A couple of weeks ago National Grid made a huge announcement - it would acquire Western Power Distribution (WPD) as part of a complicated £14bn deal with PPL Corporation (a Pennsylvanian-based energy company).

Alongside the WPD acquisition, the deal involved National Grid committing to offload its majority stake in National Grid Gas (NGG), which is responsible for the GB gas network.

In a separate-but-related deal, National Grid also announced it would sell Narragansett Electric Co. (it’s Rhode Island gas and electricity business) to PPL Corporation for an equity value of £3.8b. Confused? Here’s a diagram 👇.

Now that the dust has settled, I’ve tried to get my thoughts down into one place. The following points are not exhaustive or in any order. Here goes...

1.This is a big deal

This is the biggest UK utilities deal in a decade. National Grid (one of the largest investor-owned utilities in the world) will buy Western Power Distribution, the largest Distribution Network Operator (DNO) in the UK. WPD owns and manages the distribution networks in the Midlands, South West, and Wales. This network serves around 8m customers and covers a huge geographic area. National Grid will become an (even more) mega-utility in the UK. This means National Grid will be much more focused on / exposed to electricity than gas.

In some ways this is a continuation of National Grid’s existing moves - in 2016 it started selling its share of (what is now) Cadent, its former GB gas distribution business. The scale of this transaction may bring some real benefits too - there’s long been a disconnect between the transmission system and distribution network (reinforcement, interfaces, connection procedures, charging, etc). This may be a first step to having joined-up thinking across all voltage levels.

2. Is National Grid getting a good price for WPD?

National Grid is paying £7.8b for WPD. That’s a ~60% premium on WPD’s regulated asset base (using projected values for 20/21 FY). Does this make sense? Well, last year (19/20 FY) WPD made ~£750m of pre-tax profit. So, National Grid’s paying ~10x earnings.

Sure, valuations are overheated everywhere right now (FAANG, Peleton, Tesla, et al). But, WPD is not Peleton. It’s an asset-heavy, operational, and highly regulated utility where future cash flows are under strict supervision from Ofgem. £7.8b feels toppy (but I’m not an analyst). So, National Grid must see the additional potential for expansion (electrification trend, DSO transition, etc.). On the cost side, they’re also in a unique place to make efficiencies across both networks, which would make the deal more attractive. Let’s see.

3. Where will the money come from?

National Grid has secured bridge financing (i.e. loans) to pay for the acquisition. This is a short-term requirement for cash, that will be paid back when it sells its majority stake in the gas transmission network early in 2022. In the meantime, National Grid’s debt as a % of capital will increase to the high 70s (much higher than ‘normal’ ~60%). I guess this game of musical chairs makes sense in a low-interest environment. I’m sure this is a normal activity for investment bankers. But, if something happens in the next 12 months that makes the gas transmission network stake less attractive next, this deal will become a lot less attractive, fast. Maybe the pandemic has made me paranoid about black swan events. Maybe my gut feeling about high debt burdens is ‘old-fashioned’. I’m sure this makes a lot of sense on a spreadsheet. Maybe everyone’s a hedge fund now. Anyway...

So, the big question is...what price can National Grid secure for its gas business?

According to the International Renewable Energy Agency, electricity is going to become the global primary energy carrier by 2050. This is great news for the planet, and electricity is definitely in vogue right now. Gas is err...not (apologies to all the hydrogen-ites out there). Sure, in the medium term, things look promising for the world of pipes, pumps and compressor stations. If hydrogen takes off we’re going to need a lot of tubes. And, a regulated asset value of £6.3b for National Grid’s gas transmission assets will certainly attract a premium (but surely not the 60% premium it paid on WPD ?). Either way, this may be enough to bring National Grid’s debt back to target - National Grid surely thinks so.

4. The timing is ‘unusual’

DNOs are under pressure from Ofgem

This transaction was announced the same week that Ofgem announced it may slash allowed returns for DNOs by more than 1/3 from 2023 onwards. This is only a ‘working assumption’ for now. But, if implemented there is no doubt this will hurt DNOs and reduce the future earning potential of WPD. DNOs have of course long been criticised for profiting ‘at the expense of households’. Corbyn may have returned to the back-benches, but suspicious sentiment around monopolistic network companies lingers. And, if commodity prices/inflation takes off, the public (and i’m afraid the politicians too) will point to utilities as the cause of the ‘problem’. Reading through the Ofgem announcement, it would appear that they really are serious. Jonathan Brearly (Ofgem Chief Executive) said the plans for DNOs would ‘significantly cut investor returns to make sure consumers pay a fair price for energy whilst networks attract the investment they need to be safe and green’.

National Grid is under pressure from Ofgem

Only a few weeks ago Ofgem laid out several possible models for a new independent operator of the transmission system (i.e. stripping National Grid ESO from the role). What’s key here is that Ofgem specifically mentioned avoiding potential conflicts of interest and improving “greater strategic planning and management”.

So, Ofgem is tightening the reigns on both the transmission system and distribution network with concerns of monopoly and perceived conflict-of-interest. In light of this, the consolidation between the two largest network owners is remarkable. Surely National Grid expects Ofgem to loosen price controls? Otherwise, this could turn out to be a very expensive deal.

5. Is this deal ‘good’ for the industry?

This is actually the hardest question to answer. Is it a good idea to have the electricity transmission network owner, which has a monopoly in England and Wales, owning one of the distribution companies?

There’s no denying that this transaction will result in a huge concentration of power. This kind of power density needs highly astute regulation to be managed effectively. So, in my opinion, the finger here actually points at Ofgem.

Does Ofgem have the capability to regulate an asset-owning monopoly that owns both the transmission network and the largest distribution network? To find an answer to this question we can look at historic performance, or adjacent industries (water?) but the truth is - we don’t actually know.

So, for this, we must tune in to the most underrated decision-making tool that we have, our gut feeling.