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20 | 6Th - 12Th JUnE 2014 | UTILITY WEEK Finance & Investment Market view Steady as she goes Despite the prospect of a tough PR14 price settlement, UK water utilities remain attractive to investors, says Nick Walker. I nvestment in UK water companies has continued to grow in recent years, par- ticularly with an influx of funding from overseas investors. To name just a handful of deals, Japan's Itochu took a stake in Bristol Water in 2012, and last year Aquila Infrastructure Manage- ment of Canada invested in Thames Water. That transaction followed the acquisition of a stake in Thames by China Investment Corporation a year earlier. Meanwhile, some publicly-listed UK water companies have also been the subject of rumours suggesting they may attract investment. It is not difficult to understand the attrac- tion of water utilities for investors. First, the regulatory regime provides investors with stability and visibility. This is not to be underestimated, because not all nations offer such a favourable environment. Another benefit is Ofwat's five-year price review. The regulator is currently nearing the end of its consultation before setting the parameters for the 2015-20 period, AMP6. While this may change the pricing climate, it will provide all involved in the water industry with stability, something highly valued by investors. Finally, there is the reality that the UK remains a stable place to invest, even if investors will watch the outcome of next year's general election with interest. Two features in particular have encour- aged investment in recent years. First, equity returns have been protected by layering in debt at intermediate holding companies positioned above target companies, some- times at up to 95 per cent or more of the reg- ulatory asset value of the utility. Meanwhile, the operating companies themselves were oen fully leveraged and had securitised their assets, offering investors greater protec- tion and, importantly, providing credit rat- ings agencies with the justification to assign robust ratings, such as BBB+ and A-. As we approach the end of the Ofwat review and the beginning of AMP6, Ofwat chairman Jonson Cox has suggested that the regulator will look closely at investments in water companies. While stressing the impor- tance of UK utilities continuing to attract funding – not least to help fund huge capital expenditure – Cox has said the regulator will consider recent investments, along with the commitment to consumers, in the review. There is a continuing debate about what Ofwat will recommend, particularly in regard to how future deals are structured. This has had a knock-on effect on some of the finance options around current valuations. Ofwat has also argued for a broader stakeholder approach. It has emphasised the duties of companies and their boards to adopt a more reasonable and "through the cycle" approach to their financing structures, and to share the challenges and opportuni- ties of long-term ownership. Operational performance – measured in service levels, customer satisfaction, cost control, cheap financing, access to debt and measured divi- dends – are the primary yardsticks. Consequently, companies need to con- sider all aspects of the climate in which they operate, for example in respect of covenants and liquidity. To be viewed as responsible shareholders by the regulator, companies should demonstrate they have strong credit metrics, whether in respect of net debt, regu- latory asset value or interest cover. This does not seem to mean necessarily that regulators are looking for companies to fall into a uniform line. There appears to be no particular barrier for an efficient company to maintain a leveraged structure with rea- sonable and sustainable dividends, coupled with low cost of debt. The external landscape is changing swily. There is greater emphasis on deliver- ing value to customers – rather than simply on outputs – and the development of cus- tomer focus groups, for example, has been a resounding success. It is to Ofwat's credit, therefore, that the response of companies to the review cycle has been imaginative. Overall, opportunities for future invest- ment remain and the prospects of further funding for water utilities to continue improving their infrastructure should on bal- ance be considered positive. Nick Walker is head of regulated utilities at Lloyds Bank Commercial Banking Analysis PR14 process grinds on Ofwat has issued two more draft determinations, says Nigel Hawkins. B ack in 1984 when British Telecom (BT) was being lined up for flotation, the question of price regulation arose. As such, a basic RPI-formula was imposed to prevent BT racking up its prices. Similar price regulatory formulae were applied to the ten water companies at flo- tation in 1989. In the intervening 25 years, Ofwat's regulation of the (now) 18 water com- panies has become Byzantine in its complex- ity as increasing volumes of data are analysed. The ongoing 2014 periodic review is undoubtedly the most complex as water companies are progressively played off against one another by Ofwat. At least Ofwat has settled the paramount financial issue – its Weighted Average Cost of Capital (Wacc) assumption: its vanilla 3.85 per cent post-tax figure. Of the 18 water firms, two "fast-trackers" – South West Water and Affinity Water – received their dra determinations in April. Last week, two others – Dwr Cymru and Northumbrian Water – received dra deter- minations, thereby leaving 14 water compa- nies outstanding; the latter should receive their dra determinations in August and final determinations in mid-December. During a recent conference call, Ofwat updated City analysts and investors about the progress of PR14 and, in particular, the two latest dra determinations. Ofwat chief executive Cathryn Ross con- firmed: "We recognise that public trust and confidence is essential… These dra deter- minations will help maintain and build that trust and confidence." In Northumbrian Water's dra determina- tion, Ofwat is expecting broadly flat prices in real terms between April 2015 and March 2020: a £2.7 billion investment programme has also been factored in. For Dwr Cymru, modest real price cuts are anticipated. Importantly, given Ofwat's hith- erto lacklustre approach to tackling leakage levels, Dwr Cymru is committed to reducing leakage by 8 per cent in the coming five years. Within these two dra determinations, there are some significant variations – not least Northumbrian Water's enhanced depre-