Why do European electricity networks trade at different valuations? How regulatory return mechanisms change the timing of profits and cash flows

Why do identical investments generate different current returns?

European electricity networks are increasing capital expenditure. Bernstein believes that directly comparing price-to-earnings or EV/EBITDA ratios at this point can overlook regulatory differences: nominal-return regimes include inflation in the allowed rate of return and recover it earlier through charges, while real-return regimes allow the regulated asset base (RAB, the value of assets permitted to earn a return) to grow with inflation, retaining more value for the future.
The bank models a 20-year cycle using two hypothetical companies with identical starting RABs and investment paths: capital expenditure first expands, peaks in years 10–11, and then gradually declines. Under shared assumptions including inflation of 2%, the allowed pre-tax return is 7.3% under the nominal regime and 5.0% under the real regime. The lower current return and inflation compensation on assets are part of the same arrangement.

In the simulation, the real-regime company's RAB is 23% higher than the nominal-regime company's in year 20. But inflation also raises regulatory depreciation, offsetting growth in the asset base. As a result, the RAB growth-rate advantage is smaller than the 2% inflation assumption, becoming more pronounced only after investment slows.
The nominal-regime company earns higher current cash returns. Its cumulative free cash flow over 20 years is 25% greater than that of the real-regime company, and its cash flow also recovers faster after investment slows. The real regime requires more borrowing, and the additional interest expense depresses net profit.
Their net debt-to-RAB ratios can nevertheless remain close because the real regime also has a larger asset base. Similar-looking leverage ratios can therefore conceal different debt amounts and interest burdens.

During the expansion phase through year 11, the model shows compound net profit growth of 15.9% for the real-regime company, below the nominal regime's 16.7%. During the subsequent investment slowdown, the real regime grows at 10.4%, above the nominal regime's 6.3%. The key is the investment cycle, rather than one mechanism always growing faster.
Regulatory depreciation under the real regime rises with inflation, supporting revenue and EBITDA; accounting depreciation is based mainly on historical capital expenditure and is not increased in tandem. The widening gap between the two measures means operating profit grows faster than EBITDA, especially when investment slows; however, higher interest offsets some of the gain.

Assuming both companies have enterprise values equal to their RABs, the real regime naturally has a higher EV/EBITDA because its asset base is larger and its current EBITDA lower. Regulatory differences alone produce a gap of about 3 multiple points in the model; over 20 years, the real regime's price-to-earnings ratio averages about 8 multiple points higher.
Bernstein concludes that higher multiples can arise from the timing of earnings recognition and cannot be directly attributed to better business quality or a more expensive valuation. Conversely, identical RAB premiums are not necessarily economically equivalent: using the same nominal discount rate of 6% and assuming terminal value at the end of year 20 equals the RAB at that time, the model yields initial RAB premiums of 27% for the nominal regime and 34% for the real regime.

Yes. At the same RAB premium, the real regime's lower near-term earnings and cash flow constrain initial dividends, while its inflation-linked RAB supports higher equity value, so its dividend yield may be lower.
The model assumes a payout ratio of 50% in the first year and annual dividend-per-share growth of 3% thereafter. When earnings grow faster than dividends, the payout ratio gradually declines, leaving room for faster dividend growth or a higher payout ratio later; this depends on adjustments to dividend policy.