Utility Week

UTILITY WEEK | MAY 2023 | 19 Water This was partly due to the e ects of higher in ation. While companies' RCVs are linked to in ation, according to a recent report from ratings agency Moody's just over a half of their debts (54%) were indexed as of the end of March 2022. This means a sub- stantial share of their debt is falling in value relative to their RCV. With high in ation set to persist through- out 2023 and into 2024, there will continue to be downward momentum on gearing levels for the next several years. Moody's nevertheless gave a negative out- look for the sector, warning that the bene‡ ts of in ation-linked RCV growth will be o set by the accompanying cost pressures, with the e ects on both sides of the scale varying signi‡ cantly between companies. There is a large variation in companies' levels of index- linked debt, necessary re‡ nancing and expo- sure to oating rate debt. Although the macroeconomic environ- ment is generally putting downward pres- sure on gearing levels, Ofwat remains concerned that the companies with the greatest debt lack ‡ nancial resilience. Its most recent ‡ nancial resilience monitoring report in December singled out ‡ ve compa- nies as requiring special attention: Thames, Southern, Yorkshire, Portsmouth, and SES. The regulator says they also need more equity to maintain the e• cacy of the incen- tive regime and ensure ‡ nes are not con- strained by concerns over their solvency. The latter is likely to be of particular concern for the regulator given its massive ongoing investigation into sewage treatment works and the government's recent announcement that the sector should face unlimited ‡ nes for pollution. These issues are best exempli‡ ed by the case of Southern Water, which has incurred hundreds of millions of pounds in ‡ nes and penalties in recent years. Speaking at a Util- ity Week event in November, former Ofwat chair Jonson Cox said the regulator came "very close" to taking Southern into special administration following a "material wipe- out of equity value for poor performance". Ofwat instead accepted an o er from Macquarie to acquire a majority stake in Southern's parent company, Greensands, as part of what Cox described as a "virtual spe- cial administration", Under sustained pressure from Ofwat, Anglian and Thames have also carried out or committed to large equity injections over the last several years. Excess pro ts "For as long as I can remember … the stance of all the regulators – not just Ofwat but the Competition Commission and subsequently the CMA – has always been that the ‡ nancial structure of regulated companies is not their concern," professor Robin Mason of the Uni- versity of Birmingham tells Utility Week. The economic foundation for this stance is the Modigliani-Miller theorem, which states that the cost of capital for a company is invariant to capital structure. Although the cost of equity is higher than the cost of debt because of the greater risk of losses faced by shareholders than lend- ers, this does not mean companies are able to reduce their cost of capital by increasing their debt levels. As they take on more debt, the risk per unit of remaining equity increases, raising the amount of compensation shareholders expect in return. Meanwhile, the cost of debt also rises as the risk of default grows. These e ects completely o set the reduced weight- ing of equity in the capital structure. Despite the regulator's aspiration that it should comply with the theorem, the weighted average cost of capital (WACC) as continued overleaf Campaign groups and have proved very effective in drawing public attention to the problem of sewage being discharged off the coast and into rivers

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