Implications For Electricity Providers As NSW Deregulates

This story features ORIGIN ENERGY LIMITED. For more info SHARE ANALYSIS: ORG

-NSW margin reduction for FY15
-Longer term profitability enhanced
 

By Eva Brocklehurst

NSW will phase in a de-regulated electricity market from July 1, 2014. The changes involve a transitional tariff, which delivers a modest decline of 1.5% to prices in FY15, followed by a CPI-related increase in FY16. In FY17 the NSW Independent Pricing And Regulatory Tribunal (IPART) is expected to move to an oversight role, much like the Victorian Essential Services Commission.

Origin Energy ((ORG)), the major electricity retailer with the greater number of regulated customers, has agreed to this reduction in revenue from NSW regulated customers in FY15. This is much the same as was the case in South Australia in 2012, when AGL Energy ((AGK)) agreed to tariff reductions at the start of that state's move towards de-regulation.

Broker views are essentially unchanged. Both companies will benefit in time from higher margins and lower regulatory costs, and more effective wholesale portfolio management should, over time, lead to improved profitability. In fact, UBS considers the timing is good news for the retailers, as margin changes may be partly covered by the removal of the carbon price during the transition year. In the longer term, higher prices are likely. Assuming the Victorian prices are "fair", UBS estimates NSW margins may actually need to rise as much as $100 per megawatt hour (MWh). Admittedly, retailers may face lower volatility in NSW and take a lower margin as recompense but prices are still expected to rise. UBS estimates every $1/MWh lift in mass market margins in NSW implies a $9m lift in earnings for Origin and $6m lift for AGL.

Macquarie believes the lower price associated with the introduction of deregulation will be lost in the $144 per user decline associated with the removal of carbon from the wholesale electricity price and retailing margin. Moreover, the price war in NSW has already cost Origin close to $100m and the broker considers the slightly negative earnings impact of deregulation is trivial compared with the longer term opportunities.

It may appear to be more of a structural change than is really the case. Deutsche Bank observes over 60% of NSW customers are already on market-based contracts that are priced below the regulated tariff, given current competitive pricing activities. Origin carries a higher number of regulated customers because of the weighting of Essential Energy customers. JP Morgan estimates that Origin and EnergyAustralia, the third major NSW player, have around 40-50% of customers on regulated tariffs in NSW. The broker thinks the deregulation is broadly positive for both AGL and Origin valuations because of improved retail margins. Origin has a deeper footprint in NSW but its retail position makes up a smaller proportion of its portfolio. The impact on valuation is slightly greater for AGL, in JP Morgan's view, as there's a challenge to achieve the same level of gross margin improvement in NSW without the customer base that Origin has.

Victoria is further down the track than NSW, having de-regulated from 2009. Here brokers see competition thriving and, where margins become uneconomic, churn falling. Deutsche Bank notes electricity retailers in the longer term have realised higher margins in Victoria while market-based pricing is less prone to unexpected shocks related to regulatory risks, as witnessed by recent tariff cuts in Queensland. Still, the broker is not rushing to conclude that Origin's and AGL's margins will expand as a result of the NSW de-regulation decision. Recent irrational discounting has led to significant margin erosion in retail electricity markets across the country and contributed to a greater impact on profitability than regulated tariffs, in Deutsche Bank's opinion.

BA-Merrill Lynch observes Victorian electricity retailers have moved their standing tariffs in the same direction each year since deregulation, which explains why this state continues to be the most profitable, despite the high 25% customer churn. The broker notes the average retail tariff has increased 59% since 2009 while costs have increased 41%, resulting in an extra $30-40/MWh in margins. Consumers have now oodles of choice, with more than 15 active retailers in Victoria. The broker's analysis suggests that AGL and Origin are capturing gross margins around $50-100/MWh in Victoria which compares to the $40/MWh allowed by the current NSW regulatory regime. This also explains why second tier players have been apprehensive about the NSW market.

Further analysis shows that, while Victoria may have higher churn and retail operating expenditure, better margins and profitability exist because the cost of electricity is the lowest in the national electricity market. That benefit goes straight to margins. Merrills considers it possible that churn in NSW and Queensland will actually increase after the removal of retail tariff regulation and new second tier retailers ramp up their marketing, but the increased gross margin should offset extra churn-related operating expenditure. Attention turns to Queensland now, particularly the south east, where the government has announced plans to remove regulation of electricity prices from July 2015. These reforms are yet to be ratified by parliament.

In sum, for the two major listed electricity retailers in NSW brokers consider Origin will endure some near-term declines in earnings that will be offset in part by an increase in gas margins. For AGL the near-term pain is less apparent as NSW comprises only one third of its electricity customer base. Hence, the retail gas tariff uplift is expected to more than compensate for any earnings decline brought about by electricity tariff adjustments.

Origin retains four Buy ratings and three Hold on the FNArena database with a consensus target of $15.49, suggesting 7.7% upside to the last share price. AGL has three Buy ratings, three Hold and one Sell with a consensus target of $16.30, suggesting 7.1% upside to the last share price.
 

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