Monday 13 February 2017 3:46 pmSchroders Talk

British Gas is not overcharging customers ā€“ this is why

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Iā€™m an author on The Value Perspective blog and a fund manager on the value team at Schroders. Prior to joining in 2015, was responsible for the UK research process at Threadneedle. I began my investment career as an analyst in 2001.

As we wrote in our article Forget the acronyms, we value investors care about the treatment of stakeholders. Not just investors but staff, customers, suppliers and regulators.

Given the political, regulatory and media pressure on the so called “Big Six” energy companies, the situation at Centrica is worthy of closer examination.

Are customers paying too much, as some have been arguing? The short and perhaps unpopular answer is that, based on our own research, we think they’re offering a fair deal on the whole.

Understanding the energy “trilemma” will help explain our conclusion.

The nature of a trilemma is that there are three attractive options. While you would ideally like to pursue all of them, in reality choosing two prevents the third. In the context of UK energy policy, there are three aims of energy policy:

  • Affordability
  • Decarbonisation
  • Keeping the lights on (“security of supply” in energy parlance)

Unless or until batteries come and save us from the trilemma, only two of those are achievable at the same time.

For example, solar and wind farms provide very clean (de-carbonised) energy but the wind doesn’t always blow and the sun doesn’t always shine when EastEnders comes on, leaving security of supply as an issue. Coal is really cheap and very reliable but it, of course, fails on the de-carbonisation front. Nuclear power is good for de-carbonisation (ignoring how do you get rid of the stuff at the end!), pretty reliable but super expensive. And so on, hence the trilemma.

The really tricky bit for any government is which of the trio to sacrifice. For over 10 years, the political consensus was that it was acceptable to forego affordability in the pursuit of decarbonisation and security of supply.. However, at the Labour party conference in September 2013, the then leader Ed Miliband changed the terms of the debate.

Miliband – who had earlier spent 18 months as secretary of state for energy and climate change in Gordon’s Brown’s government – changed his mind and announced that, if Labour won the next election, it would freeze energy prices for two years. All of a sudden, affordability was the key policy from the trilemma for energy policymakers. They didn’t say how they’d achieve this. The reality was that Miliband was sacrificing security of supply and Cameron was giving up de-carbonisation.

Centrica’s share price fell almost 20% in the two months following Miliband’s speech, and it became public enemy number 1. Regular visitors to The Value Perspective blog will be aware that, rather than relying on the opinions of others, we prefer to carry out our own in-depth analysis of companies. With Centrica, we wanted to answer two questions: how expensive are UK gas and electricity prices and is Centrica over-earning from them?

The time we have spent doing our research has led us to conclude UK gas and electricity prices are not expensive and Centrica is not making egregious profit margins. Below shows a chart on respective energy prices across Europe – we suddenly don’t look so bad do we?

Source: Eurostat data as of June 2014, published in DECC’s Quarterly Energy Prices available at Note: Data sorted by electricity prices. Information on the gas price in Finland was not available.

When we looked at the Big Six, we found some interesting numbers for 2015. The average profit per customer was £26 – cheaper than buying a beer for each member of the value team. The average profit margin (EBIT or profit before tax and costs of financing) for the Big Six was 2.9%, as the chart below shows.

What happens to the revenue from energy bills

EBIT: Earnings before interest and tax; DA: Depreciation and Amortization (an asset's re-sale value minus the cost paid); Source: Ofgem 2015

Centrica is the biggest in the industry and thus can be expected to make higher margins. The figure was 5.3% in 2015 (higher in gas, lower in electricity). Compare that to some other household names: M&S at 7.4%, Reckitt Benckiser at 26%, easyJet at 11%, Vodafone at 11%, Diageo at 30%. We could go on.

Our analysis leads us to conclude that neither the industry or Centrica are overcharging or over-earning. The UK government is obtaining a good deal. Political consensus will inevitably change once more and another element of the trilemma will gain ascendancy. Investors should watch events carefully. As things stand, shareholders needn’t have a cold chill owning Centrica.

Andrew Evans is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction. Talk to the team @thevalueteam

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