SSE: May Not Be Enough Force Behind Offshore Wind

seekingalpha08-17

SSE plc output seems to point to an on-track situation with renewable development, which has been an important business driver.Electricity prices are also tending upwards a bit, which should mitigate ...

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When we last covered them during COVID-19, we highlighted the value of regulated utilities. They have since ceased the operation of the gas concession. They instead are focused on being on the receiving end of the political will for electrification, both in the regulated distribution and transmission concession in the networks business but also for the renewable portfolio. We have some concerns about offshore wind in general. We also note that we are approaching the beginning of the new RIIO-3 period. Some uglier elements will remain missing, according to Ofgem, and we think that there isn't too much reason to expect a major step change. Politics is also in SSE's favor, with the Labour lean in the UK. The value isn't too bad, either. But on the basis that network business just don't earn outstanding returns, we'll pass. Summing up disclosures The latest, more comprehensive review comes from some months ago, ended March for the full year. The story is quite straightforward, which is that the exploding renewables segment is driving overall results. This is being driven by capacity and production growth, not by electricity prices which are down, but where the CFD regime for much of that capacity guarantees generators a fixed price for renewable generation. That's why thermal, which is not seeing growing capacity but has experienced falling prices, has declined meaningfully as spark spreads fall. Operating profit evolutions (adjusted for fair value measurement changes) (FY Pres) The distribution and transmission businesses remained relatively solid. There are some declines being registered as the fixed costs of running the business get ahead of the remuneration on the assets. This is more visible in distribution. The issue is that while there is RAB growth and while regulated WACCs are higher consistent with the higher cost of capital environment, it's not enough to offset higher costs from things like labor. Some of this will be recovered, but not all of it. Transmission is doing better, and the more intense forecast investments in the segment have a lot to do with it. Indeed, this is where the electricity highway investments are going. This is where a lot of the mission-critical investments need to be made first for readying the grid for electrification and the higher grid demands that will come with that. RAB Growth Networks, other data (FY pres) More recently released is the company trading update. There isn't much financial information, but annualizing the renewable output here, we see that we hit FY 2024 levels. The company reiterates that capacity is coming online as expected, which should mean forecasts will be met in terms of volume at least. Electricity prices are tending upwards again to limit thermal trouble. Output (Trading Update Q1) We do want to point out that offshore wind is a major part of the investment sink for the company. There are a couple of things to mention here. Offshore wind developers are doing terribly, like Ørsted (OTCPK:DOGEF), as the costs for these new modalities come in higher than expected and supply chain issues cause project cancellations. Offshore wind is subsidized in the UK. It is expensive to create offshore installations. Floating installations for wind are even worse. According to some calculations for the leveled cost per MWh (including fixed capital charge rates), they end up being higher than the auction price for the CFDs that govern the compensation of generators. These auction prices are already up a lot from last year, when the starting auction price was so low that no bids were made for capacity to be compensated by CFDs. This has set the UK behind their goals, which they are now unlikely to meet due to the high costs of offshore and apparent lack of viability amid budget tightness. The starting auction price has almost doubled and will only go down from there, which has us questioning the longer-term economics of these projects. SSE is smaller scale than some competitors who are more experienced and develop larger scale offshore wind developments. As a quick review, generators bid at the lowest price that they can afford to secure a CFD, which guarantees the generator compensation at that price for a decade or two. The CFD contract is what makes the price guarantee possible, with the difference between the market and CFD price being taken on by the government. Forecast earnings growth (FY Pres) Maybe a new Labour government will find ways to accelerate this process, which will likely come from some sort of better remuneration for companies trying to make the green appeal with more favorable auctions and more ample budget allocations. Bottom Line We're still away from a new RIIO scheme, which would be finalized in late 2025. No outperformance wedge expected for the coming one, which was the rude welcome that the utilities got in the last regime change and was thankfully removed. Before the RIIO-2 changes, the UK had a pretty generous remuneration regime. There was a major step change down from then, with the current levels being more typical of a developed economy and cost of financing levels. We don't expect major negative changes in the upcoming scheme, particularly as companies will again make the appeal that insufficient remuneration would slow the energy transition, which should continue to be a popular appeal. We think that there is still a lot on the agenda that would support further RAB development for the utilities as they prepare the UK for electrification, SSE included for the Scottish market. Regulated utilities will grow, but by the nature of the business it is basically impossible to achieve super normal returns with ROICs structurally similar to WACCs. For the renewable business, we respect the execution on onshore and offshore wind developments by the company, which is significantly growing output and improving the renewable business contribution. The company continues to be on track for 2025 targets as per the latest trading update, which supports the view of continued earnings growth, albeit at a high incremental capital investment rate, limiting shareholder value creation. Furthermore, continuing to build out new capacity will not be so easy to do. While auction prices are up, it will be difficult to have efficient enough development practices to be able to bid competitively in auctions. SSE is more marginal than some other players, with plans by 2027 to have around 2 GW in offshore wind capacity from the 50 GW target around 2030. There are clear signs that the political winds favor more budget to be able to pay offshore wind developers to take on new capacity. Valuation spread ordered by FWD PE (Seeking Alpha) Seeking Alpha valuation spreads on utility peers globally put SSE plc in a nice spot, relatively speaking. But it's not that far ahead of EDP (OTCPK:EDPFY). This is a pick we'd prefer given the more proven renewable modalities like hydro that it has been focused on, and the liquid market for those assets which are frequently disposed of by EDP.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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