The long-term lease of NSW electricity networks offers excellent opportunities for fixed-income investors, writes Lochlann Kerr of Aberdeen Asset Management.
The recent re-election of the Coalition government in NSW has ensured the spotlight remains focused on its privatisation plans.
The government is seeking to monetise 49 per cent of state electricity network assets under long-term leases to the private sector for reinvestment in new infrastructure.
As incoming owners look to the debt capital markets for funding, Australian fixed-income investors will be presented with opportunities to diversify, while securing access to issuers that exhibit defensive and non-cyclical operating cash flows.
The role of the local bond market
As monopoly assets, regulated utilities are capital intensive and employ a meaningful level of debt capital as part of their funding mix.
The three NSW networks slated for lease – TransGrid, Ausgrid and Endeavour – have a combined asset value of over $26 billion, and could require around $20 billion in new debt capital as they adopt commercial gearing structures.
The Australian capital market is well positioned to play a meaningful role in the funding of these networks as they adopt efficient capital structures post-privatisation.
The domestic bond market has evolved significantly in recent years and has a proven capacity to provide benchmark funding across A and BBB-rated corporates over terms out to 10 years.
There are already five utility issuers with more than $1 billion in bonds currently outstanding in the Australian market.
Regulated utilities remain a good fit within high-grade fixed-income portfolios. Highly visible and predictable cash flows, robust investment-grade credit profiles and a constructive regulatory regime underpin the fundamental attraction of this sector.
A recent Standard & Poor’s report, for instance, noted that since 1952 regulated utilities have experienced peak-to-trough declines in revenue of just six per cent during recession periods.
Be alert to the challenges
Despite the supportive fundamentals for the sector, incoming private operators of the NSW networks will face meaningful challenges that cannot be ignored.
In addition to significant integration and execution risks, new operators will be operating under increasing regulatory scrutiny and subdued levels of network investment.
Difficulty in accessing the traditional levers to maximise equity returns may prompt operators to target unregulated revenues or higher leverage structures.
While it is premature to form a view on individual networks, it is clear that the success or otherwise of any privatised asset will be dependent on management’s ability to execute on cost-efficiency programs while maintaining both service reliability and appropriate capital structures.
We consider a proven track record of delivering successful outcomes within the Australian utility landscape as critical.
As such, we expect consortiums and partnerships to play a key role in any bidding process. In our view, potential bidders will need to successfully blend financial capital with operational and management capabilities to navigate any regulatory hurdles.
In our view, once these challenges are effectively managed, the benefits should be significant for both the operator and fixed income investors.
No need to wait
Notwithstanding the potential opportunities that privatisation may offer investors in the future, we believe opportunities exist now and there is no reason to sit back and wait.
Subject to name selection, fundamentals remain sound across the sector, giving bondholders access to regulated, inflation-linked cash flows, monopoly business profiles and robust end-user demand in major population centres.
We believe Australian fixed-income portfolios should retain a meaningful allocation to regulated utilities.
Lochlann Kerr is a research analyst specialising in credit at Aberdeen Asset Management.