Utility Week

16 | 14TH - 20TH FEBRUARY 2020 | UTILITY WEEK Policy & Regulation Ofwat shouldn't go unchallenged "Here are six areas where energy networks need water companies to challenge Ofwat at the CMA." Opinion Colm Gibson, BRG I t can been said that the main role of Ofgem and Ofwat is to make the decision to accept or reject a price control as hard as possible for companies and their investors. If it is obvious that the price control should be accepted, the regulator has been too lax. If it is obvious that it should be rejected and referred to the Competitions and Markets Authority (CMA), the regula- tor has been too harsh. Regulators should, therefore, strive to make this a difficult decision for companies. In line with this, Ofwat issued its final determina- tions for the PR19 price review in December. Water companies and their investors must now decide whether to accept Ofwat's offer or reject it and appeal to the CMA. UK energy networks facing Ofgem's RIIO2 decisions later this year have a strong vested interest in the outcome of the water companies' decision on whether or not to appeal. Having worked closely with a number of water companies through the PR19 process, I can safely say that Ofwat has le‹ companies and investors with a very difficult decision to make. Water companies know this is a particularly tough price control, with many not antici- pating paying external dividends for the foreseeable future. Equally, however, companies will find it hard to conclude that the likely outcome from challenging the CMA would be materially better and many will be (rightly) deterred from appealing. This matters to energy companies because, if no water companies appeal, the conceptual shi‹s in policy that Ofwat has made will go unchallenged. If they aren't challenged, they may be too tempting for Ofgem to ignore and may be included in its upcoming RIIO2 decisions. This would be bad news for long-term energy investors. Had Ofwat stuck at its dra‹ determination position, it would have been abundantly clear to companies and investors that they should challenge the final determina- tions at the CMA on a number of issues. These included an overly tough performance commitments and Out- come Delivery Incentive (ODI) reward/penalty regime, a very low totex allowance, unrealistic "frontier shi‹" assumptions and a number of painful conceptual shi‹s to the framework that have a material adverse impact on companies' financeability and the ability to pay future dividends. Ofwat so‹ened its position on many of these issues in the final determination, but did not yield on its conceptual shi‹s, using some of them to deal with the short-term financeability issues that its notional com- pany suffered from. Individually, each of these can result in a significant loss in long-term value for investors. In aggregate, they may even go so far as to remove the link- age between regulatory asset base (RAB) or regulatory capital value (RCV) and the cashflow investors might expect. Without this linkage, the net result of this would be that companies may no longer sensibly be valued at a multiple of RAB or RCV, and other valuation metrics will be used. At least one conceptual shi‹ is being tested at the CMA at the moment in the NATS En-route Limited (NERL) price determination case – namely whether or not regulators should take account of the very asymmet- ric consequences of setting the allowed cost of capital too high or too low. However, the only opportunity for the other conceptual shi‹s to be challenged is if water companies appeal PR19. These conceptual shi‹s include: • penalties for high gearing; • having low or no dividends for notional companies with high RAB growth; • (repeatedly) bringing forward revenues from future periods to make notional companies financeable; • setting an industry-wide weighted average cost of capital (Wacc) using a notional company that achieves far better than industry average perfor- mance with respect to rewards/penalties; • using upper quartile efficiency (that is, lowest quar- tile costs) as the benchmark for the costs of some- thing akin to upper quartile performance; • deeming higher levels of performance to be funded as part of "base" costs. Ofwat has set a tough price control with several nota- ble conceptual presumptions that, if le‹ unchallenged, may also have a considerable impact on the UK energy sector in the form of Ofgem's upcoming RIIO2 price control. It's down to the water companies and ultimately their investors to decide whether or not to challenge, but I think energy networks should be concerned that no company has yet announced that it wishes to challenge Ofwat at the CMA. Colm Gibson, managing director of BRG's London office and head of BRG's economic regulation practice for the UK, EMEA, Berkeley Research Group The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates. This is an extract of an article that can be found in full at: www.utilityweek.co.uk "Ofwat softened its position on many of these issues in the final determination, but did not yield on its conceptual shifts"

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