Jersey Electricity — Continuing dividend growth forecast

JEL is the sole supplier of electricity to the island of Jersey. The electricity business is responsible for generating around 80% of group revenues and operating profits. JEL also operates a range of other businesses including property rental, retailing and business services. The government of Jersey (States of Jersey, SoJ) remains the largest shareholder with 62% of the ordinary share capital and 86.4% of the voting rights.

We have updated our valuation analysis to reflect JEL’s reported FY18 figures and movements in market multiples. The average of our analysis (multiples/DCF/SOTP) indicates a valuation of c 560p (+2.5%) versus 546p last year. The valuation change reflects higher comparable peer group multiples, higher forecasts and a stronger balance sheet.

JEL reported a strong financial performance in FY18, with record revenues and profits. Revenue rose 4%, to £105.9m, whereas profits increased 13.3%,to £15.3m. Net debt fell £7.7m to £14.3m and DPS increased 5% to 14.9p for the year. The DPS was covered 2.7x times by earnings.

As can be seen from Exhibit 2, the core energy business continues to account for the bulk of group profits (>80%) and performed strongly in FY18, with operating profits +14.5% (+£1.8m) to £13.4m. For the first time in recent years JEL benefitted from an increase in unit sales (+2.1% to 634m kWh, thanks to cold weather and customer switching) and a tariff increase (2% implemented in June). Overall revenues rose 2.4% (+£1.9m), of which the tariff increases accounted for £0.4m. Higher revenues and gross margins (in part thanks to reduced levels of on-island generation) coupled with reductions in maintenance and manpower costs all contributed to the rise in operating profits. We estimate the five-year rolling average return on assets in the energy business (c £180m) to be slightly in excess of 7% (see Exhibit 3).

The property business benefited from a revaluation (+£0.3m) to its investment portfolio (Powerhouse retail site plus 29 private houses/flats) and ongoing rent reviews, the latter of which contributed to a 3% rise (£0.1m) in revenues and, thanks to lower costs, a £0.2m rise in profits. JEBS, the contracting arm, suffered from declining margins and exceptional costs, which resulted in to a loss of £0.2m. Retail, despite strong competition in the sector, increased both sales (+5.4% +£0.7m) and profits (+11.0% + £0.1m) and has grown in each financial year since 2014. JEL continues to exit peripheral product lines and is increasingly focusing on premium ‘smart technology’ products.

Net debt fell from £21.9m in FY17 to £14.3m in FY18, with a year-end cash of £15.7m, versus £30m of long-term debt. This year-end cash was £2.6m higher than our forecast due to better than expected cash flow. Operating cash flow was £1.9m ahead of our projections and lower capex (by £0.7m) accounted for the rest of the outperformance. Operating cash flow was largely driven by better than expected profitability (£1.7m) although income tax paid was also £0.2m lower than anticipated. The debt figure of £14.3m is modest for a stable utility business such as JEL, equating to net debt/equity ratio of c 8%. Interest cover for FY18 was c 11.6x.

Financially and operationally, JEL performed strongly in FY18. It has also been encouraged by the recent support it received for the implementation of its renewable standby charge from independent consultant NERA. Longer-term regulatory uncertainties persist and rising wholesale prices and exchange rate movements will put upward pressure on retail prices. In the short term, we expect a modest reduction in profitability; however, over the long term, having substantially completed a 10-year investment programme and with a strong balance sheet and high customer service standards, we believe JEL is well placed to continue to deliver steady returns for its shareholders.

When we last wrote on JEL at the beginning of 2018, we highlighted the regulatory debate that was taking place on the island, arising initially from JEL’s decision to impose standby charges on embedded generation. Following widespread discussions, five propositions were brought forward in the SoJ relating to the regulation of the electricity industry, of which four were duly passed and are set out below.

In accordance with provisions a and b, the consultants, NERA, were appointed in the summer of 2018 and they recently delivered their conclusions in a report, Review of Jersey Electricity’s Proposed Standby Charge for Commercial Embedded Generators. As part of its assessment of the proposed standby charge, NERA considered whether JEL’s proposed charge is; fair and reasonable; cost reflective; consistent with charging mechanisms in competitive markets; sends accurate signals to customers regarding the value of embedded generation and is proportionate to the level of embedded generation in the Jersey electricity system. However, the review did not assess the economic rationale for the provision of support to renewable generation, either by JEL or SoJ, as it was deemed to lie outside its scope.

Rationale for standby charge. JEL’s standby charge attempts to address the central problem that if customers reduce their purchases from JEL as a result of the installation of embedded generation, they do not simply deny JEL a margin on the provision of units of electricity to its customers but also remove the contribution that the sale of each unit of electricity makes to the covering of JEL’s fixed costs. NERA states that this internationally recognised problem is known as ‘inefficient grid bypass.’ As do many utilities, JEL charges a straightforward p/kWh charge for each unit consumed, which is required to cover both its variable and fixed costs. JEL’s need to cover its fixed costs means it would have to charge other users more. NERA calculated that for every 10MW of solar photovoltaic (PV) panels installed in Jersey, other customers (based on JEL’s proposed standby charge of £3.25/kW per month to all new commercial customers choosing to install embedded generation of up to 50kW of capacity) would need to pay collectively c £390k per year, equivalent to an increase of £4.56 in annual bills (average annual bills c £1,628). However, NERA notes that if JEL were to incur additional costs associated with the system management of intermittent generation this figure could rise further.

Assessment of JEL’s proposed standby charge. NERA concluded that there is a commercial justification for some charging reform to address the potential for ‘inefficient grid bypass’ and commented that JEL’s proposal ‘bears some similarity to reforms in other jurisdictions.’ NERA did, however, identify ‘some minor problems with the details of JE’s (sic) calculation, rather than with the design of the charge.’ NERA’s adjusted calculation, which assumes a higher proportion of self-consumption by embedded generators (85%, versus 50% assumed by JEL) resulted in a standby charge of £5.48/kW per month, underlining the conservative nature of JEL’s calculation. In our view, it is more important that NERA recognised the commercial justification for JEL’s charge than the minor differences of methodology it highlighted. JEL has indicated that it will also review Standby Charges for CHP systems and other technologies and has also stated that it is happy to undertake a longer-term review of its tariff structure.

As part of its review of the standby charge NERA stated that, ‘it is beyond our scope to consider whether sector-specific regulation is required to ensure that the conduct of JE promotes the economically efficient development of the energy system on the island.’ However, NERA added that ‘regulatory mechanisms in place in the electricity sectors of other jurisdictions may offer lessons to JE and SoJ in relation to the process for setting tariff structures’. We are not aware of any proposals being brought forward, in line with proposition c) above, to update the Electricity (Jersey) Law 1937. Any revision to the Electricity Law would implicitly generate a debate on the form of future regulation. Nor are we aware, as yet, of any proposals to introduce locally generated renewable electricity targets or subsidies.

For the foreseeable future, therefore, the current arrangement of self-regulation appears likely to persist. Fundamental to the regime of self-regulation JEL aims to earn a return of 6–7% (pre-tax) on its energy business (net of customer contributions) on a rolling five-year basis (see Exhibit 3) while ensuring that its tariffs remain within +/- 10% of the EU-15 average (inclusive of all taxes). Currently JEL’s five-year rolling return is slightly above the upper end of its target range but customer tariffs, despite considerable upward pressure arising from movements in wholesale markets and exchange rates, remain comfortably below EU-15 averages (Exhibit 5). In due course, some changes to the current regulatory regime may be implemented, but with high standards of customer service, JEL is in a strong position to adjust to potential changes.

JEL's annual customer survey conducted by independent group, Island Global Research (this year employing a revised methodology), showed that JEL had achieved a small improvement in its overall rating (65% vs 64%), continuing a trend evident over the last few years. As revealed by the survey, the three most important elements of customer service in order of priority were: running costs and price stability, security of supply and environmental performance.

JEL’s excellent record in each of these three key areas of customer service can, in our view, be attributed to its investment in, and maintenance of, its asset base. Over the last 11 years JEL has invested c £19m per year in its energy assets, spending a cumulative £210m and in FY18 invested £14.9m, including £1m upgrading the Normandie 2 interconnector on the French side, allowing for an increase in capacity. These figures compare to the current annual depreciation charge of £11m and an anticipated total 10-year plan for the period 2008–2017 of £100–150m (as expected in 2008).

Driving JEL's investment programme is its 'N-1' standard, which means it seeks to maintain supplies to customers in the event of the failure of the largest component of the system. Much of the expenditure has been related to the construction of two new undersea cables between Jersey and France (total Channel Islands import capacity of 263MW); however, investment in substations (most recently in St Helier West completed in December 2018) and reconditioned diesel engines (for backup power) have also formed part of the significant investment programme.

We review JEL's performance against the three service standards in the following section and outline how JEL’s investment programme has helped it deliver on service standards.

JEL has established a track record of price stability helped by its ability to import over 90% of its electricity requirements, and in June 2018 announced its first price rise in over four years (2% increase). The previous increase was 1.5% in April 2014. The price stability in Jersey contrasts favourably with the rest of the UK where, according to JEL’s estimates, the ‘Big Six’ energy suppliers have increased prices by 24% over the last two years. Figures from Ofgem suggest an average price rise of c 9% in 2018.

JEL benchmarks its tariffs against other small island operators and the average for the EU-15 and aims to keep its own tariffs within +/- 10% of the latter group (inclusive of all taxes). We calculate that JEL’s general domestic tariff (14.8p/kWh) is standing at a c 15% discount to average EU-15 figures (Exhibit 5).

JEL contracts forward on a rolling basis to minimise volatility in electricity purchase costs but current upward pressure from wholesale prices and exchange rates is likely to lead to tariff increases in 2019. We examine these trends in more detail in a later section of this report.

As we have already noted, security of supply, measured by customer minutes lost, is an important component of the overall service offering for JEL’s customers. With the exception of 2012, which was affected by the failure of the old interconnectors, the result of the investment programme has been to maintain low levels of customer minutes lost. In 2018 only six minutes were lost, the best performance since 2008 and, according to Ofgem figures, substantially below the 77 minutes recorded by the ‘Big Six’ UK distributors in 2016–17.

JEL’s investment in interconnectors has allowed it to increase the importation of low carbon electricity from France and reduce the use of on-island fossil fuelled generation in FY18 (only 0.2% c 1GWh of electricity requirements came from the on-island La Collette power station with the remaining c 5% sourced from the on-island Energy from Waste plant). In FY18 JEL imported 94.9% of electricity needs, all from low carbon sources (hydro 34% and nuclear 66%). As we have highlighted in previous reports, JEL’s ability to import electricity has allowed it to reduce oil as a generation feedstock from c 60,000 tonnes in the early 1990s, to less than 5,000 tonnes in recent years, with a beneficial effect on carbon emissions. As a result, in FY18 JEL was able to report its lowest ever level of carbon intensity, at 24g CO2e/kWh (2017 35g CO2e/kWh), around one 10th of the energy intensity of the UK system as a whole.

Although JEL has achieved what it has described as the ‘virtual decarbonisation of the electricity system, the company continues to explore opportunities to reduce carbon emissions and believes that ground-based solar PV, which is close to grid parity, represents the best opportunity for on-island renewable generation. Accordingly, last summer JEL announced plans to facilitate the development of ground-mounted solar farms on brown field sites with long-term Power Purchase Agreements; the first large-scale pilot plant is under construction. Largely as a result of JEL’s investment programme, the electricity sector has been successful in reducing its CO2 emissions (the sector now accounts for >10% of island emissions). However, the transport sector, which accounts for a third of Jersey’s overall emissions of on-island carbon emissions, has been less successful and JEL sees it as offering the next big opportunity for reducing emissions. Accordingly, in the absence of any government subsidy scheme, JEL is taking steps to encourage the use of electric vehicles (EVs). We outline JEL’s initiatives and consider the potential outlook for EVs in a later section of this report.

Beyond its provisions of secure, affordable and sustainable electricity, JEL aims to manage demand (especially peak demand which is a key driver of network capex) by encouraging energy efficiency but offsetting the demand implications of this reduced per capita consumption by growing its customer base (new build and by switching households and businesses from competing on-island fuels).

Switching customers from oil-fired central heating to electric heating is, in our view, the most significant potential driver of long-term demand growth for JEL. We estimate that there are c 20,000 fossil-fuelled heating systems on the island of Jersey compared to JEL’s total customer numbers of just over 50,000. In 2015 JEL established an energy solutions team and designed a range of tariffs and incentives with a view to encouraging customers to switch to electric heating. In 2017 the team achieved over 170 fuel switches in the domestic sector and signed 320 customers to electric heating tariffs (including new connections). In 2018 JEL added 160 fuel-switching customers out of a total of customer additions of 667. Applying JEL’s average selling price per unit (12.9p/kWh) and average consumption per customer of 12,623kWh, this amounts to extra revenue of c £0.26m (total increase in revenue of the energy business was £1.9m). In reality, JEL’s electricity heating tariffs are lower than its average selling price, so the additional revenue would be less than the £0.26m estimated above.

The switching of on-island oil-fired central heating customers to electric central heating (thereby reducing emissions), the provision of energy efficient white goods at its Powerhouse retail outlet and its ongoing Smart Switch programme all form key part of JEL’s strategy to promote energy efficiency. The £11m Smart Switch programme is now 87% complete, with over 44,000 smart meters installed, and is expected to finish in mid-2019. During FY18 JEL also established a ‘Smarter Living’ hub in its Powerhouse store. The Energy Hub demonstrates energy efficiency and smart control technologies in a domestic setting. JEL regards the Energy Hub as an ‘invaluable tool for its energy solutions team’. In August 2018, after one month of Smarter Living’s operation, JEL experienced a 50% increase in the level of switching leads to the energy solutions team, which could boost customer recruitment.

Thanks to JEL’s focus on energy efficiency over the last 10 years there has been an observable downward trend in consumption per customer. However, in FY18 the long-term trend was bucked as both the number of units sold (13m kWh increase in units sold +2%) and peak demand (to 178MW due to weather-related demand) rose. Of a total increase in revenue for the energy business of £1.9m, JEL ascribed £0.4m to the tariff increase, with the remaining £1.5m due to volume growth.

Jersey is not a member of the EU so, in theory, it should remain unaffected by the potential changes to the position of the UK. Given JEL’s purchase of electricity under contract from EdF, it is important the status quo is preserved. It is worth pointing out that in the unlikely event of the Jersey-EDF electricity purchase contract moving to World Trade Organization terms, as part of a wider trade dispute electricity purchases would be zero rated, thereby avoiding any upward pressures on tariffs. Only in an extreme scenario of a UK-France trade dispute, requiring the introduction of import tariffs, can we envisage a scenario of increased electricity purchase costs for JEL.

One of the principal results of Brexit-induced uncertainty has been the reduction in the value of sterling versus the euro. In 2015, prior to the UK’s referendum on EU membership, sterling was trading at approximately £/€1.40 compared to the recent level of c £/€1.10, a devaluation of c 20%. Given electricity purchase costs account for 6p/kWh (according to NERA) of JEL’s average selling price of 12.9p/kWh (c 47%), a 20% devaluation in the currency would, all else being equal, require a c 9.4% increase in the average selling price (12.9p*9.4% = c 1.2p/kWh). Due to its hedging policy, the exchange rate underpinning JEL’s electricity purchases in FY18 was £/€1.27, compared to an average rate of £/€1.13 for the year. Although JEL continues to hedge its electricity purchase contracts, all else being equal, a decline in the exchange rate from the €1.27 achieved in FY18 to current rates would represent a c 12% increase in electricity purchase costs, adding approximately c 6% to overall tariffs. Of greater significance still is the underlying power price, which we discuss in the next section.

A more significant threat to JEL’s electricity purchase costs is the movement in French wholesale electricity prices. Wholesale prices (year ahead) are currently c €55/MWh, significantly above the €30/MWh level prevailing for much of 2016 when a large proportion of the electricity supplied in FY17/18 was purchased. This wholesale price movement has clear implications for long-term tariff evolution. As wholesale costs amount to c 47% (6p/kWh/12.9p/kWh) of average customer costs in Jersey, the upward pressure is clear. Broadly speaking, we calculate that for each €10/MWh in French wholesale prices (at a constant exchange rate of £/€1.10) this would equate to c £9/MWh. A 50% increase in wholesale costs would require a c 24% increase in end user tariffs all else being equal (50%*47%=24%). While the current regulatory regime allows JEL to recover these extra costs via the tariff, a period of rising prices brings additional political scrutiny.

We continue to keep a watching brief on potential drivers of long-term demand growth, renewables and vehicle electrification (aside from fuel switching considered earlier).

There has been little take-up of solar generation in Jersey and the lack of indigenous renewable generation acted in part as a catalyst in triggering the current ongoing regulatory debate.

As an island, Jersey’s adoption of on-island renewable technology compares unfavourably with the rest of the UK, where renewable generation accounts for over 30% of total output (2018). It is nevertheless worth reiterating that Jersey does receive over a third of its electricity from certified renewable sources in Europe via its import contract. However, as we have stressed in previous reports on JEL, the absence of renewable generation on the island can, in large part, be ascribed to the absence of financial incentives such as those offered in the rest of the UK. Renewable generation has been supported in the UK since 2002 (with the introduction of the Renewable Obligation) although the composition of the support mechanisms has undergone significant change since its inception. What remains clear, however, is the significant financial cost associated with the deployment of renewable energy. Professor Dieter Helm, in his 2017 Cost of Energy report, estimated that for 2018/19 the cost of renewable subsidy is likely to be £7–8bn and that by 2030 the total cost is expected to exceed £100bn. Although it is clear the cost of renewable energy has declined and much of this cost is a ‘legacy’ issue, we believe some form of incentive will be required on Jersey to stimulate greater investment in renewable energy. For our sensitivity analysis we assume the number of rooftop PV installations rises to 1,430 (currently we estimate less than 100) by 2030 (5kWp, load factor 12%). Assuming each installation consumes all electricity on site, we calculate the discounted value of revenue lost from unit sales to be worth 15p/share to JEL over the period. This analysis does not include any potential revenue from the imposition of some form of standby charges, which as we have seen, were endorsed in principle by NERA.

As we highlighted last year, the move towards electrification of vehicle fleets is gaining momentum globally, both in terms of vehicle numbers and new players entering the market. Battery and plug-in hybrid vehicles comprised c 6% of new registrations in the UK in 2018. The UK aims to phase out new petrol and diesel vehicles by 2040 and has committed to providing £1bn of support for ultra low emissions vehicles, including helping customers with upfront purchase costs. The government has also pledged to invest a further £80m in charging infrastructure alongside £15m from Highways England, as well as providing £50m for Plug-in Taxi Programme (which provides taxi drivers with £7,500 off the purchase price of a new ultra-low emission vehicle taxi).

As we have noted previously, the geographical dimensions of Jersey (9 x 5 miles) appear favourable for the roll-out of vehicle electrification. However, as has been the case with renewable generation, the absence of government subsidies has meant that the growth of EVs on the island has been slow. In its recent FY18 results JEL stated that it believes the pace is beginning to accelerate, although EVs have yet to establish a significant presence on the island. In 2016, JEL estimated there were only c 215 EVs on the island (cars 131, other 84, all EVs 215 + 424 hybrids). At the end of 2017 the figure for pure EVs had risen to 271 and the latest figures for 2018 put the figure at c 388, an annual increase of 112.

Transport still accounts for a third of Jersey’s overall emissions of CO2 and JEL continues to believe that vehicle fleet electrification offers the next significant opportunity for the island to reduce CO2 emissions. As we have highlighted previously, this is supported by the original projections contained in Pathway 2050: An Energy Plan for Jersey (The Energy Plan). The SoJ has yet to devise a strategy for promoting vehicle electrification but in the meantime, JEL continues with its collaboration with Jersey Post on the electrification of its vehicle fleet and in 2018 Jersey Post added a further 17 Nissan ENV2000s to its fleet, bringing the total to 47 (out of a total fleet of 110). JEL is upgrading its current charging infrastructure and aims to extend the number of public charging points to around 50.

It is evident that in the absence of financial support the pace of adoption of EV technology on Jersey will remain slow. Our analysis suggests the impact of vehicle electrification on JEL’s profitability is likely to be modest.

The composition of the board of directors remained unchanged during FY18. Chris Ambler continued as CEO (since 2008) and Martin Magee remained CFO (since 2002). Geoffrey Grime, chairman and board member since 2003, remained in post for FY18 but announced at the time of the publication of the FY18 results (December 2018) his intention to retire as chairman and director of the company at the AGM (held on 28 February 2019). Geoffrey Grime has been succeeded as chairman by Phil Austin, a current Non-Executive Director of the Group. Mr Austin joined JEL in 2016 as a Non-Executive Director having spent most of his career in banking with HSBC. In 2001, Mr Austin became the first CEO of Jersey Finance, a joint venture between the Government of Jersey and its finance industry, established in order to promote industry at home and abroad. With effect from 28 February 2019, Peter Simon joined JEL as a non-executive director. Mr Simon is customer product and proposition director for Centrica’s UK Home business and a non-executive director of Smart Energy GB.

JEL’s three-tier shareholding structure remained (ordinary, ‘A’ shares and preference shares) unchanged during the year. The SoJ continues to hold all the ordinary shares (62% of total share capital but possesses 86.4% of the total voting rights). Ordinary shares (19m in issue) entitle holders to one vote for every 20 shares held, whereas ‘A’ shares (11.64m in issue) entitle the holder to one vote for every 100 shares held.

We have updated our valuation analysis to reflect JEL’s reported FY18 figures and movements in market multiples. The average of our analysis (based on the five metrics shown in Exhibit 9) indicates a valuation of c 560p (+2.5%) versus 546p last year. The reason for the uplift in the valuation reflects higher comparable peer group multiples and lower levels of net debt.

As a starting point for our SOTP analysis, we use the regulated asset base, which we take to be c £180m, (as revealed in JEL’s FY18 Report & Accounts). We value the property business at balance sheet FY18 and the other businesses are valued at market PE of c 12x prospective earnings. The overall SOTP analysis indicates a value for JEL of 592p (+7.2%) versus 552p previously. The 40p uplift in valuation can be ascribed to a higher valuation for the energy business (+14p, due to an increased regulatory asset value), lower net debt (+25p) and other adjustments (+12p in part due to the absence of pension liabilities). The value of the other businesses has fallen by c 12p, despite a small increase to the carrying value of the property portfolio, due to a lower multiple (12x) being applied to the earnings of these businesses.

DCF is our least-favoured valuation approach due to its sensitivity to changes in WACC, terminal growth rate and capex assumptions. For our base case, we assume a WACC of 6.6%, a terminal growth rate of 2% and average capex of c £14m producing a valuation of 459p. Exhibit 11 highlights the sensitivity of the valuation to changes in the WACC and terminal growth rate.

Exhibit 12 shows the market multiples for a group of selected peers for FY1e and FY2e. Applying the peer group multiples to our forecasts gives a wide range of values for JEL but the average figure gives an indicative valuation of 557p (this rises to 584p using a dividend cover adjusted yield) versus 528p obtained last year. The key factors behind the rise in valuation are increased forecasts for JEL’s profitability and higher P/E multiples and lower yield peer group multiples. However, the yield calculation does not take in to account the additional income that may be available to Channel Island domiciled shareholders arising from the favourable tax treatment of the DPS, nor does it take account of JEL’s higher level of dividend cover.