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Morningstar | Inefficient Market Reaction to EU Ruling Against the U.K. Capacity Market; SSE Deeply Undervalued

On Nov. 15, the EU General Court ruled that the U.K.'s capacity market is not compatible with the EU state rules. The court granted the appeal launched by Tempus Energy arguing that the U.K. capacity market discriminates technology designed to cut peak electricity demand. Consequently, capacity payments are halted until further due diligence is carried out. Brexit is a key factor to consider since in case of a hard Brexit, the U.K. government would not have to abide by the EU rules anymore. In all, this unexpected ruling increases uncertainties of the U.K. power generation market. Still, we believe the worst case scenario of a cancelation of the U.K. capacity market without any alternative scheme is unlikely. For instance, a solution could be to supplement the payments to conventional capacity with payments for voluntary demand reduction, in line with what is done in France. Accordingly, we do not use a probability weighting of the worst case scenario in our fair value estimates. We did calculate the potential negative impact and compared it with share price reactions after the news. Bottom line, we found out that most reactions were unjustified.

RWE is the most exposed to adverse changes in the U.K. capacity market. Assuming the definitive cancelation of the U.K. capacity market without any alternative scheme, the negative valuation impact for RWE would amount to EUR 2.3 per share, 13% of our fair value estimate, and net income would be reduced by 11% on average through 2022. We believe the market has been too lenient on the risk since the share price has now recovered to its level before the news. The second most exposed company is SSE. Under the worst-case scenario, our fair value estimate would be reduced by GBX 100 or 7% and our 2018-22 net income estimates by 6% on average. Unlike for RWE, the market has almost fully priced the worst-case scenario as the share price declined by GBX 87 since the ruling, which is excessive.

The third most exposed is EDF. We calculate a potential negative valuation impact of EUR 0.7 per share or 5% of our fair value estimate, versus a EUR 0.4 share price decline. Centrica is the fourth most exposed through its 20% stake in EDF's U.K. nuclear plants. We calculate a potential negative valuation impact of GBX 5 or 3% of our fair value estimate. The share price decreased by GBX 10 since the ruling, which is excessive. By selling its U.K. conventional power plants to Drax in October, Iberdrola shed exposure to any changes in the U.K. capacity market.