Bond navigators: Is evolving gas distribution regulation enough to avoid the death spiral?

In 2019, following extensive research into the UK gas sector and the impact of net zero, we published a report outlining the very real risk of asset stranding, entitled "The Death Spiral."

At that time, we concluded that the potentially existential threat to the sector from the necessary transition to electric heating for households was not priced into credit markets, leading us to exit substantially all of our exposure, switching from gas to electricity bonds with no loss of credit spread.

Since our original report, credit markets have begun to wake up to stranded asset risk, with gas network bonds materially underperforming bonds issued by electricity networks. And now credit markets are more clearly reflecting the risk, the regulator Ofgem has finally woken up to the practicalities of managing the sector’s long-term viability in its latest regulatory methodology, a subject we have recently been engaging the gas distribution network operators on.

Assuming the target of net zero by 2050, Ofgem has now explicitly recognised that the significant level of theoretical asset value implied in 2050, within the existing regulatory framework for gas networks, is not consistent with the expectation of a substantial reduction in gas demand. Encouragingly, the latest regulatory thinking is evolving to consider a level of “accelerated depreciation” that more closely reflects the likely evolution of gas usage; essentially paying investors back their investments quicker, leaving fewer assets at risk come 2050. This approach will also help enable a just transition; reducing the risk that the fixed cost of maintaining the gas network is a burden on a smaller number of customers – including those who are forced to remain users of gas due to financial constraints – and will instead be shared across the wider base of existing customers now. Furthermore, this move is better aligned with a net zero future, providing more encouragement for households to switch away from gas before 2050.

The UK remains heavily reliant on gas for heating, and domestic usage must, and will, reduce, especially if the government introduces incentives and attractive subsidies to facilitate the move to electrification. So, whilst it may not be possible to avoid the ultimate sector death spiral, the regulator is at least now looking to provide a sensible safety net for investors. Despite this shift, gas bond spreads remain elevated against equivalent electricity bonds. In much the same way as we exited the gas sector when the risks were not adequately reflected, we have now selectively increased our exposure.

As one of our earliest Environmental, Social and Governance (ESG) credit projects, it was important that we revisited our gas network analysis and engagement to ensure our understanding of sector risks remained current. Usefully, the combination of ESG and credit analysis allowed us to assess and mitigate the death spiral risks effectively. The fact that the same approach is now helping us to identify credit opportunities is even more encouraging.

Considerations referring to ESG as part of the investment process does not mean the fund or strategy is trying to achieve a particular ESG or sustainability outcome. Please check prospectus documentation for details on specific product objectives.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.