Earlier this month, Ofwat confirmed that all but one UK water company had accepted its 2015-20 AMP6 final determination. Bristol Water asked to be referred to the Competition and Markets Authority for review. For the remaining 17 companies, including Pennon, United Utilities and Severn Trent, life now moves on to delivering their AMP6 promises and preparing for the next phase of regulatory changes.
The business retail market will be open to competition in April 2017, which could both be an opportunity (and a risk) for operators to gain (or lose) market share.
We, however, are more focused on the new strategy Ofwat is expected to publish before this year end, in which it will consult on how to regulate the different parts of the water value chain and to introduce said changes as part of the 2020-25 AMP7 price review in 2019. This means the potential, but not a certainty, of having to split up the regulatory capital value (RCV) among the various components of the wholesale water business, and apply a price control on each component. The aim is for Ofwat to better understand the costs of the water value chain, identify any cost inefficiencies, promote water trading and potentially even introduce more competition within the system.
Generally speaking, investors favour Ofwat’s integrity as a regulator, the cash flow predictability of its capital-intensive, RCV-based framework, and the bankability of the underlying dividends. Ofwat’s goal of increasing efficiencies alone is unlikely to change this, however the approach Ofwat takes to achieve this will be crucial. Depending on the design, material introduction of competition along the water value chain could reduce cash flow predictability.
For now, many of today’s investors continue to like the low-risk, regulated nature of UK water companies. Indeed, recent underperformance by Pennon, United, and Severn is largely due UK deflationary concerns. However, longer-term holders will likely agree with Bank of England’s February inflation report where the Monetary Policy Committee is choosing to look through the current low level of inflation as an influence on policy-setting for the medium term. Persistent M&A expectations will likely prevent significant sell-offs, and as we progress along 2015, we look ahead to what Ofwat has in store for us down the river.
Maurice Choy, equity research analyst at RBC Capital Markets