Developing a robust approach to financeability assessment: the need for a broader view

In the third article in Economic Insight’s series on financeability, Chris Pickard and Sam Williams consider what it means for a company to be financeable in practice, and what this implies for the assessment of financeability.

Financeability is the ability of regulated companies to attract steady sources of finance on reasonable terms. This is reflected in the wording of regulators’ specific financeability duties, for example Ofwat’s duty to ensure that companies “are able (in particular through securing reasonable returns on their capital) to finance the proper carrying out of those [statutory] functions”,  and the requirement for Ofgem to have regard to “the need to secure that licence holders are able to finance the activities which are the subject of [statutory] obligations”.

The fact that financeability duties are held alongside a range of other statutory duties, however, has implications for how regulators have interpreted their financeability duties in practice. These other duties include promoting efficiency, alongside an overarching duty to promote customers’ interests. The implication is that, as well as ensuring financeability, regulators are required to prevent customers paying for company inefficiency. As such, regulators have reconciled financeability with their other duties by seeking to set price or revenue limits at a level that allows an efficient notional firm to secure finance.

Based on this interpretation of their financeability duties, regulators have taken the concept of the notional firm as their starting point for assessing financeability. The approach typically involves determining efficient costs (including a return on capital) and calculating resulting revenue allowances using the building block approach. A financial model is then used to determine whether implied cash flows are sufficient for the notional company to achieve an investment-grade credit rating. This is usually based on the metrics that ratings agencies use to assess creditworthiness.

If this analysis indicates that cash flows are insufficient to achieve an investment-grade rating, shortfalls can be compensated for by reprofiling price or revenue limits – effectively moving cash from one year to another – in a manner that leaves the net present value of total cash flows unchanged. This is done by pulling on ‘financeability levers’ within the price control, such as the proportion of expenditure added to companies’ asset bases, or the rate of depreciation thereof.

This type of analysis provides a useful top-down cross-check to revenue allowances calculated using a bottom-up building block approach. In contrast to the high-level framing of statutory financeability duties, however, this type of assessment tests one particular aspect of financeability. The question it answers is whether an efficient notional firm would have sufficient cash flows, over the course of the price control, for its debt to receive an investment-grade credit rating.  While this is clearly a very important issue to test, it is a narrow part of a much wider issue.  For regulators to meet their statutory duties we consider that a broader assessment is required.  In our view, there are three parts to this.

First, the assessment of financeability needs to consider both equity and debt.  Although short-term financeability from a debt perspective is more readily assessed using financial metrics, it is just as important to ensure that regulated companies can access equity finance.  Indeed, regulators such as Ofwat have indicated their intention for future price controls to assume that the notional company relies on equity financing to a greater extent than in the past, making a robust approach to financeability from an equity perspective even more important.

The importance of considering financeability from an equity perspective is also reflected in Ofgem’s intention, signalled in its December 2023 methodology consultation for RIIO-3, to develop the concept of ‘investability’ alongside its existing financeability tests. Ofgem indicated that this was driven by the need for a “step-change” in investment, including new equity investment, “at a time where there is greater competition for investment and capital in the UK water and global regulated infrastructure sectors”.

Secondly, while the principle of assessing financeability on a notional basis is sound, getting the notional firm ‘right’ is crucial for the accuracy of any financeability assessment. Any errors in the calculation of efficient costs and revenue allowances for the notional company will directly impact the expected level of equity return, potentially imperilling financeability from an equity perspective. Regulators therefore need to ensure such errors are minimised and, as far as possible, cancel one another out, so that allowances in totality are as accurate as possible. As well as reviewing whether targets are stretching enough, regulators need to give equal consideration as to whether the assumptions they make about the notional firm are too challenging to represent an achievable benchmark.

In addition, regulators also need to ensure that their characterisation of the notional firm’s financial structure is internally consistent with both the calculation of revenue allowances and the criteria used to assess financeability. Available evidence on financial structures will often suggest a wide potential range for metrics such as the efficient level of gearing. The need for consistency with the approach to determining cost of debt allowances and the assumptions made over target credit ratings can help to narrow down the appropriate level for the notional firm.

Finally, while it is vital to evaluate the adequacy of short-term cash flows, the assessment of financeability also needs to consider the longer term. Pulling on financeability levers to ameliorate near-term cash shortfalls can only be an appropriate response when aggregate revenue allowances over time are sufficient, so that shortfalls in one year are offset by surpluses in others. Otherwise, reprofiling revenue by changing assumptions about depreciation or the split between opex and capex is liable to store up problems for the future.  Financeability assessments will cease to provide a top-down cross-check to revenue allowances, and shortfalls in revenue allowances will be pushed into subsequent price controls, while at the same time the value of companies’ asset bases will become detached from the underlying physical infrastructure.

In conclusion, regulators’ financing duties have a wide scope, which needs to be reflected in the approach to assessing financeability. Consideration of financeability for both debt and equity is critical to ensuring that regulated companies can attract finance from a mix of sources.  It is also vital to look at financeability from a long-term perspective, as well as considering the adequacy of cash flows in the short-term. While a notional approach to financeability is sound in principle, accurately characterising the notional firm is crucial and a robust approach to this issue is required.

This is the third in a series of articles for Utility Week by Economic Insight. You can still access the first and second of these.