Utility Week - authoritative, impartial and essential reading for senior people within utilities, regulators and government
Issue link: https://fhpublishing.uberflip.com/i/1298293
20 | NOVEMBER 2020 | UTILITY WEEK Policy & Regulation Analysis CMA rocks the boat The Competition and Markets Authority's decision to overturn Ofwat's stance on the cost of capital in the PR19 price control was an unexpected and significant intervention. James Wallin and Ruth Williams examine the fallout. T he Competition and Markets Author- ity (CMA) has long cast a shadow over UK boardrooms, scuppering count- less ambitious takeover plans and thwarting many a shareholder strategy. So it must be a rare case when the compa- nies not involved in an investigation are the ones facing difficult conversations with their investors about the outcome. However, that was exactly the situation in the water sector aer the CMA's unexpected approach to the PR19 appeals and particu- larly its findings on rates of return for the four companies involved. What was so surprising? As one industry observer puts it: "We were expecting tinkering around the edges but what we got was a substantial change. This is a significant departure from previous atti- tudes expressed by the CMA." The bombshell came on the morning of 29 September when the CMA published its interim findings on the four appeals to Ofwat's final determinations on water com- pany business plans for 2020-25. Anglian, Bristol, Northumbrian and York- shire's challenges made it a record opposi- tion for a water sector price control. However, the general feeling across the industry was that precedent was against the four, with serial appellant Bristol having failed to gain significantly from previous attempts. It is understood that the CMA played its cards close to its chest, with little indication in conversations over the past few months that it was likely to depart so significantly from the regulator on such a key topic as the cost of capital. But when the 800-page provisional report came out, the CMA revealed it had ripped up Ofwat's methodology for the crucial weighted average cost of capital (Wacc) and had come up with a very different answer. Crunching the numbers The CMA disagreed with Ofwat's approach to calculating index-linked debt and to come up with the equity beta, it analysed data going back to 2005, as opposed to the two to five year historic data the regulator based its calculations on. Perhaps as significant as the methodol- ogy for the range of the Wacc is the point at which the CMA drew the line. The eventual range was between 2.82 per cent and 3.99 per cent but rather than simply pick the midway point, the watchdog plumped for the figure of 3.5 per cent, stressing that this was "pru- dent" given the "higher risk of error when estimating the cost of equity". As one investor tells Utility Week: "That could be a really important precedent because the message they are sending is that the consequences of the downside are more severe than the consequences of the upside. For the CMA to express that point of view is very powerful. It means in future that com- panies will have that case to argue." While Ofwat won many of the battles over costs and outcomes – perhaps more than expected – it will inevitably be wounded by the key areas in which the CMA has departed from its position. In particular, the CMA's explanation that adjustments to Ofwat's allowed rate of return were necessary to reflect not just market- based evidence but also "best regulatory practice" must have made painful reading. Given that Ofwat's views on Wacc have been known for more than two years and companies are still finding it possible to access financing, some commentators ques- tion whether the CMA has read the mood music right. One says: "The CMA has paved the way for a much larger return on capital and that's quite hard to square when you look out of the window at what's happening to other people." It is likely that this "real world check" will be a consistent theme in Ofwat's response to the CMA, however an outright challenge to the revised Wacc methodology seems unlikely. Top Gear In its final determinations, Ofwat sought to tackle the issue of high levels of gearing Indicative impact of our provisional determination on annual customer bills Company historical Company average Company average bill Company average bill under bills (2019/20) bill in April under Ofwat's Final CMA provisional decision business plan* Determination (FD) Anglian (water and sewerage) £422 £418 £386 £400 Bristol (water only) £182 £174 £160 £166 Northumbrian (water and sewerage) £429 £343 £323 £335 Yorkshire (water and sewerage) £383 £379 £364 £379 * The April business plan figure here is taken from Ofwat's published documents, and may not align with all of the implications of the company's submissions in its Statement of Case. Source: CMA analysis