It can been said that the main role of Ofgem and Ofwat is to make the decision to accept or reject a price control as hard as possible for companies and their investors. If it is obvious that the price control should be accepted, the regulator has been too lax. If it is obvious that it should be rejected and referred to the Competitions and Markets Authority (CMA), the regulator has been too harsh. Regulators should, therefore, strive to make this a difficult decision for companies.
In line with this, Ofwat issued its final determinations for the PR19 price review in December. Water companies and their investors must now decide whether to accept Ofwat’s offer or reject it and appeal to the CMA. UK energy networks facing Ofgem’s RIIO-2 decisions later this year have a strong vested interest in the outcome of the water companies’ decision on whether or not to appeal.
Having worked closely with a number of water companies through the PR19 process, I can safely say that Ofwat has left companies and investors with a very difficult decision to make. Water companies know this is a particularly tough price control, with many not anticipating paying external dividends for the foreseeable future. Equally, however, companies will find it hard to conclude that the likely outcome from challenging the CMA would be materially better and many will be (rightly) deterred from appealing. This matters to energy companies because, if no water companies appeal, the conceptual shifts in policy that Ofwat has made will go unchallenged. If they aren’t challenged, they may be too tempting for Ofgem to ignore and may be included in its upcoming RIIO-2 decisions. This would be bad news for long-term energy investors.
Had Ofwat stuck at its draft determination position, it would have been abundantly clear to companies and investors that they should challenge Ofwat at the CMA on a number of issues. These included an overly tough Performance Commitments and Outcome Delivery Incentive (ODI) reward / penalty regime, a very low totex allowance, unrealistic “frontier shift” assumptions and a number of painful conceptual shifts to the framework that have a material adverse impact on companies’ financeability and the ability to pay future dividends.
Ofwat softened its position on many of these issues in the final determination, but did not yield on its conceptual shifts, using some of them to deal with the short-term financeability issues that its notional company suffered from. Individually, each of these can result in a significant loss in long-term value for investors. In aggregate, they may even go so far as to remove the linkage between regulatory asset base (RAB) or regulatory capital value (RCV) and the cashflow investors might expect. Without this linkage, the net result of this would be that companies may no longer sensibly be valued at a multiple of RAB or RCV, and other valuation metrics will be used.
At least one conceptual shift is being tested at the CMA at the moment in the NATS En-route Limited (NERL) Price Determination case – namely whether or not regulators should take account of the very asymmetric consequences of setting the allowed cost of capital too high or too low. However, the only opportunity for the other conceptual shifts to be challenged is if water companies appeal PR19. These conceptual shifts include:
- penalties for high gearing;
- having low or no dividends for notional companies with high RAB growth;
- (repeatedly) bringing forward revenues from future periods to make notional companies financeable;
- setting an industry wide weighted average cost of capital (WACC) using a notional company that achieves far better than industry average performance with respect to rewards / penalties;
- using upper quartile efficiency (i.e. lowest quartile costs) as the benchmark for the costs of something akin to upper quartile performance; and
- deeming higher levels of performance to be funded as part of “base” costs.
Concept 1: Penalties for high gearing
Companies subject to Ofwat’s “tax” for high gearing (part of its “back in balance” package), face a penalty in the form of a revenue reduction, as a function of their gearing ratio. In the case of Thames Water, the impact could be almost £30 million per year.
Ofwat’s approach marks an obvious departure from the long-held regulatory mantra that the actual financial structure is a matter for investors, not customers. Whilst Ofwat has phrased it in terms of “sharing” with customers, the net impact in Thames Water’s case is that customers could face a £25 million to £30 million per annum price increase if Thames Water’s investors decide on a different financial structure with lower OpCo gearing in regulatory accounting terms. This does not necessarily mean less real-world debt (as, for example, the regulatory accounts ignore certain loans), simply less in regulatory accounting terms. Personally, I would like to see Ofwat’s explanation of why customers face higher prices if that happens, particularly as Thames Water would simply have complied with the incentive set by Ofwat.
Concept 2: Having low or no dividends for notional companies with high RAB or RCV growth
Ofwat’s view seems to be that it is acceptable for investors to be remunerated through RAB or RCV growth, rather than dividends. In line with this, in some cases it has set price controls that result in low or even zero dividends even for its notional company – let alone the actual company – with relatively low gearing and high performance. It would be interesting to ask the CMA whether it felt this was consistent with Water Industry Act 1992 duty about “securing reasonable returns on their capital”, particularly if the net result of PR19 is to break the historical correlation between dividends and RCV, leaving RCV as a poor metric for a valuation of a company.
Concept 3: Bringing forward revenues to make notional companies financeable
Another feature of Ofwat’s PR19 price control is bringing forward revenues from future price control periods to make notional companies financeable. It appears that something of the order of £0.5bn of revenue is needed to be advanced from future years (in an allegedly net present value (NPV) neutral way) to make Ofwat’s notional companies pass Ofwat’s own financeability tests.
The consequence of this is that RCVs are 500 million lower than they would otherwise have been for that level of investment. This stores up a problem for the next price control. With lower RCVs, the allowed return will be lower in pounds terms, leading to a greater strain on financeability and exacerbating the need to advance revenue to meet financeability constraints, assuming that increasing WACC to solve financeability issues is out of the question.
An interesting thought experiment that highlights the dangers of this policy is to extrapolate until the notional companies get to the position where more than all the remaining RCV needs to be advanced. Whilst this is not an imminent prospect, it does suggest that there may be something seriously wrong with the overall RCV mechanism if a regulator needs to intervene at every price control with an opaque and rather subjective nudge in order to deliver financeability. It would be interesting to ask the CMA whether an increasing need to advance revenues to make even the notional companies financeable can be said to be sustainable.
Concept 4: Using upper quartile efficiency for the costs of upper quartile performance
Ofwat has based cost allowances on a low-cost company, just below lower quartile costs, whilst basing performance targets on materially higher than average performance, often close to an upper quartile level for each specific performance measure.
Seemingly, this sidesteps the likelihood that quality is a cost driver, introducing a likely disconnect between setting upper quartile targets whilst basing costs on companies that do not meet those targets on average. Equally, it assumes that companies can both maintain a higher performance level in a steady state, and secure significant improvements in performance levels, with no additional costs. Both of these points highlight a logical inconsistency in this approach that it would be helpful for the CMA to think about.
Concept 5: Setting an average cost of capital assuming better than average performance
The performance commitments and ODI arrangements outlined in PR19 mean that companies with average performance will face significant penalties. Only those companies that are sufficiently above average performance will avoid a net penalty. However, when setting the WACC, Ofwat’s notional company is assumed to achieve materially better than the weighted average industry performance (i.e. meet its performance targets, thereby avoiding a penalty). Average companies, therefore, are unable to earn the WACC – which doesn’t seem right.
Concept 6: Deeming higher levels of performance are funded as part of “base” costs
Finally, and perhaps most concerningly, Ofwat has taken the interesting position of deeming that higher levels of performance are funded as part of “base” costs, stating that the “package of common performance commitments with stretching performance commitment levels, represents a base level of service. We expect an efficient company to be able to deliver our performance commitments levels through our base allowance”.
If Ofwat is not challenged on this issue at the CMA, Ofgem may be tempted to replicate this for energy networks and decide that any “stretching performance commitment levels” represent “a base level of service” rather than needing additional funding.
Conclusion
In conclusion, Ofwat has set a tough price control with several notable conceptual presumptions that, if left unchallenged, may also have a considerable impact on the UK energy sector in the form of Ofgem’s upcoming RIIO2 price control. It’s down to the water companies and ultimately their investors to decide whether or not to challenge, but I think energy networks should be concerned that no company has yet announced that it wishes to challenge Ofwat at the CMA.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.
Colm Gibson is a managing director in BRG’s London office, and head of BRG’s economic regulation practice for the UK, Europe, the Middle East and Africa