Despite the eurozone crisis, and while other sectors struggle as the UK economy flirts with a double-dip recession, water companies remain rather well-placed. Although the last periodic review, which applied from April 2010, was less obviously generous than its predecessor, the water sector was hardly ill-treated. The is evidenced by the recent takeover of Northumbrian Water at a very substantial premium to its 2009 share price.
Water companies have a lot going for them, including minimal competition and guaranteed prices until March 2015, many of which include real terms increases. Even so, there is speculation that some companies may submit an interim determination (IDoK) application to Ofwat. At privatisation in 1989, special provisions were included to permit “cost pass through” awards under which some unforeseen costs could be recouped before the next periodic review.
However, the specified criteria were deliberately narrow and were designed to be exceptional. In the event, these provisions have been seldom triggered, with South West Water’s award in the early 1990s being the most notable.
In recent years, Ofwat’s periodic reviews have been very – perhaps too – thorough: few regulatory stones have been left unturned. Furthermore, the regulator emphasises that its periodic review determinations are a comprehensive package, which is either to be accepted or rejected by each water company. It is not an à la carte menu whereby a water company accepts the better parts and rejects some of the more challenging elements.
In the 2009 periodic review, Bristol Water exercised its right to reject Ofwat’s determination and seek a better deal via the Competition Commission. As it turned out, Bristol Water succeeded in getting some joy from the commission.
For other water companies, the priority has been to outperform Ofwat’s cost assumptions, a task facilitated by continuing low interest rates, which have depressed borrowing costs. Certainly, few commentators expected the yield on ten-year gilts, which are a benchmark for long-term borrowing rates, to be just over 2 per cent, especially with inflation at well over twice this figure.
On the revenue front, water companies stand to benefit from higher than expected inflation. This is enhanced by the disproportionately wide financial margins earned by water companies. November’s retail price index (RPI), on which annual water charge upratings are based, showed an inflation figure of 5.2 per cent. Significantly, this increase was slightly higher than that of the consumer prices index (CPI) now commonly used in much of the public sector.
Leading water sector analyst Robert Miller-Bakewell believes that, with the RPI rising at twice Ofwat’s assumptions, successful IDoKs will be even harder to secure. In his view, “water companies will have to provide proper supporting evidence, ie for a minimum 18 months. Ideally, the whole matter can be held over until the 2014 periodic review”.
The most obvious IDoK sector issue is the transfer of private sewers and lateral drains in England and Wales to the ten privatised sewerage businesses. This process is complex, administratively and legally, while the quantum of extra costs for the ten companies is difficult to estimate. Another top City water analyst points out that companies were loath to “lock in” an artificially low operating cost base through a successful IDoK application. The likelihood is that each water company will submit the additional costs incurred up to March 2015 – and those due to be incurred subsequently – in their business plans as part of the 2014 periodic review.
With much of the water sector no longer publicly quoted, up-to-date financial information is less available than previously – a notable defect of the increasing shift to private equity ownership. Although IDoK eligibility criteria vary between companies, such discussions are bound to have surfaced in the boardrooms of at least three of the privatised companies.
Southern is a case in point. While it issued an August press release extolling the finding of a honey bee colony in Hampshire, the amount of recent detailed financial information in the public domain, which will directly affect consumer prices, is inadequate. However, an IDoK application may be under consideration, partly due to the pronounced building downturn on the south coast.
Thames Water’s position is also opaque. Given that Ofwat’s final determination in 2009 was much tougher – especially with regard to the weighted average cost of capital (Wacc) – than Thames had sought in its business plan, many believed that a comprehensive appeal to the Competition Commission was likely. No such appeal was entered, although it must have been a finely balanced decision.
In the light of the recent economic down-turn, Thames has reduced its long-term projections for house building in its supply area. However, it is currently vigorously promoting its £3.6 billion Thames Tideway Tunnels project, which is already attracting major opposition. Hammersmith and Fulham Council leader Stephen Greenhalgh has pointed out that “water experts are lining up to say that Thames Water’s case for the super sewer
is flawed”.
At any rate, financing and construction of the scheme may not follow the traditional path – it may be to some degree outsourced. While any financial arrangements to be shouldered by Thames will be principally covered by future periodic reviews – rather than by short-term IDoKs – the amount of money involved is considerable.
A third water company, Anglian (also owned by private equity) may find it necessary to consider an IDoK application: it is likely to be disproportionately affected by the private sewer transfer.
For the two largest publicly-quoted water companies – Severn Trent and United Utilities – the submission of IDoKs prior to the next periodic review is unlikely. Aside from the public relations aspect, notwithstanding the RPI benefits, it would seem more sensible for water companies to integrate such submissions within their 2014 business plans – a less controversial approach. Furthermore, the timing is more appropriate – Ofwat generally takes many months to rule on IDoK applications.
Currently, the water sector is studying the long-delayed White Paper, which was recently published. Compared with the maelstrom engulfing European financial markets, any planned changes will be small-time. Furthermore, they will need to be incorporated into a bill before being put before Parliament. As such, it is most unlikely that any pre-2014 IDoK applications will emanate from proposals in the White Paper.
With almost daily crises in the financial sector and massive doubts about how Ofgem’s ten-year £200 billion energy investment programme can be financed, the water sector is currently enjoying a low profile. It seems unlikely that a series of IDoKs will impinge upon this relative tranquillity.
Nigel Hawkins is a director of Nigel Hawkins Associates which undertakes investment and policy research.
This article first appeared in Utility Week’s print edition of 13 January 2012.
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