Ofwat’s submission in response to the CMA’s preliminary redetermination shows just how displeased the regulator feels at the outcome. The determinations it spent years completing were undermined by the CMA in a matter of months.
The main point of contention has been the CMA’s decision to raise the weighted average cost of capital (WACC) from 2.97 per cent to 3.49 per cent for the appellant companies (Anglian, Bristol, Northumbrian and Yorkshire).
In a supporting document entitled ‘Fundamental errors of approach – response to CMA provisional findings’, Ofwat accused the CMA of making both substantive and procedural errors. These, Ofwat says, relate to the consistency and rationality of the CMA’s approach, the adequacy of its reasoning and the use of evidence – which Ofwat alleges was “selective and flawed”.
Although the statutory deadline is set for 18 March 2021, the CMA is aiming to make a final decision by December. Ofwat has urged the CMA to make full use of the available time, although – because of necessary business planning – this would bind the appellants to the regulator’s final determination until the start of the following financial year in April 2022. This is something the companies obviously oppose.
Ofwat is not only concerned about what the ruling would mean for customers in terms of higher bills, but also the implications for the sector over the longer term. One analyst told Utility Week the findings “completely cut across” work Ofwat has done over the past five years to align incentives between customers, shareholders, and management teams.
A whack decision?
The CMA opted to “aim up” on WACC, setting it at the higher end of the possible range to offset investment risks. It defended its choice on the basis it had done it before, however Ofwat argues there is no evidence for this, saying it appears to be a “significant mistake”.
Ofwat asserts there is historically no link between higher returns and new investment. The CMA has largely agreed with the water regulator on allocated finance for projects over the five-year period, meaning the additional money will primarily go to shareholders rather than benefitting customers or the environment.
Ofwat describes the approach as “the panel making a radical break with the established position without acknowledging or justifying that result.”
As recently as July this year, the CMA ruled that aiming up on the cost of capital was not necessary in the case of air traffic controller service provider NERL appealing against the Civil Aviation Authority. Ofwat questions if the CMA considered and rejected its previous ruling in the aviation sector, asking what changed in such a short time.
It accuses the CMA of being inconsistent in its approach and deviating from regulatory precedent by selectively endorsing and ignoring other standing policies. Ofwat says this will undermine the predictability and stability of regulation, which could itself weaken investor confidence.
One sector commentator suggests that “messing around with the cost of capital will antagonise other water companies to start reaching out to their lawyers for legal grounds to object” to the ruling.
War of the regulators?
Sources suggested the generosity of the ruling could lead Ofwat to request a judicial review.
However, Dominic Nash, head of European utilities research at Barclays, says it would be unlikely: “The CMA ruling on cost of capital is positive for the companies but it is in the range that Ofwat and Ofgem had set out – but at the higher end, so it will be difficult for Ofwat to challenge this by appealing through a higher court.”
While another commentator suggests: “It has been a little bit face losing for Ofwat and they are naturally upset by the ruling, as is evident in their response, but to have two regulators essentially suing each other is a ridiculous situation to be in.”
Ofwat has not ruled out such a move but stated it hopes not to reach that point.
Time left on the clock
Ofwat had 15 months between receiving draft business plans in September 2018 and publishing its final determinations in December 2019. This built on years of planning and consultations to construct the framework. The CMA, by contrast, had little over six months since submissions were made in March to thoroughly review four business plans.
The CMA indicated it is seeking further evidence on issues that it has not yet reached a verdict on, including leakage, which Ofwat suggests is evidence the process was rushed. Given the seriousness of the issues, Ofwat is concerned the watchdog has insufficient time to arrive at its conclusion.
The expertise of the panel has been called into question by several sources who asked whether – especially in the time available to re-determine four companies – it has sufficient knowledge and resources to make its judgements.
Ofwat says there is “no good reason for the panel to compress its procedure” and adds that “promptness cannot outweigh the needs of procedural fairness or the imperative for the panel to correct its errors.”
Shaking the regulatory bedrock
Regulation provides a level of certainty over a medium-term for companies, customers and investors. Adopting a radically different approach now cuts across that predictability – even if the CMA reverses its decision. One analyst believes shareholder confidence in water and other sectors could be shaken for years to come.
The water regulator has been outspoken that the CMA’s decision undercuts its ability to regulate, for example with the fast-track process. Severn Trent, United Utilities and Pennon Group all gained fast-track status and accepted Ofwat’s cost of capital, but now could be getting a worse deal than those whose plans were rejected.
An extreme consequence could see management teams seeing more value in appealing than engaging with Ofwat leading to even approaches to the CMA at PR24, which could collapse the process.
However, one analyst argues that although any company would naturally like a higher cost of capital, having an extra 18 months of certainty to plan is ultimately more valuable.
Customer value
They should be at the heart of every decision and PR19 was lauded for its inclusion of consumer-based evidence in business plans, however appealing companies complain this was ignored by Ofwat in its determinations. Although the CMA permits more spending for billpayer-supported resilience schemes, it is accused by watchdog CCW of overlooking not only how bill hikes will affect households but perceptions of the industry.
Chief executive Emma Clancy says households struggling financially will take a poor view of their water company putting up prices to benefit investors. It has noted annual bill increases before inflation of £6 (Bristol), £12 (Northumbrian) and £14 (Anglian, Yorkshire) compared to Ofwat’s final determinations.
Citizens Advice and CCW urge the CMA to put customers ahead of shareholders but questions have been raised about whether the panel handling the appeals was customer-focused enough.
Chairperson Kip Meek, Robin Cohen, Anne Fletcher, Roland Green and Paul Muysert have strong collective experience in legal, financial and corporate roles, which one insider argues could make them more sympathetic to business needs and suggests the panel could have been more balanced.
RIIO2 and bill hikes
The outcome of the determinations will be closely followed by the distributed power network operators due to receive final RIIO2 price controls from Ofgem in December.
Colm Gibson, manging director of Berkley Research Group’s London office, says others may be keen for the CMA to reach a faster decision: “Ofwat is asking for the CMA to take its time, which would leave the cost of capital uncertain until after Ofgem’s RIIO2 determinations in December, giving Ofgem the problem of not knowing whether the CMA will back its proposed cost of capital allowances, and leaving energy investors with a particularly difficult choice about whether to accept Ofgem’s allowance or appeal to the CMA.”
Nash explains the impact will be “significantly larger” for Ofgem than Ofwat: “Recent changes to energy licenses mean that appeals on the RII02 price determination could be made on an individual aspect instead of taken in the round. If the CMA came up with a cost of equity it would be very hard for Ofgem to differ on the building blocks. Energy and gas companies that chose to appeal would expect the CMA to reach the same decision it had only weeks before.”
Citizens Advice calculated that should energy companies seek an appeal from the CMA and receive similar treatment the cost to billpayers would amount another £3.7 billion.
Taking sides – what other stakeholders have said
Gibson says the back and forth between the parties could make it difficult for an agreement to be reached amicably: “The style Ofwat has adopted in its responses has moved the dynamic very much into a win/lose situation, the outcome of which will have significant impacts for all parties. If Ofwat is seen as ‘losing’, the water companies that accepted their final determinations will want to level the playing field, perhaps through an interim determination or otherwise.”
Opinions are heavily divided on who is “right” or “wrong” on the WACC: Ian Byatt, the first director general of water from privatisation to 2000, describes it as “perverse” for the CMA to increase the allowed rate of returns. He says overly generous price reviews in 2004, 2009 and 2014 were redressed by Ofwat’s firmer approach at PR19 to stop customers being overcharged.
Standing to benefit from the ruling in their own upcoming determinations members of the power and energy community supported the move – and suggested the CMA should increase it further.
Chris Bennett, director of UK regulation at National Grid says the aiming up better reflects the range of evidence but suggests further adjustments to fully reflect market data. Likewise, the Energy Networks Association says the new cost of capital remains “insufficient to protect companies’ abilities to attract investors”.
Cadent and Western Power Distribution say the higher incentives are necessary to invest and drive efficiencies at a time when the UK needs critical infrastructure investments to achieve sustainability goals.
Even among other water companies there were inconsistencies, South East Water – which debated appealing its own final determination, suggests adjustments be made to the approach to resilience and ODIs rather than WACC. It says the decision could make price reviews less predictable and therefore erode investor confidence. Regardless, the company says the appeals raised key points – not least around spending on resilience projects.
Fast-tracked South West Water suggests the CMA reconsiders the WACC to be taken in the round not as a standalone, while Thames supported the CMA’s approach.
The Civil Aviation Authority asks the panel to “fully and robustly explain and justify its decisions”, particularly where they create cross-sector standards.
The UK Regulators Network adds insufficient evidence had been provided to justify the aiming up, or to explain why the deviation from the determination for NERL.
Choppy waters ahead
Looking ahead to 2024 Ofwat could face a widespread rebellion if the CMA does not readjust the WACC that sets a precedent that appealing gets a beneficial deal for shareholders. Board leadership, governance and transparency has been under scrutiny and Ofwat has modified company licences to better protect billpayers’ interests but, at a time when the UK undeniably needs investment, the CMA’s ruling puts investor interests ahead.