Price caps: Burnt fingers?

Here in Scotland it was recently the season for Burns’ supper celebrations. In case you haven’t had the pleasure, the haggis, neeps, and tatties are usually accompanied by whisky (preferably lashings thereof) and readings of the native bard’s poems.

I cannot hear the poem “To A Mouse”, and in particular the lines “the best laid schemes o’ mice an’ men, gang aft agley”, without being reminded of a notable highlight in PG Wodehouse’s “Jeeves in the Offing”.

The inevitable failure of a typically hare-brained scheme leaves its unfortunate protagonist, Bertram Wooster (or “Bertie” to his friends, among them “Kipper”!), commiserating with Kipper, as he rues,

“I don’t know if you know the meaning of the word agley, Kipper, but that, to put it in a nutshell, is the way things have ganged.”

Among the Conservative party’s “best laid schemes”, we saw the party abandon their free market mantra by voting in favour of a price cap on home energy bills.

Notwithstanding the price cap, the Conservatives remain staunch proponents of free markets when compared to Labour’s stance on utility nationalisation. Presumably, in the Tory party view, the real issue of concern to consumers was one of affordability, not of ownership.

Under the cap, the maximum monetary value that UK consumers are charged on the default Standard Variable Tariff is set (and periodically reviewed) by market regulator Ofgem. The price cap has now been in place for just over a month, and it is widely expected that this Thursday Ofgem will move to increase the cap by around £100.

A wave of smaller operators going bust, combined with job losses at Innogy’s UK subsidiary Npower, suggest all is not rosy in the capped-price world of UK energy supply. A rise in the cap is likely to be a difficult sell to the electorate, but it may be viewed by Ofgem as the most prudent approach. Against rising wholesale costs for suppliers, it is hard to argue that smaller operators going bust reflects an effectively functioning marketplace.

The rise in the cap level will doubtless counteract much of the positive spin from the introduction of the cap at the start of the year. Here as elsewhere, reality bites.

When it comes to the energy price cap, agley appears to be the way things have ganged.

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Supercalifrag-heuristic-expialidocious

Heuristics are simple efficient rules that we all use on a daily basis. We have all learned these through experience, and often they aid our decision making. They are especially helpful in making decisions with the limited resources we all have, particularly in terms of time.

As an example: many people do not have time, or perhaps the inclination, to consider the various parties’ policies and form an opinion on their impact when voting in an election. Often the quick heuristic (a rule of thumb in this case) used is “Do I like / trust this politician?” (a single factor decision). This is far easier to evaluate than the party’s position (set against other parties’ positions) on the economy, healthcare, crime, education, etc. (a multi factor decision). Even those who do not have a strong view on political matters are highly likely to have a view on whether they like a particular candidate (or not). Often a referendum result can be dictated by the popularity of the PM responsible for asking the question, perhaps reflecting this tendency. It is easier to decide whether we like David Cameron (or Boris Johnson?) than to examine the full implications of a Brexit vote.

As is ever the case with rules of thumb, nuances are lost, which can sometimes lead to suboptimal outcomes. Similarly, when we look to apply rules of thumb to Environmental, Social and Governance (ESG) investing, we should be wary of unintended consequences. For example, where portfolios are not already excluding, let’s consider one of the ESG rules of thumb that has been suggested for investors to manage their coal exposure; specifically not investing in any company with more than 10 gigawatts (GW) of electricity production from coal-fired power stations.

Let’s quickly evaluate a company that would fall foul of this limit. If we take the Italian utility Enel, its installed coal capacity of 15GW in 1H2018 would dwarf the total installed capacity of many other utilities. However, Enel has embraced renewables generation more than many others in the industry (some of which, crucially, would pass this test), focussing their investments on green energy and grids (43 GW in installed renewable capacity). Even so, because of their sheer scale, they would fall foul of the coal capacity rule of thumb. Despite not investing in new coal plants, and despite reducing coal generation by 14% year-on-year in their first half results.

Taking a company which would pass this limit rule: CEZ are a Czech utility which uses lignite (also known as “brown” coal) in their coal and lignite power plants. Lignite is widely considered to be worse than coal from an environmental perspective and comprises 76% of CEZ’s thermal and 38% of total generating capacity. They also expect new and upgraded lignite plants to continue to operate for 25 years. Contrast this with Enel which talks about ‘renewables being the driving force of growth’.

In a carbon constrained future, which is the better choice? Enel or CEZ? We would argue it is Enel, but it is CEZ that passes this test! And even though most of our portfolios do not have coal powered electricity production restrictions, we have actively made the considered choice to invest in ENEL (we passed on the recent deal for CEZ).

This is taking only one rule of thumb, so is a single factor evaluation. However, it shows that nuances can be overlooked.

This is why our long history of running ethical funds has led to a multifactor approach in our ESG evaluation, and why our preference remains to evaluate the drivers behind the exclusions, rather than applying a heuristic rule of thumb.

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If The Cap Fits

The Conservative party has long been in favour of a free and open market economy. So it was no surprise to see, at the party conference, Theresa May extolling the virtues of this at some length. Then, after a brief pause to collect ‘her’ P45 from a prankster in the audience, the PM moved against the same free market economy to hit energy suppliers with a price cap.

Summary – free market economy works, except when it doesn’t.

Subtext – free market economy works, except when your main political rival (exogenous to your own party, that is, not Boris) is espousing a ‘grass is always greener’ alternative of nationalisation and shared profits for all.

May’s speech noted the broken energy market as customers are punished for being loyal with higher prices. Though this is very difficult to justify, energy market practices of increasing bills for those who are reluctant to switch are overlooked in other industries (when was the last time your car insurance renewal quote came down in price?).

Yesterday’s price cap announcement has grabbed less headlines than intended, being overshadowed by the P45 (on which reasons for termination included “neither strong nor stable” and “we are a bit worried about Jezza”, in case you were wondering…). And in true Conservative party style of late, the announcement was light on detail (“Brexit means Brexit!”). But as some details emerge, we can make an initial assessment of the impact:

  • Ofgem is likely to be involved in implementing the cap, and it is better for utilities in the hands of the independent regulator, versus being overly punitive in the hands of MPs.
  • There will still be incentives for switching customers and the regulator will be mindful of striking a balance between incentivising competition and penalising unfairness.
  • The cap will be temporary in nature, with a date set for its removal. Who said politics was short-termist in its outlook?

So what does the announcement mean for our bond holdings? Should we sell out of bonds issued by UK energy suppliers? In summary: no.

The big six UK energy suppliers are international companies with diverse business lines. A UK price cap, in whatever form it takes, will not affect Centrica’s robust US business, nor will it affect German utility E.ON’s substantial grids business. In addition, the substance behind the headlines noted above all suggests the implemented policy will be a watered-down version from the past reports of all customers saving £100 a year.

Economic history and the unintended consequences of restricting free market forces tell us that the consumer rarely benefits in the long run. As Reagan noted, the most terrifying words in the English language are: “I’m from the Government, and I’m here to help.”

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The Future will be green, or not at all

Before President Trump began a period of mutual sabre rattling with North Korea, he made arguably his biggest decision so far as President in withdrawing the US from the Paris climate agreement.

The withdrawal of the most powerful country in the world failed to derail the other members of the G20 from their commitments, they were unwavering. Even in the States they are likely to meet their targets on emissions in spite of the President.  The move towards environmentally friendly policies feels inexorable.

It is perhaps no surprise then that issuance of green bonds is increasing (up 56% in the first half of the year) matching a growing desire among companies and investors alike to fund projects which will aid the fulfilment of the aforementioned Paris agreement.

Recently, we saw a green bond issuance from Anglian Water, the company already having several climate aligned bonds as estimated by HSBC. These are issues which are used to finance low carbon and climate resilient infrastructure. This was their first issue which could be officially labelled as green, being assessed for its eligibility by the company DNV GL.

Anglian have a practical interest in supporting action against climate change. The company operate in the British region most prone to weather related water shortages, which is likely to be exacerbated as population under their coverage is forecast to increase by one million over the next 25 years. As the company noted, environmentally friendly projects are efficient and cost effective, and in a sector that rewards efficiency (through terms set by the regulator Ofwat), this is a consideration of vital importance.

The Anglian Water green bond issue fulfilled Kames screening criteria for our ethical funds, and was added selectively throughout our fund range.

Trump may disagree, but the signs are that “the future will be green, or not at all” (Jonathon Porritt).

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