Legislation, regulation and litigation can literally change a company’s business overnight. The risk that a change in the rules governing an industry could impair an institution’s financial performance—more casually known as “stroke of the pen risk,”—is something that all companies are exposed to in varying degrees. We experienced the impact of this risk first hand with our former investment in RWE, a German electric utility company that utilizes nuclear power as one of its many fuel sources. Our learnings show that implementing certain strategies can help us avoid this risk the best we can, but ultimately, it’s one all investors must contend with and consider.
We purchased RWE in 2007 primarily because of its history of wealth creation, competitive advantages and attractive valuation. We recognized the possibly of stroke of the pen risk but felt the company’s positives—large scale, sticky customer base, and an ability to produce low cost electricity—made the stock relatively attractive.
In 2009, we received favourable news: the Christian Democrats took power and began the process of negotiating with the power utility companies for a potential life extension for nuclear plants beyond 32 years (a “phase out” of the 2000 Nuclear Phase Out Law if you will). It was expected that many nuclear facilities would be granted anywhere from 8 to 14 year life extensions. This would have had a positive financial impact on companies like RWE, as they could continue production from their existing infrastructure at a very low marginal cost.
Heading into 2011, the granting of extensions was considered by most to be a done deal, though not yet official. The government did decide to grant the extension…but only if the power utility companies agreed to pay a nuclear fuel tax, which would subsidize more resources into renewable energy. The tax would increase the cost of production for nuclear power plants, and subsequently, diminish the attractiveness of RWE from an investment standpoint. The consequences would have been huge for the company—we estimated that the tax would have been roughly EUR $1 billion per annum for RWE, approximately 14% of its group operating profit. We sold out of the company on February 26, 2011 at about €49 per share (the shares bottomed at about €11 in December 2016).
But on March 11, 2011, the Fukushima disaster occurred and, virtually overnight, Germany’s government ceased negotiations, declared there would be no extension granted to plant operators, and imposed a complete phase out of all nuclear power plants after 32 years of operation. Effectively, eight plants, including RWE’s Biblis plant, were forced to shut down within the first three months following Fukushima. Subsequently, the value of RWE’s stock took a major hit.
For us, RWE was certainly a catalyst for learning. Since then, we see utilities as a less-desirable sector because of this asymmetric risk, and currently have a zero weight in the Utilities Sector. That being said, stroke of the pen risk can occur in any market and it’s impossible to entirely avoid, but by recognizing your exposure you can help protect your portfolio. One way to manage your downside is to ensure that stroke of the pen risk is sufficiently reflected in each company’s valuation. Additional ways of managing this risk include diversification, allocating smaller portfolio weights to these types of companies, and offsetting the risk by having holdings in your portfolio that benefit from this type of risk.
Another useful insight we gained from the RWE experience is that certain developments related to stroke of the pen risk can play out over a very long time frame. Fukushima happened over six years ago and even now a stroke of the pen ruling around the nuclear fuel tax—this time a favourable one from the courts—is affecting the company’s bottom line. Germany’s highest court ruled that the government did not, in fact, have the legislative authority to impose the nuclear fuel tax and, as a result, the tax has been declared null and void. Operators can now claim a tax refund that could reach billions—although they still have to contribute to a nuclear decommissioning fund—but for most investors the damage has already been done.