Electric shares lose the tingle

LAST week's Labour potshot at the privatised utilities marks the end of a dismal spring for what many investors had regarded as the London stock market's sexiest sector, electricity.

The 12 regional electricity companies (RECs) are local monopolies supplying the whole community with an essential commodity, power. But the shares have proved the most volatile of all sectors this year. And small investors with heavy exposure to utility issues will need no reminding of the bloody nose they received as a result.

Two months ago Professor Stephen Littlechild, director general of the electricity industry's regulator, Offer, performed an incredible U-turn by tearing up a pricing regime, to put in its place a tougher structure designed to give more of the benefits of privatisation to consumers rather than shareholders.

The stock markets' reaction was that a particularly well-loaded gravy train had ploughed into the buffers. Share prices plummeted. After years of apparently effortless profits and dividend growth, investors appeared wrong-footed by the sudden emergence of regulatory risk for the RECs.

The year had got off to a good start. Trafalgar House's pounds l.2bn bid for Northern Electricity, combined with the news that market-makers at Swiss Bank Corporation had taken an 8.5 per cent "Trojan Horse" stake in Yorkshire Electricity, sent REC shares into orbit as speculators ran their calculators over likely bid targets.

The sector's fundamentals also appeared sound, with the threat to profits from Offer apparently neutralised. The regulator's original 1994 review was regarded by most RECs as the best they could have hoped for.

Indeed, most found it gave rise to an embarrassment of riches. REC managers were soon locked into frantic discussions about the best way to return surplus cash to shareholders. A rash of share buy-backs and special dividends followed.

Investors, it seemed, were on a one-way bet. It was only a matter of time before electricity shares were seen for what they were by potential predators: cash machines plugged into captive markets.

In the five years since being sold for pounds 5.2bn, the RECs have risen in market value to pounds 13.5bn, comfortably outpacing the market as a whole. In the last reporting season shareholders enjoyed dividend increases of between 21 and 47 per cent as well as pounds 1bn of special dividends and share buy-backs. But that was all before Offer made its move. Its new target for electricity price increases between next April and 2000 looks as if it will be closer to five points below the headline rate of inflation rather than the current two. Some analysts believe it could also order a one-off rebate to customers.

Investors looking for a piece of the action from the forthcoming flotation of the National Grid company are also likely to be disappointed.

The RECs currently own the power distribution company and have long wanted to release its embedded value from their balance sheets. But the current uncertainty created by Offer has put this on ice.

Investors who bought into electricity companies to take advantage of possible bids also face an uncertain future. Perceived wisdom is that outsiders are unlikely to bid while the pricing regime is so uncertain. Yet rumours persist that powerful US utilities are willing to take a gamble on the outcome of the current pricing review and strike while the shares remain depressed. It is also conceivable that this same uncertainty could provide an opportunity for strategic defensive mergers between electricity (and water) companies. A bid from whatever quarter would certainly put the spark back into electricity shares.

Finally, the prospect of a Labour government has not helped. Although the party has toned down much of its blood-boiling rhetoric toward the privatised electricity companies, its policies remain a negative influence on sentiment.

The RECs have a little room for manoeuvre in the short run. They could try and reach a quick compromise with Professor Littlechild, by paying out substantial rebates to customers. They could also appeal over his head to the Monopolies & Mergers Commission.

But a full-scale review from this Star Chamber of regulators could last well into next year, blighting share prices for months to come.

Some investors, however, are arguing both that recent share price falls were overdone and that all the utilities' basic businesses remain very solid.

So do recent price falls take full account of these threats? Professor Littlechild has given himself another few weeks to revamp his controls. But beyond that lies an election. Until that is out of the way, share prices of all the privatised utilities are likely to be strongly influenced by regulatory worries.

"Once bitten, twice shy" is a good motto, and these shares are not for the proverbial widows and orphans. But they remain a classic gambling chip for the risk-inclined investor.