China Gas Utilities:A more favorable version of downstream return regulation issued

On 22 Jun 2017, the NDRC officially released the Guidance of StrengtheningSupervisions of Distribution Tariffs, which we think is more favorable andpositive to downstream than the draft version. There are mainly 3differences/revisions compared to the draft: 1) the regulated return is set at 7%vs. 6% in the draft; 2) During cost assessment, distribution line loss is set at5% and decline to 4% within 3 years (vs. a fixed 4% in the draft); 3) In the draftversion, it requires the volume to be determined at 60% utilization of capacitywhen calculating distribution tariffs, while the final version does not mentionthe “60%” and delegate the flexibility to local govts. The NDRC requires thelocal government to issue corresponding notices based on this guidancebefore June 2018. We believe the actual impact to gas distributors should begradual and mild. We reiterate Buy on China Gas, ENN Energy, and BEHL.

    A more favorable return of 7% granted by the NDRC.

    In the notice, the NDRC caps the allowed return for gas sales business atproject company level at 7%, higher than the 6% given in the draft version. Theallowed assets only account for those related to distribution business (incl.

    pipelines, storage facilities, intangible assets and working capital). We reiterateour view that the connection fee should not be part of the regulated return (seeMarket over-reaction offers good entry point, 16 May 2017), which is also inline with the interpretations of gas companies and industry experts (Keytakeaways from expert conference call, 22 May 2017).

    Gas distributors could still record above-regulated return via efficiency gain.

    We expect gas distributors could still be able to realize higher-than-regulatedreturns. In the notice, the distribution line loss is set at 5% for cost auditingpurposes and should decrease to <4% in three years. This leaves room for gasdistributors to enjoy efficiency gains, as major gas companies are recordingline loss much lower than 5% (ENN<3%,, CR Gas <3%, China Gas 1%).

    Moreover, between cost review intervals (<3 years as suggested by theNDRC), gas companies can enjoy operating leverage from rising gas volume.

    The notice also encourage local govts to set incentive scheme for gascompanies to share the benefits of cost-savings with the end users. We believeENN’s potential cost savings via importing LNG through its own terminalshould apply to this scheme.

    Impact to gas distributors should be gradual and mild.

    In our model we have factor in a Rmb5-7cents/cm margin squeeze for C&I gassales volume over the next three years for all the gas distributors (except BEHLwhich we expect stable margin) to reflect return regulation by localgovernment and some discount offered to coal-to-gas/large industrial users.

    We believe the regulatory risks are already well digested by the market afterthe leak of the draft version of the notice in May 2017. Reiterate Buy on ChinaGas, ENN Energy, and BEHL.