When financeability assessment goes wrong: the long-term consequences

In the fifth article in Economic Insight’s series on financeability Chris Pickard and Sam Williams consider the consequences of getting the assessment of financeability wrong.

So far this series of articles has considered the role of financeability duties in economic regulation, what it means for a company to be financeable in practice, and the importance of a robust approach to estimating efficient costs when assessing financeability. In this article, we consider the consequences of getting financeability assessments wrong. As we will set out, errors in the assessment of financeability in one price control can lead to shortfalls in revenue allowances becoming ‘baked in’ over the long term, leading to a self-reinforcing cycle of underfunding.

Errors in the assessment of financeability can occur for several reasons. The assessment of financeability takes as its starting point the concept of an efficient notional firm and analyses whether such a firm has sufficient financial headroom, over and above its efficient costs. Errors in the assessment of efficient costs can therefore lead to errors in the assessment of financeability. Mischaracterising the notional firm, especially with respect to its capital structure, can also lead to available financial headroom being overestimated. Further, as we set out in the second article of this series, financeability needs to consider both the long- and the short-term and both debt and equity financing. Failure to do so can also lead to errors in financeability assessments.

Wrongly concluding that the notional firm is financeable when it is not, however this occurs, has serious consequences. The adjustments to revenue allowances that would have been made with an accurate financeability assessment will not be implemented.  Regulated companies’ revenue allowances will then be insufficient, even for the most cost-efficient firms. This will force companies to make difficult trade-offs as to which costs they incur and when.

These trade-offs are driven by the need for companies to keep their expenditure within revenue allowances in order to retain equity investment. If they do not stay within their allowances, the rate of return that equity investors earn will be lower than the opportunity cost of their capital. Investors will not remain invested in regulated companies if they are unable to earn a return commensurate with the risk of investing in the sector.  Given the level of risk they face and the level of return available, they will be better off making alternative investments. As a result, companies will be forced either to cut efficient expenditure or else lose equity investment.

In addition, companies will face a trade-off on the debt side of financeability.  Companies with insufficient revenue will struggle to achieve the financial ratios needed for target credit ratings. As their credit ratings determine companies’ abilities to raise debt in practice, this is likely to have a material impact on their financeability. As a result, companies will be forced to make a choice: either suffer falling credit ratings or decrease spending in other areas to compensate for the reduction in allowed revenue.  This further amplifies the tension in choosing the allocation of expenditure.

This can leave regulated companies facing painful trade-offs as they seek to reconcile competing demands on insufficient revenue allowances. In these circumstances, the short-term is likely to take precedence over the long term, as companies seek to stave off the more immediate consequences of under-funding (including loss of investment).  Cuts in expenditure are therefore likely to focus on areas in which their effects take longer to materialise.

For example, companies may spend less than needed to maintain the health of their assets. Under-spending on maintenance is unlikely to have immediate consequences, however the cumulative impact on asset health over time will be considerable.  Relatedly, companies may blur the distinction between opex and capex, adopting a patch-and-mend approach to extend the use of assets beyond their reasonable lifespan. While both approaches will reduce expenditure in the short-term, they will delay necessary expenditure and result in companies needing to incur higher costs in the future. Companies may also make different trade-offs between the costs they incur and the quality of service they provide than they otherwise would, leading to lower service quality for customers.

The distinction between austerity and efficiency is never clear in practice, however. To a regulator tasked with ensuring that customers do not pay for company inefficiency, reductions in expenditure are likely to be attributed to efficiency unless their impact on service quality is clear and immediate. Quality of service and asset health, on the other hand, are difficult to measure, and their link with expenditure levels is complex. As such, the question of whether expenditure reductions truly represent increased efficiency is unlikely to be an issue of primary concern to regulators.

Once a regulator interprets expenditure reductions as efficiencies, under-funding will become baked into revenue allowances through the cost assessment process. This occurs because regulators typically set efficiency challenges for companies that are based on comparisons of historical expenditure across companies. As such, companies that have not cut their expenditure to match their lower allowances will be compared unfavorably with those that have, and under-funding will become the benchmark for the forthcoming price control.

In principle this problem would be avoided if it was possible to benchmark lifetime expenditure on company assets and control perfectly for the impact on asset health and service quality of reductions in expenditure.  In practice, the timeframes over which cost efficiency is analysed are much shorter, and quality and asset health are very difficult to measure accurately.  As such, there is a significant risk that a regulator seeking to deal pragmatically with available data will instead embed an under-funding problem within its price control.

Of course, once under-funding becomes part of the benchmark, the analysis of company financeability will be based on an under-estimate of efficient costs.  It may therefore fail to identify the fact that the notional firm is not financeable, and the cycle of under-funding will continue into the next price control period.  In the final article in our series on financeability, we will set out constructive ideas for improving the approach to financeability and avoiding the problems we have set out here.

See the previous articles in this series:

Developing the gold standard for financeability

The role of financeability duties in a stagnating economy

Developing a robust approach to financeability assessment: the need for a broader view

Accurately assessing financeability: the role of efficient costs