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Comment Utility Week expert view Nigel Hawkins "Over the next 18 months, the periodic review will dominate the water sector, and especially the share prices of the quoted water companies." T he ritual of quinquennial periodic reviews of the water sector are a product of the privatisation of the ten water companies back in 1989. Another review is currently under way, with the final determinations due in just over a year. Within the sector, it is regarded as paramount, and share prices will respond sharply if the outcome is very different from market expectations. Given the various changes at Ofwat, including a new chairman, Jonson Cox – with extensive inside experience of the sector and trenchant comments about the assumed weighted average cost of capital (Wacc) – it is far from clear what the final outcome may be. History, alas, is not much of a guide. To the satisfaction of nine water companies, the 1994/95 periodic review built broadly on the principles set out in the flotation prospectus in 1989, with the exception of a very disappointed South West Water, who had previously been awarded a favourable cost pass through package. By contrast in 1999/2000, Ofwat's then regulator, Sir Ian Byatt, was far more aggressive and prescribed sizeable price cuts – for the privatised ten water companies, these averaged over 12 per cent: this momentum was not sustained. The two subsequent periodic reviews, in 2004/05 and 2009/10, were much more investor-friendly. With a five-year capital expenditure programme of c£20 billion, virtually all the price changes were marginal. The general consensus is that, for most of the past decade, water companies have benefited from benign regulation, low borrowing rates and their sought-after defensive qualities at a time of recession. For investors, the regulated business returns are crucial, since only Pennon benefits from decent non-core earnings via its prospering waste subsidiary, Viridor. In days gone by, Thames and Anglian had grand expectations of their international strategy, but not any more. Hence, Ofwat's eagerly-awaited final determination figures will drive earnings, which will determine dividends – and, hence, the share price. In 2010/11, both Severn Trent and United Utilities cut their dividends having accepted Ofwat's final determination. While the immediate impact on their share prices was negative, the policy did at least allow progressive dividend growth. And, as Severn Trent's £18-plus share price demonstrates, the sector is now firmly back in favour – despite the regulatory uncertainties. Which are the key battleground figures? First, the capital expenditure numbers are crucial. It seems unlikely that the final determination will veer too far away from the sector £20 billion five-year figure of the last two reviews, although environmental obligations will be an important driver. This estimate is before making any allowance for Thames' Tideway Tunnel project, which will presumably be treated outside Thames' regulatory asset base. Second, operating costs are always the subject of prolonged debate, with water companies arguing that additional capital expenditure normally gives rise to additional operating costs. A new water treatment plant means higher pumping costs, unless it is replacement investment. Third, the vexed issue of the Wacc assumed by Ofwat will exercise the minds of the negotiating water companies. The current Wacc is 4.5 per cent post-tax, with the assumed debt element of 3.6 per cent. Almost certainly, the 2014/15 Wacc will be lower, with the assumption of higher gearing – currently 57.5 per cent – and a noticeably lower cost of debt. However, Ofwat will have to consider the term structure of interest rates, where five-year interest rates are projected to be significantly higher than at present. Will Ofwat's Wacc sink below 4 per cent? If so, customers will benefit through price cuts. If not, shareholders will be relieved – with Severn Trent's board being entitled to feel smug that they rejected a £22 per share bid on the basis of it being an undervaluation. Over the next 18 months, the periodic review will dominate the sector, and especially the share prices of the quoted water companies. It will also have a major impact on unquoted water companies, with the Thames Water situation being the most intriguing. The company's £4.2 billion Tideway Tunnel appears to be struggling to raise finance, as the parcel is passed around potential financial backers. Furthermore, its net debt has apparently soared to over £9 billion, while its comparatively modest £29 million application for an interim determination has failed to pass muster with Ofwat. While the gap between periodic reviews for the water sector is five years – compared with the unprecedented eight-year regulatory period applicable to National Grid – its impact on water companies will still be pivotal. Indeed, it's all up for grabs now. Nigel Hawkins (nigelhawkins1010@aol.com) is a Director of Nigel Hawkins Associates which undertakes investment and policy research UTILITY WEEK | 29th November - 5th December 2013 | 7