During her speech to the Conservative Party conference on October 4, 2017, Prime Minister Theresa May announced plans to cap standard variable tariffs (SVT).
The most common tariff provided by UK energy suppliers, SVT is the default rate applied once a customer’s fixed term ceases, and its price fluctuates according to the Bank of England’s base rate. This created concern on the market about the future ability of these companies to generate cash flow.
But will the cap harm the “Big Six” ̶ Centrica (British Gas), SSE, EDF, Scottish Power, Innogy and E.ON – as severely as initially thought?
In our view, this is obviously not a good news, but even the most exposed of the “Big Six” should be equipped for change. Understandably a cap will put pressure on suppliers’ cash flow – but this could be offset by lowering operating expenses, capital expenditures (capex), and adjusting respective financial policies. In turn, the largest players’ credit ratings may not be altered immediately after the cap’s introduction, which is expected to materialise during 2018 at the earliest.
Boosting energy competition
With 14 million U.K. households operating under SVTs, their rising number has been singled out as a potential cause of the U.K. energy market’s inefficiency. This is because SVT customers are less inclined to switch to more competitively-priced providers than those on other tariffs.
The policy proposal follows a two-year inquiry by the Competition and Markets Authority (CMA), which calls for further measures to foster energy market competition. In July 2017, Ofgem, the U.K. regulator for gas and electricity responsible for implementing the measures, announced that it would act beyond the CMA’s recommendations. In addition to measures that ease customers’ ability to switch providers, tariff caps were also introduced for households with prepayment meters.
The problem, however, is that Ofgem will not implement a ceiling on all energy tariffs without legislative consent. The Prime Minister’s draft bill, presented to parliament on October 12, 2017 aims to provide the necessary framework for Ofgem to proceed.
The “Big Six” may weather the storm
Each company’s exposure to the proposed legislation depends on two factors: the number of consumers on SVTs; and the amount by which tariffs will be reduced. While Centrica has the largest consumer base (around 6.6 million SVT customers, as of June 2017 – 1.6 million of whom are already subject to a tariff cap), it also has a lower SVT rate, based on Ofgem data.
As such, Centrica, the most exposed supplier to the U.K. retail market (in terms of volume), has some buffer to protect against potential damages to its credit quality. We estimate that, even if the government’s future cap leads to a £50 deduction to the SVT tariff ceiling (totalling a £200 million decrease in Centrica’s operating profits), the country’s largest firm could still generate funds from operations (FFO) to debt close to 35%, thanks to the company’s free cash flow generation and capex flexibility. In the same scenario, SSE, with 2.2 million SVT customers, could see an £80-100 million reduction in operating profit, but would still generate FFO to debt of close to 23% ̵̶ taking into account free cash flow generation and its increased renewables output, effective from 2019.
Meanwhile, the effect on Europe-based constituents of the “Big Six” – EDF, Innogy, Scottish Power (owned by Iberdrola) and E.ON – should be less damaging. These companies’ U.K. supply operations are less significant contributors to their overall operating profit and a price cap will likely hold less influence over credit quality.
The proposed changes – together with the implementation of the CMA previously proposed measures – are likely to diminish the “Big Six’s” market share and margins.
There is still uncertainty, because Ofgem must first propose a scheme that will be subject to a public consultation before the cap is implemented. That said,companies have some some options to soften the impact – namely to lower both operating costs and capital expenditure.
What’s more, given the “Big Six” will likely pursue growth outside the UK or in other activities (thereby reducing their exposure to the UK market).
All things considered, , the cap – although harmful to some extent – may not be as severe as first assumed.
Beatrice de Taisne, is director for EMEA Utilities Rating Services, S&P Global Ratings.