The U.K. government recently approved the results of its inaugural electric capacity auction. The market power and cost advantage supporting a moat for Electricite de France’s generation in the U.K. drove outperformance in the auction and brings significant incremental cash flow for EDF’s investors.
EDF (EDF) secured €318 million in new pre-tax margin for 2018 and won a 25% share of awarded contracts while only one competing new build gas plant cleared the auction, confirming our analysis. Among European diversified utilities, we think EDF offers the best combination of valuation, yield, and dividend stability, with modest growth during the next three to five years for patient investors in the downtrodden space. Other diversifieds have more upside to power prices and similar competitive advantages, but none has EDF's cash-flow consistency and near-term visibility to support a narrow economic moat and a strong dividend with a 5.1% current yield. EDF stands head and shoulders above peers in upside potential from new European capacity markets, as the inaugural U.K. capacity auction clearly demonstrated. EDF also could realize significant incremental value from new build nuclear in the U.K.
U.K. Capacity Auction Highlights EDF’s Strength, Potential Wholesale Margin Improvement The inaugural capacity auction in the U.K. cleared at £19.4/kW-year, meaning that a generator with a 1,000 MW unit would see incremental cash flow of £19.4 million (€25.9 million) annually. While the headline cleared capacity value was low relative to the £75.0/kW-year cap, the result confirms our analysis of our companies’ competitive positions in the market.
The primary winner in the auction was EDF, which garnered 25% of all contracts and should see roughly €318 million in incremental margin in 2018. Two of its plants secured three-year refurbishment agreements, giving further security of operation but truncating upside potential from higher 2019 capacity-year values. Only one of EDF’s units didn’t clear, West Burton A Unit 3. E.On and RWE also outperformed our expectations in terms of megawatts cleared.
We highlighted these three utilities, which would have the biggest EBITDA and fair value upside in the U.K. and across the Continent if new capacity markets were to follow in the U.K.’s footsteps. Centrica had a disappointing auction with its smaller gas units, though it owns a 20% stake in EDF’s nuclear units, so it will see some support from those. SSE also disappointed with 40% of its capacity failing to clear, including a large combined cycle gas turbine (CCGT) at Peterhead.
Iberdrola and GDF Suez also had some large units fail to clear. EDF has significant market power with a roughly 20% share of U.K. capacity and some very large, critical nuclear units that could materially influence pricing. We think EDF bid conservatively for two reasons: first, security of cash flow from a new construct to protect against wholesale margin weakness; second, to keep new build, low-cost, and efficient CCGT from securing contracts that would help their sponsors decide to move forward with construction. Prior to the auction, the U.K. regulator had estimated the cost of new entry (CONE)—representing a price that would give a reasonable rate of return for a new construction project—for new CCGTs at roughly £30/kW-year.
This likely acted as a cap for many bidding generators hoping to keep new build participation to a minimum. Pricing new build out of the auction, especially if the trend continues in subsequent auctions, could be a meaningful positive for wholesale pricing over the next few years should the U.K.’s reserve margin shrink as it is expected to. The ENTSO-E data doesn’t include the impact of many of the closures we expect to come from units that did not clear the capacity auction, possibly bending the reliable available capacity number downward after 2016. For EDF, the auction results still add roughly €1 per share of value to our €28 per share fair value estimate.
Is the U.K. an Island of Optimism for EDF?
While we view the developments in the U.K. as positives for EDF’s growth and returns, the situation elsewhere in Europe isn’t as clear. At present, EDF’s flagship business is French power generation, distribution, and supply, which in 2013 generated just under two thirds of consolidated EBITDA.
We expect this share to hold steady between 63% and 65% until U.K. capacity revenues would begin in 2018. We have never projected aggressive moves toward greater market pricing in France—a fantasy that we believe has caused much of the volatility in EDF’s shares during the past few years—nor have we expected that EDF would be able to capture full economic rents from reforms. The framework for setting power tariffs and the government’s plans for the country's capacity mix,which would also determine capital-expenditure levels, remains fluid.
We think it’s unlikely that the government will actually push to close any nuclear reactors other than Fessenheim, the low-hanging fruit due to its age and proximity to a fault line.
