Utility Week - authoritative, impartial and essential reading for senior people within utilities, regulators and government
Issue link: https://fhpublishing.uberflip.com/i/1298293
UTILITY WEEK | NOVEMBER 2020 | 21 Policy & Regulation among water companies and the ensuing risk to billpayers. This resulted in the Gear- ing Outperformance Sharing Mechanism (GOSM) which seeks to share the benefits of higher gearing with customers. The CMA agreed with the need to tackle the issue but expressed concern as to the effectiveness of the GOSM in improving financial resilience, as well as questioning the specifics of its design. It also shed doubt on "whether the financial benefits of higher gearing assumed by Ofwat in its design of the GOSM exist". This is likely to have been one of the most frustrating outcomes for Ofwat given that the CMA has effectively agreed there is an issue for which the regulator needs to find a solu- tion but has rejected its chosen solution and provided no guidance on a new one. High gearing and company returns are a sensitive topic in an industry still bearing the scars of last year's privatisation debate. Is there a risk that this complex process could be reduced to accusations of share- holders being favoured over customers and drag the sector back into the same old argu- ments about nationalisation? Lawrence Slade, chief executive of the Global Infrastructure Investor Association, rejects this view, saying: "It's very important to remember that bills are still coming down – by 9.3 per cent over the five years. What this is about is getting the balance right between a fair deal for billpayers and the incentives to invest for the future." What about the rest? The CMA process is very clear – you have to be in it to win it. So, for the 13 companies that accepted their final determinations, there will be no automatic adjustment to the cost of capital. However, Colm Gibson, managing direc- tor at Berkley Research Group, suggests there could be another option. "The management of the other compa- nies may be considering whether they could trigger an interim determination because, if Ofwat rejects that, they would have the right to appeal to the CMA," Gibson says. Individual companies can approach the regulator to make an interim determination that could address the cost of capital within that process. Gibson suggests that the impact of Covid, particularly on future levels of bad debt, could well be significant enough to warrant such requests. Another sector commentator warns that while an interim determination would be an option for some, they are "quite a messy pro- cess" that would involve a lot of hard work with no guarantee of being effective. They suggest a better approach would be for companies to collectively bypass the regulatory process and persuade government that Ofwat's rate of return is wrong. How- ever, a case to encourage green recovery to boost the post-Covid economy without cost- ing the Treasury may struggle to gain trac- tion at a time when government has so many pressing issues to attend to. Despite an inevitable frustration from the companies that did not appeal, they are likely to take heart from the evidence that the CMA process can work in their favour in future. This is the view of Peter Antolik, of Arjun Infrastructure Partners, which manages the fund that owns 55 per cent of South Staffs Water. He says: "This shows the strength of hav- ing merits-based appeals. It's a crucial part of the checks and balances of the sector and it gives investors confidence. It's enormously important for companies to have that right to have their case re-evaluated on its merits." Energy effect This stone thrown into the water sector will cause ripples far and wide and immedi- ate thoughts will turn to Ofgem's approach to RIIO2. The CMA's recalculation puts the real cost of equity at 5.08 per cent as opposed to 4.19 per cent in Ofwat's final determination and the 3.95 per cent Ofgem is currently propos- ing in its dra determinations for the gas and electricity transmission networks. Asked how Ofgem is likely to respond, one former regulator says: "Each CMA case is a different panel and they are fully entitled to take a different approach, especially in uncertain times, so Ofgem aren't necessarily beholden. "The CMA went for a wide range for the Wacc figure and then went to the upper end of it, so Ofgem could pitch something that was within that range but a different quar- Totex by type of cost, 2020-25 (£m, 2017-18 CPIH deflated prices) Anglian Bristol Northumbrian Yorkshire Modelled base allowance (including CAC) 3,414 343 1,949 2,883 Unmodelled allowance 359 44 391 320 Enhancement allowance 1,522 29 365 1,008 Other totex allowances* -85 -6 -54 -67 Total 5,209 410 2,651 4,146 Change vs Ofwat FD +144 +5 +22 +92 * Other totex allowances include operating lease adjustments; strategic regional water resources solutions and other cash items; third party costs; non-section 185 diversions; ex-ante cost sharing adjustment; grants and contributions (aer adjustment for income offset); and pension deficit recovery costs. Prices are deflated for inflation (based on Consumer Prices Index Including Owner Occupiers' Housing Costs (CPIH) measure). Source: CMA analysis. tile. But it would be a risky move because it could look as if they are snubbing the CMA." For one investor, who has experience in both the water and energy sectors, the mes- sage from the CMA is loud and clear – and it is one Ofgem would be foolish to ignore. "They are fully entitled to pick their own figure [on cost of capital] because in appeals to RIIO2 the CMA would have to prove Ofgem was wrong. But they know that any deviation from the precedent the CMA has set will be jumped on by the companies. Do they want to spend the next few years fighting multiple appeals? They've got enough on their plate." A new kind of regulation Whether of the view that the CMA got it right or wrong, all observers agree that this is going to have long-term implications for all regulators. One says: "This is just going to increase calls for government to give more concrete guidance on what regulation should be about. What are the priorities? Investment for the future as quickly as we can? Driving down bills? Protecting the vulnerable? You can't simply ask an economic regulator to stick their finger in the air and judge all this themselves." A former regulator says: "This is likely to feed into conversations already ongo- ing within Ofwat about whether a new approach is needed for PR24. The current regulatory model was one set up for an inef- ficient industry and it hasn't really kept step with the evolution we've seen. If you look at where we are now it's increasingly difficult to justify a one-size-fits-all approach. "The CMA may have been the nudge that was needed to really get that ball rolling. "If nothing else, Ofwat has at least had a glimpse of what the determination process looks like from the company point of view. I don't think they're enjoying it." James Wallin, digital editor; Ruth Williams, water correspondent