Littlechild's reputation as the weakest of the watchdogs is unjust. 'The original price controls were set up by the Government. He has always said he would respect that regime until it expired in April 1995.'

Certainly, he has been consistent in his belief that dividends are the business of the RECs and their shareholders. However, earnings are another - though not unrelated - matter. It is high earnings, after all, that has allowed the RECs to pay large dividends without eroding their cover.

As a result, few now doubt that he will be tightening the regulatory regime. 'He's going to aim for cash neutrality by the end of 1995 and thereafter. But how he's going to get there is anybody's guess,' said Andrew Wheeler, utilities analyst at NatWest Securities.

In fact, Mr Littlechild has two main options: an RPI minus X formula that bites steadily, or a big one-off cut followed by a more gradual reduction. But, independent of mind though he is, he may yet find the choice is not his alone.

A sharp one-off reduction, to take effect in April 1995, would coincide nicely with the imposition of VAT at the full 15 per cent. Of course, it would not be enough to eliminate the increase, but it would help to offset the rise in bills. So the Government may decide this is too good a chance to miss. This route would be favoured by some RECs. Paul Marsh, Eastern's financial controller, said a one-off cut would hit the share price but have a less demoralising effect than constant contraction under a tough price-capping formula.

The fear, however, is that Mr Littlechild may be forced by the Government into another sort of corner. He is expected to indicate before Christmas whether or not he plans to refer PowerGen and National Power to the Monopolies and Mergers Commission. A referral would delay the Government's planned pounds 3bn sale next year of its remaining stake in the two generators and make Mr Littlechild extremely unpopular.

At the same time, he cannot afford to exacerbate his public image as the least aggressive of the regulators. He may therefore be driven to assert himself with a touch of shock treatment for the RECs.

(Photograph omitted)