Utility Week

UTILITY WEEK | 1ST - 7TH FEBRUARY 2019 | 11 Policy & Regulation Analysis I n the almost 30 years since the ten water and sewerage companies were privatised, all (apart from not-for-profit Welsh Water) have prospered and delivered good returns to shareholders. Customers have done less well, but 2019 may be the year that changes. Ofwat was about to publish its initial assessment of water companies' business plans as Utility Week went to press. It was slight odds against any company being judged "exceptional" or best of breed. The regulator will make its final determi- nations in December. Given the miserly circa 2.4 per cent weighted average cost of capital (Wacc) flagged, tougher regulation is coming. In terms of the business plans, Ofwat's assessment focuses on nine criteria: • Engaging customers; • Addressing affordability and vulnerability; • Delivering outcomes for customers; • Securing long-term resilience; • Targeted controls, markets and innovation; • Securing cost efficiency; • Aligning risk and return; • Accounting for past delivery; • Securing confidence and assurance. Every firm will have pored over these and would expect to satisfy Ofwat on each. But clearly, if a firm has nothing to offer on a crite- rion, it cannot expect to be very highly rated. Ofwat will rank the water companies in four categories. Top of the list is "excep- tional", which is followed by "fast-track". Third is "slow-track" and, at the bottom, is "significant scrutiny" which, like relega- tion, is the grouping to be avoided. It can be assumed Ofwat's approach will not be totally formulaic – judgements will be needed on several fronts. It is difficult to imag- ine, for example, that Thames will be rated exceptional, given the political controversy it has generated and its poor leakage record. But if a water company is rated as excep- tional, what are the tangible benefits? In its Delivering Water 2020: Our final methodology for the 2019 price review, Ofwat said a water company rated as exceptional will receive "an amount equivalent to 20 basis points (bp) to 35bp addition to the return on regulated equity (RoRE) over the whole price period, based on notional gearing of 60 per cent". This effective Wacc enhancement, although not vast, is certainly worth having. Furthermore, exceptional and fast-track companies will be subject to less intrusive regulation, with an early final determination being promised. By contrast, the firms Ofwat prescribes as significant scrutiny will find their finances subject to heavy regulatory analysis. And reduced cost-sharing rates will apply; outcome delivery incentives (ODIs) may also be capped. How they might fare Of the quoted companies, Severn Trent is probably the most likely to be placed in the top two categories – and has a decent chance of being rated as exceptional. Pennon-owned South West Water will also fancy its chances. AŸer all, it has been rated in Ofwat's top category previously. Some water-only companies may also be optimistic, given the inherent advantages, especially for regulatory purposes, of not owning and operating a sewerage business. At the other end of the scale, there are several potential laggards. While new chairman Ian Marchant is try- ing to turn around Thames, its performance in recent years has been unimpressive. Its inability to finance the Thames Tideway Tunnel from its own balance sheet, net debt being racked up, massive dividend payouts, minimal corporation tax payments and wors- ening leakage levels – in 2017/18, it was more than 8 per cent above the 2015/16 figure – will hardly endear Thames to Ofwat. Other private equity-owned water com- panies have also faced challenges, including Southern, which was required by The Pen- sions Regulator to find £50 million to top up its under-funded pension scheme. Bristol, which has crossed swords with Ofwat in the past, is a likely contender for one of the bottom spots. Its management team may have been overhauled, but some Ofwat executives have long memories. With the low indicative Wacc, it is evi- dent PR19 will be the toughest review yet. Of course, Ofwat may boost the 2.4 per cent – especially if the term structure of interest rates indicates pronounced upward movement. However, the projected US interest rate rises now seem less certain so it will be sur- prising if the water companies benefit from a material upliŸ in Ofwat's Wacc assumption. Interestingly, most water companies seem relatively sanguine about the aggressive Wacc figure, which effectively has been cut by a third from the comparable PR14 Wacc. Reputedly, Malaysian-owned Wessex is not happy with it; and some of the highly geared water companies in private equity ownership must also harbour serious concerns. On the operational front, much of the focus will be on Ofwat's totex figures for each company; these are effectively the merged operating costs and capital expenditure out- lay over the five-year regulatory period. Ofwat will assume some efficiency savings, which will be aligned with the ODIs. Assessing the capital expenditure ele- ment of totex accurately is a challenge. The water firms know this and will expect to out- perform Ofwat's overall totex assumption – and boost their dividend growth potential. For Severn Trent and United Utilities, dividend cuts are quite likely. Pennon has the advantage of Viridor, a decent (though volatile) waste business, whose earnings have enhanced its dividends. While the dividend issue is less impor- tant for private equity-owned water firms, the much tougher determinations expected for PR19 will put heavy pressure on their finances; their gearing levels are higher than average and, in many cases, their net debt lev- els are formidable. Thames reported under- lying net debt of £11.3 billion at March 2018. Aside from Ofwat, water firms and their investors need to be aware of likely politi- cal fall-outs as Brexit moves to a conclusion. Crucially, it could lead to an early general election, which Labour could win. Given its declared policy to return the water sector to public ownership, this would be a hammer blow to the privatised companies. Food for thought – an exciting year awaits. Nigel Hawkins, utilities analyst, Hardman & Co Water firms await PR19 fate As Ofwat publishes its initial assessment of water companies' business plans, Nigel Hawkins asks if 2019 could be the year that the firms' customers do better than their shareholders.

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