In January, Ofwat published its initial conclusions on the PR19 business plans submitted by water companies in England and Wales.
Yet despite 30 years in the private sector and some £150 billion of investment, Ofwat’s marking of the ten privatised water authorities (as was) and their smaller water-only brethren was unremittingly harsh.
In incentivising companies to compile credible business plans, Ofwat had offered various regulatory and financial benefits for those rated in the top two categories of “exceptional” and “fast-track”.
Unsurprisingly, no company qualified for the elusive excellent category.
Winners emerge
Each company was awarded marks – from A to D – under nine test areas. Since the original ten big water and sewerage companies (WASCs) became 11 with the formation of Hafren Dyfrdwy, there was a potential 99 As up for grabs by the WASCs. In the event, just three As were awarded – a dreadful sector return. And there were 16 Ds, three each were allocated to Thames and Southern.
Indeed, if A levels were marked as rigorously, UK universities would have few students. But three comparative winners emerged in the form of United Utilities, Severn Trent and South West Water. They were awarded “fast track” status, and United Utilities seemingly came top.
UU’s success came as a surprise, although both Severn Trent and South West Water had been tipped – not least by Utility Week – to do well.
Ofwat concluded that United Utilities’ submission was “an ambitious, innovative and high-quality approach to addressing affordability and vulnerability”
There were five companies in the position beloved by regulated utilities – the middle of the pack.
Stuck in the middle
Anglian was criticised for its high cost base – its wholesale clean water figure was 32 per cent above Ofwat’s benchmark; the comparable wastewater figure was 19 per cent above it.
Anglian collected a second D under the “Securing Confidence and Assurance” category, with Ofwat giving the thumbs down to some of its financial proposals, including its dividend policy.
Both Yorkshire and Northumbrian managed to keep a D off their cards, although neither managed to secure an A rating.
Wessex will have been disappointed not to have secured “fast-track” status; instead, it picked up a D under the “Aligning Risk and Return” head.
Ofwat’s marking of Dwr Cymru was something of a curate’s egg. Under the “Securing Confidence and Assurance” head, it did win Ofwat’s confidence.
But it fell well short on the cost efficiency front, with its wholesale clean water costs being 26 per cent above Ofwat’s benchmark. And its retail clean water costs were even more of an outlier – at 40 per cent above Ofwat’s benchmark.
Bad though some of these marks were, it was Thames and Southern who fared worse, coming in the “Significant Scrutiny” categorisation – which also included Affinity Water and Hafren Dyfrdwy. Ofwat did not hold back in its trenchant criticism.
For years, Thames has faced many brickbats for its £11.3 billion net debt, its massive dividend payments, its poor leakage record and its minimal corporation tax payments, notwithstanding the effective contracting out of its Tideway Tunnel project.
Now, Ofwat has awarded the company three Ds and six Cs – with neither an A nor a B in sight. And the phrase “…its plan falls (significantly) short…” appears under all nine heads.
Ofwat focused on the lack of resilience of its operations, for which it was marked with a D. It noted, too, that Thames does not seem to have “a good understanding of the condition of its assets…”
Cost efficiency
The cost efficiency figures were also dire – and yielded a second D. Ofwat reckons that Thames’ clean water costs, despite the vast Ring Main investment made in previous decades, are about 36 per cent above its efficiency benchmark – a formidable gap to close.
Unsurprisingly, the third D arose under the “Accounting for Past Delivery” head. Ofwat is not persuaded that Thames can meet its leakage targets, especially given well-publicised past failures.
In its analysis, Ofwat has expressed concern about Thames’ finances and the very high debt it has accumulated as a private equity-owned company.
Southern received an equally caustic review, and was allocated three Ds.
The first D covered long-term resilience. Ofwat listed many shortcomings in Southern’s business plan in this area and even cast doubt on its plans for a capital injection.
On the cost efficiency front, the 21 per cent clean water and 26 per cent wastewater premiums over Ofwat’s efficiency benchmark were pivotal in the second D that was given.
The third D was allocated under the “Accounting for Past Delivery” head, partly because Ofwat has underlying doubts about Southern’s ability to deliver its plans – and various environment-related prosecutions have not helped. Hafren, a new Welsh-based company under Severn Trent ownership, did not distinguish itself. Indeed, it collected five Ds, as its Business Plan fell short on numerous counts. Almost inevitably, it was consigned to the ‘significant scrutiny’ corner – clearly, it has much work to do.
Although Ofwat is undoubtedly talking tough, the gap between some water company costs and its efficiency benchmarks is vast. How Ofwat addresses this issue is unclear.
On the financial front, some water companies, led by Thames, have vast debts. Tough regulation raises the issue, especially for private equity-owned water companies, as to whether their owners will be required to inject more share capital.
But the water companies have a crucial backstop against tough regulation, like British Telecom and its pension fund affordability “joker”, which it plays when tough regulation is threatened.
In the water companies’ case, retaining investment-grade credit ratings is paramount – something that ultra-tough price reviews do not permit.
After all, Ofwat’s indicative Weighted Average Cost of Capital (WACC) of 2.4 per cent – roughly a third off its 2014/15 predecessor – is not being aggressively challenged.
Certainly, United Utilities will have earned brownie points from Ofwat by submitting its business plan based on “adopting an RPI-stripped appointee cost of capital of 2.4 per cent consistent with Ofwat’s early view”.
In contrast, Wessex was criticised by Ofwat for “limited and unconvincing evidence in support of the company’s proposed uplift to the early view cost of capital”.
Clearly, Ofwat is not anticipating a Transco-like regulatory battle over its proposed WACC.
The fact that the three quoted water companies were the only ones to secure “fast-track” status is significant. The chances of this quoted trio out of all 11 companies doing so are very long – Hafren excepted. Otherwise, the clean fast-track sweep of the three quoted companies is tarnished by Hafren’s inclusion. Coincidence – as Ofwat is reputed to have implied – it was not.
The other eight companies had to re-submit their business plans to Ofwat by 1 April – their chance to rebut Ofwat’s coruscating judgements. But, having savaged so many of its regulated companies, is Ofwat’s bark far worse than its bite?
Almost certainly so. Maintaining investment grade credit ratings is the pivotal backstop.
