PR19: all eyes on the WACC
Ofwat has warned its next price control period – PR19 – will be “tougher for the average company”. Nigel Hawkins looks at how the weighted average cost of capital will be calculated, and what might affect it.
Earlier this month, Ofwat published a 282-page tome on the forthcoming 2019 periodic review of water charges; it was accompanied by a City briefing on various financial aspects of the review. Inevitably, though, the City’s leading investment analysts turned to page 202 of the document where the focus is on the pivotal weighted average cost of capital (WACC) that Ofwat will adopt. Without doubt, Ofwat’s chosen WACC figure will be highly price-sensitive.
Furthermore, the regulator has confirmed that “we consider that there is strong evidence that the allowance for total market returns will be much lower at PR19…” In analysing this statement, a careful distinction needs to be made between RPI-linked figures and those that will be driven by Ofwat’s “glide-path” switch to CPIH – the latter includes many owner-occupier housing costs. By way of comparison, Ofwat’s base 2014/15 WACC figure, using RPI-data, was 3.74 per cent in real terms.
Shares in quoted utilities such as Severn Trent and United Utilities will move sharply if Ofwat’s eventual figure is markedly different from market expectations.
In recent months, Ofwat has undertaken several initiatives that could impact its eventual WACC figure; crucially, it plans to publish an indicative figure in December. In doing so, Ofwat will need to assess both the likely cost of equity – difficult in today’s politically-driven financial markets – and the cost of debt, much of which is embedded: the sector’s average debt maturity is circa 18 years. For newer debt, Ofwat is proposing some form of indexation to current debt issuances.
The final calculation will also need to take account of Ofwat’s current gearing ratio assumption – debt/regulatory capital value (RCV) – of 62.5 per cent.
Interestingly, Ofwat has re-booted its rating regime by establishing four new criteria for the regulated water companies – “exceptional”, “fast-track”, “slow-track” and “significant scrutiny”. Whilst no company may be awarded the coveted exceptional status, there is a promised financial bonus, in terms of a 0.2 per cent enhanced return. Furthermore, an exceptional company will attract a distinct hands-off approach from Ofwat.
As they fine-tune their business plans, expect some of the better water companies to move mountains in their quest to secure the treasured blue riband exceptional rating. In fact, most water companies will assuredly be rated in the intermediate range, being designated either a fast-tracker or a slow-tracker. At the bottom of Ofwat’s rating will be those water companies requiring significant scrutiny; this is a “naughty step” category which will give rise to persistent regulatory intervention.
As PR19 progresses, speculation about which water company falls into which rating category will grow, although Paddy Power is unlikely to open a book on it. If it were to do so, Wessex would be an obvious outsider to emerge from the significant scrutiny box. Equally, given its recent deep-seated travails, Thames would be an undoubted long-shot for Ofwat’s exceptional category.
In fact, the Thames situation is very interesting given Ofwat’s recent left-field initiative, whereby it demanded a raft of very specific financial and operational information: Thames currently has net debt of £10.7 billion. The feedback from Ofwat’s fishing expedition into Thames should tease out key financial data; this could yield a valuable read-over into other water company finances – and the degree to which they can absorb tighter financial regulation. After all, Ofwat will be eager to cut its WACC assumption – and, in consequence, retail prices – provided that the coveted investment grade credit rating can be maintained.
In the electricity sector, it is significant that Ofgem is already “on manoeuvres” regarding the next networks regulation review: inevitably, the prescribed WACC lies at its core. Regulators have also noticed that several utility disposals in recent years have yielded a substantial premium to their implicit RCVs, partly due to companies out-performing the financial assumptions. No doubt, they would prefer such surpluses to be re-cycled to consumers via lower prices.
These views on the WACC are obviously utility-centric. But, more generally, future trends in UK interest rates will be crucial. In the UK, after a near decade of low interest rates following the credit crisis, any future movement is likely to be upward. But leading credit rating agency, Standard and Poor’s, does not expect any increase until mid-2019.
The highly uncertain UK political situation undoubtedly complicates matters. After all, the Labour party manifesto advocated the return of water companies to public ownership on a regional basis.
All in all, Ofwat has a big call to make on its assumed WACC – simultaneously, it seeks price cuts, high investment and the maintenance of an investment grade credit rating.
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