Utility Week

14 | JULY 2021 | UTILITY WEEK Policy & Regulation Analysis Is Wacc back on the table? Pennon Group's takeover of Bristol Water has reignited industry debate over the cost of capital. Ruth Williams looks at the wider implications of the deal. T he PR19 appeals to the Competition and Markets Authority (CMA) may have concluded but the debate around rates of returns for investors is far from over. The announcement by Pennon Group at the start of June that it was acquiring Bristol Water for £425 million is the latest catalyst. According to one sector analyst, the pre- mium offered by the South West Water owner could call into question the decision arrived at by the CMA. Bristol was one of four companies to appeal Ofwat's final determination for the 2020-25 asset management plan period (AMP), which resulted in each being permit- ted a higher weighted average cost of capital (Wacc) than the regulator had allowed. Colm Gibson, managing director at Berk- ley Research Group, notes that the regulatory capital value (RCV) multiple is potentially over 1.4x, based on an enterprise value of £814 million, and that this may rekindle speculation as to whether the regulatory return allowed by the CMA was too high. "If the merger goes ahead, Pennon may be in the unique position of having two dif- ferent regulatory determinations applying to the different areas, given Bristol Water's successful appeal to the CMA," Gibson says. "This would create an interesting opportunity from the regulatory accounting framework. To the extent that there are sig- nificant cost savings, the financial benefit will depend on their accounting allocation between the two entities. It remains to be seen how Ofwat will view these unintended incentives." Pennon was the last company in the sec- tor to buy another when it added Bourne- mouth Water to its portfolio in 2015. Like Bournemouth, Bristol is geographically close to Pennon's heartland, and chief executive Susan Davy says the two businesses have much to learn from one another. She tells Utility Week the Bristol Water brand will remain in the long term and sen- ior management teams are expected to stay on, including Mel Karam as head of Bristol. Davy says: "We're really excited about the opportunities this brings to Pennon Group. The experience we had when acquiring Bournemouth Water meant we had the best of the best and had opportunities to inte- grate. It is very important to us that the Bris- tol Water management team are very much a part of the Pennon family." The deal will be subject to approval by both Ofwat and the CMA, a process that could take several months. Davy says the proposition presented to the regulatory bod- ies will focus on what it means to customers. "There are real benefits such as the Water- Share+ Scheme, there are benefits to Bristol coming back into the listed space, opera- tional benefits. This will help services to cus- tomers and bring operational efficiency that will help with the lowering of customer bills in the future as well." Since assuming the role of chief executive last year when the Viridor deal completed, former chief financial officer Davy and her team have assessed opportunities for acqui- sitions across the UK water sector. Bristol Water has not been in a reward situation for outcome delivery incentives on supply interruptions, which is an area of strength for South West Water. Meanwhile Bristol has been ahead of its new parent group on C-Mex scores. "It really is an oppor- tunity for us as a group to come together and learn from each other," says Davy. AŸer the sale of Viridor last year, Pen- non has had £2.7 billion burning a hole its pocket. Chief financial officer Paul Boote says £1.3 billion from the sale will be used to lower debt and reduce the pension deficit, as well as targeting group level gearing of below 65 per cent by the end of the AMP cycle. A further £100 million will be invested in the green recovery initiative. Of the remaining £1.9 billion proceeds, £1.5 billion will be returned to shareholders via a special dividend of £3.55 per share. "We can look at further opportunities if they come across our desk and we find them attractive," Boote says. He points out that Pennon has been an acquisitive group over the years and is unlikely to ever say it is done with further gains. Pennon is understood to have run the slide rule over Northumbrian and Southern last year but is thought to have been looking for an outright acquisition rather than con- trolling stakes, which leŸ mostly water-only companies. AŸer selling Viridor, Pennon was itself a smaller business and one commentator sug- gested it needed to "eat or be eaten". Martin Young, an analyst at Investec, says that Pen- non is likely to remain an acquisition target. "Pennon is a well-run company, con- trasted with some other companies in the sector it is not exposing itself to reputational angst. Why wouldn't someone be interested in a growth opportunity in a well-run com- pany?" he says The benefits of managing water resources within a closer geographical area deliver benefits to both companies and also to stake- holders. Young tells Utility Week he thinks the selling points may have been down- played by the organisation. He says Bristol was a logical acquisi- tion and an excellent business fit, expand- ing wholesale capabilities and RCV growth, however Pennon could have done more to evangelise the "big picture" benefits for other stakeholders. "It's almost as if they're downplaying what they believe they can deliver," he says. Ruth Williams, water correspondent "This will help services to customers and bring operational efficiency that will help with the lowering of customer bills." Susan Davy, chief executive, Pennon

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