National Grid PLC is planning to appeal a decision by Britain's energy regulator to cut investor returns in the company's electricity and gas transmission business, and expects its credit rating could be knocked down a notch as a result of the tighter framework and a slower recovery of revenues lost due to COVID-19.
The utility said it will file a technical appeal to the Competition and Markets Authority, or CMA, on March 3 to seek a higher allowed return on equity, which has been set by the Office of Gas and Electricity Markets, or Ofgem, and will apply for the next five years.
In December 2020, Ofgem softened its proposed cuts to investor returns after heavy opposition form National Grid and others, including SSE PLC and Iberdrola SA subsidiary Scottish Power Ltd. But the company said the allowed returns, which are roughly 40% below current levels, are still too low.
The company also wants Ofgem to do away with a so-called outperformance wedge, a downward adjustment to the allowed returns made in expectation of future outperformance by the utilities, which National Grid CEO John Pettigrew said undermines productivity incentives.
"We still believe there are strong technical arguments that should lead to a higher level," Pettigrew said on a March 2 call to discuss the appeal.
Pettigrew said National Grid wants a cost of equity of at least 5.6%, whereas Ofgem's final determination set a level of 4.02% for electricity transmission and 4.3% for gas transmission and gas distribution. The company is not appealing the new framework for its far smaller system operator business, which manages the wider energy network in the U.K.
National Grid welcomed Ofgem's move to a higher allowance for total expenditure and greater flexibility around future investments to facilitate Britain's move to net-zero emissions. The company said it expects to invest about £10 billion in capex, or £12 billion in total expenditure, over the five-year regulatory period, which is known as RIIO-2 and starts on April 1. Nearly 60% of the total is focused on asset health, Pettigrew said.
That is higher than the baseline capex set in Ofgem's final determination, which analysts at Bernstein said would have delivered annual growth in National Grid's regulated asset base of about 2.5%. Pettigrew said the £10 billion capex would deliver growth of about 4.5%.
"This package will allow the critical investment required to maintain the resilience and reliability of our networks. We are also pleased to see greater flexibility in the mechanisms that will enable further investment required to deliver the energy transition," the company said in a statement.
National Grid expects the appeal process to conclude by early October, although it noted that an appeal by other networks could prolong the process. So far, none of the other utilities affected by the framework have announced a challenge.
Impact on credit rating, dividend
National Grid said the lower returns and higher investment under RIIO-2 will put pressure on its credit metrics and, coupled with lower expected revenue growth in the short term as a result of the pandemic, expects this could lead credit rating agencies to knock down its BBB+/Baa1 debt ratings by a notch.
Andy Agg, the company's CFO, said he still expects a hit of about £400 million to operating profit as a result of COVID-19, with a cash impact of up to £1 billion. Although National Grid expects to eventually recoup some of the lost revenue through its regulated businesses both in the U.K. and the U.S., Agg said the slower recovery from the virus will drag out the timeline longer than initially expected.
Asked by analysts about the potential impact of a favorable ruling from the CMA, Agg conceded that the credit outlook would stay unchanged even under that scenario. He emphasized that National Grid is confident it would nonetheless retain broad access to debt markets.
National Grid said it will target to grow its dividend per share in line with U.K. inflation under the CPIH index from financial year 2021-2022. The current dividend policy of delivering growth at least in line with inflation under the RPI index remains in place for the current financial year. The company will continue to offer a scrip dividend alternative.
National Grid's share price was up by around 1% following the announcement.