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Finance & Investment Analysis Ofwat gets tough on business plans Investor view Daniel Wong Regulator's latest changes to price review process are not welcomed by the markets, says Ellen Bennett. "A large sum of capital is required to reach the target, and investors will expect to earn a return on, and return of, capital." C I hristmas came early for water customers, it seemed in December, when most companies issued releases trumpeting price rises in line with or below inflation – in other words, price cuts in real terms. But would it be enough to satisfy the regulator Ofwat, in light of its tough stance on affordability, and the current political row over the cost of living? It would not. A squint at the small print of the water companies' PR14 business plans showed they were proposing an average weighted average cost of capital in the 4 per cent range. Ofwat had already indicated in a series of public and private conversations that it hoped to see figures in the 3 per cent range. So, just days before the end of the working year, Ofwat gave the companies a Christmas present of its own. In a surprise announcement, it ticked off the water companies for failing to be "in alignment with market evidence for the water sector on risk and reward". Or, in other words, for proposing higher investor returns than the regulator thinks reasonable. To address this, Ofwat will set out further guidance on its expectations this month. The regulator is going to identify a group of "prequalified" water companies that have business plans that meet its tests for outcomes, costs and affordability, and that have demonstrated robust board assurance. In March, it will invite those companies to accept its guidance on risk and reward. If they do so, they will be awarded enhanced status and be fast tracked through the rest of the price review process. If a pre-qualifying company does not accept the guidance, it will be reclassified as standard. Those companies that do not pre-qualify will receive Ofwat's initial decision on their business plan in April, as originally planned. Ofwat also announced an extension to its query process, meaning it could ask companies for information to explain elements of their business plans. These unexpected alterations to a process that already entailed significant changes and unanswered questions have gone down badly with the markets. Unsurprisingly, ratings agency Moody's has reacted to the likely squeeze on investor returns by warning it would be credit negative for the sector and result in downward rating pressure for companies that are already weakly positioned within their rating category. Water companies will be anxiously awaiting the publication of Ofwat's guidance and the naming of prequalified companies. The regulator has shown it means business, and the devil now is in the detail. t is no secret that infrastructure investment is a corner tone of the UK government's plan for ecos nomic recovery. The Autumn Statement identified well over £300 billion of capital required to be invested in new UK infrastructure. The global financial crisis has increased the demand for stable, yielding assets – infrastructure assets provide exactly that and there is no shortage of capital willing to invest in core European economies such as the UK. However, a large sum of capital and foreign investment will be required to reach the target. Investors will also expect to earn a return on, and return of, capital. The government will have to ensure that both regulation and legislation are transparent, consistent and attractive to ensure these sums can be raised. At the same time, government and regulators face the challenging task of ensuring customer bills are affordable – all against Decc's a backdrop of projection is low economic growth and a for energy government in bills to rise by a weak fiscal 18% , in real position. In the end terms, it is customers by 2030s and taxpayers who pay for new infrastructure spending decisions, as well as the ongoing cost of maintaining the infrastructure. Improvements in the water, gas and electricity sectors will be funded by increased utility bills. The Department of Energy and Climate Change's central projection is for an 18 per cent increase in energy bills, in real terms, by 2030. This will exceed household income growth and put pressure on household affordability. Despite these challenges, the UK needs this investment to replace ageing assets, meet EU policy commitments, ensure security of supply and service the needs of a growing population. Companies will be under scrutiny to ensure that every project delivers value to the consumer. Regulatory bodies are already beginning to recognise this importance and are encouraging companies to engage with representatives of the end-user. As institutional investors look closely at the opportunities ahead in UK infrastructure, this will be a factor they cannot afford to ignore. Daniel Wong, head of power & utilities, i nfrastructure and real estate, Macquarie Capital Europe UTILITY WEEK | 10th - 16th January 2014 | 19