Stock Story: Red Electrica

Stock Story: Red Electrica

July 2020

Europe wants to become greener in energy terms. Spain is ambitious in this area too. In April, Madrid submitted its plan to the EU that declared the country is aiming for renewables to produce 74% of total electricity by 2030 and 42% of total energy demand. To show how ambitious Spain is, the plan entails installing more than two gigawatts of wind energy capacity and three gigawatts of solar capacity each year through the decade. This is a huge investment in clean energy.

This is a big opportunity for Red Electrica, which operates Spain’s electricity power transmission grid. The Madrid-based utility, which earned two billion euros in revenue in 2019, performs a critical role in the functioning of the electricity market. Its responsibilities include not only building and maintaining the high-voltage transmission grid but also the day-to-day operations of the market and the long-range planning for the system through its role as the transmission system operator.

To keep up with the rapid growth in maintenance, intra-European connectivity and renewable energy, the company plans to spend about 2.9 billion euros over 2018 to 2022, a 39% increase in the annual rate of spending compared with the prior business plan. While the company is still working through its latest long-term plan, it is likely Red Electrica’s investment spending will remain at these elevated levels.

In many businesses, capital expenditure would be considered a cost to investors. However, in a well-functioning regulated utility market, the company is entitled to receive compensation for the fair costs of running the business. This cost is paid primarily by customers and businesses through a component of the electricity access tariffs. As such, the capital spending falls within the ‘fair costs’ on which the company earns a regulated return, the source of 91% of Red Electrica’s gross profits in 2019. It is already decided that Red Electrica will be allowed to earn a base return of 5.58% on its regulated asset base from 2021 to 2025, with an opportunity for higher returns if the company can find efficiencies in its operations.

Another favourable dynamic is the recent improvement in the regulatory oversight for the company. In 2019, the Spanish government granted increased independence to the National Commission of Markets and Competition, the regulatory body tasked with, among other things, setting the fair level of revenues that Red Electrica can charge. This came about due to a mandate from the European Commission. From an investment perspective, independent economic regulation is critical to investors receiving predictable, transparent and fair outcomes. This is especially true in areas as politically sensitive as energy prices.

In addition to its Spanish grid, Red Electrica has been gradually developing and acquiring a collection of electricity transmission assets in South America, including assets in Chile, Peru and, more recently, Brazil. These assets typically generate capacity-payment (that is, predominantly fixed) income streams.

Overall, the better regulation and capital expenditure opportunity in Spain position Red Electrica to deliver what investors expect from a utility and infrastructure stock; namely, one that will deliver reliable income streams with some capital growth.

However, like any investment, Red Electrica comes with risks. The company, for instance, has in recent years acquired a stake in a satellite provider Hispasat that is too far outside of the core business to be judged an attractive acquisition. However, this investment is a minority in the business mix and doesn’t undermine the overall investment case.

Further, like many utilities, Red Electrica employs significant debt to fund its significant capital needs. However, the rating agencies are sanguine about Red Electrica’s financial profile. (Moody’s has an investment-grade Baa1 rating on the company; Standard & Poor’s and Fitch rate it A-.)

Finally, as for every business now, covid-19 poses operational and financial challenges. In Spain, electricity demand has fallen significantly during the lockdown and is still gradually recovering to prior levels. However, from an investment perspective, Red Electrica’s exposure to this is minimal and its revenues are largely fixed, with any shortfall legally required to be compensated in future years.

Sources include company filings and website and Bloomberg.

 

Important Information: This material has been produced by Magellan Asset Management Limited trading as MFG Asset Management (‘MFG Asset Management’) and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision.

This material may include data, research and other information from third party sources. MFG Asset Management makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of MFG Asset Management. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.
Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of MFG Asset Management.