The water industry has been bracing itself for a tough price review ever since Ofwat published its draft methodology for PR19 back in July 2017, perhaps even longer. And in December, they found out just how low the regulator is prepared to go. Katey Pigden investigates.

Companies knew to expect a “significant reduction” in the weighted average cost of capital (Wacc) but until the 13 December 2017, they couldn’t be sure exactly how far it would fall. The regulator had previously hinted the figure would start with a two, and companies have been hedging their bets since then as to what was most likely to follow the decimal point.

Although some companies would have been disappointed it was the lower end of the expected range, it is unlikely to have taken too many of them by complete surprise. And now, whether they like it or not they will need to get on with preparing their business plans for 2020 to 2025 accordingly.

Ofwat has outlined what it expects to see from companies in its tome of a methodology, which stretches to almost 260 pages. The document includes an initial view of the cost of capital of 2.4 per cent in RPI terms, a record low for a regulated utility. The regulator estimates this reduced cost of capital could result in an average saving per customer of £15-£25 per year from 2020 onwards.

The cost of capital is the allowance Ofwat makes within its price controls for the costs of raising debt or equity to fund improvements. The 2.4 per cent figure represents a material reduction of 1.3 per cent since PR14, which Ofwat says has been driven by lower expectations of the market cost of debt and equity.

Disappointing decision

While companies themselves had been expecting a lower Wacc, industry analysts who spoke to Utility Week prior to the publication of the PR19 methodology had been expecting the Wacc to be confirmed at 2.6 per cent at the lowest.

However, Ofwat says that having considered the range of evidence available to it, it considers a more tightly-bounded plausible range for the Wacc is 2.2 per cent to 2.6 per cent. Investors will no doubt be disappointed with Ofwat’s decision.

On the morning of the publication, David Black, senior director, Water 2020, spoke to Utility Week and said the 2.4 per cent Wacc shouldn’t be of significant surprise for the industry as Ofwat had signalled this was the direction of travel. “Obviously it is much lower than it was previously, but this does reflect the fact that they [water companies] can borrow for lower cost in the market, so we think there should be an appreciation that this is the world that we live in,” he explained.

Ofwat will review the cost of capital at the draft and final determinations. Final determinations will be set out in December 2019. Utilities analyst Nigel Hawkins says the initial headline figure is “tougher than most forecasts”, but whether it will endure at the final determination “remains to be seen”. (Read the full column here)

Future expectations

Outgoing Ofwat chief executive Cathryn Ross says the next decade will see “profound changes” in customers’ expectations and the regulator is pushing the water sector to be at the forefront.

The industry has been embroiled in a row over the best way to set the cost of capital for several months. Ofwat made little secret of its plans for PR19 and it stressed its determination customers rather than investors, should benefit this time round. In a speech in October 2017, Ross acknowledged the regulator has set too high a Wacc in previous years. “We expect to place less weight on history, which we have finally learned is not the best predictor of the future and more weight on market observation and future expectations,” she explained.

This statement has caused concern among water companies who have questioned, if you can’t base assumptions on what’s happened in the past, what can you base them on?

Richard Khaldi, water sector expert at PA Consulting Group, tells Utility Week: “The 2.4 per cent Wacc figure didn’t come as a bolt from the blue. Some people may have been hoping it would have been at the higher end of general expectations, but we anticipate that most companies have modelled down to round about the 2.4 per cent level.”

“For companies not performing well now, they will have to catch up quickly,” he adds. “There will be less revenue for them to start with, while the operational ask is increasing. They are likely to find themselves between a rock and a hard place.”

Prime example

And water companies are already looking at what they can do to ensure they are in a good position, he says, citing Yorkshire Water’s announcement of a multi-million-pound package to transform its operational performance by tackling issues such as leakage and pollution as a prime example.

“Others will be looking at the way they operate too. What companies are realising is they can’t continue the way they have been. How they react will depend on the management teams steering the ship,” he says, adding “this is a complex price review, probably the most complex price review there has been.”

He should know, with 10 years’ experience in economic regulation of the water sector, and having most recently worked as senior director of customers and casework at Ofwat prior to joining PA Consulting Group in May last year. “The methodology for PR19 has taken around 260 pages to explain it but companies will only have around 300 pages to do it, in terms of their business plan. It’s certainly an interesting scenario,” he says.

“Some people have suggested investors will leave the sector, but there’s not likely to be a massive flight of capital. Although, we may end up seeing a different kind of investor profile. Investments in the water industry have an RPI linked cash return and not many investments do that.”

Particularly exposed

In October last year, Moody’s Investors Service published a report about the UK water sector, suggesting lower returns will pressure credit quality from 2020, with highly leveraged companies being “particularly exposed”. And the water only companies are likely to suffer the most, as their size makes it difficult for them to obtain capital at rates as low as those obtained by the larger companies.

PwC water sector leader Richard Laikin says Ofwat has “toughened its resolve” with its price review final methodology, and the “bar remains high” for companies preparing their business plans. The methodology will benefit the top performers, who will expect to earn higher financial rewards for cost savings and out-performance against targets. “Ofwat has also increased incentives for companies to improve their plans,” Laikin adds. “Poor performers, however, will face greater financial challenges.”

Laikin acknowledges companies are likely to focus on Ofwat’s early view of the cost of capital. “With much to do before the September 2018 business plan submission date, it will be a challenging time ahead for water and wastewater companies. Pressure is ramping up to create effective and robust plans in line with the methodology and deliver the quality of evidence Ofwat is looking for.”

This year will certainly be busy for water companies and did we mention they may find it “tough”?

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