19 January 2017 Europe/United Kingdom Equity Research Multi Utilities

UK Utilities Research Analysts SECTOR REVIEW Mark Freshney 44 20 7888 0887 [email protected] Three points of focus for the coming months Guy MacKenzie, CFA 44 20 7883 9534 Figure 1: Ratings and total potential return up/downside to our TPs [email protected] Vincent Gilles OUTPERFORM NEUTRAL UNDERPERFORM 25% 22% 44 20 7888 1926 [email protected] 20% 18% 16% 14% Specialist Sales: Jason Turner 15% 44 20 7888 1395 9% 8% [email protected] 10% 5% 3% 0% (5%) (3%) (6%) (10%) (15%) DONG Centrica United Drax UK Utils SSE Severn Pennon National Energy Utilities Trent Grid

Source: Thomson Reuters, Credit Suisse estimates (priced as of market close on 12 January 2017) ■ Action: Following poor performance in 2016, we are more positive on UK utilities, and see potential average c9% total return upside on a 1-year view. Consistent with our recent report entitled Brave new world, we prefer commodity-exposed names (DONG Energy, Centrica (CNA) and Drax (DRX)) as they have EPS growth and positive earnings momentum. Overall, we view regulated stocks as less expensive now than in mid-2016, and we see total potential return upside of c16% on United Utilities (UU). ■ Three themes: (1) We expect domestic electricity prices to rise c8- 10% in March: We think the risk is more manageable and the likelihood of adverse intervention is low, not least as discounts on fixed tariffs have halved, to c£69-113 p.a.; (2) Improved power market conditions benefit Centrica and Drax: We see increased volatility in the spot power market, which should benefit generators. We run our new 42p/therm gas price through our model (from 54p) but coal is on the margin, so our power price estimate only falls to c£44/MWh (from c£46/MWh); and (3) Low returns on new projects: Increased cash flows will be difficult to deploy in capex, given competitive tendering has bid down post-tax returns on equity to c6- 9% (i.e. cost of equity). The risk would stem from more share buybacks (a contrarian signal) or M&A (risk of overpaying). Ending scrip dividends would demonstrate better discipline, in our view. ■ Stock calls: We reduce our TP on CNA (TP 255p from 270p, Outperform) on our lower gas price, but see EPS growth in 2017E and 2018E. We upgrade UU to Outperform from Neutral (TP 1,000p from 990p) and SVT to Neutral from Underperform (TP 2190p from 2100p). We reduce our TP on NG (TP 850p from 860p, U/P). PNN (TP 750p, U/P) is our least preferred stock due to risks on energy from waste. We include DONG (TP DKK310, O/P) as, albeit listed in Denmark, c70% of its enterprise value is in the UK and it is the largest investor in UK wind.

DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 19 January 2017

Key charts Figure 3: Percentage of group EBIT and EPS from GB Figure 2: Total shareholder return over 2016, % domestic supply for the 'big six' 60% 56% 60% 50% 51% 50% 40% 37% 30% 40% 19% 28% 20% 14% 30% 8% 10% 6% 6% 6% 19% 3% 0% 20% 13% 8% 7% 6% 10% 5% (10%) (0%) 4% s s x 0 a T E l l U N G i i a c 0 0% t t V i S r U N N r 1 t U S U

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E (1%) (0%) 0 e e S p 5 (10%) C T 3 o

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I T F C

S % of Net Income % of EBIT M Source: Thomson Reuters, Credit Suisse research * We compare 2015 supply profits with 2016 estimates Net Income and EBIT. Consensus for EDF) Source: Credit Suisse research Figure 4: GB baseload power; our new and old Figure 5: Premium to RAB of recent deals (line is trailing forecasts, and the forward curve, £/MWh average of last five deals), % premium to RAB 53 51 60% 50 49 50% 47 48 47 46 40% 45 46 45 30% 44 44 44 20% 41 41 39 10% 38 40 0% … … … … … … … … … … … r s k s y s k n n h n 1 h 5 a K U N D G r t t r e r c a e e e 1 1 d o t i l l l o u u U (10%) t - e U e - O l G

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Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: Credit Suisse research, Credit Suisse estimates Figure 6: IRRs discounted by different assets, along Figure 7: Synthetic FY+1 dividend yield less 10Y bond with the CS estimated cost of equity, % yield 9% 5% Cost of debt Market-implied cost of equity 8% instruments 7% 4% 3.5 % 7.5% 7.5% 7.1% % 6% 6.9% 8 6.7% . 5% 7 - 3%

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Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse research

UK Utilities2 19 January 2017

Table of contents

Key charts 2

Executive summary 4

1. Political risk on bills looks manageable 7

2. Tight power markets and the advent of capacity payments from Oct. 2017 11

3. Returns for new projects low … M&A and on-market buybacks likely 17

4. Valuation: Multiples lower, still not cheap 22

Our recent research 28

DONG Energy A/S (DENERG.CO) 29

United Utilities (UU.L) 31

Centrica (CNA.L) 33

Drax (DRX.L) 35

SSE (SSE.L) 37

Severn Trent (SVT.L) 39

National Grid (NG.L) 41

Pennon Group (PNN.L) 44

UK Utilities3 19 January 2017

Executive summary In this report, we update our commodity price forecasts and roll forward our company valuations by one year to December 2017 (or March 2018) and adjust our target prices. We upgrade UU to Outperform (from Neutral) and Severn Trent to Neutral (from Underperform) on valuation. We show in Figure 8 the changes to our estimates. Note that we include DONG for the first time in a UK Utilities sector review. Although the stock is listed in Danish krone on the Danish exchange, we think it is worth including because c70% of its enterprise value is in the UK and it is a major investor involved in many of the themes. DONG shares are also exposed to movements in EUR:GBP. We recommend being positioned in generators ■ We maintain our Outperform on DRX, CNA and DONG: Consistent with our report of 19 December, Brave new world) we have turned more positive on the sector. Despite strong performance in 2016 (Figure 2), generators and hydrocarbon producers such as Centrica (TP 255p from 270p, Outperform) and Drax (TP 425p, Outperform) continue to be our preferred stocks. We see EPS growth, cash-flow generation, scope for higher dividends (Drax) and ending the scrip (Centrica) as positives. Earnings momentum on both is positive. We like DONG (TP DKK310 from DKK315, Outperform) for the exposure to a pipeline of offshore wind projects earning c15-16% project-level IRRs. UU (TP 1,000p from 990p, Outperform from Neutral) is the only regulated utility on which we have an Outperform rating. ■ SSE and now SVT are our Neutral-rated stocks: Regulated utilities have underperformed the wider market across 2016, especially following the rise in bond yields in Q4 2016. SSE has the highest cash dividend yields (i.e. ex. scrip) at 4.6% (Figure 7) albeit with low growth. We see SVT's valuation as more reasonable, and the cash dividend yield is higher than PNN and NG. ■ Remain Underperform on Pennon (PNN) and National Grid (NG): Pennon has exposure to energy from waste projects, where we believe pricing will become competitive. NG is still trading on a c40% premium to RAB and the rate base, which makes it the most expensive pure-play regulated stock in our coverage. We also see a shortage of value-accretive growth at NG. Key themes to focus on in 2017 Theme #1: Domestic prices need to rise c8-10%. Political risk looks manageable (page 7) ■ The energy commodities relevant to the GB power and utility markets—gas and coal— have risen in the past six months. Utilities normally buy and sell their commodity 12-24 months forwards, which delays the impact of commodity price movements. For the first time in two-and-a-half years, forward hedge books are below the market price (a positive for earnings momentum). ■ We believe GB domestic energy suppliers will all raise prices from March 2017, for the first time in more than three years. We think they need the rise to support earnings (Figure 3). The recent c8.2% rise from EDF for March sets a precedent, and is the level needed in our view. We expect the rest of the big six to raise prices from March. We assume domestic supply margins remain at c5%, falling back c50-100bps by 2018E. ■ Price rises tend to attract criticism from the public and media, and therefore politicians, but we do not expect adverse intervention. Companies have voluntarily frozen prices until March/April. The government decided against intervention in 2016, despite some media speculation to the contrary. Tariff differentials between the 'big six'; and new entrants were one of the big criticisms, but the differentials have halved, to c£69-113.

UK Utilities4 19 January 2017

Theme #2: Tight power markets and capacity payments help generators (page 11) ■ We reduce our long-term natural gas price forecast from 54p/therm to 42p/therm (market prices are c48p/therm), driven by a recent cut by our Oil and Gas analysts (click here), who believe that there will be a step-change after 2017 as US LNG lands in Europe (the marginal cost of LNG from the US is c37p/therm). This does not have a material impact on our power price forecast, as thermal coal is on the margin (Figure 4). ■ Across Q4 2016, the GB power market experienced scarcity pricing owing to French nuclear outages. Day-ahead prices rose to c£155/MWh and volatility increased to above 2017 levels. Going into results in February, we see a risk of big gains and losses if a market player does not have appropriate risk management systems. ■ While the French nuclear reactors have mostly re-started, capacity margins are still tight in the GB market (<9%) and the thermal and nuclear generation fleet is only getting older. We expect scarcity pricing to be a theme in the next few years, consistent with the capacity market. ■ We accept that the cost of new entry has come to very low levels (e.g. £22.5/KW for OCGT peaking plant). This will work to keep a cap on prices in the GB capacity market. We expect c£20/KW-yr in future auctions, including the extra auction for 2017/18. However, the payments are still c£0.9-1.3bn for the industry in the first three years, and we anticipate EPS growth at Centrica, SSE and Drax as a result. Theme #3: Returns on new projects low... M&A and share buybacks likely (page 17) ■ On the whole, UK utilities have improved their balance sheets. We notice that they have either: (a) de-levered; or (b) have improved cash flows due to higher commodity prices. They are therefore starting to once again seek out growth. ■ There will hardly be any value-accretion from organic capex, as returns have been driven to low levels by competitive tendering. The c6-9% returns observable for new competitively-won projects are equivalent to cost of equity and the levels discounted by share prices, as evidenced by recent deal premia (Figure 5) and tender wins. ■ Legacy returns should shield DONG and SSE until 2020. We expect the CfD allocation round which starts in April to clear at c£80/MWh; lower than the £140-150/MWh for CfDs awarded in early 2014. Only SSE and DONG have project pipelines on attractive legacy returns, with c£6bn and c£7.5bn capex, respectively, through to 2020. ■ Given the dearth of value-accretive returns, we think companies will continue to return capital or pursue M&A. We would prefer companies to first end scrip elections, as they are dilutive. However, we think share buybacks and acquisitions are likely. We note buybacks are a contrarian sell indicator (click here) and acquisitions carry risk of asymmetric selection (i.e. overpaying). This is something to track. Dividend yields higher, but regulateds still not cheap ■ We prefer an approach of backing out the equity IRR discounted from our cost of capital for regulated stocks. We estimate that the stocks discount between c6.7-7.5%. This is around our view of the cost of equity, and +c150bps vs. one year ago. While PNN and NG look expensive, SVT is closer to fair value, and UU is cheap, in our view. ■ Dividend yields are correlated with our ratings. On a cash dividend yield basis, SSE is highest, followed by UU, Centrica and Severn Trent (Figure 6). We do not have an Outperform rating on SSE, as we think it is distributing much of its earnings. The cash yields of PNN and NG are low and are most at-risk in 2020/21, in our view. Drax could reach a c6.6% yield in 2017E, and DONG has c10% p.a. growth, on our estimates.

UK Utilities5 19 January 2017

Changes to our estimates

Figure 8: Key changes to our earnings estimates Year Old New Diff. Rationale 2016E 15.1p 16.7p 11% Increased guidance at the trading statement in December. The main reason CNA (y/e dec) was higher output from British Energy. Increased 2017 profits from gas and 2017E 15.6p 17.8p 14% oil (cost-cutting) and BGRE (higher underlying profits ex connected homes). 2016E 3.1p 3.1p (1%) We include the EPS accretion due to the acquisition of Opus. We assume Drax (y/e dec) Opus is consolidated from 1 April 2017. We do not include any fair value 2017E 10.4p 17.4p 67% adjustments. We run our new gas, power and oil price forecasts through our model. While DONG Energy 2016E 26.0 DKr* 26.0 DKr* (0%) the company is mostly sold forwards for 2017, weaker power prices will have (y/e dec) 2017E 21.0 DKr 20.4 DKr (3%) a small impact. 2017E 122.8p 124.0p 1% Impact of the recent scarcity pricing in power prices should marginally SSE (mar y/e) improve FYmar17 profitability. We include the 225MW Stronelairg onshore 2018E 131.4p 131.9p 0% wind project. 2017E 63.8p 63.8p 0% We assume a near-term drag on earnings through the company undertaking NG (mar y/e) an on-market share buyback for up to c£1bn of the c£4bn of capital due to 2018E 63.3p 60.6p (4%) be returned (we previously assumed all would be returned in March 2017). 2017E 44.7p 43.4p (3%) We update our model to reflect slightly more front-loaded infrastructure renewals expenditures over AMP6, as well as claw-back of FY-16 volume UU (mar y/e) 2018E 45.9p 45.8p (0%) benefit in FY-18. We also update our RPI forecasts for 2017-20E, with our economists’ latest forecasts. 2017E 41.1p** 41.1p** 0% Note these are company-adjusted EPS. We updated our estimates in our PNN (mar y/e) 2018E 41.8p** 41.8p** 0% report of 17 January entitled Energy-from-waste risks materialising. 2017E 105.8p** 105.7p** (0%) Company-adjusted EPS. Our forecasts are broadly unchanged for SVT (mar y/e) FYmar17E. We update our RPI modelling with the outturn for November 2018E 105.0p** 106.0p** 1% 2016 (2.5%, vs CS est. 2.2%) which contributes +1% to FYmar18E EPS.

* Excludes capital gain from disposal of gas grid ** Company metric (i.e. excluding deferred tax) Source: Credit Suisse estimates Our estimates versus consensus

Figure 9: Our EPS forecasts against Thomson Reuters SmartEstimates® consensus Year CS est. Consensus Diff. Rationale 2016E 16.7p 15.8p 6% We believe that consensus is more bearish than us on GB domestic energy CNA (y/e dec) supply margins. We also believe that the cost-cutting (especially in gas and 2017E 17.8p 16.3p 8% oil production) are not being portrayed accurately in the market. 2016E 3.1p 4.9p (36%) We believe that EPS is distorted through being very low on a historical basis Drax (y/e dec) and hence is less relevant. At the EBITDA level, we are c1% and c6% ahead 2017E 17.4p 19.4p (10%) of consensus. We are slightly above consensus for 2016E as we think consensus has not DONG Energy 2016E 26.0 DKr* 24.6 DKr* 6% yet updated for the disposal of Race Bank. We see potential upside to (y/e dec) 2017E 20.4 DKr 21.0 DKr (3%) 2017E EPS if c50% of Walney is disposed of at an attractive price. 2017E 124.0p 121.9p 2% We believe that consensus is more bearish than us on GB domestic energy SSE (mar y/e) supply margins. We also believe that the company will get more accretion 2018E 131.9p 128.8p 2% from the growth projects. 2017E 63.8p 62.2p 3% We believe that de-consolidation of gas distribution as well as the delay in NG (mar y/e) the c£1bn buyback (our base case was that all £4bn would be returned to 2018E 60.6p 65.9p (8%) shareholders in March) will temporarily reduce EPS in FYmar18E. 2017E 43.4p 45.0p (4%) Consensus may not fully reflect the more frontend-loaded nature of UU’s UU (mar y/e) 2018E 45.8p 45.2p 1% TOTEX relative to its allowances over 2015-20E. This will net off by 2020E. 2017E 41.1p** 42.4p** (3%) We think Viridor results are more likely to disappoint, given declining landfill PNN (mar y/e) and limited operational leverage in recycling. Higher taxes resulting from 2018E 41.8p** 44.6p** (6%) changes in legislation yield further downside risk. 2017E 105.7p** 105.8p** (0%) We forecast limited growth in SVT’s unregulated Business Services unit, SVT (mar y/e) particularly driven by renewables, where we think overcapacity in anaerobic 2018E 106.0p** 110.3p** (4%) digestion could reduce growth potential.

* Excludes capital gain from disposal of gas grid ** Company metric (i.e. excluding deferred tax) Source: Thomson Reuters, Credit Suisse estimates

UK Utilities6 19 January 2017

1. Political risk on bills looks manageable We assume 2017E domestic EBIT margins of c5%, falling back c50-100bps in 2018E ■ Political risk moderated: The new UK government led by Theresa May seemed focused on fairness in domestic energy markets, despite measures imposed by the CMA. However, this risk of intervention appears to have receded, in part due to some companies' voluntary price freezes (to March/April) and engagement with government. ■ We expect price rises during March/April: EDF's c8.2% increase in domestic electricity prices sets a precedent, and we expect price rise announcements from March 2017. There may need to be a further rise in Q4 2017. Rises typically attract criticism, which increases valuation discounts on suppliers. But it will be hard for the government to act given that intervention has previously led to worse outcomes for consumers, in our view. ■ Diminishing differentials a positive: Like-for-like dual fuel tariff differentials between new entrants and the 'big six' are down to £70-113 p.a. This has halved in the past nine months. Lower differentials remove what has been a key criticism of the industry in recent times, and lead to fewer account losses (more optical than relevant for value). 1.1 Prices must rise to cover increased policy costs We think a three-and-a-quarter-year period of flat-to-falling bills is now over. In the GB utility market, the 'big six' typically buy their gas and electricity on an 18-month rolling basis. The fall in commodity prices across Summer 2014-Q1 2016 helped offset the rises in non-commodity costs within bills, and worked to ensure that bills overall still fell.

Figure 10: Credit Suisse estimate of wholesale gas Figure 11: Credit Suisse estimate of wholesale on 18-month rolling hedge as of 1 Jan, p/therm power on 18-mth rolling hedge as of 1 Jan, £/MWh 85 70 65 75 2013 2009 2014 h 60

2009 2012 W m r

65 M / e 2015 55 2012

£ 2014 h 2013 t / -

p 2011 e 2015 - c 55 2010 50 i

r 2011 e 2010 p c i 2016 2017 2018 r 2018 y t p 2016 45

c i s 45 2017 r t a c

G 40 e l

35 E 35 25 30 0 7 3 9 5 6 1 8 1 4 8 9 3 6 2 4 0 7 0 7 3 9 5 6 1 8 1 4 8 9 3 6 2 4 0 7 0 1 1 1 1 1 1 1 0 1 1 1 1 1 1 1 1 1 0 1 1 1 1 1 1 1 0 1 1 1 1 1 1 1 1 1 ------l t t r l r r t t r r r c v c y y b n n n g p g c v c y y b n n n g p g u c c p u c c a a p a a a a e o e e a u a u e u a a e o e e a u a u e u J J A O O J J J A O O M M F J J J D N D A S A M M F M M D N D A S A M M Weighted ave. wholesale gas cost (18 month rolling hedge) Weighted ave. wholesale power cost (18 month rolling hedge) Weighted average for year Weighted average for year

Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse research Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse research

Lower commodity prices There is no longer a commodity price benefit to prevent energy bills from rising. We show are no longer shielding in our proprietary hedging models in Figure 10 that wholesale gas costs in 2017 are up customers from slightly, while in Figure 11, electricity costs are flat. The overall effect would be +c£15 p.a. price increases on bills if this is passed through (which we think it will be). However, there is a c£40 yoy increase in tariffs required to pass through policy costs in 2017E (transmission and distribution, renewable subsidies and capacity payments). Given that most of the margin is made in gas1, this means electricity tariffs need to rise, likely in March/April 2017. We explain below the challenge for this.

1 We note that domestic gas margins were c7.5% in 2015A, while domestic electricity margins were c1.5%

UK Utilities7 19 January 2017

1.2 Government intervention now appears less likely The government Prime Minister Theresa May assumed office on 13 July 2016, and she and senior indicated during Q4 2016 members of the new government have been very critical of energy companies and the that there would be tariff structures. For instance, the Conservative party conference in the first week of intervention. However, October 2016 contained the following statements: the companies froze prices voluntarily and this ■ Theresa May (Prime Minister): "It’s just not right that two thirds of energy customers seems to have averted are stuck on the most expensive tariffs." adverse risk. ■ Greg Clark (Energy Minister): “Knowing that £2 billion of detriment exists, we have to act on this in the next few weeks and months.” Media reports (most prominently The Sun tabloid on 23 September 2016) speculated the government was considering three potential options: (i) extending tariff caps from prepayment to vulnerable customers; (ii) limiting price rises when fixed deals end; or (iii) forcing companies to put long-standing customers onto the cheapest tariff. These actions could have been negative for companies. Thus far, however, the government has not intervened. The budget of 23 November included the following message: ■ Philip Hammond (Finance Minister): "We will look carefully over the coming months at the functioning of key markets, including the retail energy market, to make sure they are functioning fairly for all consumers." Our assumption is that the current government—like those before it—may have intended to intervene to reduce prices, but after analysing the situation, found it hard to justify intervention in a market where prices / margins are relatively low. Voluntary measures Rather than wait for intervention, companies have voluntarily delayed price increases. Four—SSE, British Gas, EON and EDF—have 'frozen' prices until March/April. Two companies—EDF and Scottish Power—reduced gas tariffs by c5%. We believe this will have helped ward off intervention. We show below why we do not expect freezes to be extended, and why we expect potentially larger increases later. 1.3 Supply margins need to be maintained for 2017

Figure 12: Profits from GB domestic supply, % Figure 13: Absolute sector EBIT from GB supply, %

60% 1,800 4.5% 51% 1,600 4.0% 50% 1,400 3.5%

37% ) 40% )

m 1,200 3.0% % £ ( (

n i 28% n i

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30% r r a a m m 800 2.0% 19% T T I

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600 1.5% E E 10% 8% 7% 6% 4% 5% 400 1.0% 0% 200 0.5% (1%) (0%) 0 0.0% (10%) 2009A 2010A 2011A 2012A 2013A 2014A 2015A Centrica EON SSE Innogy IBE EDF

% of Net Income % of EBIT Domestic Non-domestic EBIT margin (%)

* Note, we compare 2015 GB supply profits with 2016 Net Income and EBIT * Adjusting for one-time Billing system issues at nPower and BG Business in 2015A Source: OFGEM, Thomson Reuters, Credit Suisse estimates Source: OFGEM, Credit Suisse research

UK Utilities8 19 January 2017

We see that GB domestic Our view is that the industry will maintain GB margins. We show in Figure 12 that the supply margins are low, average utility present in GB domestic energy supply earns c11% of group EBIT and c18% and are needed by all the of group net Income from the activity. Losing this revenue would likely put at risk both the players to support dividend payouts and credit ratios of some companies. Aggregate profits across domestic their activities and non-domestic have been stable for the past four years (Figure 13). We do not expect a breakdown in discipline at the 'big six' in pricing policy. The first price rise by one of the 'big six' in 3.25 years has been announced. In December 2016, EDF Energy announced a c5.2% price cut in domestic gas from January but a c8.4% price rise in electricity from March 2017. While the gas cut takes EDF to the average, we think that the c8.4% electricity price rise is of the magnitude that the rest of the industry must put through. We expect the rest of the industry to follow with c10% electricity-only price increases in March/April.

Figure 14: Illustrative breakdown of bills, based on our commodity and non-commodity price forecasts (industry margins have reached c5% in 2016E), £ p.a. for dual fuel

1,200 74 55 71 72 1,000 52 69 70 174 57 114 162 70 168 169 168 59 75 32 166 800 19 41 165 143 89 53 126 135 66 15 93 75 65 14 225 261 600 237 258 221 325 341 184 271 288 307 400

514 448 495 492 461 200 407 375 370 376 373 370

- A A A A A A E E E E E 0 1 2 3 4 5 6 7 8 9 0 1 1 1 1 1 1 1 1 1 1 2 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2

Fuel Network tariffs Social spend Renewable subsidies Operating costs Profit VAT

Source: Company data, Credit Suisse research, Credit Suisse estimates

Concerns over perceived Rises tend to attract criticism from the public and media and therefore politicians, which in political risk will likely be turn increases valuation discounts on suppliers. Traditionally, as in 2007-08 and 2010-13, present. But we doubt each round has attracted progressively more criticism. that government will act. But it will be hard for the government to act given that intervention has previously led to inferior outcomes (e.g. delayed price drops in early 2015, when the opposition leader threatened a 20-month price freeze). We think investors should be cognisant of this. 1.4 Lower tariff differentials reduce political risk and mean that the 'big six' will stem account losses The big six have c85% market share of the GB domestic market, from c98% in 2014. Our view is that customer losses are less relevant for value than for sentiment. Energy supply companies trade on only c7x EV/EBITDA (i.e. reflecting profit declines and not sustainable profit streams) and the value of lost customers is far less than the annual profits. Nonetheless, lower customer numbers have been unsettling for investors. There have been four reasons why new entrants have won this market share:

UK Utilities9 19 January 2017

1. Lower hedged electricity and gas costs than the 'big six': The 'big six' buy their commodities forwards on an 18-month average, limiting their ability to pass through sharp falls in commodity prices. This has been worth up to c£100 p.a. on bills, but is now around zero; 2. Lower non-commodity costs: New entrants have some cost advantages, including lower ECO costs (c£70 p.a., falling to c£34 from April) and not being active in some segments (e.g. prepayment meters, which is a more expensive market to serve); 3. Genuine competitive advantage: This includes cost-to-serve, innovative use of new technology, customer service, advertising, direct debits, being able to focus on dual fuel, etc; and 4. Lower margins: Some new entrants are more focused on cash flows (e.g. paying interest on credit balances to attract customer prepayments) than profits. One supplier—GB Energy—ceased trading (see our report of 28 November 2016: Independent supplier ceases trading). This shows that in some cases, they may be pricing too low. The difference between We expect the advantage from Point 1 to have fallen away as forward curves are slightly tariffs of the 'new-new' above hedged costs, and may even go into decline as energy prices start to rise. The entrants and the big six advantage from Point 2 has fallen, leaving just Points 3 and 4. We show how this has has halved to c£69-113 affected competition below. p.a. This reduces one of the big political Figure 15: Average dual fuel domestic energy bills show small differentials arguments for £ per household p.a., based upon average consumption intervention. Discounted / standard variable Cheapest Difference to Standard Difference to discounted tariffs new entrants variable tariffs new entrants 10 Cheapest new entrants (<7% market share) 878 953 3 Established new entrants* (c8% mkt share) 915 37 1,020 67 'Big six' ** (c85% market share) 947 69 1,066 113 * Including Ovo and Utility Warehouse ** British Gas, EDF, EON, nPower, SSE and Scottish Power Source: Company data, Credit Suisse estimates

Differentials have nearly halved in the past nine months. We show in Figure 15 that the recent new entrants (such as Ovo) have a c£69-£113 lower price versus the 'big six' and a c£37-672 lower price versus the established new entrants. This will likely have two effects: (1) Customer losses will slow: As we mentioned earlier, this is more 'optical' in nature than relevant for value, but it should bode well; and (2) Perceived disadvantage of customers on standard variable tariff: The argument that customers could save more by switching—and the feeling of a need to act by government and regulators—should recede. Note that British Gas does not currently advertise any tariffs that are cheaper than the standard variable. We do not argue that perceived political risk should pass entirely, but rather that some of the key points of criticism should recede. And that as the hedged positions of the big six work for rather than against customers, there is less need for political intervention. We think overall margins will be flat, and political risk will be manageable. We therefore keep our domestic margin assumptions for the industry at c5% for 2016E and 2017E (albeit c6-8% for Centrica and SSE, which make margins that are slightly better than the average). We assume that they fall back c50-100bps in 2018E.

2 We compare like-for-like, whereas data cited by OFGEM /CMA often tend to focus upon the difference between the standard variable tariff and the cheapest discounted tariffs, which in our view is not comparable.

UK Utilities 10 19 January 2017

2. Tight power markets and the advent of capacity payments from Oct. 2017 GB day-ahead power prices have reached their highest levels in eight years, even if the clearing prices for the capacity auctions are disappointing ■ Slightly lower power prices, driven by lower gas: Thermal coal is now mostly the marginal winter fuel in the UK, and we increase our near-term power price estimates due to higher thermal coal prices. Our long-term thermal coal-price forecasts remain unchanged at US$50/tn. We update our power price model for our lower house forecasts (42p/th, from 54p/th). This reduces our power price estimate by c£2/MWh. ■ GB power market likely to remain tight: October-December 2016 experienced record volatility in the electricity balancing market and scarcity pricing, due partly to French nuclear outages. While the reactors have re-started and capacity margins in GB will improve +c200bps in 2017/18 (from c6.6% to 8.6%) much of the generation fleet is older. We would not be surprised to see scarcity pricing in future winters, not inconsistent with capacity payments. ■ Capacity auctions likely capped at c£22.5/KW-yr: We see that new entry is coming in much cheaper than previously anticipated, in part due to low equipment prices, but also because of low returns acceptable (see next section). We assume a c£20/KW-yr long-run capacity payment price. While much lower than the c£49/KW-yr cost of new- entry assumed by the UK government, it still provides c£0.9-1.2bn p.a. extra revenue and some EPS growth for the stocks exposed (Centrica, SSE and Drax).

2.1 Reducing our gas and power price forecasts

Figure 16: UK natural gas; our new and old Figure 17: GB baseload power; our new and old forecasts, and the forward curve, p/therm forecasts, and the forward curve, £/MWh 70 53 67 65 51 50 49 60 58 54 48 47 55 51 53 47 46 46 45 50 47 48 48 49 45 44 44 45 43 44 43 42 42 42 40 41 41 34 40 35 39 38 40 30 25 35 A A A A E E E E A A A A E E E E 3 4 5 6 7 8 9 0 3 4 5 6 7 8 9 0 1 1 1 1 1 1 1 2 1 1 1 1 1 1 1 2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

Market price (11 Jan. 17) Market price (11 Jan. 17) CS estimate of System Marginal Price (11 Jan. 17) CS estimate of System Marginal Price (11 Jan. 17) CS estimate of System Marginal Price (6 Oct. 16) CS estimate of System Marginal Price (6 Oct. 16)

Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates

UK Utilities 11 19 January 2017

We have cut our natural gas price forecasts by c20% from 2018E onwards We run our new gas Our European Gas Analyst, Ilkin Karimli, reduced his natural gas forecasts on price forecasts through 14 November 2016 in his report, Adjusting the pricing model. Our long-term European gas our model. However, price forecasts have fallen from US$6.5/mmbtu to cUS$4.9/mmbtu. In GBP terms, this there is minimal effect on means we reduce our long-term UK gas price forecasts from 54p/therm to c42p/therm. We GB power as thermal note that the forward curve is currently c5p/therm higher than our new forecasts. coal is on the margin The reasoning for Ilkin's reduction is that our house oil price forecasts fall from US$70/bbl to US$65/bbl. Furthermore, we believe the European gas market will undergo a step change after 2017 as oversupply in the global LNG market is exacerbated. Assuming that US LNG comes to the UK, the landed price in the UK—at US$3.5/mmbtu Henry Hub—is c37p/therm; so we assume a small premium (+c5p/therm) for UK prices. We think Gazprom will aim to price-out its US LNG competition in its bid to protect its market share. We also note that the gas price is close to the coal-to-gas switching cost, suggesting some of the increase in gas demand has occurred already. Power price forecasts do not fall by as much We note that thermal coal is now the marginal price-setting technology in GB for winter. Hence GB power is now driven more by coal than by gas, and the lower gas prices do not have much impact at current coal prices. Our long-term thermal coal price estimate is unchanged at US$50/tn. Hence our power price estimates for 2018-20E fall by c£2/MWh (Figure 38). Our near-term power prices increase due to the impact of higher coal prices. We have increased our thermal coal price forecasts in the near term due to higher coal prices in China. Our analysts expect price parity between seaborne thermal and the spot price in China ($74/tn). In the longer term, the team expects coal supply in China to continue to recover in H117 and this could lead to an 'under-shoot' in prices just as current levels have 'over-shot' government targeted levels. Hence they retain their US$50/tn estimate. See their report of 7 December 2016, Re-rating has further to go.

2.2 Scarcity pricing in GB power during winter 2017

Figure 19: Volatility in Balancing market prices (i.e. Figure 18: Day-ahead power prices, £/MWh the physical market), %

250 50% 45% 200 40% 35% 150 30% 25% 100 20% 15% 50 10%

- 5% 7 4 5 9 2 6 0 1 5 2 6 9 3 6 8 5 6 8 1 3 5 0 0 1 1 1 0 1 0 0 1 1 1 1 0 1 0 0 1 1 0 1 ------l l

t t 0% r r r r c v c v y y n n b b p g p c c u u a a p p 0 3 6 8 8 1 1 4 4 7 5 8 1 4 9 0 3 6 9 2 2 5 a a e o e o u a e e e u e J J O A O A 0 0 1 1 1 1 1 1 0 1 1 J J 0 1 1 1 0 1 1 1 1 1 1 M M F F D N D N S A S M M ------t t r r r r r v v c y n n n n n n n p g g g c c p p a a a a o o e a u a u a u a e u u u A A O O J J J J J J J M M M N N D S A A A Day-ahead electricity Month-ahead electricity M

Source: The BLOOMBERG PROFESSIONAL™ service , Credit Suisse research Source: Thomson Reuters, Credit Suisse research

UK Utilities 12 19 January 2017

For the first time in eight years, there has been sustained scarcity pricing in the GB power market3. We note that day-ahead prices reached c£155/MWh recently and month-ahead c£150/MWh (Figure 18), the highest since 2006. Volatility in the day-ahead markets has exceeded 2008 levels for the first time (Figure 19). In order of importance, we point to the following causes: 1. Nuclear outages in France: There were extended outages on 18 nuclear reactors in France owing to inspections by the French Nuclear safety authority (ASN) on steam generator components. These reactors now have approval to restart, and are coming back online, with most back now. This turned the UK from being a net importer to a net exporter with France. There were outages on nuclear assets in Switzerland as well, which pulls supply away from the UK; 2. Interconnectors: The interconnector with France has recently been running at half capacity, due to a ship dragging its anchor across the interconnector. There is also extended maintenance on the Dutch interconnector; 3. Some assets have not been able to deliver when expected: Many gas-fired assets have been subject to low clean spark spreads, and have not been properly maintained. Coal-fired assets are approaching the end of their lives, so capex has been cut. Other assets have been on extended outages or their owners have restricted running to be are available during winter peaks; 4. System rule changes: From 5 November 2015, a new rule was created such that the average of the marginal 50MW in the supply stack is used to calculate cash-out prices (previously the marginal 500MW). It will go to the marginal 1MW in 2018. This was done to price-in the cost of voltage reductions to electricity costs; and 5. Cold snap with low wind generation: The winter heating season saw temperatures c3-5C below the seasonal norm. At the same time, the cold weather was caused by low pressure and low wind speeds, which reduced renewable generation. We do not rule out large Gains and losses are possible gains and losses–due to To the extent that assets are able to run, it is positive for un-hedged thermal assets and the recent scarcity fixed cost generation such as nuclear and hydro that can run and capture the high prices. pricing—when We show clean spark spreads imply that CCGTs will have had a very strong year companies report historically (Figure 20). It is negative for renewables, which may have sold forward power FYdec16 results. they cannot deliver, or supply businesses that have been short power in their hedge book. We would not be surprised to see some of the companies report large swings in profits from retail to generation and vice versa. We cannot rule out some companies without risk management systems and experience in hedging policies to have lost money.

3 We define scarcity pricing as when the spreads rise far in excess of what the marginal cost of power might normally be expected to be, which is to say that a highly expensive source of power—e.g. capacity that might not normally be dispatched, and with very high running costs—is used.

UK Utilities 13 19 January 2017

Figure 20: Day-ahead clean spark spread (53% efficiency, 10 day moving average) Figure 21: Key forward power contracts, £/MWh

35 75 70 30 65 60 25 55 20 50 45 15 40 35 10 30 25 6 6 6 6 7 6 6 6 6 6 6 6 5 6 1 1 1 1 1 1 1 1 1 1 1 1 1 ------l t r r v c y b n n n g p u c p a a o e e a u a u e J A O J J J M F N D A S - M 5 6 5 6 5 6 5 6 5 6 5 6 1 1 1 1 1 1 1 1 1 1 1 1 ------l l r r v v y y n n p p u u a a Q1 17 UK Power Winter 2016/17 a a o o a a e e J J J J M M N N S S M M Summer 2017 Winter 2017/18

Source: The BLOOMBERG PROFESSIONAL™ service , Credit Suisse research Source: The BLOOMBERG PROFESSIONAL™ service , Credit Suisse research 2.3 Capacity margins are tight and assets now older, indicating tight prices to continue GB capacity markets are The scarcity pricing was contained to the near-term markets (e.g. through to Q1 2017: due to improve by winter Figure 24), where the power price was much higher than the forward curves. However, we 2017/18, and we expect show below that we believe the same could happen again. Capacity margins in GB are a c200bps improvement. c6.6% currently, including strategic reserve. We expect a small improvement moving into However, the thermal winter 2017/18. We note the following major moving parts: and nuclear fleet is only getting older and we Negative expect higher - There is no new thermal generation coming online prices again. - 1.5GW of coal-fired generation at Aberthaw potentially not running economically, or even closing (-2.5%). Positive + We would expect peak load demand to fall by c0.5GW p.a. (+c1%) + 0.8GW from South Humber bank back from refit (+0.7%) + 0.4GW from Lynemouth biomass conversion by EPH (+0.4%) + c3GW of onshore and offshore wind additions (+2%) This should add c2% to GB capacity margins. Indeed, we note that the UK government has instructed National Grid to procure c53.6GW for the year across October 2017- September 2018 in the early auction. This should help keep capacity margins above c5%. Our view is that the thermal and nuclear generation fleet connected to the transmission grid will be c45GW (c85%) of capacity margins and much of this is very old. We expect the generation fleet to age over time, and we cannot rule out scarcity pricing.

UK Utilities 14 19 January 2017

2.4 Capacity auction appears capped at c£22.5/KW-yr (cost of new entry) but does bring some growth We believe that capacity Figure 22: Capacity payments auctions are capped at c£22.5/KW-year, by £ in millions, unless otherwise stated cheap new-entry (see 350 next section on returns). However, the start of 300 payments in October 2017 should still bring 250 some EPS and 200 cash flow growth. 150

100

50

- SSE* Centrica EDF RWE Uniper** SPW Drax Engie Others 2014 T-4 (delivery in Oct 2018 - Sept. 2019) 2015 T-4 (delivery in Oct 2019 - Sept. 2020) 2016 T-4 (delivery in Oct 2020 - Sept. 2021)

* Note we include the Marchwood and Seabank assets in here, which are tolled to SSE ** EON until the 2016 T-4 Source: Company data, Credit Suisse estimates

The first three T-4 auctions for GB have taken place. The clearing prices—without estimate of the nominal amount of payments for the industry—are as follows: 2014 T-4 (Dec 2014): Covering October 2018-March 2019 – c£19.4/KW-yr – c£1bn 2015 T-4 (Dec 2015): Covering October 2019-March 2020 – c£18/KW-yr – c£0.9bn 2016 T-4 (Dec 2016): Covering October 2020-March 2021 – c£22.5/KW-yr – c£1.3bn We think there are two notable factors that have caused the auction to clear at low prices, despite new entry being required in each auction: − Bidding in existing assets at zero: We assume owners of some assets in the first two auctions bid in at a low price and accepted whatever the payment cleared at, rather than looking at a business case. We say this because EDF, RWE, Uniper, Drax and Scottish Power all got close to 100% of their capacity in the first two auctions, despite some assets being loss-making. It appears that SSE, Centrica and Engie were more disciplined as they took assets out (Fiddler's Ferry, Peterhead, Rugeley) albeit we note that EDF have taken out Sutton Bridge and gone back on 3-year refurbishment contracts. − Low cost of new entry: In the first auction, a large CCGT (Carlton Power) won a payment at £19.4/KW-yr, but will not be taking up their contract. Hence Carlton reduced the clearing price. In the second auction, cheap small diesel-fired engines appeared to be the marginal new-entry generation, hence may have caused low clearing prices. In the third auction, it was gas-fired stations and OCGTs (Spalding) that we believe set the price. We think equipment costs have come down, but that low-hurdle rates (next section) have caused players to bid low prices. We believe that the low cost of new entry—and low returns that bidders are prepared to accept—has been holding back profitability. For this reason, we assume that the future auctions will also clear at around c£20/KW-yr. Until discount rates rise and capital is more scarce, we think £20/KW-yr is the right level.

UK Utilities 15 19 January 2017

We assume a c£20/KW-yr clearing price for the 2017/18 early auction The forthcoming extra auction (covering October 2017-September 2018) will be different in that there is no new-entry, and it will be a 'T-1' in nature. There will be 56.3GW of assets chasing c53.6GW of capacity payments, with a c4.5GW of new entry (likely new entry assets bought forward from future years) and 1.2GW of demand side response. We think the marginal asset will likely be coal-fired generation such as Eggborough or SSE's Peterhead asset pulling out. However, we think this auction is likely to be more difficult to predict than previous auctions.

UK Utilities 16 19 January 2017

3. Returns for new projects low … M&A and on-market buybacks likely New projects are not value accretive for listed utilities, given low market returns ■ Value-accretive growth sparse: UK Utilities are seeking to increase capex. But competitive tendering and specialist infra-fund capital have compressed post-tax nominal ROE to c6-9%, suggesting little value-accretion, in our view. We expect low prices for offshore wind—c£80/MWh—in the coming CfD allocation round to demonstrate this. ■ Some have 'locked in' attractive projects for three years: Some utilities have been able to move ahead of the competitive tendering and fix some attractive returns (e.g. SSE and DONG in offshore wind up until 2020). In DONG's case, it is also 'farming down' the capex to generate value. The value deployment is a question for 2019-20. ■ We expect UK utilities to resort to buybacks and M&A: We think a first step to offsetting low capex and slow growth would be to eliminate scrip dividends (which we would view as a positive). A second step would be to resort to share buybacks (we argue this is a contrarian sell indicator and IRRs in the share prices are equivalent to the c6-9%) or M&A (which carries risks of asymmetric selection). 3.1 Switch from de-leverage/balance sheet focus and back to increased investment opportunities

Figure 23: Credit ratings of the sector have improved: Only two negative outlooks S&P Moody's Our notes Energy DONG BBB+ (stable) Baa1 (negative) Sale of Race Bank (for a higher price) likely to support the balance sheet Centrica BBB+ (negative) Baa1 (stable) Working capital inflow reduces net debt to £3.9bn at Dec 16 (from £5.3bn at Dec 15) Drax BB (stable) n/a CfD and diversification into supply increases sustainability of cash flows National Grid A- (stable) Baa1 (stable) Sale of gas distribution stake improves ratios. Still tight on RCF:net debt, in our view SSE A- (negative) A3 (stable) Sale of gas distribution stake and capacity revenue improves credit ratios UK water United Utilities BBB- (positive) Baa1 (stable) Note that the regulated water company is BBB+ (positive) / A3 (stable) Severn Trent BBB- (stable) Baa1 (stable) Note that the regulated water company is BBB+ (stable) / A3 (stable) Pennon n/a n/a No public credit ratings Source: Moody's, S&P, Credit Suisse estimates

We believe the focus We think management teams are more confident about the amount of debt they carry. within companies is With the exception of Pennon—which has hybrid debt due to be refinanced in March switching back to 2018—we believe the companies have all seen a reduction in leverage, be it from asset investing from growth, sales (NG, SSE, Centrica and DONG), equity issues (Centrica), increased inflation given that expectations (SVT and UU) or improved cash flow (Centrica, SSE and Drax). balance sheets have become stronger. In line with the views from our sector outlook of 19 December 2016 (click here), we believe utilities are ready to begin to invest more capex for growth, owing to improved financial strength. This has been a theme for 6-12 months and should gain in importance. We do not argue that the large amount of debt remains a risk in the future. For example, all investment-grade companies apart from Severn Trent and UU use hybrids. Such instruments are generally c225bps more expensive than senior bonds, need to be called regularly to keep the cost down, and the market is not always liquid for new issuance4. But what we do argue is that the companies have less debt and more cash flow than in 2015.

4 One company—Pennon—makes use of a non-consolidated financing vehicle called Peninsula MB.

UK Utilities 17 19 January 2017

3.2 Competition means that post-tax nominal ROE has been bid down to c6-9% (i.e. ~cost of equity)

Figure 24: Premium to RAB of recent deals (line is Figure 25: Transaction multiples for offshore wind trailing average of past five deals), % RAB premium assets, €/MW

60% 7.0 Burbo Bank Westermost €6.6m/MW 50% 6.5 Rough (£150/MWh 6.0 €5.8m/MW CFD) 40% Sherringham Rampion Race Bank ) 5.5 London Array Shoal €5.2m/MW €6.6m/MW 30% W €4.9m/MW Gode Wind 1 M / 5.0 €4.8m/MW €4.7m/MW 20% m Lincs €

( Ormonde 4.5 Gode Wind e €4.7m/MW l €4.6m/MW

10% p Gwynt y Mor

i Rampion t 4.0 €4.8m/MW l

u €4.6m/MW €4.1m/MW

0% M … … … … 3.5 t t t r r r r r s k s y k y h n a K D s s t G t r n e e e e e i k c a e a d t t t t t i l l a i e r o U e u c l G

r a a r a i a W a

G o e w o

(10%) E r a

w 3.0 t a b W

t T d t A i

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m d t l n t 6 o t Lynn and Inner e e 7 n Barrow s e n n r G e u l n G o s s o

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t c N t N -

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a E u T - 1 u - u 3 0

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- O J v c u - e g 0 r 1 t u p 1 9 6 - J o - u t O D - c a J 0 0 A b N c - A g - 1.0 t O M e v u O c F o A Nov-13 May-14 Oct-14 Apr-15 Oct-15 Mar-16 Sep-16 Feb-17 O N

Source: Company data, Credit Suisse research, Credit Suisse estimates Source: Company data, Credit Suisse research

There is a 'returns The challenge for UK utility companies is that capital is oversupplied and returns have crunch' and we observe fallen to low levels. Whereas c10-20% post-tax nominal equity IRRs were achievable that post-tax nominal across 2008-13, we think those have now halved in recent years. We see three broad returns on equity have reasons: fallen to c6-9%. This is equivalent to levels 1. Existing assets have increased in value: We see valuations of traded assets discounted in the share generally at or above the previous peak of 2008. We note that c45-50% RAB premia prices (see next section). for regulated assets is now the norm in private transactions (Figure 24). We have also observed offshore wind farms trade for c2.1x newbuild cost (Figure 25). 2. Newbuild projects have gone to competitive tenders: The capacity auction, CfD allocation rounds, offshore transmission tenders, and competitive tendering for large projects in electricity transmission and UK water mean that discretionary new projects could be awarded competitively. 3. New entrants: Utility capex is no longer the domain of just utilities, and there are financial owners taking an interest in earlier-stage projects. Infrastructure funds—that were previously more financial owners—have extended into greenfield projects such as Thames Tideway (Dalmore, Amber, DIF and Allianz).

Figure 26: Our view of the post-tax nominal cost of equity acceptable to bidders Post-tax nominal ROE Type of asset Recent precedent transactions 6.0% Low-risk cash-flow-generative assets not subject to price controls PFI-type projects and asset sale-and-leasebacks. 7.0% Networks subject to price-cap regulation by OFGEM and OFWAT Sale of stakes in SGN at 44% RAB premium and NG GD at 48%. 8.0% Onshore wind assets, offshore wind assets with a CfD Burbo bank offshore wind project. Sale of Clyde 9.0% Offshore wind assets without an EPC and with power price risk Race Bank offshore wind project, receiving 1.8x ROC Source: Credit Suisse research, Credit Suisse estimates

We show in Figure 26 our view of what the marginal bidder is prepared to accept. We think the assets with the perceived lowest risks are prepared to accept as low as c6% post-tax nominal returns on equity. This is all consistent with c1.5% risk-free rates, c5.5% equity risk premia and c0.8-1.2x equity betas. In short, the returns have fallen to the cost of equity.

UK Utilities 18 19 January 2017

Case study: move from the Renewable Obligation to CfD allocation rounds The renewable obligation (which was anchored around c12% project-level IRRs, meaning c15-20% levered equity IRRs) was the main source of subsidy across 2000-13. Utilities were able to put forward projects (albeit many were limited by the balance sheet). The Renewable Obligation will be closed for most technologies except for certain projects due to complete by 2018. Instead, there is c£730m (real, 2011/12 money p.a. cost) available in three tenders for 15-year fixed price power contracts in the current Parliament (these are called 'Contracts for Difference'). Any new CfDs allocated outside of this (e.g. Swansea Bay tidal lagoon) will see more rigorous cost controls. Unless there is a fall in value (e.g. due to a rise in discount rates) and/or contraction in capital (e.g. if there were to be a shortage of bidders in tenders), we think there is unlikely to be an improvement in returns on offer. The returns will likely be set by the levels that marginal bidders are prepared to accept; currently the c6-9% cost of equity we see.

3.3 UK CfD allocation round to see lower prices

Figure 27: Nominal pricing for Contracts for Figure 28: Post-tax nominal project-level IRRs for Difference (real 2011/12 prices to the right), £/MWh offshore wind CfDs at different load factors, %

£220 16% 52% £150/MWh CfD (FIDeR) )

% 14%

( 48% £200 £140/MWh CfD R R

(FIDeR) I

12%

l 44% a n

£180 i

£114/MWh CfD m 10% o

(T1) n

x

£120/MWh CfD a

£160 t 8% - (T1) t s o p

l 6% £140 £105/MWh e v e

(Future tenders) l -

t 4% c e

£85/MWh j o

£120 r (Future tenders)

P 2%

£100 0%

E E E E E E E £60 £70 £80 £90 £100 £110 £120 £130 7 9 1 3 5 7 9 1 1 2 2 2 2 2 0 0 0 0 0 0 0

2 2 2 2 2 2 2 CfD strike price (£/MWh)

Source: DBEIS, Credit Suisse estimates Source: Credit Suisse estimates

The CfD allocation The next major auction for new projects is scheduled for April 2017, when there will be a rounds across summer second Contracts for Difference allocation round. The government intends to make 2017 will again see very c£290m (p.a. subsidies) available for less established technologies, which include offshore low prices, in our view. wind, advanced conversion technologies, wave and geothermal. It will be for projects We expect c£80/MWh for starting in FYmar22 and FYmar23. We believe offshore wind is by far the cheapest new offshore wind scalable technology eligible, and will take most of the pot in this round. projects. We expect the price to surprise on the downside Offshore wind now has a c£105/MWh cap on bids for FYmar22, falling to £85/MWh by 2026. But we expect the auction to clear at c£80/MWh. Projects in the Netherlands— Borssele III & IV—have cleared at c£46/MWh, and we believe that this is with a very low return, likely below c6%. We do not expect UK prices to go as low as Borssele, but returns will, in our view. There are additional costs of transmission in the UK (+c£15/MWh) and front-end engineering costs (+c£10/MWh). Some of the projects are deep and far offshore (+c£10/MWh); hence we would expect c£80/MWh if bidders take their cost of capital. This would imply c6% project-level IRRs (Figure 28). With leverage, this would barely get the owners to a c9% equity IRR. This is not enough to generate value accretion to move the shares.

UK Utilities 19 19 January 2017

We expect the auction to be oversupplied The allocation round could support up to c2.0GW of offshore wind, on our estimates, but we think the auction will nonetheless still be >c2x over-supplied. We do not know who will be bidding but looking at the planning consents and some companies' intentions, we see c4.6GW which could bid. We assume there to be up to 1.8GW from DONG (at Hornsea), 0.9GW from Statkraft (Triton Knoll), 0.8GW from SDIC (Inchcape) and 1.1GW from an EDPR-led consortium (Moray Firth). It is possible Dogger Bank (SSE, innogy, Statkraft, Statoil) bids, albeit we doubt all the owners would take it forward. We note that the CfDs were awarded by the government outside of a price-competitive framework in late-2013 at prices of £140-150/MWh, which led to c15-16% project-level IRRs for DONG. Strike prices have almost halved, and returns more than halved. We think there are seldom value-generative investment opportunities available. We note that DONG and DONG and SSE are exceptions SSE are the only Two utilities have been able to move ahead of the competitive tendering and fix some companies with attractive attractive returns: project pipelines through to 2020. ■ SSE has a c£6bn capital investment programme in FYmar17-FYmar20 (of which c£5bn is committed): This amounts to c25% of EV. Most of this is in offshore wind (where there are CfDs) or projects that have met the criteria for grace periods (onshore wind). We also note much capital investment within the regulated grids. ■ DONG has a c£7.5bn retained project pipeline to finance (c45% of EV across 2016-20): These have c15-16% CfDs awarded in early 2013, just ahead of the move to competitive tendering. As the company builds these out and farms down (i.e. sells) on stakes, it should generate value. Low returns work for DONG—in terms of asset sale prices—and not against the company. The growth projects should help cushion either company from diminishing returns and value destruction, and is a reason we have an Outperform rating on DONG and a Neutral rating on SSE. However, unless returns improve post-2020, both companies may need to change their strategies.

3.4 Acquisitions, share buybacks and ending scrip election options look increasingly likely We expect companies to Given returns are so low—and showing no signs of improvement—we expect companies resort to acquisitions to resort to options for growth that do not involve organic capital investment. We would (M&A) and on-market expect to see the companies apply the following methods, in order of priority: share buybacks. However, we would ■ Acquisitions: We expect there to be options to buy assets outside of the mainstream prefer to see an end to regulated grids and wind assets. We would not rule out companies buying in the gas scrip elections as a show and oil-production sector, where there is more variability in returns. Going abroad is of financial discipline. also possible. ■ Buying back shares: NG and SSE have both sold assets and announced share buybacks. NG also regularly buys back some of its scrip dividend in order to manage dilution and enhance the RCF:net debt credit ratio to keep the A- / Baa1 credit rating. ■ Ending scrip elections: SSE, NG, Centrica and Pennon provide for elections—on shareholders' option—which allows shareholders to take their dividend in new shares (which may be at a discount) rather than cash. We expect Centrica to be in a position to end its scrip election from late-2017. Our view is that ending scrip elections would be a positive. We have long argued that the 'free option‘ imposes a cost on shareholders who do not elect for the shares and that it is done to enhance the RCF:net ratio. At times, the shares appear to have traded on a cash yield rather than a scrip yield (see Figure 37).

UK Utilities 20 19 January 2017

Acquisitions are more difficult to generate value on—we note that Centrica destroyed some value in gas and oil, and NG achieves lower returns in its US business. Acquisitions carry asymmetric risk and a risk of overpaying for the earnings acquired, in our view. 3.5 Buy-backs a contrarian sell indicator

Figure 29: UK Utilities outperform by an average of Figure 30: … but underperform an average -c300bps +c500bps over the course of a share buy-back … in the month following the end of the buy-back …

24% 14% 20% 10% 16% 6% 12%

8% 2%

4% (2%) 0% (6%) (4%) (10%) (8%) vs. FTSE100 vs. FTSE100

NG '06 - 07 NG '07 - 08 SSE '07/08 PNN '06-08 NG '06 - 07 NG '07 - 08 SSE '07/08 Drax '07 Centrica '13 Centrica 2'14 SVT '15/16 Average Average (ex. PNN) Drax '07 Centrica '13 Centrica 2'14 SVT '15/16

Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research

We highlight our Finally, we re-cap on our view of share buy-backs, and why we view them as a contrarian research from October underperform signal for the UK Utility sector (see our note of 25 October 2016). We note 2016, where we argued that in the 1-2 years following a buy-back, shares have fallen in price an average c22% that share buy-backs are and c9% respectively. a contrarian sell indicator. All UK Utilities have bought back shares in the past 11 years, except United Utilities. All have issued back the same shares within 24 months (range 9-23 months) for an average c22% less. The sector has destroyed c£1.5bn of value in the process, on our numbers. The exception is Severn Trent, which only completed its buy-back one year ago. The stocks which currently have on-market share buy-backs are: ■ SSE: Has a plan to purchase c£500m of shares with proceeds from the sale of a c1/6th stake in Scotia Gas. The company has thus far bought back c5.6m shares (c0.5% of the share capital) at an average price of c1,461p/share, indicating c£418m is left. ■ NG: Undertakes buy-backs to offset scrip dividend dilution. Bought back c80m shares across c4 buy-back programmes at an average c862p/share. It plans to buy back another c£1bn shares with some of the proceeds from the sale of a c61% stake in UK gas distribution. Our view is that buying back stock is indicative that the companies do not have value- accretive growth options. And yet there appears to be just as low returns from buying shares as doing capex. We believe that buying back shares is an implicit acknowledgement that the companies have run out of value-accretion.

UK Utilities 21 19 January 2017

4. Valuation: Multiples lower, still not cheap Favouring stocks with commodity exposure and farm-down potential ■ Momentum in commodity-exposed stocks: Generators are experiencing EPS upgrades. There is also growth as GB capacity payments start in October 2017. Although CNA and Drax shares have reacted—we see c9% average return upside for the sector, vs. c31-32% in January 2016—we remain positive as power market conditions have improved. There is scope for Centrica to end the scrip and for a higher dividend payout at Drax. ■ Less negative on regulated utilities: Regulated utilities now appear closer to fair value. They are discounting a 6.6-7.5% cost of equity (vs. our 7.1-7.8% estimate). It is also possible for bidders to afford a premium (in mid-2016, the sector was trading on takeover valuations). However, the premia to RAB is at the highs of 2007-08, and will still be highly sensitive to interest rate movements, in our view. ■ Cash dividends and growth good indicators: Half of the sector offers scrip dividends (PNN, NG, SSE, CNA) which is dilutive. After an illustrative c25% take-up, SSE and UU have the highest cash dividends, at c4.6% and 4.5% respectively. We think Centrica is the most-likely to end the scrip—something we would applaud—and would yield c5.7% cash, and for this reason, we favour it. Pennon and National Grid have the lowest cash dividends of the regulated stocks if taking the scrip into account, and dividends that appear most at risk in 2020/21.

4.1 Earnings momentum of commodity-exposed stocks has improved. Self-help is showing through.

Figure 31: Earnings momentum of Centrica, relative Figure 32: Earnings momentum of Drax, relative to to share price performance, % share price performance, % 40% 40% 40% 40% 30% 30% 30% 30% 20% 20% 20% 20% 10% 10% 10% 10% 0% 0% 0% 0% (10%) (10%) (10%) (10%) (20%) (20%) (20%) (20%) (30%) (30%) (30%) (30%) (40%) (40%) (40%) (40%) (50%) (50%) 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 0 0 1 1 1 1 1 1 1 1 0 0 1 1 1 1 1 1 1 1 ------n n n n n n n n n n n n n n n n n n n n a a a a a a a a a a a a a a a a a a a a J J J J J J J J J J J J J J J J J J J J

Net EPS upgrades/downgrades (3M MA-LHS) Net EPS upgrades/downgrades (3M MA-LHS) CNA vs FTSE 100 return (3M MA-RHS) Drax vs FTSE 100 return (3M MA-RHS)

Source: Thomson Reuters, Credit Suisse research Source: Thomson Reuters, Credit Suisse research

Earnings momentum on Adverse impact from lower energy prices has worked through the commodity book Centrica and Drax turned To recall, the years 2014-15 saw large weaknesses in the commodity-driven businesses positive in 2016, after such as fixed-cost generation and gas and oil production. This caused the weaknesses in prolonged EPS Drax and Centrica: downgrade cycles ■ Drax: On a 2017 basis, the company lost c60% of consensus EBITDA (c£300m), and c40% of our forecast EBITDA (£150m) on lower clean dark spreads, and lower power prices, and hopes of a fourth unit conversion falling away.

UK Utilities 22 19 January 2017

■ Centrica: The company has had weaknesses in a number of businesses. However, the biggest weakness has been due to lower commodity prices. The gas and oil production business of Centrica has lost c7p/share of EPS across 2014-16 due to: (a) lower oil and gas prices; and (b) lower GB power prices, mainly on British Energy. After 2-2½ years of EPS downgrades—and underperformance versus the FTSE-100 benchmark—both Centrica and Drax are beginning to see consensus EPS upgrades (Figure 31 and Figure 32), suggesting the full impact of the falls is priced-in. Small movements from a low base provide the basis for positive surprise The very low base from We do not argue that commodity prices will recover to their highs of H1 2014. We are which generation and running c42p/therm natural gas and US$65/bbl oil and £40/MWh baseload power (e.g. hydrocarbon earnings cUS$100/bbl oil, c65p/therm winter natural gas and c£52/MWh power in 2014). In this come mean that small report, we also adopt a new—lower—natural gas price assumption. upwards movements in commodity prices have a But rather the falls have worked through hedging, with forward curves above hedged large effect on EPS costs. And a combination of lower opex and capex, running power assets in near-term markets and playing volatility will help. We also note that the GB capacity revenue—worth c£1bn p.a. for the industry—starts from October 2017. Note that we are slightly ahead of consensus for Drax and Centrica.

4.2 Premium to RAB has de-rated, but still near highs

Figure 33: Premium to combined RAB and rate base: National Grid, % Figure 34: UK Water premium to RAB, % 80% 45% 60% 35% 40% 25%

B 15%

20% A R

o 5% t

0% m

u (5%) (20%) i m e

r (15%) p

(40%) r e

t (25%) (60%) a W (35%) (80%) K U 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6

9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 (45%) ------

c c c c c c c c c c c c c c c c c c c c c c 1990 1995 2000 2005 2010 2015 e e e e e e e e e e e e e e e e e e e e e e D D D D D D D D D D D D D D D D D D D D D D AMP AMP AMP2 AMP3 AMP4 NG Premium to combined RAB/Rate base Lattice Premium to RAB Regulatory reset date UK Water RAB premium

Source: Thomson Reuters, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse estimates

Regulated utilities are UK regulated utilities went up c12% across H1 2016, and de-rated by c12% in Q4 2016. cheaper than they have The re-rating was caused by lower bond yields following the UK's decision to exit the EU, been for 2015 and 2016, while the fall was triggered by the c50bps rise in UK bond yields across the past three in our view months, triggered by the Government announcement to invoke Article 50 by the end of March 2017. The sector appears to have moved with interest rates. The spot premium to RAB for National Grid fell from c64% to c43%, and for UK water from c35% to c25%. These are lower than they have been for much of 2016, but still higher than they have been for almost all of the time since privatisation in 1989 and 1996, and around the high levels seen in the last cycle 2007.

UK Utilities 23 19 January 2017

We think bid premia are now possible We note that in summer 2016, UK regulated utilities were trading at or above takeover premia. That is to say the kind of valuations that infra funds could offer for such assets— and the leverage benefit to equity returns—were priced into the shares of listed companies (e.g. NG was trading at a c64% RAB premia, whereas Gas distribution was sold for c48%). This made it very difficult for potential infra-funds to acquire assets. We argue that the cheaper valuations of UK-listed utilities does mean there is scope for a bid premium in the case of UK water. However, bid premia would merely take the sector to where it was at points in summer 2016, in the days following the UK's referendum result to leave the EU. We are not sure shareholders would be willing to accept this. We look into this from another angle—IRRs—below.

4.3 IRRs discounted in the share prices

Figure 35: Equity IRRs discounted by different Figure 36: Synthetic FY+1 dividend yield less 10Y assets, along with the CS estimated cost of equity bond yield 5% 9% Cost of debt Market-implied cost of equity 8% instruments 7% 7.5% 7.5% 4% 3.5 % 7.1% % 6% 6.9% 8 6.7% . 7

5% - 3% 4% % 1 4.4% . 3% 7 2% 2% 1% 2.0% 1.4% 0% 1% d d d 5 n E E E E n e e 2 o d i l t t O O O O t 0 o e n n i C C C C p d d 2 b

d

u u y t e e r

s d m t e t e o o o 0% i n t y t n s e r e n c c n

i e n 0 s t o s s d u u l r d i i i i i G l l u l 1

t UK utils yield - UK 10Y treasury yield

o i e o

T u l a t e o r t D D

p c i c

d

a c S c l v n U y s s

d i m i n

r E E s t t e o i i i - n e s d e o

D (1%) D O i O y d r G D o t v d i e d

f e t i C C b i e a e r r

K r r n S b n N C E

U UK utils yield - UK 10Y treasury yield Average y y o U S 0 n H S

1 n

(2%) e G G P N N Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates Source: Thomson Reuters, Credit Suisse research

We see c6.7-7.5% equity Our favoured sense-check method for regulated utilities is for the equity IRRs discounted IRRs being discounted in (Figure 35). We calculate this by backing out the cost of equity from our sum of the parts, the share prices, versus and benchmarking against a dividend discount model to increase accuracy. It allows us to our estimate of a compare some of the debt returns with equity returns. On this basis, the sector appears to c7.1-7.8% cost of equity be less expensive. We note in absolute and relative terms the following: ■ On an absolute basis, +c150bps versus where it was 6 months ago: In the aftermath of the Brexit referendum, we estimate that the cost of equity was 5.8-6.5%. It is now c150bps higher on a like-for-like basis. ■ On a relative basis, +c100bps relative to bonds: The cost of equity is now +c240- 350bps versus some of the yields to first call on the hybrid bonds on National Grid. This is a risk premium for losing the equity buffer. The buffer was as low as 160- 230bps, but is now higher. This level of the equity return priced-in is still only the levels of early 2015. And the risk premia is still small, given our view that regulated utilities are businesses exposed to risk. We still see a strong risk that the shares continue to move with interest rates. A rise in bond yields from the current levels (e.g. GBP 10yr at 1.4%) is not priced-in, in our view.

UK Utilities 24 19 January 2017

Dividend yield relative to bond yield We note that there is a large spread between the dividend yield and the 10-year bond yield. The level is c3.6% above the 10-year, and it has been c2.5-4% across the past four years. Hence the spread looks slightly attractive, consistent with the fact equity returns have risen more than the 10-year (as stated above). However, as we mentioned earlier, rises and falls in rates will remain a key driver for regulated utilities.

4.4 Dividend yield

Figure 37: FYdec17E Dividend Yield (FYmar18E) on a cash basis using Credit Suisse estimates. Boxed areas are the 25% assumed SCRIP take-ups, % 7%

6% 1.5% 5% 1.4%

4% 1.2% 1.2%

3% 3.8% 4.2% 4.5% 4.6% 3.6% 5.2% 4.3% 4.5% 2% 2.9% 3.6%

1%

0% t ) y x s 0 + + + U l n

i P a g 0 ) t I r e r ) h h h U ) 1 r P s s s e U

R P I D P

T I I a a a n

E C R U R R E n C C C S S

r ( ( ( C E

C

C

T e I S G + S E

F S

N v G

C N h e S N N S s O S S P a M D C (

A N C

Note: We arbitrarily assume c25% scrip take-up. This is the approximate average across the sector. The data showing how this varies over time can be provided to interested clients. Source: The BLOOMBERG PROFESSIONAL™ service consensus for FTSE 100 and MSCI EU Utils; Credit Suisse estimates for all others

Finally, we look to dividend yield, both before and after the scrip dividend. Adjusting for scrip dividends SSE and UU have the Pennon, National Grid, Centrica and SSE have scrip dividends. Shareholders can elect to highest cash dividends receive their dividend in new shares. We see this as dilutive, and we show in Figure 37 (i.e. after scrip). Ending potential dividend yields for all the regulated stocks. the scrip election option would be a large positive, The reference price is usually set when the shares are weak (just after going ex-div) and but we think only there is a >2 week election period, hence more often than not, there is a benefit of getting Centrica will be in a shares rather than cash (which averages +3% in value terms). The option is offered by the position to do so. companies to enhance credit ratios, and we think it shows rating agencies that management teams are prepared to protect debt at the expense of equity. Our long-standing view is that a scrip dividend is dilutive and if all shareholders do it in the same proportion, it becomes a bonus issue with a dividend cut. We make the following observations: 1. Of the pure-play regulated stocks (PNN, UU, SVT and NG), UU has the highest dividend yield after adjusting for the scrip dividend. 2. Of the regulated stocks, Pennon has the lowest dividend yield after adjusting for the scrip dividend. NG is not far behind, albeit we note NG undertakes share buy-backs to partly offset the dilution.

UK Utilities 25 19 January 2017

3. Of all stocks, SSE has the highest dividend yield in notional terms, and also with the scrip. However, the scrip is needed to fund the growth pipeline. 4. If Centrica can stop the scrip dividend, then it would have the highest cash yield in the sector. Conclusion 1: SSE, followed by UU, have the highest cash dividends ■ We estimate that SSE has a c4.6% dividend, after adjusting for the scrip dividend. We estimate that UU has c4.5%. This is slightly better than the FTSE100, but less than the MSCI EU Utils sector headline number based on consensus. ■ We discuss in the Centrica company section how the business has substantially de- levered (CS est. c£3.2bn net debt by December 2017, from c£5.3bn at December 2015). We believe the company has capacity for c£3.5-3.8bn of net debt. We think Centrica management may choose to take the decision to end the scrip, if not for the FYdec17 interim, then for the FYdec18 final.

Conclusion 2: Drax and DONG are the only stocks with material DPS growth that we think is sustainable ■ We view DONG as the stock with high growth and no scrip: DONG has said that it intends to pay out DKK 2.5bn (CS est. DKK 6/share) and aspires to grow the dividend by high single-digits. We assume c10%, given multiples achieved on the farm-downs. After taking the scrip element out of other stocks, DONG would have a dividend in-line with the sector within five years. ■ We believe Drax is due a large step-up: We expect Drax to release their new dividend policy at results on 16 February. The company has the CfD and a more diversified earnings stream. We think it possible that Drax pays out a dividend as a function of free cash flow, rather than as a function of EPS (e.g. currently c50% of EPS). Note that Pennon has a policy of growing the dividend by RPI+4% until March 2020, albeit we think this will be most at risk in 2020. UU, Severn Trent, NG and SSE have DPS growth policies of a minimum of UK RPI, and in practice grow by just RPI. Centrica has a policy of growing by c3-5%, and we assume c4% (versus long-term RPI at c3.2%).

UK Utilities 26 19 January 2017

Figure 38: Our commodity price estimates (New vs Old) 2016A 2017E 2018E 2019E 2020E NBP gas (pence/therm) New 33.6 43.4 41.6 41.9 41.9 Old 33.6 39.9 50.8 52.9 53.8 Diff (%) 0% 9% (18%) (21%) (22%)

Baseload power (£/MWh) New 40.9 47.2 44.8 44.7 43.8 Old 40.9 39.3 44.4 45.8 46.4 Diff (%) 0% 20% 1% (2%) (6%)

Brent Crude (US$/bbl) New 44.0 56.3 65.0 65.0 65.0 Old 44.0 56.3 67.5 67.5 70.0 Diff (%) 0% 0% (4%) (4%) (7%)

Henry Hub (US$/mmbtu) New 2.4 3.3 3.5 3.5 3.5 Old 2.4 3.3 3.5 3.5 3.5 Diff (%) 0% 0% 0% 0% 0%

Thermal coal ($/tn) New 57.2 74.0 70.0 60.0 50.0 Old 57.2 50.0 50.0 50.0 50.0 Diff (%) 0% 48% 40% 20% 0%

GBP:USD FX New 1.32 1.22 1.22 1.22 1.22 Old 1.32 1.22 1.22 1.22 1.22 Diff (%) 0% 0% 0% 0% 0%

GBP:EUR FX New 1.22 1.16 1.16 1.16 1.16 Old 1.22 1.16 1.16 1.16 1.16 Diff (%) 0% 0% 0% 0% 0% Source: The BLOOMBERG PROFESSIONAL™ service, Credit Suisse estimates

UK Utilities 27 19 January 2017

Our recent research Pennon: Energy-from-waste risks materialising (33 Pages, 17 Jan 2017)

DONG Energy: Profit alert flags high value of offshore wind (15 pages, 22 Dec 2016)

European Utilities - 2017 Outlook: Brave new world (55 pages, 19 Dec 2016

Drax: Balance sheet use more than value accretion (17 Pages, 7 Dec 2016)

GB Power: T-4 2020/21 capacity auction preview (17 Pages, 6 Dec 2016)

UK Utilities: Independent supplier ceases trading (11 Pages, 28 Nov 2016)

DONG Energy: Investor feedback: What are you saying? (21 Pages, 17 Nov 2016)

National Grid: We focus on the business and not bond yields (13 Pages, 11 Nov 2016)

SSE: Improvements in the operating environment (6 Pages, 9 Nov 2016)

UK Utilities: Share buy-backs as a contrarian signal (18 pages, 25 Oct 2016)

UK Utilities 28 19 January 2017

Europe/Denmark Electric Utilities

DONG Energy A/S (DENERG.CO) Rating OUTPERFORM [V] Price (12 Jan 17, Dkr) 259.40 Target price (Dkr) (from 315.00) 310.00 Market Cap (Dkr m) 109,046.9 Build-out and farm-down of wind transforms Enterprise value (Dkr m) 151,844.0 Target price is for 12 months. DONG [V] = Stock Considered Volatile (see Disclosure Appendix) ■ Remain Outperform: Low returns in recent tenders indicate an increased Research Analysts value for DONG's existing project pipeline. The company has c50% stakes in Mark Freshney four projects which we think can generate DKK20bn profit (cDKK 47/share). 44 20 7888 0887 We reduce our EPS by c3% in 2017E and c2% in 2018E, reflecting our new [email protected] commodity price assumptions of US$65/bbl oil (from US$70/bbl) and c42p/therm natural gas (from 54p). Our sum-of-the-parts-based TP falls to DKK310 (from DKK315). ■ Investment overview: (1) Turning high-returning CfDs (c31% of EV) into value: DONG has three offshore wind Contracts for Difference with the UK government which generate c15-16% post-tax nominal project-level returns (vs. c6.1% WACC). These are the highest risk-adjusted returns in the sector, and will grow EBITDA from offshore wind by c70% across 2016-20; (2) Returns and cash flow generation to 2020: DONG's policy is to farm-down (i.e. divest) c50% stakes in offshore wind assets to partners. This generates up-front cash flows through profits on disposal and construction gains to help fund DONG's own retained stakes. We expect to see very high multiples; and (3) Oil and Gas at optimum point in profits cycle: DONG has c13% of EV in North Sea gas and oil production. Capex has been cut, tax rates have fallen and opex efficiencies are coming through, all at a time that oil prices have recovered to US$58/bbl. DONG has looked at divesting the business, and there could be upside to our cDKK19bn (cDKK44/share) EV valuation. ■ Risks: The key risk is that DONG does not remain disciplined and wins tenders on sub-WACC returns. A weaker GBPEUR is also a risk. ■ Catalysts: 2016E results and the investor day on 2 Feb. Returns in tenders for new projects have gone to low levels recently (e.g. c6%, or WACC) hence we do not value post-2020 projects. We expect the Walney farm-down in H1. ■ Valuation: On our forecasts, DONG trades on c8.3x 2017E EV/EBITDA, excluding the development business. We think it should trade on 9.6x. DONG has a c14% equity free cash-flow yield from 2020, when the current pipeline is due to be completed. Share price performance Financial and valuation metrics

2 9 0 Year 12/15A 12/16E 12/17E 12/18E Revenue (Dkr m) 70,850.2 66,119.9 65,257.5 72,963.7 2 7 0 EBITDA (Dkr m) 18,484.0 24,470.8 21,954.9 23,635.7 2 5 0 Adjusted net income (Dkr m) -12,829.00 12,444.23 8,570.85 9,806.74 2 3 0 CS EPS (adj.) (Dkr) -30.71 29.70 20.40 23.34 2 1 0 Prev. EPS (Dkr) - 29.71 20.98 23.89 Ju l- 1 6 Sep - 1 6 N o v- 1 6 Jan - 1 7 ROIC (%) -15.4 21.1 13.8 12.7 P/E (adj.) (x) -8.4 8.7 12.7 11.1 D EN ERG.CO O M XC 2 0 P/E rel. (%) -41.2 47.5 76.7 75.1 The price relative chart measures performance against the EV/EBITDA (x) 8.6 6.2 7.3 7.2

OMXC 20 which closed at 883.8 on 12/01/17 Dividend (12/16E, Dkr) 6.00 Net debt/equity (12/16E,%) 33.3 On 12/01/17 the spot exchange rate was Dkr7.43/Eu 1.- Dividend yield (12/16E,%) 2.3 Net debt (12/16E, Dkr m) 15,807.0 Eu.94/US$1 BV/share (12/16E, Dkr) 97.9 IC (12/16E, Dkr m) 63,264.2 Performance 1M 3M 12M Free float (%) 19.9 EV/IC (12/16E, (x) 2.4 Absolute (%) 6.7 -1.1 Source: Company data, Thomson Reuters, Credit Suisse estimates Relative (%) 3.9 -1.6

UK Utilities 29 19 January 2017

DONG Energy A/S (DENERG.CO) Price (12 Jan 2017): Dkr259.4; Rating: OUTPERFORM [V]; Target Price: (from Dkr315.00) Dkr310.00; Analyst: Mark Freshney Income statement (Dkr m) 12/15A 12/16E 12/17E 12/18E Company Background Revenue 70,850 66,120 65,258 72,964 DONG Energy is a developer, builder, owner of offshore wind farms, EBITDA 18,484 24,471 21,955 23,636 mainly in the UK but also globally. There is a Danish-UK-Norwegian Depr. & amort. (8,701) (7,274) (7,668) (7,773) oil and gas production segment and Danish regulated distribution EBIT (7,250) 17,947 14,287 15,862 and sales businesses, as well as thermal generation. Net interest exp. (1,450) (1,571) (1,510) (1,632) Associates (8) (10) (10) (10) Blue/Grey Sky Scenario PBT (9,367) 17,680 12,766 14,220 Income taxes (2,717) (4,509) (3,469) (3,686) Profit after tax (12,084) 13,171 9,298 10,534 Minorities (31) (75) (75) (75) Preferred dividends (714) (652) (652) (652) Associates & other (1,428) (1,304) (1,304) (1,304) Net profit (12,829) 12,444 8,571 9,807 Other NPAT adjustments 0 0 0 0 Reported net income (12,829) 12,444 8,571 9,807 Cash flow (Dkr m) 12/15A 12/16E 12/17E 12/18E EBIT (7,250) 17,947 14,287 15,862 Net interest (659) (921) (860) (982) Cash taxes paid (5,091) (4,470) (5,239) (4,849) Change in working capital 1,318 0 0 0 Other cash and non-cash items 25,132 5,454 5,152 7,273 Cash flow from operations 13,450 18,010 13,339 17,305 CAPEX (18,739) (18,087) (20,908) (26,098) Free cashflow to the firm (5,289) 13,910 10,489 14,455 Acquisitions - - - - Divestments 2,605 6,696 2,888 1,725 Other investment/(outflows) 16,948 18,727 13,359 17,325 Cash flow from investments 814 7,336 (4,662) (7,048) Net share issue/(repurchase) 0 0 0 0 Dividends paid 0 0 (2,506) (2,775) Issuance (retirement) of debt - - - - Our Blue Sky Scenario (Dkr) 375.00 Cashflow from financing (1,495) (702) (3,208) (3,477) Brent crude oil at US$80/bbl. TTF natural gas at €20/MWh. Changes in net cash/debt (5,227) 6,634 (7,870) (10,525) Recurring 700MW p.a. of projects across 2020-30 with c20% value- accretion / premium on farm-down. No LNG losses Net debt at start 17,214 22,441 15,807 23,677 Change in net debt 5,227 (6,634) 7,870 10,525 Our Grey Sky Scenario (Dkr) 230.00 Net debt at end 22,441 15,807 23,677 34,202 Brent crude oil at US$30/bbl. TTF natural gas at €10/MWh. No Balance sheet (Dkr m) 12/15A 12/16E 12/17E 12/18E further cost-cutting in the upstream gas and oil business. Only c20% Assets value-accretion on remaining UK projects. No accretion on any Total current assets 14,323 9,371 7,371 6,760 further products post-2020. Nordpool power falls to €18/MWh. Total assets 98,881 101,533 109,855 125,814 Liabilities Share price performance Total current liabilities 10,457 10,271 11,227 9,880 Total liabilities 60,393 54,075 58,309 67,822 Total equity and liabilities 98,881 101,533 109,855 125,814 290 Per share 12/15A 12/16E 12/17E 12/18E 270 No. of shares (wtd avg.) (mn) 418 419 420 420 CS EPS (adj.) (Dkr) (30.71) 29.70 20.40 23.34 250 Dividend (Dkr) 0.00 6.00 6.60 7.26 Free cash flow per share (Dkr) (12.66) 33.20 24.97 34.40 230

Key ratios and valuation 12/15A 12/16E 12/17E 12/18E 210 Growth/Margin (%) Jul- 16 Sep- 16 Nov- 16 Jan- 17 Sales growth (%) 2.8 (6.7) (1.3) 11.8 EBIT growth (%) (516.0) 347.5 (20.4) 11.0 Net income growth (%) (115.6) 197.0 (31.1) 14.4 DENERG.CO OMXC 20 EPS growth (%) (106.7) 196.7 (31.3) 14.4 EBITDA margin (%) 26.1 37.0 33.6 32.4 The price relative chart measures performance against the OMXC 20 which EBIT margin (%) (10.2) 27.1 21.9 21.7 closed at 883.8 on 12/01/17 Pretax profit margin (%) (13.2) 26.7 19.6 19.5 On 12/01/17 the spot exchange rate was Dkr7.43/Eu 1.- Eu.94/US$1 Net income margin (%) (18.1) 18.8 13.1 13.4 Valuation 12/15A 12/16E 12/17E 12/18E EV/Sales (x) 2.3 2.3 2.5 2.3 EV/EBITDA (x) 8.6 6.2 7.3 7.2 EV/EBIT (x) (22.0) 8.5 11.2 10.8 Dividend yield (%) 0.00 2.31 2.54 2.80 P/E (x) (8.4) 8.7 12.7 11.1 Credit ratios (%) 12/15A 12/16E 12/17E 12/18E Net debt/equity (%) 58.3 33.3 45.9 59.0 Net debt to EBITDA (x) 1.2 0.6 1.1 1.4 Interest coverage ratio (x) (5.0) 11.4 9.5 9.7 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 30 19 January 2017

Europe/United Kingdom Water Utilities

United Utilities (UU.L) Rating (from NEUTRAL) OUTPERFORM Price (12 Jan 17, p) 896.00 Target price (p) (from 990.00) 1000.00 Market Cap (£ m) 6,109.8 Risk-reward now looks compelling Enterprise value (£ m) 12,852.6 Target price is for 12 months. ■ Upgrade to Outperform: UU was the worst performing pure-play UK regulated utility in 2016, underperforming SVT and NG by c6% on a total Research Analysts returns basis. We increase our TP to 1,000p/share (from 990p) on a valuation Guy MacKenzie, CFA roll-forward to 2018E, indicating c16% total return upside potential. 44 20 7883 9534 [email protected] ■ Investment overview: (1) Dividend sustainability: UU has the strongest Mark Freshney balance sheet amongst UK Water stocks with an FFO/debt of c11-12% over 44 20 7888 0887 2017-20E (vs SVT at c10%) and is the only UK utility on positive outlook with [email protected] S&P. We think these factors mitigate medium-term downside risk to UU's Marcelo Preto dividend, even in the face of a challenging 2020 regulatory settlement. UU 44 207 888 0873 [email protected] also offers the most attractive cash dividend yield amongst UK regulated peers; (2) Financing benefit is still key: UU outperforms its regulatory settlement on financing costs, with an embedded cost of debt of 3.5%, which supported c110bp of outperformance on equity returns in FY16, on our numbers. OFWAT's proposals on sharing financing outperformance beyond 2020E look benign. We add that UU's index-linked debt masks the benefit of higher RPI inflation, given the two-year lagged impact on EPS; (3) Growth discount more-than priced-in: UU has the lowest regulated asset base growth amongst listed peers over 2015-20E at c40bp p.a. real (vs. SVT at c1.6% and SWW at c45bp). But it is at a c4% EV premium to its 2020E RAB, after adjusting for dividends (SVT at c11%, and SWW at c18%). We do not see relative growth over 2015-20 as indicative of potential beyond 2020E. ■ Risks: We see adverse regulatory changes from 2020E as the main risk, with scope for higher bond yields the most important near-term risk factor. ■ Catalysts: UU reports its pre-close trading update March 22nd ahead of full- year results May 26th. OFWAT will publish a methodology consultation on the 2019 price control review in July 2017. ■ Valuation: UU trades at a c20% premium to its FYmar18E RAB. This is a discount to SVT at c29% and PNN at c44%. The dividend yield is c4.4%, growing in-line with RPI inflation to 2020E. The stock discounts a cost of equity of c7.6%. Share price performance Financial and valuation metrics

1 ,1 0 0 Year 3/16A 3/17E 3/18E 3/19E EBITDA (£ m) 931.6 979.8 1,021.3 1,083.5 1 ,0 0 0 EBIT (£ m) 604 603 632 684 Pre-tax profit adjusted (£ m) 353.50 368.30 382.65 424.54 9 0 0 CS EPS (adj.) (p) 47.70 43.37 45.77 51.37 8 0 0 Prev. EPS (p) - 44.65 45.85 52.36 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 38.45 38.85 39.69 40.90 P/E (adj.) (x) 18.8 20.7 19.6 17.4 UU.L FT SE A LL SH A RE IN D EX Dividend yield (%) 4.3 4.3 4.4 4.6 The price relative chart measures performance against the Dividend cover (x) 1.2 1.1 1.2 1.3 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 7.3 7.2 7.1 6.8

12/01/17 Free float (%) 100.0 Number of shares (m) 681.9 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) 1.1 -6.3 -2.2 Relative (%) -3.3 -10.7 -26.2

UK Utilities 31 19 January 2017

United Utilities (UU.L) Price (12 Jan 2017): 896.00p; Rating: (from NEUTRAL) OUTPERFORM; Target Price: (from 990.00p) 1000.00p; Analyst: Guy MacKenzie Income statement (£ m) 3/16A 3/17E 3/18E 3/19E Company Background Revenue 1,730 1,707 1,745 1,809 United Utilities Group PLC , formerly United Utilities PLC, is EBITDA 932 980 1,021 1,084 engaged in water business. It owns & manages the regulated water Depr. & amort. (364) (377) (389) (399) & wastewater network in the North West of England, through its EBIT 604 603 632 684 subsidiary United Utilities Water PLC (UUW). Net interest exp. (219) (240) (260) (271) Associates 5 5 11 11 Blue/Grey Sky Scenario PBT 354 368 383 425 Income taxes 44 (17) (71) (74) Profit after tax 398 352 312 350 Minorities - - - - Preferred dividends - - - - Associates & other (72) (56) 0 0 Net profit 325 296 312 350 Other NPAT adjustments 72 56 0 0 Reported net income 398 352 312 350 Cash flow (£ m) 3/16A 3/17E 3/18E 3/19E EBIT 604 603 632 684 Net interest (219) (240) (260) (271) Cash taxes paid - - - - Change in working capital 8 0 0 0 Other cash and non-cash items 254 288 302 306 Cash flow from operations 647 652 674 719 CAPEX (648) (630) (590) (500) Free cashflow to the firm (1) 22 84 219 Acquisitions - - - - Divestments 0 0 0 0 Other investment/(outflows) (31) (31) (31) (31) Cash flow from investments (678) (661) (621) (531) Net share issue/(repurchase) 0 0 0 0 Dividends paid (259) (263) (267) (273) Issuance (retirement) of debt - - - - Our Blue Sky Scenario (p) (from 1350.00) Cashflow from financing (259) (263) (267) (273) 1300.00 Changes in net cash/debt (363) (272) (214) (86) Our blue sky scenario is that UU is bought out at a c45% premium to RAB (the high end of recent transaction multiples), following Net debt at start 6,401 6,764 7,037 7,251 National Grid's gas distribution sale. This would suggest Change in net debt 363 272 214 86 1,300p/share. Net debt at end 6,764 7,037 7,251 7,336 Balance sheet (£ m) 3/16A 3/17E 3/18E 3/19E Our Grey Sky Scenario (p) 680.00 Assets Our grey sky scenario assumes a sharp cut to returns combined Total current assets 668 668 668 668 with a sharp rise in interest rates to the point where UU does not Total assets 11,907 12,233 12,513 12,695 earn a spread over its cost of capital. The valuation assumes par to Liabilities RAB (i.e. a 0% RAB premium), suggesting 680p/share. Total current liabilities 538 542 542 540 Total liabilities 9,201 9,439 9,674 9,778 Share price performance Total equity and liabilities 11,907 12,233 12,513 12,695

Per share 3/16A 3/17E 3/18E 3/19E 1,100 No. of shares (wtd avg.) (mn) 682 682 682 682 CS EPS (adj.) (p) 47.70 43.37 45.77 51.37 Dividend (p) 38.45 38.85 39.69 40.90 1,000 Free cash flow per share (p) (0.12) 3.20 12.32 32.12 Key ratios and valuation 3/16A 3/17E 3/18E 3/19E 900 Growth/Margin (%) Sales growth (%) 0.6 (1.4) 2.3 3.7 800 EBIT growth (%) (9.1) (0.2) 4.9 8.2 Jan- 15 Jul- 15 Jan- 16 Jul- 16 Jan- 17 Net income growth (%) (8.1) (9.1) 5.5 12.2 EPS growth (%) (6.9) (8.3) 5.0 11.1 EBITDA margin (%) 53.8 57.4 58.5 59.9 UU.L FTSE ALL SHARE INDEX EBIT margin (%) 34.9 35.3 36.2 37.8 Pretax profit margin (%) 20.4 21.6 21.9 23.5 The price relative chart measures performance against the FTSE ALL SHARE Net income margin (%) 18.8 17.3 17.9 19.4 INDEX which closed at 3949.0 on 12/01/17 Valuation 3/16A 3/17E 3/18E 3/19E On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/Sales (x) 7.3 7.5 7.5 7.2 EV/EBITDA (x) 13.5 13.1 12.8 12.1 EV/EBIT (x) 20.9 21.3 20.6 19.1 Dividend yield (%) 4.29 4.34 4.43 4.57 P/E (x) 18.8 20.7 19.6 17.4 Credit ratios (%) 3/16A 3/17E 3/18E 3/19E Net debt/equity (%) 250.0 251.8 255.4 251.6 Net debt to EBITDA (x) 7.3 7.2 7.1 6.8 Interest coverage ratio (x) 2.8 2.5 2.4 2.5 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 32 19 January 2017

Europe/United Kingdom Gas Utilities

Centrica (CNA.L) Rating OUTPERFORM Price (12 Jan 17, p) 227.00 Target price (p) (from 270.00) 255.00 Market Cap (£ m) 12,459.0 Cyclical upswing now showing through Enterprise value (£ m) 20,070.3 Target price is for 12 months. ■ Remain Outperform: Cost-cutting and a commodity price tailwind is helping Centrica. We lower our TP to 255p/share (from 270p) to reflect our lower gas Research Analysts price forecasts (c42p, therm versus 54p previously). But we believe that the Mark Freshney business has potential to surprise positively (we forecast 17.8p EPS in 17E, 44 20 7888 0887 [email protected] vs. Bloomberg consensus of c16.3p). Our long-term estimates fall on a lower Guy MacKenzie, CFA oil price (US$65/bbl, from US$70/bbl) and gas price (42p/th, from 54p/th). 44 20 7883 9534 ■ Investment overview: (1) Hedging in-the-money: For the first time since [email protected] H1 2014, net forward purchases of gas and electricity are at lower prices than in the forwards market, thus making British Gas more competitive and providing a tailwind for the upstream. We estimate mark-to-market EPS of c20p/share. (2) Oil and Gas production at the best point in the profits cycle: We forecast c25% lower cash production costs and c60% lower capex, with volumes down only c10%. While our base case is not for large commodity price increases, the operational gearing works positively for Centrica. (3) Improving cash flow generation: The c£0.7bn working capital outflows of 2015 and have reversed. Adjusted operating cash flow should be c£2.5bn for each of 2016 and 2017 (vs. c2.25bn in 2015A). We estimate the RCF:net debt ratio will reach c38% in 2018E (>c25% for Baa1). We think it is possible Centrica ends the scrip dividend from 2018 onwards. ■ Risks: We expect a c10% electricity-only price rise announcement by April. While recent political comment has abated, we would not rule out further concern, albeit tariff differentials have narrowed. ■ Catalysts: The capacity auction for the Oct 2017-Sept 2018 year starts on 31 Jan. FYdec16 results are due on 23 Feb. There will be two investor days in H1 2017 focused on the downstream, planned for 11 May and 21 June. ■ Valuation: We estimate that the stock trades on a 2017E P/E of 12.7x, versus the pan-Euro sector on 13.5x. We forecast c4% DPS growth for 2016E (to c12.5p, which means c5.7% 2017E dividend yield). Share price performance Financial and valuation metrics Year 12/15A 12/16E 12/17E 12/18E 3 0 0 EBITDA (£ m) 2,359.7 2,344.2 2,542.5 2,749.7 EBIT (£ m) 1,397 1,486 1,634 1,919 2 5 0 Pre-tax profit adjusted (£ m) 1,118.48 1,184.23 1,337.00 1,639.51 2 0 0 CS EPS (adj.) (p) 17.22 16.74 17.83 21.55 Prev. EPS (p) - 15.11 15.61 21.01 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 12.00 12.48 12.97 13.49 P/E (adj.) (x) 13.2 13.6 12.7 10.5 CN A .L FT SE A LL SH A RE IN D EX Dividend yield (%) 5.3 5.5 5.7 5.9 The price relative chart measures performance against the Dividend cover (x) 1.4 1.3 1.4 1.6 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 2.3 1.7 1.3 1.0

12/01/17 Free float (%) 100.0 Number of shares (m) 5,488.5 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) -0.5 4.7 9.4 Relative (%) -3.5 1.9 -11.9

UK Utilities 33 19 January 2017

Centrica (CNA.L) Price (12 Jan 2017): 227.00p; Rating: OUTPERFORM; Target Price: (from 270.00p) 255.00p; Analyst: Mark Freshney Income statement (£ m) 12/15A 12/16E 12/17E 12/18E Company Background Revenue 27,971 28,852 30,334 31,186 Centrica plc is an integrated energy company operating EBITDA 2,360 2,344 2,542 2,750 predominately in United Kingdom and North America. In the United Depr. & amort. (1,103) (959) (976) (938) Kingdom, it operates in two key areas: upstream and downstream. EBIT 1,397 1,486 1,634 1,919 Its upstream assets include c75mmboe of gas and oil production. Net interest exp. (277) (292) (287) (270) Associates 141 100 67 107 Blue/Grey Sky Scenario PBT 1,118 1,184 1,337 1,640 Income taxes (286) (296) (351) (422) Profit after tax 833 888 986 1,218 Minorities 30 10 (0) (8) Preferred dividends - - - - Associates & other 0 0 0 (0) Net profit 863 898 985 1,209 Other NPAT adjustments 0 (67) (100) (100) Reported net income 863 831 885 1,109 Cash flow (£ m) 12/15A 12/16E 12/17E 12/18E EBIT 1,397 1,486 1,634 1,919 Net interest (273) (292) (287) (270) Cash taxes paid (349) (341) (331) (417) Change in working capital 303 672 5 (16) Other cash and non-cash items 1,009 989 929 924 Cash flow from operations 2,088 2,515 1,950 2,140 CAPEX (970) (815) (749) (896) Free cashflow to the firm 1,118 1,766 1,309 1,399 Acquisitions (79) (349) 0 0 Divestments 207 48 220 0 Other investment/(outflows) 876 631 565 712 Cash flow from investments 34 (485) 36 (184) Net share issue/(repurchase) 272 837 174 184 Dividends paid (598) (654) (695) (734) Issuance (retirement) of debt - - - - Our Blue Sky Scenario (p) 300.00 Cashflow from financing (295) 193 (522) (559) US$75/bbl oil and 60p/therm European natural gas, with some cost Changes in net cash/debt 727 1,408 715 501 inflation offsetting the commodity price rises in the upstream. £50/MWh power in British Energy. British Gas Residential continues Net debt at start 6,091 5,364 3,956 3,241 to earn a c7% GB domestic supply margin. Return to small profits at Change in net debt (727) (1,408) (715) (501) the Rough gas storage facility. Net debt at end 5,364 3,956 3,241 2,740 Balance sheet (£ m) 12/15A 12/16E 12/17E 12/18E Our Grey Sky Scenario (p) 162.00 Assets US$25/bbl oil and 25p/therm European natural gas, with cost-cutting Total current assets 7,233 6,983 7,323 7,550 to help keep the business cash-flow neutral. £35/MWh power, Total assets 18,847 18,744 18,663 18,862 ongoing low clean spark spreads and c4% GB domestic supply Liabilities margins. No profits from Rough gas storage. Total current liabilities 7,754 7,827 8,109 8,243 Total liabilities 17,505 16,388 15,943 15,584 Share price performance Total equity and liabilities 18,847 18,744 18,663 18,862 Per share 12/15A 12/16E 12/17E 12/18E No. of shares (wtd avg.) (mn) 5,012 5,363 5,526 5,610 300 CS EPS (adj.) (p) 17.22 16.74 17.83 21.55 275 Dividend (p) 12.00 12.48 12.97 13.49 Free cash flow per share (p) 22.30 32.94 23.70 24.94 250 Key ratios and valuation 12/15A 12/16E 12/17E 12/18E 225 Growth/Margin (%) 200 Sales growth (%) (3.8) 3.1 5.1 2.8 EBIT growth (%) (10.9) 6.3 9.9 17.5 Net income growth (%) (4.5) 4.0 9.7 22.7 Jan- 15 May- 15 Sep- 15 Jan- 16 May- 16 Sep- 16 Jan- 17 EPS growth (%) (4.3) (2.8) 6.5 20.9 EBITDA margin (%) 8.4 8.1 8.4 8.8 CNA.L FTSE ALL SHARE INDEX EBIT margin (%) 5.0 5.2 5.4 6.2 Pretax profit margin (%) 4.0 4.1 4.4 5.3 The price relative chart measures performance against the FTSE ALL SHARE Net income margin (%) 3.1 3.1 3.2 3.9 INDEX which closed at 3949.0 on 12/01/17 Valuation 12/15A 12/16E 12/17E 12/18E On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/Sales (x) 0.8 0.7 0.6 0.6 EV/EBITDA (x) 9.1 8.6 7.6 6.8 EV/EBIT (x) 15.4 13.5 11.8 9.8 Dividend yield (%) 5.28 5.50 5.72 5.94 P/E (x) 13.2 13.6 12.7 10.5 Credit ratios (%) 12/15A 12/16E 12/17E 12/18E Net debt/equity (%) 399.7 167.9 119.2 83.6 Net debt to EBITDA (x) 2.3 1.7 1.3 1.0 Interest coverage ratio (x) 5.0 5.1 5.7 7.1 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 34 19 January 2017

Europe/United Kingdom Electric Utilities

Drax (DRX.L) Rating OUTPERFORM [V] Price (12 Jan 17, p) 381.00 Target price (p) 425.00 Market Cap (£ m) 1,549.5 Start of a new era; macro working in Drax's Enterprise value (£ m) 1,682.2 Target price is for 12 months. favour [V] = Stock Considered Volatile (see Disclosure Appendix) ■ Raising EBITDA: Drax now has EC state aid approval on the c£100/MWh Research Analysts CfD, so for the first time in 3½ years, it is able to communicate on strategy Mark Freshney and distribution policy. We increase our 2017E EBITDA by c29% for the 44 20 7888 0887 [email protected] acquisition of Opus (debt-financed) and also higher near-term power prices, Guy MacKenzie, CFA taking us c6% ahead of consensus in 2017E. We remain Outperform as we 44 20 7883 9534 see positive power market conditions, strong FCF and immediate catalysts. [email protected] ■ Investment overview: (1) Power price working in its favour: For the first time in 2½ years, GB power prices are above the levels where Drax has hedged (forwards are c£49/MWh for the rest of 2016, vs a c£45/MWh hedged price). This means Drax can begin to grow earnings. Scarcity pricing and increased volatility—as seen in Q4 2016—should also work in Drax's favour; (2) Dividend potential: After 7 years of waiting for the biomass investments, Drax is able to communicate a new dividend policy. Our base case is for a c100% Net Income payout to be applied from 2016 (before adjustments on the Opus acquisition). This would place Drax on a 2017E yield of 4.6%, rising to c6.5% in 2017E. Only EDP pays a higher dividend yield; (3) Drax now more physically balanced: Drax has c24.5TWh of supply (over Haven, Opus and the CfD) versus c21TWh of production, which should bring synergies and further working capital benefit. We would not be surprised to see Drax raise prices to industrials (in Haven) to turn the industrials to a profit (0.5% margins) at the expensive of volume. ■ Risks: A weaker natural gas price—perhaps due to cheap US LNG—is the key risk facing the shares. We would not rule out further acquisitions (e.g. of pelletisation plants in North America, or CCGTs) and assets are not cheap. ■ Catalysts: The GB 2017/18 extra capacity auction starts on 31 Jan., and we assume a £20/KW-yr clearing price. Drax's results are due 16 Feb., when we expect the new dividend policy. We expect an investor day in H1 2017. ■ Valuation: Drax trades on c6.9x 2018E EV/EBITDA. The 2018E FCF yield is c11%, rising to c14% in 2019E. Share price performance Financial and valuation metrics

5 0 0 Year 12/15A 12/16E 12/17E 12/18E EBITDA (£ m) 169.0 144.0 249.9 277.8 4 0 0 EBIT (£ m) 76 30 126 154 Pre-tax profit adjusted (£ m) 58.96 15.67 88.51 125.66 3 0 0 CS EPS (adj.) (p) 11.26 3.10 17.44 24.84 2 0 0 Prev. EPS (p) - 3.14 10.41 23.00 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 5.80 2.80 17.44 24.84 P/E (adj.) (x) 33.8 123.0 21.8 15.3 D RX.L FT SE A LL SH A RE IN D EX Dividend yield (%) 1.5 0.7 4.6 6.5 The price relative chart measures performance against the Dividend cover (x) 1.9 1.1 1.0 1.0 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 1.1 0.9 1.5 1.0

12/01/17 Free float (%) 100.0 Number of shares (m) 406.7 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) 17.4 18.1 79.6 Relative (%) 13.0 12.8 55.5

UK Utilities 35 19 January 2017

Drax (DRX.L) Price (12 Jan 2017): 381.00p; Rating: OUTPERFORM [V]; Target Price: 425.00p; Analyst: Mark Freshney Income statement (£ m) 12/15A 12/16E 12/17E 12/18E Company Background Revenue 3,065 2,776 3,468 3,506 Drax Group plc is the holding company of the Drax group of EBITDA 169 144 250 278 companies. The principal activities of the Company are the Depr. & amort. (217) (114) (124) (124) generation & sale of electricity at the Drax Power Station. There is EBIT 76 30 126 154 also Haven (an Energy supply business) and a biomass business. Net interest exp. (17) (14) (37) (28) Associates - - - - Blue/Grey Sky Scenario PBT 59 16 89 126 Income taxes (21) (3) (17) (25) Profit after tax 38 13 71 101 Minorities - - - - Preferred dividends - - - - Associates & other 116 0 0 0 Net profit 155 13 71 101 Other NPAT adjustments (99) 0 0 0 Reported net income 56 13 71 101 Cash flow (£ m) 12/15A 12/16E 12/17E 12/18E EBIT 76 30 126 154 Net interest (17) (14) (37) (28) Cash taxes paid (4) 4 (2) (5) Change in working capital 9 40 4 (7) Other cash and non-cash items 86 128 161 152 Cash flow from operations 151 187 251 265 CAPEX (179) (109) (382) (30) Free cashflow to the firm 121 157 221 235 Acquisitions - - - - Divestments - - - - Other investment/(outflows) 0 0 0 0 Cash flow from investments (179) (109) (382) (30) Net share issue/(repurchase) 2 0 0 0 Dividends paid (50) (11) (71) (101) Issuance (retirement) of debt 0 0 (75) (50) Our Blue Sky Scenario (p) 710.00 Cashflow from financing (59) (24) (182) (178) £45/MWh power, US$50tn thermal coal, £12/MWh clean dark Changes in net cash/debt (88) 54 (239) 106 spreads, 2x units on ROCs with 1x on CfD and capacity payments at £30/KW-yr. Results in £418m p.a. EBITDA. Net debt at start 99 187 133 371 Change in net debt 88 (54) 239 (106) Our Grey Sky Scenario (p) 123.00 Net debt at end 187 133 371 265 £36/MWh power, US$50/tn thermal coal, £4/MWh clean dark Balance sheet (£ m) 12/15A 12/16E 12/17E 12/18E spreads, 3x units on ROCs with no CfD and capacity payments at Assets £20/KW-yr. Results in £77m p.a. EBITDA. Total current assets 1,278 1,270 1,267 1,276 Total assets 3,237 3,223 3,477 3,393 Share price performance Liabilities Total current liabilities 762 737 1,053 1,000 Total liabilities 1,634 1,619 1,873 1,788 500 Total equity and liabilities 3,237 3,223 3,477 3,393 Per share 12/15A 12/16E 12/17E 12/18E 400 No. of shares (wtd avg.) (mn) 407 407 407 407 CS EPS (adj.) (p) 11.26 3.10 17.44 24.84 300 Dividend (p) 5.80 2.80 17.44 24.84 Free cash flow per share (p) 29.64 38.60 54.34 57.72 200 Key ratios and valuation 12/15A 12/16E 12/17E 12/18E Jan- 15 May- 15 Sep- 15 Jan- 16 May- 16 Sep- 16 Jan- 17 Growth/Margin (%) Sales growth (%) 9.3 (9.4) 24.9 1.1 EBIT growth (%) (60.9) (61.1) 325.5 22.5 DRX.L FTSE ALL SHARE INDEX Net income growth (%) 20.3 (91.8) 463.1 42.4 EPS growth (%) 26.0 (92.2) 463.1 42.4 The price relative chart measures performance against the FTSE ALL SHARE EBITDA margin (%) 5.5 5.2 7.2 7.9 INDEX which closed at 3949.0 on 12/01/17 EBIT margin (%) 2.5 1.1 3.6 4.4 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 Pretax profit margin (%) 1.9 0.6 2.6 3.6 Net income margin (%) 5.0 0.5 2.0 2.9 Valuation 12/15A 12/16E 12/17E 12/18E EV/Sales (x) 0.6 0.6 0.6 0.5 EV/EBITDA (x) 10.3 11.7 7.7 6.5 EV/EBIT (x) 22.8 56.9 15.3 11.8 Dividend yield (%) 1.52 0.73 4.58 6.52 P/E (x) 33.8 123.0 21.8 15.3 Credit ratios (%) 12/15A 12/16E 12/17E 12/18E Net debt/equity (%) 11.6 8.3 23.1 16.5 Net debt to EBITDA (x) 1.1 0.9 1.5 1.0 Interest coverage ratio (x) 4.5 2.1 3.4 5.4 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 36 19 January 2017

Europe/United Kingdom Multi Utilities

SSE (SSE.L) Rating NEUTRAL Price (12 Jan 17, p) 1547.00 Target price (p) 1550.00 Market Cap (£ m) 15,656.3 High quality, but already reflected in the price Enterprise value (£ m) 24,507.7 Target price is for 12 months. ■ Remain Neutral: SSE has one of the best organic capital investment pipelines of the sector. However, SSE shares are at fair value, in our view, Research Analysts and reflect the c20% EPS growth over the next three years fueled by capex Mark Freshney and capacity payments, albeit multiples are in-line with the sector. The key 44 20 7888 0887 [email protected] strategic question is where value-accretive growth post-2020 comes from. Guy MacKenzie, CFA ■ Investment overview: (1) Value generation: SSE is investing c£7.1bn 44 20 7883 9534 across 2016-20E, including the Beatrice wind project and SGN associate. We [email protected] estimate >15% equity-level IRRs on the c£1.6bn wind capex and c13% equity IRRs on the c£3.4bn networks capex element. Overall returns on equity for these new projects are above the c6-9% return on equity available in the market (but are in our SOTP valuation); (2) Best generation fleet in GB and Eire: SSE has a blend of wind, coal, gas and most importantly hydro. This means the company has been able to generate steady EBITDA (ex. free CO2 permits which ended from 2013). To the extent that power prices rise (an upside risk rather than our base case) the business will be a net beneficiary; and (3) EPS growth a mix of organic growth and pricing benefit: The advent of capacity payments brings SSE an extra +c4p/share of EPS in each of FYmar18E and FYmar19E, assuming a clearing price of c£20/KW-yr for the 2017/18 auction. The wind capex pipeline should bring another +c6% growth, with the rest coming from networks and higher clean spark spreads. ■ Risks: Delays on some of the capital projects—particularly at Beatrice—is the key risk facing the shares. The company also has hybrid refinancing due. ■ Catalysts: The Q1 trading statement due 31 Jan., and the stock goes ex- dividend 27.4p/share on 26 Jan. We expect SSE to confirm adjusted EPS >120p during the trading statement. The capacity auction starts on 31 January 2017. The company has bought back shares below c1,500p, and we think this could be a support level for SSE. ■ Valuation: SSE trades on 13.7x FYmar18 P/E (IFRS basis), falling to c12.3x FYmar19E. This is in-line with the average of the integrated sector. The FYmar18 dividend yield is c6.1%, albeit SSE pays out much of its returns in dividends, and needs the SCRIP election option to retain A-/A3 credit ratings. Share price performance Financial and valuation metrics

1 ,8 0 0 Year 3/16A 3/17E 3/18E 3/19E 1 ,7 0 0 EBITDA (£ m) 2,158.8 2,279.5 2,458.1 2,653.2 1 ,6 0 0 EBIT (£ m) 1,501 1,556 1,687 1,849 1 ,5 0 0 Pre-tax profit adjusted (£ m) 1,513.43 1,582.33 1,634.20 1,794.23 1 ,4 0 0 CS EPS (adj.) (p) 119.54 124.04 131.91 145.85 1 ,3 0 0 Prev. EPS (p) 119.55 122.82 131.43 139.24 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 89.37 91.34 94.08 97.09 P/E (adj.) (x) 12.9 12.5 11.7 10.6 SSE.L FT SE A LL SH A RE IN D EX Dividend yield (%) 5.8 5.9 6.1 6.3 The price relative chart measures performance against the Dividend cover (x) 1.3 1.4 1.4 1.5 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 3.9 3.9 3.8 3.5

12/01/17 Free float (%) 99.4 Number of shares (m) 1,012.0 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) 2.4 1.0 9.1 Relative (%) -2.0 -4.2 -15.0

UK Utilities 37 19 January 2017

SSE (SSE.L) Price (12 Jan 2017): 1547.00p; Rating: NEUTRAL; Target Price: 1550.00p; Analyst: Mark Freshney Income statement (£ m) 3/16A 3/17E 3/18E 3/19E Company Background Revenue 28,781 28,744 29,269 29,675 SSE is a fully-integrated utility focused on GB (c95% of EV) and All- EBITDA 2,159 2,279 2,458 2,653 Ireland (c5%). The business earns c50% of EBIT from regulated Depr. & amort. (658) (724) (771) (804) networks and c25% from renewables. The wind and hydro assets EBIT 1,501 1,556 1,687 1,849 generate large FCF and support the cash cost of the dividend. Net interest exp. (315) (311) (363) (367) Associates - - - - Blue/Grey Sky Scenario PBT 1,513 1,582 1,634 1,794 Income taxes (281) (330) (339) (364) Profit after tax 1,233 1,253 1,295 1,430 Minorities -0 -0 -0 -0 Preferred dividends - - - - Associates & other (37) 6 28 43 Net profit 1,195 1,259 1,324 1,473 Other NPAT adjustments (735) 194 (192) (208) Reported net income 461 1,453 1,131 1,266 Cash flow (£ m) 3/16A 3/17E 3/18E 3/19E EBIT 1,501 1,556 1,687 1,849 Net interest (315) (311) (363) (367) Cash taxes paid (139) (169) (181) (189) Change in working capital 207 (203) 208 16 Other cash and non-cash items 827 770 834 867 Cash flow from operations 2,081 1,641 2,184 2,177 CAPEX (1,940) (1,872) (1,815) (1,338) Free cashflow to the firm 1,664 669 1,237 1,666 Acquisitions (669) 0 0 0 Divestments 312 760 0 0 Other investment/(outflows) (42) 0 0 0 Cash flow from investments (2,339) (1,112) (1,815) (1,338) Net share issue/(repurchase) 14 (204) (201) 51 Dividends paid (708) (678) (694) (716) Issuance (retirement) of debt (1,161) 0 0 0 Our Blue Sky Scenario (p) 2000.00 Cashflow from financing (1,840) (821) (835) (605) UK bond yields go to 1% for a sustained period of time. Long-term Changes in net cash/debt (827) (456) (504) 193 RPI remains at 3.2% p.a. Natural gas prices are 60p/therm in the long-run (implying cUS$100/bbl oil) which keeps power at £54/MWh. Net debt at start 7,568 8,395 8,851 9,355 The dividend is sustainable in the long-run because the company is Change in net debt 827 456 504 (193) able to keep capex at c£1.5bn p.a. for FYmar19E and FYmar20E. Net debt at end 8,395 8,851 9,355 9,162 Balance sheet (£ m) 3/16A 3/17E 3/18E 3/19E Our Grey Sky Scenario (p) 1300.00 Assets Natural gas prices are 30p/therm in the long-run (implying Total current assets 7,695 8,403 8,684 9,087 cUS$50/bbl oil) which keeps power at £32/MWh. The WACC rises Total assets 23,556 24,560 25,889 26,831 by c50bps (e.g. because the company’s credit rating is downgraded Liabilities to Baa1/BBB+ and there are concerns about a Second referendum Total current liabilities 7,638 8,019 8,366 8,647 on Scottish independence). The dividend is rebased downwards by Total liabilities 20,549 21,537 22,624 22,959 c30% from 2020 because there is no growth. Total equity and liabilities 23,556 24,560 25,889 26,831 Per share 3/16A 3/17E 3/18E 3/19E Share price performance No. of shares (wtd avg.) (mn) 1,000 1,015 1,003 1,010 CS EPS (adj.) (p) 119.54 124.04 131.91 145.85 1,800 Dividend (p) 89.37 91.34 94.08 97.09 Free cash flow per share (p) 166.38 65.90 123.29 164.93 1,700 Key ratios and valuation 3/16A 3/17E 3/18E 3/19E 1,600 Growth/Margin (%) 1,500 Sales growth (%) (9.1) (0.1) 1.8 1.4 EBIT growth (%) (2.4) 3.6 8.5 9.6 1,400 Net income growth (%) (1.9) 5.3 5.1 11.3 1,300 EPS growth (%) (3.7) 3.8 6.3 10.6 EBITDA margin (%) 7.5 7.9 8.4 8.9 Jan- 15 Jul- 15 Jan- 16 Jul- 16 Jan- 17 EBIT margin (%) 5.2 5.4 5.8 6.2 Pretax profit margin (%) 5.3 5.5 5.6 6.0 SSE.L FTSE ALL SHARE INDEX Net income margin (%) 4.2 4.4 4.5 5.0 Valuation 3/16A 3/17E 3/18E 3/19E The price relative chart measures performance against the FTSE ALL SHARE EV/Sales (x) 0.8 0.9 0.9 0.8 INDEX which closed at 3949.0 on 12/01/17 EV/EBITDA (x) 11.1 10.8 10.2 9.4 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/EBIT (x) 16.0 15.8 14.8 13.4 Dividend yield (%) 5.78 5.90 6.08 6.28 P/E (x) 12.9 12.5 11.7 10.6 Credit ratios (%) 3/16A 3/17E 3/18E 3/19E Net debt/equity (%) 279.2 292.7 286.5 236.7 Net debt to EBITDA (x) 3.9 3.9 3.8 3.5 Interest coverage ratio (x) 4.8 5.0 4.6 5.0 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 38 19 January 2017

Europe/United Kingdom Water Utilities

Severn Trent (SVT.L) Rating (from UNDERPERFORM) NEUTRAL Price (12 Jan 17, p) 2212.00 Target price (p) (from 2100.00) 2190.00 Market Cap (£ m) 5,213.8 The key beneficiary of higher UK RPI inflation Enterprise value (£ m) 10,508.7 Target price is for 12 months. ■ Upgrade to Neutral (from Underperform): Inflation expectations are rising, SVT is outperforming its regulatory contract, and the stock no longer trades at Research Analysts a high premium to our TP. We see negative regulatory developments from Guy MacKenzie, CFA 2020 and do not see compelling value, but the downside risk looks limited. 44 20 7883 9534 [email protected] We tweak our EPS forecasts c1-2% to reflect latest RPI inflation forecasts. Mark Freshney ■ Investment overview: (1) A play on higher inflation: SVT equity returns 44 20 7888 0887 are c2.3x levered to RPI inflation; the highest amongst listed UK regulated [email protected] utilities. A transition towards CPI indexation presents a risk for the sector Marcelo Preto 44 207 888 0873 beyond 2020, given potential implications for growth and returns, but on a 12- [email protected] month view higher inflation expectations are supportive; (2) Rising bond yields unhelpful: SVT has the most floating rate debt amongst listed peers at c23% (PNN 17%, UU 10%) and has c£553m of debt maturing in FYmar18. We expect the cost of debt to fall from the current c4.3% (CS est. c3.8% in FYmar18E) but higher bond yields would reduce the benefit. Falling bond yields have also been the primary driver of UK water sector valuations since 2014, so from a discount rate perspective there is potential downside; and (3) Exposed to negative regulatory changes: Bond yields remain lower than at the time of the 2014 price control review, suggesting further downside for returns from current levels (3.74%, real). We think more competition upstream and a move to direct procurement for large capital projects (>£100m total expenditure) will reduce growth prospects beyond 2020E. ■ Risks: We see adverse regulatory changes from 2020E as the main risk, with scope for higher bond yields the most important near-term risk factor. ■ Catalysts: Full-year results May 23rd. OFWAT will publish a methodology consultation on the 2019 price control review in July 2017. ■ Valuation: SVT trades at a c29% premium to its FYmar18E RAB. This compares with UU at a c20% premium. PNN trades at a c44% premium to its FYmar18E RAB. The dividend yield is c3.8%, growing at least in-line with RPI inflation to 2020E. The stock discounts a cost of equity of c6.9%. Share price performance Financial and valuation metrics

2 ,6 0 0 Year 3/16A 3/17E 3/18E 3/19E EBITDA (£ m) 839.0 841.6 861.1 904.2 2 ,4 0 0 EBIT (£ m) 524 514 523 550 2 ,2 0 0 Pre-tax profit adjusted (£ m) 322.30 305.86 305.65 325.78 2 ,0 0 0 CS EPS (adj.) (p) 101.60 100.02 100.45 107.09 1 ,8 0 0 Prev. EPS (p) - 100.30 99.57 106.30 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 80.65 81.50 83.26 85.80 P/E (adj.) (x) 21.8 22.1 22.0 20.7 SVT .L FT SE A LL SH A RE IN D EX Dividend yield (%) 3.6 3.7 3.8 3.9 The price relative chart measures performance against the Dividend cover (x) 1.3 1.2 1.2 1.2 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 5.8 5.9 6.0 6.0

12/01/17 Free float (%) 100.0 Number of shares (m) 235.7 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) 1.5 -4.5 6.3 Relative (%) -3.0 -9.8 -17.7

UK Utilities 39 19 January 2017

Severn Trent (SVT.L) Price (12 Jan 2017): 2212.00p; Rating: (from UNDERPERFORM) NEUTRAL; Target Price: (from 2100.00p) 2190.00p; Analyst: Guy MacKenzie Income statement (£ m) 3/16A 3/17E 3/18E 3/19E Company Background Revenue 1,787 1,810 1,865 1,946 Severn Trent Plc provides & treats water & waste water in the UK & EBITDA 839 842 861 904 internationally through its two complementary businesses, Severn Depr. & amort. (316) (328) (338) (354) Trent Water & Severn Trent Services. EBIT 524 514 523 550 Net interest exp. (194) (208) (224) (233) Blue/Grey Sky Scenario Associates 0 (0) 5 6 PBT 322 306 306 326 Income taxes 10 (67) (66) (70) Profit after tax 411 239 240 255 Minorities (1) (1) (1) (1) Preferred dividends - - - - Associates & other (168) 0 0 0 Net profit 241 237 238 254 Other NPAT adjustments 90 0 0 0 Reported net income 331 237 238 254 Cash flow (£ m) 3/16A 3/17E 3/18E 3/19E EBIT 524 514 523 550 Net interest (186) (180) (185) (190) Cash taxes paid - - - - Change in working capital (21) 0 0 0 Other cash and non-cash items 224 244 256 268 Cash flow from operations 540 578 594 628 CAPEX (415) (490) (560) (616) Free cashflow to the firm 130 88 34 12 Acquisitions - - - - Divestments 0 0 0 0 Other investment/(outflows) (0) 0 0 0 Cash flow from investments (416) (490) (560) (616) Net share issue/(repurchase) (108) 0 0 0 Dividends paid (198) (191) (194) (199) Our Blue Sky Scenario (p) (from 2700.00) Issuance (retirement) of debt - - - - 2770.00 Cashflow from financing (306) (191) (194) (199) Our blue sky valuation assumes M&A materialises and SVT is Changes in net cash/debt (101) (133) (201) (232) bought out at a c45% premium to RAB, towards the high end of recent transaction multiples and in-line with where National Grid and Net debt at start 4,750 4,851 4,984 5,186 SSE sold stakes in their gas distribution assets. Change in net debt 101 133 201 232 Net debt at end 4,851 4,984 5,186 5,417 Our Grey Sky Scenario (p) (from 1200.00) Balance sheet (£ m) 3/16A 3/17E 3/18E 3/19E 1170.00 Assets Our grey sky scenario assumes a sharp cut to returns combined Total current assets 834 837 842 850 with a sharp rise in interest rates to the point where SVT does not Total assets 8,645 8,810 9,042 9,318 earn a spread over its cost of capital. The valuation assumes par to Liabilities RAB (i.e. a 0% RAB premium). Total current liabilities 1,073 1,079 1,093 1,114 Total liabilities 7,627 7,745 7,933 8,154 Share price performance Total equity and liabilities 8,645 8,810 9,042 9,318

Per share 3/16A 3/17E 3/18E 3/19E 2,600 No. of shares (wtd avg.) (mn) 237 237 237 237 CS EPS (adj.) (p) 101.60 100.02 100.45 107.09 2,400 Dividend (p) 80.65 81.50 83.26 85.80 Free cash flow per share (p) 54.99 37.02 14.25 5.00 2,200 Key ratios and valuation 3/16A 3/17E 3/18E 3/19E 2,000 Growth/Margin (%) Sales growth (%) (0.8) 1.3 3.0 4.4 1,800 EBIT growth (%) 0.5 (1.9) 1.8 5.2 Jan- 15 Jul- 15 Jan- 16 Jul- 16 Jan- 17 Net income growth (%) (6.5) (1.6) 0.4 6.6 EPS growth (%) (12.5) (1.5) 0.4 6.6 EBITDA margin (%) 47.0 46.5 46.2 46.5 SVT.L FTSE ALL SHARE INDEX EBIT margin (%) 29.3 28.4 28.0 28.3 Pretax profit margin (%) 18.0 16.9 16.4 16.7 The price relative chart measures performance against the FTSE ALL SHARE Net income margin (%) 13.5 13.1 12.8 13.1 INDEX which closed at 3949.0 on 12/01/17 Valuation 3/16A 3/17E 3/18E 3/19E On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/Sales (x) 5.8 5.8 5.7 5.6 EV/EBITDA (x) 12.4 12.5 12.4 12.0 EV/EBIT (x) 19.9 20.5 20.4 19.8 Dividend yield (%) 3.65 3.68 3.76 3.88 P/E (x) 21.8 22.1 22.0 20.7 Credit ratios (%) 3/16A 3/17E 3/18E 3/19E Net debt/equity (%) 476.3 468.2 467.7 465.4 Net debt to EBITDA (x) 5.8 5.9 6.0 6.0 Interest coverage ratio (x) 2.7 2.5 2.3 2.4 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 40 19 January 2017

Europe/United Kingdom Multi Utilities

National Grid (NG.L) Rating UNDERPERFORM Price (12 Jan 17, p) 950.60 Target price (p) (from 860.00) 850.00 Market Cap (£ m) 35,714.5 Attractive sale price, but the old challenges Enterprise value (£ m) 57,264.2 Target price is for 12 months. remain

Research Analysts ■ Remain Underperform: National Grid has sold a 61% stake in UK Gas Mark Freshney distribution for a c48% RAB premium, and there will be a c£4bn return of 44 20 7888 0887 capital (>£3bn via a cash payment to shareholders). We do not argue with [email protected] the logic—we think the strategy to sell is the right one—but rather we believe Guy MacKenzie, CFA 44 20 7883 9534 the fundamental issue of low growth in the UK remains. We adjust our EPS [email protected] and TP for weaker interconnector earnings, and the fact some of the shares will be bought back, which takes time to offset dilution from the asset sale. ■ Investment overview: (1) We believe asset base growth will remain low: We forecast c5% p.a. asset base growth over the coming four years (a blend of c7% in the US and c3.2% in the UK). We see falling transmission system demand as the main reason. Across the 10 years to FYmar16, electricity transmission demand was down c18%. The gas transmission asset base grew by just c3% across the five years to March 2016. (2) Non-regulated growth projects: We expect NG to increasingly focus upon business development projects such as interconnection. Unlike the regulated asset bases and rate bases, these are not remunerated while under construction, thus reducing balance sheet capacity. In the case of interconnection, these also carry a degree of merchant risk. (3) Still tight on balance sheet: The sale of gas distribution is positive for the credit metrics, on our forecasts, but the RCF:net debt ratio is still tight, at c10% excluding the scrip dividend (the threshold is >9% for the Baa1 group rating with Moody's). We think the fundamental challenge is that NG is over-distributing the dividend by c20%. ■ Risks: The stock appears highly correlated with nominal interest rates in the short run. Selling an extra c14% stake in UK gas distribution could lead to an extra c£1bn (+c25p/share) being available for a capital return. ■ Catalysts: We would expect a shareholder circular for the sale by early February. We forecast a c80p/share capital return and a c43-for-47 share consolidation. ■ Valuation: On our forecasts, NG trades on a c41% premium to the combined regulated asset base and rate base. We believe the multiple should be c33%. The FYmar18E dividend yield is c4.8%, the same as the regulated sector.

UK Utilities 41 19 January 2017

Share price performance Financial and valuation metrics

1 ,2 0 0 Year 3/16A 3/17E 3/18E 3/19E EBITDA (£ m) 5,710.0 5,994.1 5,070.1 5,147.2 1 ,1 0 0 EBIT (£ m) 4,096 4,252 3,561 3,599 1 ,0 0 0 Pre-tax profit adjusted (£ m) 3,141.53 3,149.36 2,721.35 2,802.34 9 0 0 CS EPS (adj.) (p) 63.53 63.77 60.59 63.08 8 0 0 Prev. EPS (p) - - 63.26 65.22 Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 43.34 44.29 45.58 47.05 P/E (adj.) (x) 15.0 14.9 15.7 15.1 N G.L FT SE A LL SH A RE IN D EX Dividend yield (%) 4.6 4.7 4.8 4.9 The price relative chart measures performance against the Dividend cover (x) 1.5 1.4 1.3 1.3 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 4.4 3.6 4.7 4.9

12/01/17 Free float (%) 91.2 Number of shares (m) 3,757.0 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) 2.8 -9.8 2.4 Relative (%) -1.6 -15.1 -21.6

UK Utilities 42 19 January 2017

National Grid (NG.L) Price (12 Jan 2017): 950.60p; Rating: UNDERPERFORM; Target Price: (from 860.00p) 850.00p; Analyst: Mark Freshney Income statement (£ m) 3/16A 3/17E 3/18E 3/19E Company Background Revenue 15,116 16,719 16,118 16,627 National Grid is an owner of UK and US transmission and EBITDA 5,710 5,994 5,070 5,147 distribution activities in electricity and gas. The major asset is the Depr. & amort. (1,614) (1,742) (1,509) (1,548) electricity transmission grid in England and Wales. The company EBIT 4,096 4,252 3,561 3,599 also owns and develops interconnectors between the UK and Net interest exp. (940) (1,069) (984) (927) Europe Associates 59 41 32 23 PBT 3,142 3,149 2,721 2,802 Blue/Grey Sky Scenario Income taxes (753) (740) (640) (659) Profit after tax 2,389 2,409 2,082 2,144 Minorities (3) (3) (3) (3) Preferred dividends - - - - Associates & other 0 (0) 0 0 Net profit 2,386 2,406 2,079 2,141 Other NPAT adjustments 205 2,665 0 0 Reported net income 2,591 5,071 2,079 2,141 Cash flow (£ m) 3/16A 3/17E 3/18E 3/19E EBIT 4,096 4,252 3,561 3,599 Net interest (811) (1,069) (984) (927) Cash taxes paid (292) (417) (308) (290) Change in working capital 39 120 18 (21) Other cash and non-cash items 746 642 705 733 Cash flow from operations 3,778 3,527 2,992 3,095 CAPEX (3,628) (4,097) (3,802) (3,980) Free cashflow to the firm 150 (569) (811) (885) Acquisitions 0 0 0 0 Divestments - - - - Other investment/(outflows) (628) (9) 0 0 Cash flow from investments (4,256) (4,106) (3,802) (3,980) Net share issue/(repurchase) 295 288 457 432 Dividends paid (1,616) (1,629) (1,536) (1,553) Issuance (retirement) of debt (832) (2,908) 16 0 Cashflow from financing (2,449) 6,181 (2,400) (1,441) Our Blue Sky Scenario (p) (from 1221.20) Changes in net cash/debt (1,987) 3,669 (2,227) (1,399) 1207.00 UK and US Bond yields go to 1% for a sustained period of time. Net debt at start 23,232 25,219 21,550 23,776 Long-term RPI remains at c3.2% p.a. NG avoid having their projects Change in net debt 1,987 (3,669) 2,227 1,399 subject to competitive tender. Asset base growth rises c1% to c5.3% Net debt at end 25,219 21,550 23,776 25,176 p.a. for 10 years. US rate review programme better than expected Balance sheet (£ m) 3/16A 3/17E 3/18E 3/19E and gets NG to c9.5% achieved ROEs. Assets Total current assets 5,264 5,180 4,592 4,198 Our Grey Sky Scenario (p) (from 713.80) 705.50 Total assets 57,330 51,507 53,242 55,363 UK and US bond yields go to 3% for a sustained period of time. Liabilities Long-term RPI runs c100bps below the historical average of 2.2%. Total current liabilities 7,184 7,770 7,626 7,759 Asset base growth falls to c3% p.a. US only achieves c8.5% ROEs. Total liabilities 43,765 41,931 43,985 45,403 Total equity and liabilities 57,330 51,507 53,242 55,363 Share price performance Per share 3/16A 3/17E 3/18E 3/19E No. of shares (wtd avg.) (mn) 3,755 3,773 3,431 3,393 1,200 CS EPS (adj.) (p) 63.53 63.77 60.59 63.08 Dividend (p) 43.34 44.29 45.58 47.05 1,100 Free cash flow per share (p) 3.99 (15.09) (23.63) (26.09) Key ratios and valuation 3/16A 3/17E 3/18E 3/19E 1,000 Growth/Margin (%) Sales growth (%) (0.6) 10.6 (3.6) 3.2 900 EBIT growth (%) 5.9 3.8 (16.3) 1.1 800 Net income growth (%) 8.8 0.9 (13.6) 3.0 EPS growth (%) 9.1 0.4 (5.0) 4.1 Jan- 15 Jul- 15 Jan- 16 Jul- 16 Jan- 17 EBITDA margin (%) 37.8 35.9 31.5 31.0 EBIT margin (%) 27.1 25.4 22.1 21.6 NG.L FTSE ALL SHARE INDEX Pretax profit margin (%) 20.8 18.8 16.9 16.9 Net income margin (%) 15.8 14.4 12.9 12.9 The price relative chart measures performance against the FTSE ALL SHARE Valuation 3/16A 3/17E 3/18E 3/19E INDEX which closed at 3949.0 on 12/01/17 EV/Sales (x) 4.0 3.4 3.7 3.7 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/EBITDA (x) 10.7 9.6 11.7 11.8 EV/EBIT (x) 14.9 13.5 16.7 16.9 Dividend yield (%) 4.56 4.66 4.80 4.95 P/E (x) 15.0 14.9 15.7 15.1 Credit ratios (%) 3/16A 3/17E 3/18E 3/19E Net debt/equity (%) 185.9 225.1 256.8 252.8 Net debt to EBITDA (x) 4.4 3.6 4.7 4.9 Interest coverage ratio (x) 4.4 4.0 3.6 3.9 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 43 19 January 2017

Europe/United Kingdom Water Utilities

Pennon Group (PNN.L) Rating UNDERPERFORM Price (12 Jan 17, p) 809.00 Target price (p) 750.00 Market Cap (£ m) 3,348.1 We are cautious on energy-from-waste Enterprise value (£ m) 6,889.4 Target price is for 12 months. ■ Maintain Underperform, TP 750p: We are cautious on potential medium- term downside to energy-from-waste gate fee pricing. We also see risks Research Analysts associated with an unconsolidated financing joint venture, where loss of tax Guy MacKenzie, CFA credits could yield near-term downside to EPS. Our EPS forecasts are c3-6% 44 20 7883 9534 [email protected] below consensus for FYmar17-18E. Mark Freshney ■ Investment overview: (1) Risks in energy-from-waste (c30% EV): We see 44 20 7888 0887 [email protected] (a) local authority counterparty risk, (b) exposure to competitive pricing risk Marcelo Preto which our research suggests will intensify from 2020E, (c) execution risk on 44 207 888 0873 construction of the Glasgow plant, and (d) financing risk with a potentially [email protected] expensive new hybrid. We do not see drivers of sustainable upside to pricing over the medium-term; (2) Peninsula MB joint venture (PMB): We estimate loss of tax credits could reduce EPS c7-10% p.a. going forward. Reported 2013-15 EPS could have been 26-30% lower if PMB were fully consolidated. Any liability to PNN associated with PMB is not yet clear. We see the 75%- owned JV presenting risk to PNN equity value. We would welcome more clarity from Pennon on its economic exposure; and (3) Bond yields the risk in water (c70% EV): We value SWW at a premium to reflect outperformance vs. peers, but we see bond yields as the main near-term driver for UK Water valuations. Higher RPI inflation is helpful, with every 1% to RPI adding c2% to its equity regulated asset base (RAB), on our numbers. We model flat WACC allowances from 2020E but see a balance of downside risk. ■ Risks: The main upside risk is potential M&A, where our blue sky valuation is 990p/share. Pennon could also crystallise value and delever by selling stakes in EfWs, for example. ■ Catalysts: Q3mar17 trading update Feb 9 th. We estimate a potential hybrid issuance could yield c2-5% downside to EPS. ■ Valuation: With SWW at c1.37x FYmar18E RAB (our valuation), Viridor (exc. JVs) trades at c14x EV/EBITDA. With Viridor at our DCF-derived £1.9bn (c12x EBITDA), SWW is at c1.44x March 2018E RAB. Share price performance Financial and valuation metrics

1 ,1 0 0 Year 3/16A 3/17E 3/18E 3/19E EBITDA (£ m) 438.2 469.4 488.3 541.9 1 ,0 0 0 EBIT (£ m) 262 286 300 342 9 0 0 Pre-tax profit adjusted (£ m) 211.60 221.21 226.95 263.15 8 0 0 CS EPS (adj.) (p) 29.94 35.59 36.19 45.82 7 0 0 Prev. EPS (p) - - - - Jan - 1 5 Ju l- 1 5 Jan - 1 6 Ju l- 1 6 Jan - 1 7 Dividend (p) 33.57 35.79 38.36 41.13 P/E (adj.) (x) 27.0 22.7 22.4 17.7 PN N .L FT SE A LL SH A RE IN D EX Dividend yield (%) 4.1 4.4 4.7 5.1 The price relative chart measures performance against the Dividend cover (x) 0.9 1.0 0.9 1.1 FTSE ALL SHARE INDEX which closed at 3949.0 on Net debt /EBITDA (x) 6.3 6.3 6.3 5.7

12/01/17 Free float (%) 100.0 Number of shares (m) 413.9 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Source: Company data, Thomson Reuters, Credit Suisse estimates Eu.94/US$1 Performance 1M 3M 12M Absolute (%) -5.8 -7.5 -11.0 Relative (%) -8.8 -10.3 -32.3

UK Utilities 44 19 January 2017

Pennon Group (PNN.L) Price (12 Jan 2017): 809.00p; Rating: UNDERPERFORM; Target Price: 750.00p; Analyst: Guy MacKenzie Income statement (£ m) 3/16A 3/17E 3/18E 3/19E Company Background Revenue 1,352 1,336 1,323 1,374 Pennon Group Plc is engaged in the provision of water & sewerage EBITDA 438 469 488 542 services, waste management, recycling & renewable energy. The Depr. & amort. (186) (184) (188) (200) Company?s business is operated through two main subsidiaries. EBIT 262 286 300 342 South West Water Limited and Viridor Limited. Net interest exp. (49) (67) (77) (82) Associates 4 3 3 4 Blue/Grey Sky Scenario PBT 212 221 227 263 Income taxes (38) (57) (59) (68) Profit after tax 174 164 168 195 Minorities - - - - Preferred dividends - - - - Associates & other (50) (16) (16) 0 Net profit 124 148 152 195 Other NPAT adjustments 29 0 0 0 Reported net income 153 148 152 195 Cash flow (£ m) 3/16A 3/17E 3/18E 3/19E EBIT 262 286 300 342 Net interest (65) (83) (93) (82) Cash taxes paid (33) (35) (36) (42) Change in working capital (55) (12) (12) (19) Other cash and non-cash items 139 167 171 183 Cash flow from operations 249 322 331 382 CAPEX (312) (376) (387) (286) Free cashflow to the firm 77 128 135 203 Acquisitions - - - - Divestments 0 0 0 0 Other investment/(outflows) (239) 4 19 19 Cash flow from investments (551) (372) (367) (266) Net share issue/(repurchase) 100 0 0 0 Dividends paid (123) (111) (119) (129) Issuance (retirement) of debt (65) (83) (93) (82) Our Blue Sky Scenario (p) 990.00 Cashflow from financing (23) (111) (414) (129) Our blue-sky scenario assumes an M&A valuation where SWW is Changes in net cash/debt (287) (160) (156) (13) bought out at a c50% premium to FYmar18E RAB (top end of historical multiples) with Viridor's EfWs valued at c13x 2019E Net debt at start 2,492 2,779 2,939 3,095 EBITDA, the high end of recent transactions. Change in net debt 287 160 156 13 Net debt at end 2,779 2,939 3,095 3,108 Our Grey Sky Scenario (p) 370.00 Balance sheet (£ m) 3/16A 3/17E 3/18E 3/19E Our grey sky scenario reflects zero value for Greater Manchester Assets and Glasgow (given counterparty and operational issues, Total current assets 985 987 989 1,007 respectively), a cut in UK Water returns to 3% real from 2020, and Total assets 5,663 5,864 6,058 6,153 consolidation of the NPV of future interest payments on PMB, and Liabilities merchant energy-from-waste pricing of c£10/tonne (from £70/tonne) Total current liabilities 451 440 429 433 after 2020E as competition intensifies. Total liabilities 4,467 4,634 4,798 4,830 Total equity and liabilities 5,662 5,864 6,058 6,153 Share price performance Per share 3/16A 3/17E 3/18E 3/19E No. of shares (wtd avg.) (mn) 413 416 421 426 1,100 CS EPS (adj.) (p) 29.94 35.59 36.19 45.82 Dividend (p) 33.57 35.79 38.36 41.13 1,000 Free cash flow per share (p) 18.66 30.84 31.98 47.65 Key ratios and valuation 3/16A 3/17E 3/18E 3/19E 900 Growth/Margin (%) Sales growth (%) (0.4) (1.2) (1.0) 3.8 800 EBIT growth (%) 6.3 8.9 5.2 13.7 700 Net income growth (%) (10.0) 19.9 2.8 28.1 EPS growth (%) (14.4) 18.8 1.7 26.6 Jan- 15 Jul- 15 Jan- 16 Jul- 16 Jan- 17 EBITDA margin (%) 32.4 35.1 36.9 39.5 EBIT margin (%) 19.4 21.4 22.7 24.9 PNN.L FTSE ALL SHARE INDEX Pretax profit margin (%) 15.6 16.6 17.2 19.2 Net income margin (%) 9.1 11.1 11.5 14.2 The price relative chart measures performance against the FTSE ALL SHARE Valuation 3/16A 3/17E 3/18E 3/19E INDEX which closed at 3949.0 on 12/01/17 EV/Sales (x) 5.0 5.2 5.1 4.9 On 12/01/17 the spot exchange rate was £.87/Eu 1.- Eu.94/US$1 EV/EBITDA (x) 15.3 14.7 13.8 12.5 EV/EBIT (x) 25.6 24.1 22.5 19.8 Dividend yield (%) 4.15 4.42 4.74 5.08 P/E (x) 27.0 22.7 22.4 17.7 Credit ratios (%) 3/16A 3/17E 3/18E 3/19E Net debt/equity (%) 232.6 239.0 245.6 234.9 Net debt to EBITDA (x) 6.3 6.3 6.3 5.7 Interest coverage ratio (x) 5.4 4.2 3.9 4.2 Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates

UK Utilities 45 19 January 2017

Companies Mentioned (Price as of 12-Jan-2017) Centrica (CNA.L, 227.0p, OUTPERFORM, TP 255.0p) DONG Energy A/S (DENERG.CO, Dkr259.4, OUTPERFORM[V], TP Dkr310.0) Drax (DRX.L, 381.0p, OUTPERFORM[V], TP 425.0p) EDP (EDP.LS, €2.77) Engie (ENGIE.PA, €11.74) Gazprom (GAZPq.L, $5.27) National Grid (NG.L, 950.6p, UNDERPERFORM, TP 850.0p) Pennon Group (PNN.L, 809.0p, UNDERPERFORM, TP 750.0p) SSE (SSE.L, 1547.0p, NEUTRAL, TP 1550.0p) Severn Trent (SVT.L, 2212.0p, NEUTRAL, TP 2190.0p) Statoil (STL.OL, Nkr160.8) Uniper (UN01.DE, €13.6) United Utilities (UU.L, 896.0p, OUTPERFORM, TP 1000.0p) innogy (IGY.F, €30.87)

Disclosure Appendix Analyst Certification The analysts identified in this report each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

3-Year Price and Rating History for Centrica (CNA.L)

CNA.L Closing Price Target Price Target Price Closing Price CNA.L Date (p) (p) Rating 350 14-Jan-14 327.00 310.00 U 325 10-Mar-14 327.40 310.00 N 300 24-Oct-14 292.70 300.00 275 27-Nov-14 287.70 290.00 250 27-Jan-15 282.70 310.00 O 225 10-Mar-15 235.50 290.00 200 24-Mar-15 256.60 R 14-May-15 276.60 290.00 O 01- Jan- 2014 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017 22-Jul-15 276.90 300.00

01-Dec-15 218.70 270.00 U N D ERPERFO RM N EU T RA L 11-Dec-15 210.90 280.00 O U T PERFO RM 15-Feb-16 192.40 270.00 REST RICT ED 06-May-16 209.90 260.00 27-Jul-16 242.00 270.00 * Asterisk signifies initiation or assumption of coverage.

3-Year Price and Rating History for DONG Energy A/S (DENERG.CO)

DENERG.CO Closing Price Target Price Target Price Closing Price DENERG.CO Date (Dkr) (Dkr) Rating 330 04-Oct-16 278.90 310.00 O * 22-Dec-16 265.60 315.00 310 * Asterisk signifies initiation or assumption of coverage. 290

270

250

230 01- Nov- 2016 01- Dec- 2016 01- Jan- 2017

O U T PERFO RM

UK Utilities 46 19 January 2017

3-Year Price and Rating History for Drax (DRX.L)

DRX.L Closing Price Target Price Target Price Closing Price DRX.L Date (p) (p) Rating 950 03-Jul-14 688.00 750.00 O 15-Jul-14 700.00 805.00 08-Aug-14 651.00 750.00 700 26-Jan-15 364.80 430.00 18-May-15 416.60 460.00 450 09-Jul-15 273.30 365.00 31-Jul-15 298.30 375.00 200 07-Jan-16 217.90 320.00 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017 15-Feb-16 233.90 290.00

05-Apr-16 286.10 325.00 O U T PERFO RM 27-Jul-16 341.60 415.00 17-Oct-16 322.10 425.00 * Asterisk signifies initiation or assumption of coverage.

3-Year Price and Rating History for National Grid (NG.L)

NG.L Closing Price Target Price Target Price Closing Price NG.L Date (p) (p) Rating 1,200 15-Jan-14 783.00 800.00 O 29-May-14 887.00 870.00 N 1,100 14-Jan-15 905.00 780.00 U 1,000 24-Sep-15 869.10 R 11-Nov-15 909.30 780.00 U 900 18-Nov-15 922.90 810.00 800 07-Jan-16 949.80 820.00 700 27-Apr-16 980.40 825.00 01- Jan- 2014 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017 17-Jun-16 958.80 820.00

27-Jul-16 1101.00 840.00 O U T PERFO RM N EU T RA L 11-Nov-16 955.70 860.00 U N D ERPERFO RM * Asterisk signifies initiation or assumption of coverage. REST RICT ED

3-Year Price and Rating History for Pennon Group (PNN.L)

PNN.L Closing Price Target Price Target Price Closing Price PNN.L Date (p) (p) Rating 1,000 23-Jan-14 684.00 630.00 U 01-Apr-14 740.50 645.00 900 01-Aug-14 802.00 655.00 29-Jan-15 904.50 715.00 800 05-Oct-15 805.00 755.00 N 07-Jan-16 852.00 770.00 700 16-Feb-16 813.50 730.00 U 600 21-Jul-16 915.00 815.00 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017 09-Sep-16 879.50 790.00

09-Nov-16 816.50 800.00 N U N D ERPERFO RM N EU T RA L * Asterisk signifies initiation or assumption of coverage.

UK Utilities 47 19 January 2017

3-Year Price and Rating History for SSE (SSE.L)

SSE.L Closing Price Target Price Target Price Closing Price SSE.L Date (p) (p) Rating 1,700 25-Mar-14 1498.00 1600.00 O 11-Nov-14 1580.00 1700.00 1,600 17-Sep-15 1437.00 1600.00 N 07-Jan-16 1487.00 1500.00 1,500 15-Feb-16 1367.00 1450.00 21-Jul-16 1611.00 1550.00 1,400 * Asterisk signifies initiation or assumption of coverage. 1,300 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017

O U T PERFO RM N EU T RA L

3-Year Price and Rating History for Severn Trent (SVT.L)

SVT.L Closing Price Target Price Target Price Closing Price SVT.L Date (p) (p) Rating 2,750 23-Jan-14 1685.00 1540.00 U 01-Aug-14 1877.00 1730.00 N 2,500 29-Jan-15 2199.00 1870.00 U 2,250 05-Oct-15 2254.00 1990.00 21-Jul-16 2450.00 2100.00 2,000 * Asterisk signifies initiation or assumption of coverage. 1,750

1,500 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017

U N D ERPERFO RM N EU T RA L

3-Year Price and Rating History for United Utilities (UU.L)

UU.L Closing Price Target Price Target Price Closing Price UU.L Date (p) (p) Rating 1,100 23-Jan-14 705.50 680.00 N 01-Aug-14 856.00 730.00 U 1,000 29-Jan-15 1042.00 880.00 N 900 05-Oct-15 969.50 970.00 O 21-Jul-16 1013.00 990.00 N 800 * Asterisk signifies initiation or assumption of coverage. 700

600 01- Jan- 2015 01- Jan- 2016 01- Jan- 2017

N EU T RA L U N D ERPERFO RM O U T PERFO RM

The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts’ stock rating are defined as follows: Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark* over the next 12 months. Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An

UK Utilities 48 19 January 2017

Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July 2011. Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Not Rated (NR) : Credit Suisse Equity Research does not have an investment rating or view on the stock or any other securities related to the company at this time. Not Covered (NC) : Credit Suisse Equity Research does not provide ongoing coverage of the company or offer an investment rating or investment view on the equity security of the company or related products. Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation: Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months. *An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors. Credit Suisse's distribution of stock ratings (and banking clients) is:

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Target Price and Rating Valuation Methodology and Risks: (12 months) for Centrica (CNA.L) Method: Our main valuation methodology is discounted cash flow analysis and sum-of-parts with reference to physical multiples and where possible with a view to ensuring consistency with precedent transactions in the sector. We have analysed separately the cash flows generated by division including where applicable specific assets within each division (for instance, individual generation assets) taking account of e.g. asset life, projected organic growth rates which reasonably accord with historic performance, the appropriate discount rate (c6.3% post-tax nominal WACC for the group) based on CAPM analysis and estimated impact of the commodity and investment cycle on financial and operational performance. Our method gets us to a target price of 255p/share. We rate the stock Outperform given the upside potential indicated by our target price. Risk: At present, the risks to our rating and target price are regulatory and financial. Within the British Gas segment, there is potential for significant market share erosion if Centrica's competitors behave aggressively or Centrica misjudges the appropriate extent of its own tariff cuts. Political intervention - perhaps in response to media reports - could reduce earnings at Centrica, albeit we think it unlikely just Centrica would be singled out. Centrica could destroy value in asset or company acquisitions which is a particular risk given the extent of free cash flow we project. While Centrica is well-experienced upstream in oil and gas production, there is a risk of catastrophic events. These risks are not exhaustive and Centrica faces many other commercial and regulatory risks in the UK and US not listed here. We think that the risk to our rating is that the political risk perception on supply businesses rises to very high levels. There is also a risk that the CO2 tax is taken away, which would have an adverse impact on the nuclear generation.

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Target Price and Rating Valuation Methodology and Risks: (12 months) for DONG Energy A/S (DENERG.CO) Method: We value DONG on a Sum-of-the-Parts basis. We look at DONG on a division-by-division DCF (as reported in the segmental analysis) in our SOTP, using an average 6.1% post-tax nominal discount rate. For the wind business, there are three broad revenue streams: (1) Assets in operation; (2) Assets under construction and to be retained; and (3) Assets under construction and to be sold. We value the distribution network (Radius) at around the value of its RAB. We value the gas and oil business on the basis of declining production. We sense-check multiples for all the main businesses (e.g. EV/EBITDA for wind, US$/2p reserves for oil and gas). We also look at the multiples on a group basis (EV/EBITDA, P/E and dividend yield) and compare to peers. We rate the stock Outperform given the upside potential indicated by our DKK 310 Target Price. Risk: Risks to our target price and rating include: (i) returns on the CfDs are too high, and despite change in law provisions, a future Government finds something to remove (e.g. as with the LEC exemption); (ii) Trading arrangements for power post the UK's referendum to leave the EU; (iii) a risk that UK infrastructure is less-attractive post-Brexit; (iv) construction risks on the wind pipeline; (v) a risk that ROC prices collapse; and (vi) political risk in Denmark because of the relatively low price for which the company issued shares (diluting the Danish Government) in early 2014; and (vii) oil-linked contracts which may cause some volatility for EBITDA. Target Price and Rating Valuation Methodology and Risks: (12 months) for Drax (DRX.L) Method: We value Drax using a Discounted Cash Flow, out until 2030 - our assumed date of closure - based upon the forward curve (near-term) and our team power price / energy commodity / CO2 assumptions (long-term). Our DCF analysis also includes three components: (i) The value of biomass burning assuming conversion of three units; (ii) The value of the clean dark spreads on the three units that will not convert to biomass; and (iii) the spreads that we believe are in the hedge book. Given total return upside potential, we rate the stock Outperform. Our target price is 425p/share. Risk: The principal risks to our rating and target price are: (a) biomass costs increase; (b) the mix of relative coal, carbon and UK natural gas prices are not favourable for the spreads that Drax's makes; (c) emissions standards become tighter and too expensive to meet and Drax has to come offline; (d) large outages mean that Drax cannot run, losing output and potentially leading to expensive buybacks of clean dark spreads sold forwards. Target Price and Rating Valuation Methodology and Risks: (12 months) for National Grid (NG.L) Method: We value National Grid on a Sum-of-the-Parts basis. We look at NG on a division-by-division DCF (as reported in the segmental analysis) in our SOTP, using an average 5.2% post-tax nominal discount rate. For the UK businesses, we assume returns converging to just c10% above cost of capital after eight years of RIIO-T1 and RIIO-GD1, and for the US businesses we assume flat returns on equity. We deduct the economic value of net debt from the enterprise value to arrive at the equity value. Our target price is 850p/share. We rate the stock Underperform because of the high market valuation and the risk that returns fall through competitive tendering. We note that low UK RPI inflation and a falling cost of debt index are also risks. Risk: National Grid is a cost of capital business, in our view. The principal risk to our target price and rating is that discount rates increase, or inflation decreases. This could be through either higher risk-free rates or higher risk-premia. Other risks include NG's inability fund its renewals of debt or capex plan. There are also risks that National Grid cannot achieve its regulatory allowed returns (Nominal return on equity in the US, Real return on capital in the UK). Target Price and Rating Valuation Methodology and Risks: (12 months) for Pennon Group (PNN.L) Method: We value the core water businesses based upon the regulatory asset bases, the RAB. Our RAB for FYmar17E is consistent with final determinations (c£3.3bn combined for SWW and Bournemouth). We then review the spread between the allowed return for SWW and the Credit Suisse estimate of the cost of capital faced by the company and use this to calculate the implied level of financing performance. OFWAT currently allows a c3.85% (inc. retail margins). We discount the value of operational outperformance and incentive remuneration, as well as a premium to the terminal RAB (2030). We use a c1.8% post-tax real WACC in our water DCF. Pennon also has a significant non-water business called Viridor waste. The business is active in landfill, power generation, contracting, recycling and incineration (Energy from Waste). We value these components separately on a DCF basis. We have an Underperform rating owing to relative downside to our TP with a balance of downside risk. Risk: The principal risks to the target price are the movement of interest rates, recyclate prices, the movement in inflation, and M&A activity/speculation. Water company valuations are expected to increase in an environment of declining interest rates and increasing inflation. The most immediate upside risk we see to our target price is the potential for an acquisition. A sharp increase in recyclate prices or power prices would benefit waste subsidiary Viridor and pose some upside risk to our TP as well. Our rating would similarly be at risk if there were a material fall in the share price without a corresponding deterioration in fundamentals relative to our expectations. Target Price and Rating Valuation Methodology and Risks: (12 months) for SSE (SSE.L)

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Method: Our main valuation methodology is sum-of-the-parts. We have analysed separately the cash flows we estimate will be generated on a division-by-division basis, including where applicable specific assets within each division (for instance, generation units) taking account of e.g. asset life, projected organic growth rates which reasonably accord with historic performance. We use an appropriate discount rate based on our cost of capital analysis and we estimate the impact of the commodity and investment cycle on financial and operational performance. We combine all and deduct net debt and hybrids as liabilities. Our Target Price is 1,550 pence per share. The shares look fairly valued hence we have a Neutral rating. Risk: High risk - One of the key risks to our target price is generation spreads on gas, coal and hydro plant (the key generation types operated by SSE). If these fall, it could have a substantial impact on earnings. We also see regulatory risks arising from SSE's five-year price controls on its UK networks, and also ongoing interest from OFGEM, the UK regulator. Finally, SSE has financial debt, and so any stress on operational cash flows could endanger the financial strength of the business. These points may impact our Neutral rating. Target Price and Rating Valuation Methodology and Risks: (12 months) for Severn Trent (SVT.L) Method: We value the core water business based upon the regulatory asset, the RAB. We add the NPV of allowed returns relative to the actual cost of capital across 2016-30, then take a premium to the 2030 RAB as a terminal value. We include outperformance on operational and cost incentives (50bp on regulated equity returns for ODI, 65bp for TOTEX). Ofwat currently allows 3.74% from FYmar16-20E, and we use a c4.9% post-tax nominal cost of capital (and an adjustment for the difference in yield on embedded debt). Severn Trent's non-regulated businesses are small, and we value these on an EV/EBITDA multiple. We then derive the equity value of the Severn Trent by taking away our forecast estimate of net debt, provisions, and minority interests. We rate the stock Neutral given the limited total return potential indicated by our target price. Risk: The principal risks to our target price are regulation, the movement of interest rates and the movement in inflation. For instance, a move by the regulator to penalise the company (perhaps for infringements), or a change in the methodology are amongst the most immediate risks. Water company valuations are expected to increase in an environment of declining interest rates and increasing inflation. The most immediate upside risk we see to our target price is higher inflation owing to quantitative easing or the potential for an acquisition. Severn Trent does not have any substantial non-regulated businesses which significantly impact the valuation of the Group (the Services business is c1% of EV, on our numbers). Our rating would similarly be at risk if there were (a) a material movement in share price without a corresponding change in the company's earnings power, (b) a deterioration (or improvement) in fundamentals or earnings power without a corresponding decline (rise) in the share price, or (c) corporate activity (e.g. M&A). Target Price and Rating Valuation Methodology and Risks: (12 months) for United Utilities (UU.L) Method: We value the core water business based upon the regulatory asset, the RAB. Our RAB for FYmar18E is £10,718m, based on OFWAT's PR14 final determination. We then review the spread between the allowed return and the Credit Suisse estimate of the cost of capital faced by the company and use this to calculate the implied level of financing performance. We add the NPV of a premium to the 2030 RAB, reflecting expected terminal returns > WACC. Ofwat currently allows a 3.74% vanilla real allowed return, and we use a c1.8% real post-tax cost of capital (and an adjustment for the difference in yield on embedded debt). We then derive the equity value of the United Utilities by taking away our forecast estimate of net debt and provisions. Our Outperform rating is based on UU having above average upside to our TP, relative to the sector, with what we would perceive as amongst the lowest risk profiles. Risk: Principal risks to the target price are regulation that is less favourable than anticipated. This primarily relates to reforms from 2020E and potential cuts to company return allowances. Potental value destruction depending upon the regulator (OFWAT's) approach to regulatory reform, such as the inflation indexation and Water company valuations are expected to decrease in an environment of rising bond yields, given the relative stability of dividends and earnings. Our rating would be at risk if there were (a) a material rise in the share price without a corresponding improvement in the company's earnings power, (b) a deterioration in fundamentals or earnings power without a corresponding decline in the share price.

Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections. See the Companies Mentioned section for full company names The subject company (CNA.L, DENERG.CO, DRX.L, PNN.L, NG.L, SSE.L, SVT.L, IGY.F, UN01.DE, GAZPq.L, ENGIE.PA, EDP.LS, STL.OL) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (PNN.L, NG.L, SSE.L, IGY.F, UN01.DE, ENGIE.PA, STL.OL) within the past 12 months. Credit Suisse has managed or co-managed a public offering of securities for the subject company (IGY.F) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (PNN.L, NG.L, SSE.L, IGY.F, UN01.DE, ENGIE.PA, STL.OL) within the past 12 months Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (CNA.L, DENERG.CO, DRX.L, PNN.L, NG.L, SSE.L, SVT.L, IGY.F, UN01.DE, GAZPq.L, ENGIE.PA, EDP.LS, STL.OL) within the next 3 months. Credit Suisse has a material conflict of interest with the subject company (GAZPq.L) . Economic sanctions imposed by the United States and European Union prohibit transacting or dealing in new equity of Gazprom issued on or after the date when the Company became the target of such sanctions. This report should not be construed as an inducement to transact in any such sanctioned securities.

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