Jersey Electricity — Update 21 February 2016

Jersey Electricity (JEL) is the monopoly supplier of electricity to the island of Jersey. The electricity business is responsible for generating more than 80% of group revenues and operating profit. In addition to its core electricity assets, JEL operates a range of other businesses including property rental, retailing and business services. Its largest shareholder is the government of Jersey, with 62% of the issued share capital and 82% of the voting rights.

We use a SOTP-based approach and comparable company analysis to value JEL. Our SOTP analysis, which does not include any discount to reflect liquidly/minority shareholder discount, indicates a valuation of 527p. Peer group analysis produces a valuation of 585p based on an average of FY16e and FY17e multiples.

Jersey Electricity’s (JEL) core business remains the supply of electricity to the island. The business is “self-regulated” and vertically integrated across the electricity industry value chain, encompassing generation, transmission, distribution and supply. In generation JEL operates two power plants (Queens Road, 46MW, and La Collette, 121MW) during winter demand peaks and when the interconnectors with France are unavailable. The commissioning of a new interconnector in September 2014 (Normandie 3) has allowed JEL to increase the proportion of electricity it imports from France back to levels (c 95%) previously seen before the interconnector failure in 2012. JEL also manages the island distribution network of c 1,500km (>90% underground) and at the end of 2015 had 49,320 supply customers. In 2015 it sold 627m kWh of electricity at an average price of 12.8p/kWh. Beyond the core electricity operations JEL operates a number of other businesses including Building Services, retail, property, software development for utilities (Jendev) and an environmental and building services company (Jersey Energy). The Energy business remains the largest contributor to group profits (Exhibit 1).

JEL is seeking to grow its share of the Jersey energy market by maintaining electricity price stability and affordability and by supplying its customers with low-carbon electricity. In FY15, in line with this strategy, the carbon intensity of the electricity distributed by JEL fell to 33g CO2e/kWh, an all-time low, and c 10x lower than the average UK level. Customer tariffs also remained stable and at a discount to EU levels. In addition, JEL is focused on its position in energy services, enhancing the security and reliability of supply via investment in its energy infrastructure and strengthening its relationship with customers. A co-operative agreement with Guernsey Electricity, as in the case of the Normandie 3 interconnector, form part of its operational strategy, but JEL currently has no ambitions to extend its corporate reach beyond the Channel Islands.

JEL operates with an unusual shareholding structure, with four classes of shares: 11.64m ordinary “A” shares, 19m ordinary shares and two tranches of preference shares. Each class of shares carries different voting rights, but by virtue of its holding of the entire class of ordinary shares, the States of Jersey retains 86% of the voting rights. In 2015 the States of Jersey received £7.3m from JEL in the form of dividends (£2.4m), goods and services tax (£4.1m) and social security (£0.8m). No corporation tax was paid in either FY14 or FY15 due to the capital allowances associated with its capex programme.

JEL posted a further improvement in profitability in FY15 due to lower electricity supply costs and additional returns on newly commissioned assets. Increased interconnector capacity facilitated the use of cheaper imported electricity, allowing returns to rise, while holding tariffs at a discount to European levels and reducing the carbon intensity of the business. Thanks to the substantial investment programme of recent years, JEL is now well positioned to continue to earn normalised returns for shareholders after the trough years of FY12 and FY13.

The FY15 results demonstrated a further rise in profitability, with operating profits +39% versus FY14 (before £0.8m of exceptional items). The improvement was, in large part, due to a rise in operating profitability in the core Energy business (FY15 £11.5 m vs FY14 £8.0m). Boosting core profitability was a fall in electricity purchase costs (-£3.9m), thanks to an increased use of cheaper imported electricity (94% in FY15 vs 80% in FY14) and the additional return earned on the enlarged asset base. Greater use of the interconnectors also allowed JEL to reduce the carbon intensity of the power it distributes to an all-time low of 33g CO2e/kWh. Although the Building Services business continued to record small losses (<£0.1m), due to competitive pressures, the retail business reaped the benefit of the previous year’s restructuring, converting an operating loss of £0.1m in FY14 into an operating profit of £0.3m in FY15. Thanks mainly to the benefit of higher occupancy levels, the property business recorded a further rise in profitability from £1.4m to £1.6m. Capex, which had been boosted by expenditure on the N3 interconnector, fell significantly (49.1%) versus FY14. Lower capex, combined with improved profitability, allowed for improved cash flow, with net debt falling from £20.2m to £17.5m. JEL remains modestly geared, with net debt/equity at c 12%.

Demand growth over the last 15 years has been modest (CAGR of c 0.8% over the period 2000-15). A secular move to energy efficiency (more efficient appliances/lighting) and JEL’s strategy of encouraging the use of high-efficiency, lower-cost off-peak heating has helped restrain overall demand growth and moderate the growth in peak demand. The 2015 maximum demand figure of 148MW shows that there has been little growth in peak demand since 2005 (2005-15 CAGR 0.4%). JEL’s policy of seeking to flatten the load curve has helped to limit infrastructure costs and keep prices to customers lower than would otherwise have been the case. We believe the outlook for demand growth is likely to remain modest and, with the scheduled commissioning of N1 in Q117, we expect JEL to be able to satisfy incremental demand via imports from France.

Electricity Law and Competition Law exist to govern corporate behaviour, but JEL continues to operate as a self-regulated business. JEL aims to earn a 6-7% return (pre-tax) on its energy assets (net of customer contributions and working capital adjustments) on a rolling five-year basis. In extreme circumstances, such as with the interconnector failures of 2012, unexpected costs may arise that cannot be recovered through the tariff setting process, leading to sub-target returns for the year. Equally, in some years (such as in FY15), returns may rise above the upper end of the targeted range.

JEL also aims to ensure that tariffs remain within ±10% of the EU-15 average once all taxes are included. Currently, JEL’s general domestic tariff is 14.5p/kWh including the goods and services tax (GST). At an exchange rate of €0.72/£, JEL’s tariffs translate to a price of €0.201/kWh. Eurostat data show that the average EU-15 domestic tariff in H115 was €0.215/kWh, leaving JEL’s prices at a c 6% discount to the EU average. In broad terms, this accords with JEL’s own study, which shows prices at a 5% discount.

There appears to be little appetite to change the regulatory framework. In December 2012 CICRA published a review of the electricity market in Jersey, which found that JEL earned a return on its assets comparable to the UK utilities and offered a reasonable level of service to its customers. The report also found that the risk of inefficiencies appeared low and concluded that it was not minded to recommend modification to the existing regime. In addition, a recent review of the Jersey regulatory and competition framework prepared by Oxera for the Government of Jersey concluded that “in some parts of the economy the role of the regulator is essentially taken on by the government, and, in many cases, the regulatory cost is (or at least appears to be) relatively low. Although a full analysis of the approach of government as ‘regulator’ is outside the scope of this review, it is noticeable that one element of this approach appears to be a much simpler regulatory system”. In our view, sub-peer group tariffs, high levels of system reliability and a simple low-cost system of regulation reduce the likelihood of regulatory change.

JEL’s strategy is focused on continuing to grow its share of the Jersey energy market by replacing other sources of energy. In pursuit of its strategic objectives, JEL seeks to ensure high levels of network reliability (minimising customer minutes lost) and affordability of supply for its customers by sourcing cheaper off-island electricity (no tariff rises in 2015), and, by building a relationship with the customer, to embrace other aspects of energy provision (maintenance/installation) via its Building Services division. In addition, the import agreements with EdF have enabled JEL to reduce the carbon intensity of the electricity it supplies, making a valuable contribution to the States of Jersey’s long-term carbon reduction targets and allowing it to offer substantially cleaner energy than other on-island sources (heating oil 265g CO2e/kWh, LPG 234g CO2e/kWh). JEL’s strategy appears to be bearing fruit, with the third successive year of improved customer service ratings according to its annual survey. Co-operative agreements with Guernsey Electricity also form part of its strategy, as for example in the case of the N3 interconnector, but JEL currently has no ambitions to extend its reach beyond the Channel Islands. In the event that renewable investment grows in importance on the island, JEL will seek to provide the required infrastructure to facilitate the proposed investment rather than invest directly itself, as it believes the risks associated with large offshore investment are too great for a utility of its scale.

JEL’s gross asset base of the energy business of c £191m has been growing at a CAGR of c 7% over the last 10 years. Gross energy assets differ from JEL’s regulatory asset base, which deducts customer contributions and working capital items. Since 2005 depreciation has averaged c £7.1m pa compared to capital expenditure of c £14.8m. For the early part of the period 2005-10, depreciation and capex were more closely aligned (capex £8.6m/depreciation £6.6m), although post-2012 capex rose sharply, in large part due to heavy expenditure on a new interconnector with France (N3 total project cost £70m), but also reflecting the repair of the connection with Guernsey, on-island network refurbishment and the installation of two 11MW diesel gensets.

Future capex is likely to be focused on two areas: the installation of additional interconnector capacity with France (N1, £40m – 30% payable by Guernsey Electricity) and the construction of a new primary substation (£17m) to reinforce the on-island network. The N1 interconnector will replace the original EdF1 (55MW) interconnector, which failed in 2012. The old cable (EdF1) is scheduled for removal in the spring, with the surface lay of the new cable anticipated for summer 2016, and commissioning possible in Q117. JEL has also acquired a site from the Parish of St Helier for a new 90kV primary substation (granted planning permission in May 2014). Groundworks have started and commissioning is scheduled for 2018. We also expect JEL to continue to roll out its smart metering programme. We expect capex to return to relatively high levels in FY16 due to forecast expenditure in N1 and the substation. In FY17 we expect expenditure to decline to c £16m. Beyond 2017 we expect that capex will return to normalised levels of £10-15m pa.

The main plank of Jersey Electricity’s strategy for ensuring continuity of power supply has been to focus on maintaining and expanding the interconnectors with France, particularly after the failures that occurred in the summer of 2012. We expect this strategy to enable Jersey to import c 95% of its electricity in the future (similar to the level achieved in FY15). However, to meet its security of supply standards, JEL maintains its on-island generation capacity. Although some uneconomic and inflexible capacity at La Collette was decommissioned during the year, during 2016 JEL is installing a ‘black start’ diesel generator (5.5MW) at La Collette and £12m was spent in 2012 on a project to install two 11MW diesel gensets (now four in total). The remaining capacity at La Collette, taken together with the fast-start capacity at Queens Road and the States of Jersey’s EfW plant, mean that on-island capacity exceeds the island’s all-time peak demand of 161MW. Given the additional interconnector capacity scheduled to be commissioned in 2016/17, we do not expect significant expenditure on generating capacity in the near term.

Interconnectors remain critical to the profitability and carbon intensity of JEL’s business, but no less important in ensuring the reliability and affordability of electricity supply. As part of its infrastructure plan, JEL aims to deliver three submarine cables between Jersey and France. The significance of the interconnectors was underlined by the impact of the N3 cable on the FY15 results. The new 32km Normandie 3 (N3) interconnector (100MW) first began importing power in September 2014, entering service ahead of schedule and below budget at around £60m (project total shared with Guernsey Electricity). The new interconnector follows a different route and is connected to a different part of the French network to the existing N2 interconnector, enhancing security of supply beyond the headline additional capacity. In February 2015 JEL also supported Guernsey Electricity in a pre-emptive repair to the Jersey-Guernsey link (GJI).

In the summer of 2015, JEL signed a contract for a third power cable link (100MW) with France, known as Normandie 1 (N1). N1 is designed as a direct replacement for EdF1 (55MW, 1984), which failed in 2012. N1 is also a Channel Islands Electricity Grid (CIEG) project and is expected to cost £40m in total. The project, on a £/MW basis, is significantly cheaper than N3, helped by the fact that N1 will follow the same route as EdF1, minimising the need for additional infrastructure. In addition, the cable will be laid on the surface of the seabed (rather than buried like N3), reducing installation time. It is expected that the existing cable will be removed in the spring of 2016, with new cable laying occurring in the summer. JEL anticipates full commissioning of N1 in Q117.

JEL operates a transmission (90kV) and distribution network (>33kV) of c 1,600km (90% underground). The network is well maintained and enjoys high levels of availability and low levels of customer minutes lost (7 minutes in FY15 c 10x better than the UK average), an important service indicator for JEL. Independent research into energy security on islands concluded that, of the 25 jurisdictions studied, JEL was placed in the top four for security of supply. 2012 and 2014 were exceptions to the high level of network reliability, although a large proportion of the total minutes lost can be attributed to problems with interconnectors. In 2012 the failure of EdF1 and EdF2 dominated, while in 2014 (January) a lightning strike in France severed supplies to the sole operational interconnector and accounted for 97 of the 110 minutes lost. JEL continues to invest in strengthening the resilience of the distribution network (around 34km of new cable and 6MVA of new transformer capacity in FY15) and will invest in a new primary substation in St Helier over the next two to three years.

Jersey has a target of reducing carbon emissions by 80% by 2050 (compared to 1990). Jersey has made progress in reducing CO2e emissions, in large part due to JEL’s supply agreement with EdF, which guarantees power from low carbon sources (nuclear 65%, hydro 35%). In FY15 JEL achieved its lowest ever annual carbon intensity – 33g CO2e/kWh – more than 10 times cleaner than the UK electricity system. While carbon intensity has been reduced, little has been done to encourage investment in renewable energy despite significant indigenous renewable resources (wind/tidal/solar). Although the States of Jersey Energy Plan’s (2012) key objective was to “introduce an Energy Policy to move towards a low-carbon economy”, no subsidy or incentive arrangement was established. Given the already low-carbon intensity of electricity supplied on the island, developing a case for a programme of renewable subsidy remains difficult and, as a consequence, investment in on-island renewable generation has been negligible. In the event that either suitable incentive arrangements are provided to encourage large-scale renewable investment, or renewable generation costs become competitive (more difficult at current low commodity prices), JEL would seek to participate through the provision of network services rather than via direct investment in renewable infrastructure. In short, JEL believes it could play an important facilitation role in the introduction of renewable energy to Jersey and thereby develop an opportunity to create value.

Retail: due to the significant restructuring programme (reduced retail floor space, reduction in staff numbers and revised terms and conditions, completed in February 2014) and the enhanced online platform (powerhouse.je), in FY15 JEL achieved a return to profitability in retailing (FY15 £0.3m vs
-£0.1m FY14). However, the market is said to remain challenging, and in our view it is unrealistic to expect a further significant rise in profitability.

Property: the property business generates income from both the residential and commercial market. Residential income is generated from legacy properties, originally built to house staff, while commercial income comes from developments adjacent to JEL’s offices on the Powerhouse Retail Park. Over the last 10 years, the profitability of this business has increased by c 2.5% annually and we expect a similar rate of growth going forward (facilitated by rent reviews).

Building Services: the Building Services division (JEBS) includes the provision of services in the following areas: public lighting, heating installation, air conditioning and maintenance work, and is designed to strengthen JEL’s relationship with the customer “beyond the meter”, as well as helping to build load for the core electricity business. Competitive pressure on margins and the limited scale of the market suggest that JEBS will find it challenging to make a positive contribution to group profits.

Other: other businesses contributed c £0.6m to group profits in FY15 (£0.7m in FY14). Jendev focuses on software development for utilities and generated turnover in excess of £1m in FY15. JEL envisages a period of sustainable revenue for the business and Jendev is currently exploring commercial opportunities with partners. Jersey Energy provides environmental and building services expertise for developers and architects and continues to perform satisfactorily, achieving revenue of £0.5m in FY15, with profits said to be “ahead of expectations”.

From 17 December 2015, Alan Bryce joined the board as a non-executive director. Mr Bryce is also a non-executive director of Scottish Water and chair of Viking Energy Shetland. He will replace Clive Chaplin, who will stand down at the next AGM. Other board positions remain unchanged.

There have been no changes to the shareholding structure. JEL retains 30.6m ordinary shares in issue (nominal value 5p) and 235k preference shares. However, there are two classes of ordinary shares, with only the “A” shares listed on the London Stock Exchange. The 11.6m “A” shares carry one vote for every 100 shares held. The other ordinary shares (19m) are held directly by the States of Jersey and entitle it to five votes for every 100 shares held. In addition to the ordinary shares, there are two classes of preference shares, both with a par value of £1, but with different voting entitlements. The 0.1m 5% cumulative participating preference shares carry 20 votes per 100 shares, while the 0.135m 3.5% cumulative non-participating preference shares carry 10 votes for every 100 shares held. The States of Jersey continues to control 86% of all the voting rights of JEL.

Regulation: failure to earn the targeted pre-tax return would pose a threat to profitability and valuation. The energy business has gross assets of c £191m but regulatory assets (after deduction of customer contributions and working capital) of c £150m. A 0.5% variation in the return would reduce/increase profitability by c £750k.

Interconnector failure: interconnector failure with France poses a threat to security of supply and enforces reliance on indigenous generation – the cost of which is dictated by oil prices. Higher generation costs may not necessarily be recoverable through the tariff setting process.

FX: the largest item of expenditure for JEL is the cost of purchasing electricity. It incurs a significant proportion of its costs in euros, while its principal source of revenue is denominated in sterling. However, the potential effect of this currency mismatch is mitigated by the fact that by the time JEL announces its tariffs for the following year (setting a significant proportion of its revenue base), it will already have contracted for over 90% of its electricity needs.

Minority: the States of Jersey owns the majority of the shares and retains the majority of the voting rights. Other shareholders bear the risk associated with the position of a minority shareholder.

Micro generation: there are no subsidies available for the installation of micro generation technologies currently available on Jersey, so in the short term JEL’s supply volumes should remain robust. In the event that subsidies are introduced, or costs for generation (eg solar) and storage, over time, become competitive with grid supplied electricity, then this could pose a threat to supply volumes. Pathway 2050: An Energy Plan for Jersey (States of Jersey 2014) envisages that by 2050 9,527 properties could have installed micro-renewables. There are currently c 44,700 households on Jersey, of which c 19,000 use hydrocarbons currently for space and water heating.

Our SOTP analysis, which does not include any discount to reflect liquidly/minority shareholder discount, indicates a valuation of 527p. Peer group analysis produces a valuation of 585p based on an average of FY16e and FY17e multiples. This approach does not reflect the value of advantageous tax treatment that may be available to Channel Island-based shareholders.

We continue to believe that a sum-of-the parts (SOTP) serves as a useful guide to valuation. We value the electricity business with reference to its asset base and assume JEL’s cost of capital is equal to its return. As previously, we include the property business at balance sheet value. The other businesses have been valued on a P/E basis, applying industry-specific or market multiples to determine a valuation. The result of this approach produces a SOTP valuation of 527p.

Comparable companies trade on average P/E multiples of 17.6x (FY16e) and 17.7x (FY17e). The average EV/EBITDA multiples for the peer group are 11.6x (FY16e) and 11.5x (FY17e), while dividend yields are 4.4% (FY16e) and 4.6% (FY17e). Placing JEL on these multiples yields an average valuation of 585p.