As the UK heads for elections next May and a cost-of-living crisis is a major concern for the public and policymakers alike, it seems quite reasonable for the country’s water regulator, Ofwat, to focus on customer affordability as the basis of its price review for the period 2015 to 2020, otherwise known as PR14.
Just by skimming Ofwat’s 40-page draft price determination notice released in August – “Getting the best deal for customers”, “Ensuring customers are protected”, “Delivering what customers want” – it could not be more obvious where the regulator is coming from. The objective is to reduce average bills for water and wastewater customers in the upcoming five-year period by 5 percent in real terms.
“At the same time, customers would benefit from better levels of service and improvements as a result of substantial expenditure of more than £43 billion [€55 billion; $68 billion],” Ofwat states.
According to the Cave Review, named after its author, Warwick Business School Professor Martin Cave, which was released in April 2009, household water bills increased 42 percent in real terms since the sector was privatised in 1989. Despite attracting investments totaling £80 billion between 1989 and 2009, the Cave Review found that the sector’s record on innovation and investment in research and development (R&D) was lacking.
A BALANCED APPROACH
That finding, along with the desire to address customer affordability, has prompted Ofwat to propose a weighted average cost of capital (WACC) of 3.85 percent (3.7 percent for the wholesale segment) in the price review, which is significantly lower than the 5.1 percent adopted in the previous review (PR09) for the period 2010-2015.
“It has been highlighted in the last year or two that dividend payouts for some companies have been rather large, too large for the regulator’s wish, so it might be a factor, but I don’t think it’s the main factor,” Mark Davidson, credit analyst at ratings agency Standard & Poor’s (S&P), comments in reference to the proposed WACC.
According to S&P, the proposed WACC reflects a decline in borrowing costs. The ratings agency does not expect PR14 to have a significant impact on water companies’ credit ratings in the near- to medium-term. While it acknowledges that a lower cost of capital will reduce companies’ profitability and cash flows, it believes the regulator has taken a “balanced approach” by offering companies in the sector new tools to mitigate the potential effects on their bottom line. These include the ability to combine the operating cost allowance (opex) with the capital cost allowance (capex) into a single allowance for total expenditures (totex). This is the first time this is being done in the 20 years that Ofwat has been issuing price reviews.
Companies will be able to choose how to allocate their totex allowances between capex and opex, S&P states in its Infrastructure Outlook note of March 2014. By being able to shift from capex to opex, companies will be able to give their cash flows a short-term boost since opex is remunerated within the year it is incurred, Davidson explains.
The second tool that will provide water companies some flexibility is the ability to adjust the depreciation life of regulated capital value (RCV). By shortening the depreciation life of the regulated asset base, companies will be able to increase their depreciation charge for each year.
“It’s like EBITDA and so the more depreciation you have the more cash flows you have,” Davidson says. “Ofwat expects these two tools to only allow adjustments at the margins; not anything huge,” he notes.
HEADING FOR THE EXIT
Investec, the UK investment bank, on the other hand, considers the lower WACC and PR14 in general to be much more detrimental in terms of investment in the sector, particularly if it is lower in the final review which will be released on December 12.
“With the ‘allowed’ cost of equity being set at all-time lows at precisely the time that sector risks are rising, we are concerned that regulators are ‘pulling the plug’ on equity,” the investment bank said in an 80-page analyst note released on October 31.
“Our view is that the lower WACC makes it more difficult for equity investors to earn an attractive return,” Investec analyst and one of the authors of the note, Roshan Patel, says. “A permanently more aggressive stance on the WACC would make valuations difficult to sustain.”
According to Patel, for listed equity this might mean an exit from the sector either through leverage or high dividends and/or a shift from listed equity to private equity.
“In either case, equity is searching for ways to boost returns in a low WACC environment through a combination of leverage, high dividends, and private equity investment. The important point is that we don’t believe this is sustainable in the long run,” Patel stresses.
Investec also points to another key change in PR14 that shifts power from the regulator to the customer in influencing the level and type of investment in the sector. This has come in the form of Customer Challenge Groups (CCGs), part of the PR 14 methodology aimed at giving a greater voice to customers in terms of the business-planning process.
“Companies have engaged directly with over a quarter of a million of their customers, the biggest ever programme of engagement in the sector,” Ofwat notes in its draft determination notice.
The danger in that however, according to Investec, is that customers will support “the cheapest ‘do-minimum’ option”. This in turn “may strain long-run outcomes, especially in relation to resilience and the environment – precisely the outcomes that are most critical for the industry,” Investec states in its October note.
REWARDS AND PENALTIES
Outcomes are indeed critical for operators in the sector as they will be rewarded or penalised based on their ability to outperform on certain measures, including costs and quality of service. For the first time, Ofwat has said that it will not necessarily reward companies for simply improving their performance based on their own track record, but for managing to rank in the upper quartile.
“We have moved from basing our efficiency challenge to companies on the average efficiency measure that we used in the past to a more stretching upper-quartile challenge of efficiency,” Ofwat explains in its draft.
While infrastructure fund managers which have invested in the sector declined to comment for this feature on how they view Ofwat’s proposal, Andrew Briggs, a partner at law firm Hogan Lovells, whose clients include companies in the sector, provides some insight.
“If a reduced WACC determination leads to a lower financial return for equity investors for the next five years, clearly that is not a good thing. But I have no sense – from talking to people in the market – that it’s so catastrophic,” he says.
“Most investors take a longer-term view and I don’t think this particular review will start all of the pension funds and infrastructure funds rushing to sell their assets; I think it’ll focus their mind on managing their business more efficiently and seeing what happens next time,” he adds.
S&P’s Davidson echoes that view: “Despite the current reset which is quite challenging, I think global infrastructure investors still view the UK water sector as attractive in terms of long-term returns. They like the regulatory framework and, as long as they are long-term investors, I don’t think they will be deterred by it.”