Regulatory Crisis To Further Damage Power Sector
BMI View: The Spanish government's decision to intervene directly in the country's power market to cap electricity price rises in the first quarter of 2014 creates yet more uncertainty for investors in Spain's embattled power sector. It is not an exaggeration to say that the Spanish power sector is in crisis, with the erratic regulatory environment weighing on investment as the government attempts to balance the competing aims of reducing the country's tariff deficit and constraining spiking electricity bills. While Prime Minister Marion o Rajoy's government is in a difficult position, if it does not act quickly to establish greater regulatory certainty we expect to see an uptick in the number of investors exiting the sector - a view supported by unconfirmed reports that German utility E.ON is considering offloading its entire Spanish power portfolio.
We have long noted that the erratic regulatory environment in the Spanish power market is a consequence of competing and often irreconcilable dynamics - a view that has been given credence by Prime Minister Mariono Rajoy's recent claim that reforming the country's electricity market is one of the 'most complicated' issues his administration has faced since taking office in 2011. To put Rajoy's comments in context, his government is caught between having to contain electricity prices as the country recovers from two years of economic contraction (with unemployment still running at 26%), and having to scale back a significant tariff deficit, which is estimated at between EUR26-28bn after it grew because tariffs have been set artificially low for years as an anti-inflationary measure ( see ' Tariff Deficit Weighs On Already Negative Outlook', July 16).
Yet, as if this process of reform wasn't difficult enough, in late December 2013 the Spanish regulator, Comision Nacional de los Mercados y la Competencia (CNMC), annulled the results of a quarterly electricity auction due to what it called 'atypical circumstances', according to Reuters. To this end, Spain's electricity prices have thus far been partially set via quarterly wholesale power auctions (known as Cesur); however, the most recent auction came under fire due to allegations that utilities had manipulated proceedings to guarantee an overall price increase of 25.6% for the first quarter of 2014 - a rise that would have translated in an 11% rise in basic rate tariffs for consumers. In response, the government decided that such a rise would be untenable for hard-pressed consumers and has moved instead to cap the price increase at 2.3% over the first quarter of 2014 - using a temporary procedure that would use futures trading as a benchmark.
|Price Spike Raises Concerns About The Futures|
|Spain - Wholesale Baseload Electricity Price OTC First Quarter (EUR/MWh)|
In our view, this latest development comes at a critical juncture for the Spanish power sector and this current crisis will need to be resolved swiftly. As things stand, the government has stated it is looking to establish a new method for pricing electricity - with CNMC suggesting that using electricity futures prices could help provide a longer-term basis for the setting of quarterly electricity prices.
Unsurprisingly, the decision to invalidate the auction has been criticised by Unesa (an industry body representing utilities operating in Spain), which has claimed the setting of an artificial price 'does not resolve fundamental questions about the functioning of the system'. This is a view with which we broadly agree. Although the allegations of price manipulation need to be investigated, the most pressing problems in the Spanish power sector are clearly those linked to pervasive regulatory uncertainty and sudden changes to policy.
To this end, we highlight that the government is already reportedly considering rewriting some of its retroactive reforms, which were only announced in July 2013 and are particularly damaging for investors in renewables ( see 'Rewriting Electricity Reforms To Generate Greater Uncertainty', November 27). These reforms include slashing regulated costs - which include renewable energy subsides - by EUR2.7bn a year and also implement a policy of 'reasonable profitability', which will limit the returns on investment that can be made by Spanish renewable companies to 7.5% and electricity distributors to 6.5%. We highlight that if this has not made investment in Spain's power sector unpalatable enough already, then the annulment of the recent electricity auction will almost certainly have compounded the already-prevalent view that Spanish power sector is onerous.
With this in mind, we highlight that we will be watching investigations into these utilities very closely, but more importantly, we reiterate that regardless of the outcome, the operating environment remains extremely challenging for both current and prospective investors. Indeed, Reuters has reported that German utility E.ON is considering offloading its Spanish portfolio, as it looks to shore up its balance sheet. In this context, it is worth bearing in mind that the utility (like many of its regional compatriots) is under huge financial pressure as tepid demand for electricity in Europe, low wholesale electricity prices and a huge surge in renewable energy capacity in Germany take a toll. As such, while these reports of a Spanish exit are unconfirmed, the aforementioned retroactive alterations to tariffs and the recent annulment of the auction will have done little to encourage E.ON to stay in Spain. Indeed, many other utilities might be thinking the same thing, creating huge risks to investment in Spain's power sector and ratcheting up the pressure on the government to establish a greater degree of regulatory certainty.