Most economic regulators have a financeability duty, requiring them to ensure that companies can attract the finance needed for them to perform their regulated activities. For example, Ofwat has a duty to ensure that companies “are able (in particular through securing reasonable returns on their capital) to finance the proper carrying out of those functions”, while Ofgem must have regard to “the need to secure that licence holders are able to finance the activities which are the subject of obligations”.
The existence of financeability duties reflects the capital-intensive nature of utilities, which require regular investment in the maintenance and improvement of the assets they use in their day-to-day activities. This means that steady and reliable sources of finance, available on reasonable terms, are vital for regulated companies to be able to provide the required level of service to their customers.
Regulators hold financeability duties alongside other statutory duties, which typically include requirements to protect consumers’ interests and ensure that regulated companies can carry out their functions. The centrality of a steady source of finance to their operations means that there is arguably a degree of overlap between financeability duties and other statutory duties. For example, a regulator failing to meet its financeability duty would lead to a dearth of investment in the industry in question, preventing companies from carrying out their functions and ultimately harming customers through a reduction in service. Indeed, when it introduced the Civil Aviation Authority (CAA)’s financeability duty, the government acknowledged that it was arguably “implicit within the economic regulator’s proposed primary duty” to promote the interests of consumers.
The existence of financeability as a distinct duty is nevertheless important and highlights the role of investors (in both debt and equity) as distinct stakeholders in the industry, alongside customers, firms and regulators. Again, when it introduced the CAA’s financeability duty, the government emphasised that “the existence of such a duty is important to provide reassurance to investors” and that “the financing duty provides investors with confidence that whilst the regulator will seek to promote the interests of consumers … this will not be regardless of an economic and efficient company’s ability to finance itself”.
Reflecting this, regulators usually conduct a ‘financeability assessment’ as part of the price control process. This typically occurs as a final step in the setting of a price control, and involves an analysis of whether the implied cash flows are consistent with an investment-grade credit rating.
The question of whether a regulated company is financeable is, however, much broader than a single piece of financial modelling tacked onto the end of the price control process. Instead, it goes to fundamental issues around the design and conduct of the regulatory process. For example, the need for large investment to be made in long-lived assets makes stranded asset risk a very real threat to the financeability of regulated utilities. Mechanisms such as the regulated asset base (referred to as the ‘regulatory capital value’ or ‘regulatory asset value’) are fundamental to ensuring financeability in this context, as they provide a form of commitment from one price control to another. Again, achieving financeability aligns with customers’ interests, as keeping risk low reduces pressure on the cost of capital and helps to keep customers’ bills down.
Viewed in their wider context, financeability duties reflect the vital contribution of investment, including investment in infrastructure, to economic growth across the whole economy. Investment in productive assets allows the economy to function more efficiently, and this is especially true for infrastructure, which facilitates productive activity across the economy. Conversely, an outdated energy network increases the risks of power cuts and exposure to international price shocks, while inadequate transport links impede product delivery and water supply failures stymie industrial processes.
Finally, it is important to think about the role of investment in addressing the UK’s disappointing economic performance. There is widespread acknowledgement that this problem is, at its core, one of low productivity since the global financial crisis. In turn, low productivity reflects a history of under-investment, stemming from a wider culture of short-termism in which investment is deferred and asset lives are stretched beyond reasonable limits.
To illustrate this point, the figure below shows UK business investment as a percentage of GDP since 1995, compared with other G7 countries. This shows that, having been broadly ‘middle of the pack’ in the mid-1990s, the UK has, from the mid-2000s and even before the financial crisis, consistently had some of the lowest levels of business investment among major developed economies. Seen within this context, financeability in the utility sector can make an important contribution to tackling the UK’s wider problem of short-termism.
In conclusion, a robust approach to financeability is vital to safeguarding consumer interests, so that regulated companies can make the investments they need to secure future service levels. Financeability duties will therefore play an increasingly important role in ensuring adequate levels of investment over the long term, thereby enabling the utilities sector to play its part in addressing the UK’s under-investment problem.
As part of the development of our financeability blueprint, in the coming months we will consider how financeability duties can best support a long-term perspective for investment in utilities.
See the first article in the series here