Equity financeability and the long-term perspective

In the sixth and final article in Economic Insight’s series on financeability, Chris Pickard and Sam Williams consider practical ways of achieving a robust assessment of financeability.

Across this series of articles, we have stressed the need for a rigorous, evidence-based approach to financeability assessment. In this final article in our series, we set out practical steps for addressing two important gaps in the existing approach, namely the assessment of equity financeability and the safeguarding of financeability over the longer term.

Financeability is more readily assessed from a debt perspective than an equity perspective.  In part this is because the role of credit ratings agencies means that credit metrics provide an obvious and measurable way of assessing debt financeability (notwithstanding the difficulties of determining the notional company’s efficient costs). Equity financeability is, however, just as important as debt financeability. This is reflected in Ofgem’s intention to introduce the concept of “investability” to complement its existing financeability assessment. Indeed, equity investors bear the risk of any mistakes in revenue allowances (including mistakes in allowances for debt costs), while significant equity investment will be required if the UK is to address its under-investment problem.

In the absence of an obvious equity market equivalent to ratings agency credit metrics, regulators have typically focused their assessment of equity financeability on ensuring that regulated companies can achieve the allowed return on equity. For example, Ofgem has identified the need for betas to reflect forward-looking risk as a key component of investability. Similarly, Ofwat undertakes risk modelling to check that the notional firm can be expected to achieve the allowed return after taking account of factors such as uncertainty over future inflation and interest rates.

We agree that this type of analysis is an important component of achieving equity financeability. A key weakness, however, is that its accuracy depends on having a reliable view of the cost of equity. Regulators typically use the capital asset pricing model (CAPM) to estimate the cost of equity, but this is inherently uncertain. This is not just because of the potential for interest rate movements in the future, but also because of divergent evidence over equity market performance and the level of equity risk in regulated sectors.  Indeed, equity market performance is so volatile from year to year that it is generally necessary to look at average returns across a very long timeframe.

When conducting equity risk analysis, much greater focus is therefore required on the potential for the true cost of equity to be different from regulators’ assessments. This does not necessarily mean that regulators should set the allowed return on equity above their central estimate thereof. It does, however, mean that they need to model such scenarios when assessing equity financeability, and understand the implications of companies being unable to achieve a return that is commensurate with the level of risk that they face.

Greater attention should be paid to developing observable and objective metrics to assess equity financeability. In our view, the fact that infrastructure investors are increasingly diversified internationally provides opportunities to develop additional cross-checks. Realised returns earned by infrastructure equity investors in jurisdictions outside the UK could provide a useful benchmark for allowed equity returns. This type of analysis provides direct evidence of the rates of return that are available for alternative infrastructure equity investments and avoids the need to draw on a series of uncertain parameters (as is the case for the CAPM cost of equity).

Analysing financeability over the longer term is clearly more challenging than establishing a near-term view, given the lack of long-term cost and revenue information. As we set out in the third article of this series, it is, nevertheless, essential for a comprehensive assessment. In our view, there are three ways in which regulators can ensure that a long-term perspective is embedded in financeability.

In the first place, regulators can rule out the use of short-term fixes that make near-term revenues appear larger, at the expense of storing up problems for the future. This includes fudging depreciation rates and/or the distinction between capex and opex to move cash from future price controls to the current one. When ratings agencies look at the water sector, for example, they typically subtract depreciation and surplus pay-as-you-go revenue when calculating credit metrics. This ensures that underlying revenue shortfalls cannot be masked by financial engineering across price controls.

Secondly, regulators should make greater use of indicators of whether revenue allowances are consistent with the long-term health of regulated companies’ physical assets. This includes enhanced checks that depreciation profiles are consistent with actual asset lives, and that RCV run-off is consistent with depreciation, alongside checks that opex/capex splits are consistent with the amount of expenditure that is added to the asset base. In addition, greater use should be made of data on the age profile and expected useful lives of companies’ assets,  and their consistency with planned asset renewals (and changes in these over time).

Thirdly, regulators should add further safeguards to ensure that their approach to cost assessment does not conflate austerity, meaning cuts to necessary expenditure, with efficiency. The risk of this occurring is greatest when econometric models are used to benchmark capital maintenance expenditure. Unless companies’ maintenance expenditure requirements are uniformly distributed over time, or can be reliably controlled for within the models, there is a risk that an uptick in expenditure will be attributed to inefficiency when it is, in fact, driven by natural variation in asset renewal requirements over time.

Regulators should therefore consider whether their approach to efficiency benchmarking adequately accounts for differences between: (i) short-term expenditure, such as opex, which is necessary to keep the business running from day to day and is less likely to vary from year-to-year; and (ii) long-term expenditure, such as maintenance and enhancement expenditure, which secures the health of the business in the longer term.

At a minimum, when benchmarking costs that include maintenance expenditure, regulators should check the position of potential benchmark firms in relation to their asset renewal profiles and exclude them if they are atypical of the sector.  They will also need to be open claims for company-specific adjustments from firms with renewal requirements that differ materially from the benchmark firms. More fundamentally, they should consider whether the introduction of separate analysis for long-term and short-term expenditure is required, so that prudent outlays to secure long-term asset health are not mistaken for short-term inefficiency.

A robust approach to financeability is a crucial part of ensuring that regulated companies can make the investments they need to secure future service levels for customers and of enabling the utilities sector to play its part in addressing the UK’s under-investment problem. We will set out further details of these, and other recommendations, as part of our overall financeability blueprint.

See the previous articles in this series:

Developing the gold standard for financeability

The role of financeability duties in a stagnating economy

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

Accurately assessing financeability: the role of efficient costs

When financeability assessment goes wrong: the long-term consequences