KPMG report for Anglian, Northumbrian and Affinity Water challenges regulator’s financial assumptions for total market return

Ofwat got its sums wrong on PR19, according to a report commissioned by three water companies which challenges the financial assumptions underlying the regulator’s proposed framework for the next price review.

The report, by consultancy KPMG for Anglian Water, Northumbrian Water and Affinity Water, claims the calculation Ofwat has used for total market return (TMR), a key element of the cost of equity, is flawed.

The report, which will form part of the three companies’ response to Ofwat’s price review consultation, suggests the sector will not accept the regulator’s plans to cut investor returns in the next price review without a fight.

In the report, KPMG takes issue with a number of the assumptions underlying the calculations of TMR made by PwC, a rival consultancy which advised Ofwat. It says the PR19 consultation “signals a possible fundamental change to the approach that Ofwat as well as other regulators have previously employed” in calculating TMR.

PwC’s estimated nominal TMR for PR19 is 8.0-8.5 per cent, which equates to 5.1 per cent to 5.5 per cent real. KPMG says this “is a significant reduction from UK regulatory precedent of 6.1 per cent-7.3 per cent, based on 100 years-plus of data.” KPMG’s rival analysis, which is based on long-run averages, puts TMR at 6.25 per cent to 7.3 per cent.

KPMG goes on to say that, even using short-term market data, “a correction for the shortcomings in PwC’s analysis” results in a real TMR of approximately 6.5 per cent.

The report says: “Ofwat appears exclusively to rely on PwC analysis and PwC’s estimates of TMR, which in turn, are mainly based upon analysis using the dividend discount model (‘DDM’), with additional evidence from market to asset ratios and investor surveys. The estimates appear to place no weight on historical outturn equity returns, achieved by investors over the long-run or take account of the limitations and uncertainties associated with these estimates. They also do not appear to take into account other important market evidence such as negative correlation between interest rates and market risk premia.”

In its consultation document, Ofwat explains its approach to setting TMR by saying: “Our work so far, and PwC’s analysis, suggest that placing too much weight on long-term, historical evidence is likely to overstate the cost of equity for 2020-2025. This would lead customers to pay more than should reasonably be expected. This is because there is good reason to expect significantly lower returns to persist to 2025 than observed from long-term historical evidence.”

Ofwat’s consultation on the PR19 methodology closed last week. The regulator received more than 60 responses, which it will publish and respond to alongside its final methodology in December. A spokesperson said: “We commissioned the PWC report to support our consultation on the PR19 methodology. We will be carefully considering all the submissions we have received ahead of the publication of our final methodology in December.”


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