The Competition and Markets Authority’s preliminary redetermination is a step in the right direction but still leaves business plans unfinanceable, appellant water companies have argued.
As part of the price review process for 2020 to 2025, Anglian, Bristol, Northumbrian and Yorkshire Water appealed to the CMA after rejecting Ofwat’s final determination in February. The CMA published its interim decision at the end of September which surprised many with the generosity of its allowed returns. Ofwat said there is insufficient evidence that customers or the environment will benefit from the CMA’s proposals.
In its response to the ruling, Anglian Water said the decision has brought the price controls closer in line with customer’s preferences to spend more money to achieve greater resilience but expressed disappointment that the CMA otherwise agrees with much of Ofwat’s final determination.
The company, which focused its grounds for appeal on its duty to customers to invest in resilience, said the CMA’s decision would still leave the company with “an acute risk of not being able to meet the demand for water in its region during AMP7”.
Although the CMA suggested a significantly higher rate of returns for investors, Anglian noted that it would nevertheless be 30 per cent lower when compared to the previous regulatory period. It said it would still be left with “essentially no risk buffer” to maintain its credit rating and highlighted acute financial risks in relation to leakage.
It emphasised the challenges faced in the East of England and asked the CMA to give greater consideration to how services are delivered in the driest part of the country.
Bristol Water, the smallest of the four appellants, said that although the CMA’s findings showed “movement in the right direction”, material gaps remain. The water-only company based its appeal on what it described as material errors in Ofwat’s calculations including not permitting small companies a higher cost of capital.
The company said the preliminary redetermination strikes a “better balance between risk and reward” and welcomed the reaffirmation of the precedent from its two previous appeals to the CMA to apply a company specific adjustment to its allowed cost of debt.
However, the business asked the CMA to reassess its estimation of this adjustment, claiming the competition watchdog was inconsistent in its application.
It said not only is the baseline cost of capital still too low, the adjustment also remains less than what it requires to deliver on the service levels expected of the company.
Bristol requested the CMA reassess its approach to setting leakage cost allowances as it had only offered extra funding for exceeding upper quartile performance but had based cost models on average performance.
It approved of the “more robust and realistic” approach the CMA took to financebility testing based on credit rating agencies’ metrics.
Northumbrian, which was outspoken in its rejection of its final determination as unfinanceable and faced the most significant bill cut, said the totex allowance remains insufficient.
It identified a gap of £83 million in its base costs during AMP7. The CMA increased overall totex allowance by around £22 million, of which £20 million is for its Essex Resilience scheme, so Northumbrian said it remains at significant risk.
Its submission said the redetermination would still represent the one of the largest bill cuts while posing a “right and proper” stretch on performance.
The company asked the CMA to go further to support investment in resilience and in particular to reconsider the funding of its sewer flooding proposals. It criticised the regulatory framework for overlooking the need to invest in such programmes, which Northumbrian noted several companies proposed in PR19 but had funding rejected by Ofwat.
Northumbrian raised concerns that the use of customer engagement had not been fully evidenced by Ofwat in its determination and asked the CMA to set an expectation as to how engagement and feedback will be treated in future price controls.
Yorkshire, like Anglian, said it would be left with limited financial headroom and that its business plan would be “significantly challenging” to deliver.
The company maintained the package was stretching but said in the round the CMA’s determination was “a significantly more balanced package than Ofwat’s final determination and mitigates much of the harm that it would have caused.”
However, Yorkshire said the CMA’s financeability assessment put more weight on outcome delivery incentive rewards than penalties, so the downside risk remains material.
The company said the CMA’s approach to costs and outcomes was too close to Ofwat’s and meant the company would be materially underfunded to achieve the required step-change in performance on internal sewer flooding.
It said the asymmetric penalty-only ODIs proposed by the CMA expose companies and investors to risk and that it expected returns below the cost of capital.
In its own response, Ofwat said there had been no evidence in the 30 years since the sector was privatised that a higher cost of capital actually increases the level of investment. It said the certainty of a regulated sector meant shareholders should not need more compensation for investing and that the CMA’s decision would cost billpayers £0.5 billion over the five-year period.
The regulator expressed concern that, if unchanged, the determination would result in “a very material and unnecessary” increase in expected returns for investors in water and other regulated sectors.
Ofwat feared investors could extract the newly increased returns in the form of higher dividends or sale values.
“The history of the water sector, as recently as a decade ago, demonstrates that we can have no confidence that these higher returns will translate into increased investment in services for the benefit of consumers and the environment,” it explained.