As countries in emerging Asia seek to develop their infrastructure to improve living standards and facilitate economic growth, key utilities industries have become attractive areas for credit investors. These sectors may offer an attractive risk/reward profile relative to the underlying sovereigns (see Figure 1); most utilities in emerging Asia are wholly or partially owned by governments who view infrastructure development as systemically important to their country. That said, uncertain regulatory frameworks and other risks mean credit research is crucial.
Governments play an important role in the utility sector in emerging Asia
There are several reasons governments are strongly interested in the health and development of the utility sector, thus opting to have control over key utility companies:
- Stability is crucial. In the power sector, for example, adequate and consistent electricity is essential not only for security, but also for improving living standards for the millions of people in emerging Asia who currently do not have enough electricity. The electrification ratios in Indonesia and India are only 73% and 75%, respectively, compared with the 100% we see in developed nations and the near 100% in other emerging countries in Asia such as China and Thailand (source: World Bank as of 2012). A stable power supply is also a prerequisite for the sustained development of business and economic activity. Access to electricity is therefore an important government initiative, and ownership of these entities gives governments greater control over the sector’s development.
- Sovereigns can regulate tariffs. Utility tariffs in much of the world usually take into account fuel and other operating costs, but this may not be possible in some emerging Asian countries at current levels of household income. For example, PLN, the largest power utility in Indonesia, is 100% government-owned and in 2011 charged its customers on average an electricity tariff 21% lower than what it paid for the fuel needed to generate its electricity (according to company filings), meaning PLN is subsidized by the state. Or take KEPCO, a government-controlled utility in Korea: The government did not allow the increase in the price of liquefied natural gas and other fuels in recent years to fully pass through to customers' electricity tariffs, causing KEPCO to take operating losses in 2011 and 2012 (according to the company annual report). The political quest to better manage inflation and social risks is therefore also a motive for governments to regulate utility tariffs, a task most efficiently carried out by government-related entities; the longer-term unknowns on risk and return can make it difficult for the private sector to invest heavily in this sector.
- Ensure power and energy policies are aligned with social and environmental needs. A country that is largely dependent on imported fuel, like Korea, would need to ensure its policies for energy and fuel procurement are aligned with economic and social goals. Korea cannot develop its resources economically and has chosen nuclear power for its base load to provide a stable and relatively cheaper source of electricity. Sovereign support and oversight is essential where the use of nuclear power is concerned given the social sensitivity over its usage and the risk of potentially high and uncertain liabilities.
Sovereign-related utilities tend to have operational and financial advantages
Sovereign support is not the only reason why we believe sovereign-related utilities are usually more attractive investment candidates. In general, we have found that state-owned enterprise (SOE) utilities benefit from a range of operational advantages, partly as a result of the government’s vested interest.
The Indian power SOE utilities, NTPC and Power Grid, offer examples of these advantages. Their projects are governed under a regulatory agreement whereby both are allowed to earn a certain pre-tax return on equity on their existing, and to a certain extent, new capacity built, which allows for their fuel and operating costs to be passed through to tariffs. Compare this with some Indian independent power producers who have taken on ultra-mega power project contracts: An unexpected increase in fuel costs in recent years could not be fully passed through under those power purchasing agreements, resulting in significant losses to these projects.
Another example is the water treatment industry in China, where quasi-sovereign operators can often win contracts from local governments because their stronger financial backing offers higher assurance on the development and ongoing stability of these projects.
Finally, SOE utilities often have access to lower financing costs compared with their private counterparts, and this can translate to significant competitive advantages: Banks are usually willing to lend to SOEs at more favourable rates, and because a meaningful portion of utilities’ capital expenditures are financed by debt, the ability to expand their capacity at a cheaper cost tends to have a direct impact on their financial performance.
Needed expansion may translate into investment opportunities
The scope for infrastructure development in emerging Asia is tremendous, and the utilities sector has potential to contribute to and benefit from that growth. In the power sector, for example – the largest sector open for investment – electricity consumption and installed capacity per capita in the largest emerging Asian countries (by GDP) have a long way to grow to compare with the largest developed countries (see Figure 2), with South Korea a notable exception.
While emerging countries are in an earlier stage of economic development and are unlikely to consume the same level of electricity on a per capita basis as developed countries, there is ample room for growth in consumption as installed capacity expands over time. Our estimates suggest that it will take China around 20 years to catch up to Japan’s level of consumption on a per capita basis, and India and Indonesia will require many more. This means that continual investment will be needed to build the necessary infrastructure; we expect this investment will be partly funded by borrowings, in turn creating opportunities for credit investors. In the last 5 years, the amount of debt issued by utilities in Asia has quadrupled to $19 billion (USD), and in 2013, existing and new issuers have already visited the offshore bond market (source: JACI).
Regulatory risks should not be underestimated
Navigating the region’s regulatory regimes can be tricky, however: Each framework is different and some may not hold in practice. Hence, despite the strong state support that many key utilities enjoy via government ownership, their underlying operating cash flow can be volatile and credit fundamentals can weaken. For instance, tariffs could increase less than anticipated despite soaring fuel costs and weaken cash flow generation; this has occurred in many emerging Asian countries.
The sector’s expansion strategy could also be flawed: Can the power grid develop as quickly as the new capacity being commissioned (or vice versa)? Can the country source enough fuel economically to power new generation capacity? What controls are in place to mitigate receivables risk, since customer concentration risk can be high? All these could affect a utility’s operating performance and cash flow generation.
Utilities subsidized by the government also present other uncertainties to balance the potential benefits: The level of subsidies required can change from year to year, and the amount the government is willing to provide can also change due to budget constraints. Investors should be aware of these potential pitfalls, and should leverage deteriorate and balance sheets weaken significantly, the risk of a ratings downgrade could become very real.
On the other hand, we deem the risk of end-user tariffs deregulation in emerging Asia to be low over the medium term. The governments’ desire to be able to control tariffs makes it unlikely the tariffs will become fully market-based, as they have in the power markets of some developed countries. Conversely, utilities in the power and gas sectors buy their fuel at prices that are generally ‘more deregulated’ than end-user tariffs. Careful credit selection is important here: As fuel prices fluctuate, there will be times when utilities have to bear more of the financial burden than customers do.
We believe there are pockets of value in the utilities sector in emerging Asia, and that companies with dominant market positions, strong regulatory frameworks that reflect changing market conditions, and limited regulatory uncertainty make the best investment candidates.
However, the reality is that no single utility credit in emerging Asia incorporates all these qualities. Instead, opportunities continue to emerge over time. Differentiating the various bond structures is increasingly important – it can reveal the level of sovereign support to the company and the degree of implicit guarantee of the bond, which can enhance investment value. Overall, our bottom-up research allows us to analyze evolving company- and sector-specific factors within the greater macroeconomic picture to identify the best investment ideas for our clients.