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20 | 14th - 20th February 2014 | utILIty WeeK Policy & Regulation Analysis F or utility stocks, the weighted average cost of capital (Wacc) set by the indus- try regulator is the Holy Grail of finan- cially modelling. It is also both a key share price driver and a major determinant of the level of utility charges. Sorting out the various permutations of Waccs across the various sub-utility sectors is a complex task. In recent weeks, the focus has been on Ofwat's proposed 3.85 per cent Wacc for the current periodic review, PR14, which will be implemented in April 2015. Ofwat's methodology is based on the capital asset pricing model, which has been used for several decades in utility regulation. Indeed, it derives much of its academic cred- ibility from the long-standing, and seemingly insoluble, debate in the early 1990s about the appropriate rate of return for British Gas's vast Transco network business. Subsequently, regulatory bodies, most notably Ofwat and Ofgem, have refined the capital asset pricing model. Central to its operation is the determina- tion of the appropriate Wacc for a particular periodic review. Inevitably, there is a read- across the various utility sub-sectors, both to identify anomalies and for utilities to argue their case that they have been short-changed on their allocated Wacc. To facilitate this read-across, regulators have set a "vanilla" Wacc yardstick, which is calculated from the pre-tax cost of debt and the post-tax cost of equity. It excludes any adjustment for taxation. In the water sector, it was Ofwat's pro- posed 3.85 per cent vanilla Wacc that was the key number in its recent announcement. To determine this figure, Ofwat made three key assumptions: the cost of debt (pre-tax) was 2.75 per cent; the cost of equity (post-tax) was 5.65 per cent; and the gearing ratio was 62.5 per cent. Compared with 2009/10, partly on the back of low interest rates and also on the proven ability of water companies to raise cheap debt, this provisional figure represents a sharp cut. By way of comparison, Ofwat's 2009/10 Wacc was 5.1 per cent, based on debt costs (pre-tax) of 3.6 per cent and equity costs (post-tax) of 7.1 per cent. The assumed gearing ratio was 57.5 per cent. Now the race is on, led aggressively by Severn Trent, to secure fast-track status, which – if successful – should boost its share price, if only because much of the regulatory uncertainty would have been removed. Nevertheless, the 3.85 per cent vanilla Wacc is the first sub-4 per cent figure pro- posed by any utility regulator – and at a time when the redemption yield on ten-year gilts has been rising. It is now 2.7 per cent, com- pared with just over 2 per cent a year ago. The most obvious comparator comprises the 12 regional electricity companies, floated in 1990 but now compressed into a group- ing of just six undertakings. Recently, Ofgem confirmed that the business plans of five companies – covering an eight-year regu- latory period from April 2015 – were unac- ceptable, with only that of Western Power Distribution (WPD) passing muster. As a prospective fast-tracker, WPD pro- posed a Wacc of just over 4 per cent in its business plan. However, Ofgem still has to announce what Wacc it believes is appropri- ate for this sub-sector. Curiously, it seems that UK utility Waccs are currently driven by the regulatory ruc- tions taking place in Northern Ireland, whereby Northern Ireland Electricity (NIE) – ironically now owned by the Republic's state-controlled ESB – appealed its case to the Competition Commission. Given Ofwat's read-across views, the Competition Commission's monster 589- page report at the end of 2013 seems to be regarded as the test case for Wacc deter- minations. It set a Wacc for NIE of 4.1 per cent, based on debt (pre-tax) of 3.4 per cent, equity (post-tax) of 4.8 per cent, and a gear- ing assumption of 50 per cent. Elsewhere in the electricity sector, Europe's most valuable utility, National Grid, was awarded a generous Wacc to cover its unprecedented eight-year UK transmission pricing period, which began last April. The Wacc was 4.55 per cent, based on a sub-3 per cent debt cost (pre-tax) but a cost of equity figure (post-tax) of 7 per cent. Aside from NIE, some very relevant Wacc- related data has recently emerged from the Civil Aviation Authority (CAA), which regu- lates Heathrow and Gatwick airports. Managing an international airport is a different proposition from running a rural sewage treatment works. Nonetheless, it is relevant that the CAA is proposing a Wacc of 4.66 per cent for Heathrow Airport and 4.90 per cent for Gatwick Airport. The lat- ter's ownership recently changed following the Competition Commission-driven airports divestment policy. In its latest report on the issue, the CAA published a table of comparable Waccs, parts of which are reproduced here: the Wacc is the Holy Grail WEightEd avEragE cost of capital across varioUs sEctors regulator sector status date of Wacc decision Ofwat Water View 2014 3.85% Ofgem Western Power Distribution Business Plan (Fast Track) 2013 4.02% CC Northern Ireland Electricity Re-Determination post Referral 2013 4.10% Ofgem Gas Distribution Determination 2012 4.11% ORR Network Rail Determination 2013 4.22% Ofgem Gas Transmission Determination 2012 4.30% Ofgem Electricity Transmission (National Grid) Determination 2012 4.45% CAA Heathrow Final View 2014 4.66% Ofgem Electricity Transmission (Scotland) Determination 2012 4.68% Ofcom Openreach View 2013 4.90% CAA Gatwick Final View 2014 4.90% Source: CAA (as adapted) For regulated industries the Wacc set by the regulator is pivotal to the success of the business. Nigel Hawkins explains why the figure differs so much across different sectors and companies.