Utility Week

20 | MAY 2023 | UTILITY WEEK Water determined by Ofwat is not in fact invariant to capital structure. Due to the speci cs of the calculation, lowering the notional gear- ing, as the regulator has proposed to do for PR24, also reduces the WACC slightly. But Mason says the Modigliani-Miller the- orem "doesn't hold in real life" either, mean- ing "the intellectual basis for not worrying about the nancial structure of companies is removed immediately". The theorem importantly assumes perfect market conditions, with companies facing the full costs and bene ts of their decisions. And natural monopolies with prices set by a regulator are no economist's idea of a perfect market. For a number of years now, Ofwat has been concerned that some of the risks of gearing decisions are being borne by con- sumers and taxpayers rather than sharehold- ers, allowing companies to generate excess returns by increasing their debt levels. It was for this reason the regulator intro- duced GOSM for PR19 to claw back some of this bene t for consumers. The GOSM initially applied to compa- nies with a gearing ratio of 74% or more in 2020/21, with this threshold sliding down a glide path by 1% per year to 70% in 2024/25. It requires liable companies to return to con- sumers 50% of the di" erence between their notional cost of equity and nominal cost of debt for gearing in excess of 65%. It's fair to say the introduction of the mechanism has not gone smoothly a– er the CMA promptly overturned it for the four companies that successfully appealed their nal determinations. 'One-sided bet' Following the CMA's decision, Ofwat com- missioned Mason and fellow academic Ste- ven Wright to produce a report on gearing and nancial resilience, including potential alternatives to the GOSM. Mason says the "nub" of the gearing issue is the failure of the regulatory regime to capture the full externalities of compa- nies' nancing decisions. He says there is a "moral hazard" if companies know they won't bear the "full brunt of the downside" of their chosen capital structure. As well as reduced investment and service levels if companies get into di™ culties and the signi cant fallout if they fail completely, the report from Mason and Wright said these externalities include "any explicit or implicit insurance o" ered by the regulator when there are concerns about nanceability". "This leads to lower risk to equity and hence the WACC can be lowered through increased gearing. It is, of course, di™ cult to collect direct evidence that this behaviour occurs." It continued: "No regulator would be will- ing to state the insurance explicitly: the pref- erence will be to assert that no adjustment to the terms of a regulatory contract will occur in the face of impending nancial failure, and special administration procedures will sort it out." Investors also have little incentive to acknowledge this insurance in case there is an "adverse regulatory reaction". Mason says the issue of gearing outper- formance is exacerbated by information asymmetry between the companies and the regulator. In general, this has led the latter to err on the side of overcompensation when setting price controls, "aiming up component by component" for fear of underinvestment. "Of course, the regulated rms contest that very energetically and enthusiastically, but it's undoubtedly the case," he adds. Mason says the fact that the regulatory settlement o" ers excess returns to compa- nies is demonstrated by recent acquisitions "where the market asset ratio is well above one. "That's really rež ecting the kind of one- sided bet that I think there is for utility companies, that regulators really don't want utility companies to fail, because although there's a special admission administration regime, it's really costly to bring in so they would prefer to ensure that there's a little bit of upli– on the cost of capital to keep them well away from any nance stability concerns." When asked to quantify the size of the externalities from companies' gearing deci- sions, Mason responds: "It's really hard to answer in water because we haven't really had any incidents of failure, and therefore we don't have any empirical evidence as to the size of the externality." The special administration regime is intended to minimise the social costs of com- pany failure, but the report said it is "ques- tionable whether special administration procedures, on their own, or at least in their current form, are su™ cient to address the externalities present". Remedies Mason and Wright's paper suggested sev- eral alternative options to address the issue of gearing, one of which Ofwat has now decided to press ahead with – strengthening the existing cash lock-up condition in com- panies licences. These conditions currently prevent water companies from paying out dividends with- out prior approval from the regulator if any of their credit ratings fall to the minimum investment grade of BBB-/Baa3 with a nega- tive outlook. From the beginning of the next asset management period on 1 April 2025, this trig- ger will be raised by one grade to BBB/Baa2 with a negative outlook, albeit with a three- month grace period in which companies can request a subsequent exemption. Yet another suggestion of Mason and Wright was the creation of a new charge on highly geared companies that would be put into a fund and used to cover the costs of the special administration regime in the event that it is triggered. They said the charge could be levied on the basis of gearing lev- els or other measures of nancial resilience such as credit ratings. Alternatively, they said the conditions for triggering the special administration regime could be tightened such that "failure to meet service conditions by some margin, over some time period, is a su™ cient condition to trigger special administration … irrespective of the degree of nancial distress of the com- pany concerned". As the cost of maintaining and restoring services levels would be treated as a "prior claim on the assets before both equity hold- ers and all creditors". the paper said this would provide a strong incentive for incum- bent companies to avoid triggering the regime. In its report on water regulation in March, the House of Lords Industry and Regulators Committee also noted that a special admin- istration regime that Ofwat is less scared to trigger could also be used to address poor operational performance. Links to performance One question that has been raised is whether there has been any link between the owner- ship, gearing and operational performance of companies. In terms of ownership and capital struc- tures, there certainly seems to be a relation- ship. All three of the listed water companies (Severn Trent, United Utilities, and Pen- non Group's South West Water) have gear- ing ratios below the sector average and close to the notional gearing. None of them are among the nine securitised compa- nies, which as previously mentioned have an average gearing ratio 8.6 percentage points higher than the eight non-securitised companies. Allen Twyning from Pension Insurance Corporation, a regular lender to the sec- tor, says it is only the private equity owners that have been able to adopt the securitisa- Analysis continued from previous page

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