National Grid PLC (NGG, Financial) recently held an investor event that provided key insights into the company's important Electricity Distribution segment and its plans for the new RIIO-ED2 regulatory period.
Two years ago, National Grid acquired Western Power Distribution, which has now been fully rebranded as National Grid Electricity Distribution and has put a new management team in place, including President Cordi O'Hara and chief financial officer Darren Pettifer. The acquisition was a strategic pivot that fundamentally shifted National Grid from a low growth gas transmission business to a higher growth, more visible utility business. Investors have been confused about the company's direction since the acquisition, but the company made things clear in its latest investor presentation.
RIIO-ED2 and National Grid's plans
RIIO-ED2, which spans from April 2023 to March 2028, operates under U.K. gas and electricity market regulator Ofgem's framework. The details of RIIO-ED2, such as the total expenditure allowances (totex) for different Distribution Network Operators (DNOs), were confirmed in March 2022. National Grid now has a clearer understanding of its capital expenditure plans for the upcoming five-year period and presented them at the event.
One of the main differences between RIIO-ED1 and RIIO-ED2 is the more than 30% higher baseline allowance in totex – which now stands at 8 billion pounds ($10.32 billion). This means that National Grid has the capacity to undertake more and larger projects. However, outperforming the set totex and revenue allowances is more challenging under RIIO-ED2. The scale and scope of ED2 is markedly different to ED1 in that there is an increased size and volume of capital projects, leading to increased supply chain efficiencies which will require National Grid to demonstrate comprehensive asset management capabilities.
Regulatory framework and incentives
The regulatory financial framework gives an allowed equity return of ~5.3% indexed to U.K. government interest rates. The reason for the investor event was largely to reassure investors National Grid has a strong focus on totex efficiency and is targeting return on equity outperformance of 1% to 1.25%.
The regulatory system in the U.K. works on an incentives basis, which means extra returns in revenue allowance beyond the baseline allowance are rewarded based on performance that is linked to customer satisfaction ratings and reliability metrics amongst other metrics. National Grid is mainly focused on synergies as well as introducing changes to how the Distribution System Operator (DSO) is managed.
Capital expenditure plans and asset management
The presentation laid out National Grid Electricity Distribution’s capital expenditure plans for the next five years, which will be focused on asset health and maintenance, new connections (which are desperately needed as the U.K.’s electrification ramps up and to reduce congestion across the electricity network) and network reinforcement given expectations of a 10% increase in total electricity demand on the network over the period. For new load and connections, 75% of the spend will be for demand connections (for example, electric vehicle charging and heat pumps) and 25% will be for generation coming from solar and battery storage. Asset health and maintenance will focus on maintaining high levels of reliability and enabling climate resilience, for instance better protections against storm damage.
Source: National Grid Electricity Distribution Investor Event 2023 presentation
Reform of the Distribution System Operator
Last summer, discussions arose regarding the potential separation of the DSO from the DNO, similar to the separation of the Electric System Operator (ESO) from the Transmission business. While this separation is not part of ED2, an update on the ESO reveals that it will be rebranded as the Future System Operator (FSO) and made public within the next 12-18 months.
Within National Grid's ED segment, there is now a standalone DSO subsegment with separate reporting, like the early days of the ESO within Transmission. The DSO is responsible for managing smart home systems, including heat pumps and electric vehicles. Customers can set their preferences on their apps, allowing the supplier or the grid to smartly manage demand and supply. This approach is implemented at various infrastructure levels, ranging from discharging batteries to meet demand to controlling home supplies.
Unlike in the Transmission business, where grid capacity poses a major barrier to electrification, the Distribution business has ample pipeline and cable capacity. Currently, the infrastructure has a capacity of 37 Gigawatts, while the demand ranges from 7.5 to 11 GW, with an additional 0.4 GW connected in the past year through EVs. Therefore, the primary challenges within Electricity Distribution are congestion and installation/connection issues.
Congestion is a significant concern that requires effective DSO management. Generally, DSO work takes priority over building new infrastructure. However, factors such as the end of cable lifetimes (typically 40 years) may necessitate both replacement and upgrade to future-proof the system, considering the expected growth in demand.
Connection refers to the process of linking new developments or individual electric vehicles to the grid. Currently, the connection queue operates on a first-come, first-served basis. As part of the reform, National Grid is transitioning to a first-ready, first-connected approach. A beta algorithm is set to be released in July/August, allowing project milestones to influence the order in the queue. This means that projects showing concrete progress will be prioritized for connection, potentially reducing average waiting times.
Future system operator and regional system planner
Within the Future System Operator, the government plans to establish a Regional System Planner (RSP). Unlike being owned by National Grid, the RSP will be part of the public FSO. The RSP will oversee all four regions within electricity distribution and address congestion and smart management across the borders. It will also consider factors related to both gas and electricity, enabling decisions regarding reinforcing electricity capacity or heat pipes to accommodate hydrogen. Despite its broad oversight, the RSP will maintain a regional focus.
Investor perspective
National Grid’s Electricity Distribution Investor Event helps investors allay fears that the U.K.’s electric revolution would be an operational risk for National Grid. The company seems to have a good strategy in place to meet or exceed the regulatory returns allowed for this segment and grow its regulated asset value quickly via sensible and necessary total expenditure allowances. Thus, I believe the stock could be a great source for decent capital returns to investors, meeting or exceeding inflation and provides the stability that one would expect from an important national utility.
