The Competition & Markets Authority (CMA) has long cast a shadow over the boardrooms of the UK, scuppering countless ambitious takeover plans and thwarting many a shareholder strategy.
So, it must be a rare case when the companies not involved in an investigation are the ones facing difficult conversations with their investors about the outcome.
However, that is exactly the situation in the water sector this week after the CMA’s unexpected approach to the PR19 appeals and particularly its findings on rates of return for the four companies involved.
Utility Week asked a range of industry figures for their view on why this case is so unusual and what it means for the appellants, the regulator and price controls in the energy sector. And, will the 13 water companies that accepted their final determinations really just shrug this off and accept their lot?
What was so surprising?
As one industry observer puts it: “We were expecting tinkering around the edges but what we got was a substantial change. This is a significant departure from previous attitudes expressed by the CMA.”
Another says: “Anyone who is telling you they saw this coming is lying. This has caught everyone out. The companies and the investors will feel they have won a significant victory, even if they’ve been pegged back in other areas. Ofwat have had the rug pulled completely from under them. This is pretty embarrassing for them.”
The bombshell came yesterday (29 September) morning when the CMA published its interim findings on the four appeals to Ofwat’s final determinations on water company business plans for 2020 to 2025.
Anglian, Bristol, Northumbrian and Yorkshire’s challenges made it a record opposition for a water sector price control. However, the general feeling across the industry was that precedent was against the four, with serial appellant Bristol having failed to gain significantly from previous attempts. Inside Ofwat there was a feeling that with 13 companies accepting the final determination (albeit begrudgingly in many cases) it had got its “tough but fair stance” about right.
It is understood that the CMA had played its cards close to its chest, with little indication in conversations over the past few months that it was likely to depart so significantly from the regulator on such a key topic as the cost of capital.
But when yesterday’s 800-page provisional report came out, the CMA revealed it had ripped up Ofwat’s methodology for the crucial Weighted Average Cost of Capital (WACC) and come up with a very different answer.
Crunching the numbers
The CMA disagreed with Ofwat’s approach to calculating index-linked debt and to come up with the equity beta it analysed data going back to 2005, as opposed to the two to five year historic data the regulator based its calculations on.
Perhaps as significant as the methodology for the range of the WACC is the point at which the CMA drew the line. The eventual range was between 2.82 per cent and 3.99 per cent but rather than simply pick the midway point the watchdog plumped for the figure of 3.5 per cent, stressing that this was “prudent” given the “higher risk of error when estimating the cost of equity”.
As one investor tells Utility Week: “That could be a really important precedent because the message they are sending is that the consequences of the downside are more severe than the consequences of the upside. For the CMA to express that point of view is very powerful. It means in the future that companies will have that case to argue.”
While Ofwat won many of the battles over costs and outcomes – perhaps more than expected – it will inevitably be wounded by the key areas in which the CMA has departed from its position.
In particular, the CMA’s explanation that adjustments to Ofwat’s allowed rate of return were necessary to reflect, not just market-based evidence, but also “best regulatory practice”, must have made painful reading.
Given that Ofwat’s views on WACC have been known for more than two years and companies are still finding it possible to access financing, some commentators question whether the CMA has read the mood music right.
One says: “The CMA has paved the way for a much larger return on capital and that’s quite hard to square when you look out of the window at what’s happening to other people.”
It is likely that this “real world check” will be a consistent theme in Ofwat’s response to the CMA, however an outright challenge to the revised WACC methodology seems unlikely.
A sector analyst assesses the CMA’s approach in blunt terms: “If I was (Ofwat chief executive) Rachel Fletcher, I’d be spitting feathers reading what the CMA has done. Ofwat must feel extremely upset and surprised.
“All the work Ofwat has done over the past three years has been rejected. They are a team of experts and have been overruled by CMA, who aren’t as knowledgeable.
“Thirteen out of the 17 companies accepted the WACC set by Ofwat so the CMA should not have gone close to it.”
Top Gear
In its final determinations, Ofwat sought to tackle the issue of high levels of gearing among water companies and the ensuing risk to billpayers. This resulted in the Gearing Outperformance Sharing Mechanism (GOSM) which seeks to share the benefits of higher gearing with customers.
The CMA agreed with the need to tackle the issue but expressed concern as to the effectiveness of the GOSM in improving financial resilience as well as questioning the specifics of its design. It also shed doubt on “whether the financial benefits of higher gearing assumed by Ofwat in its design of the GOSM exist”.
This is likely to have been one of the most frustrating outcomes for Ofwat given that the CMA has effectively agreed there is an issue for which the regulator needs to find a solution but has rejected its chosen mechanism and provided no guidance on a new one.
High gearing and company returns are, of course, an extremely sensitive topic in an industry still bearing the scars of last year’s privatisation debate.
Is there a risk that this complex process could be reduced to accusations of shareholders being favoured over customers and drag the sector back into the same old arguments waged during last year’s nationalisation debate?
Lawrence Slade, chief executive of the Global Infrastructure Investor Association, rejects this view, saying: “It’s very important to remember that bills are still coming down – by 9.3 per cent over the five years. What this is about is getting the balance right between a fair deal for billpayers and the incentives to invest for the future.”
What about the rest?
The CMA process is very clear – you have to be in it to win it. So, for the 13 companies that accepted their final determinations, there will be no automatic adjustment to the cost of capital.
However, one former regulator expresses the view that the CMA’s diversion from Ofwat’s final determination on this issue is so substantial that the impact on the rest of the sector will have to at least be considered.
“There is no formal mechanism but those companies will be desperate to find some way of evening things up because you are now in a situation where the investors in four out of 17 companies are going to be doing considerably better than the rest.
“I wonder if they might try to take this direct to the government. I’m not sure whether they’d even get a hearing in the current climate but that doesn’t mean they won’t try.”
However, others pointed out that while the ‘gang of four’ may have gained on WACC, the operational and management costs involved with a CMA appeal are huge and there are plenty of areas in which the watchdog has been tougher on them than Ofwat.
Despite an inevitable frustration from the companies that did not appeal, they are likely to take heart from the evidence that the CMA process can work in their favour in future.
This is the view of Peter Antolik, of Arjun Infrastructure Partners, which manages the fund that owns 55 per cent of South Staffs Water.
He says: “This shows the strength of having merits-based appeals. It’s a crucial part of the checks and balances of the sector and it gives investors confidence. It’s enormously important for companies to have that right to have their case re-evaluated on its merits.”
Energy effect
This stone thrown into the water sector will cause ripples far and wide and immediate thoughts will turn to Ofgem’s approach to RIIO2.
The CMA’s recalculation puts the real cost of equity at 5.08 per cent as opposed to 4.19 per cent in Ofwat’s final determination and the 3.95 per cent Ofgem is currently proposing in its draft determinations for the gas and electricity transmission networks.
Asked how Ofgem is likely to respond, one former regulator says: “Each CMA case is a different panel and they are fully entitled to take a different approach, especially in uncertain times, so Ofgem aren’t necessarily beholden.
“The CMA went for a wide range for the WACC figure and then went to the upper end of it so Ofgem could pitch something that was within that range but a different quartile. But it would be a risky move because it could look as if they are snubbing the CMA. They could also do something with the outperformance wedge but the CMA probably wouldn’t look too kindly on that either.”
For one investor, who has experience in both the water and energy sector, the message from the CMA is load and clear and it is one Ofgem would be foolish to ignore.
“They are fully entitled to pick their own figure (on cost of capital) because in appeals to RIIO2 the CMA would have to prove Ofgem was wrong. But they know that any deviation from the precedent the CMA has set will be jumped on by the companies. Do they want to spend the next few years fighting multiple appeals? They’ve got enough on their plate.”
For the regulated energy companies themselves, clearly there will be a spring in their step. National Grid’s share price rose nearly 5 per cent in the wake of the announcement while SSE also saw an uptick.
Barclays analyst Dominic Nash has pointed out that the beta in electricity and gas assets is higher than in water and predicted this could ultimately add up to another 25 basis points to the real cost of equity for the networks.
A new kind of regulation
Whether of the view that the CMA got it right or wrong, all observers agree that this is going to have long-term implications for all regulators.
One says: “This is just going to increase calls for government to give more concrete guidance on what regulation should be about. What are the priorities? Investment for the future as quickly as we can? Driving down bills? Protecting the vulnerable? You can’t simply ask an economic regulator to stick their finger in the air and judge all this themselves.”
A former regulator says: “This is likely to feed into conversations already ongoing within Ofwat about whether a new approach is needed for PR24. The current regulatory model was one set up for an inefficient industry and it hasn’t really kept step with the evolution we’ve seen. If you look at where we are now it’s increasingly difficult to justify a one-size-fits-all approach.
“The CMA may have been the nudge that was needed to really get that ball rolling.
“If nothing else, Ofwat has at least had a glimpse of what the determination process looks like from the company point of view. I don’t think they’re enjoying it.”