An analyst note from the investment bank stated that the balance of risk and reward is “no longer attractive” for traditional equity investors, and that the government “may be called upon as an equity investor of last resort”.
The risk/reward balance is said to have shifted against investors because Ofwat stated that the weighted average cost of capital (Wacc) was being cut from 5.1 per cent under PR09 to 3.85 per cent under PR14.
The regulator has said that the Wacc could be cut even further in the final determinations in December.
Investec added that the reduction of the Wacc has contributed to the operational risks being shifted “from consumers to equity investors”.
The note stated that the existing industry structure and financing models “may no longer be fit for the challenge” and that “alternative models may emerge”.
These alternatives, aside from money being provided by the government, could include “Thames Tideway Tunnel clones”; state-owned companies – such as Scottish Water, or no shareholder structures – such as Welsh Water.
Roshan Patel, an analyst at Investec, said additional risks to investors in the sector come from “unanticipated increases in real interest rates beyond those implicit in the yield curve, or more blatant political intervention”.
He added that there is a positive impact on the share prices and potential returns from M&A activity, but warned “the heady premiums witnessed in the past may not be seen in future, given the new risk/reward outlook”.
Investec made the recommendation to sell for shares in United Utilities and Severn Trent, but kept Pennon, South West Water’s parent company, as a hold because of its “differentiated financing structure and potential upside from Viridor”.