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UTILITY WEEK | 27Th FEbrUarY - 5Th March 2015 | 17 Finance & Investment E arlier this month, Ofwat confirmed that all but one UK water company had accepted its 2015-20 AMP6 final determination. Bristol Water asked to be referred to the Competition and Markets Authority for review. For the remaining 17 companies, including Pen- non, United Utilities and Severn Trent, life now moves on to delivering their AMP6 promises and preparing for the next phase of regulatory changes. The business retail market will be open to competi- tion in April 2017, which could both be an opportunity (and a risk) for operators to gain (or lose) market share. We, however, are more focused on the new strategy Ofwat is expected to publish before this year end, in which it will consult on how to regulate the different parts of the water value chain and to introduce said changes as part of the 2020-25 AMP7 price review in 2019. This means the potential, but not a certainty, of having to split up the regulatory capital value (RCV) among the various components of the wholesale water business, and apply a price control on each component. The aim is for Ofwat to better under- stand the costs of the water value chain, identify any cost inefficiencies, promote water trading and potentially even introduce more competition within the system. Generally speaking, investors favour Ofwat's integrity as a regulator, the cash flow predictability of its capital- intensive, RCV-based framework, and the bankability of the underlying dividends. Ofwat's goal of increasing efficiencies alone is unlikely to change this, however the approach Ofwat takes to achieve this will be crucial. Depending on the design, material introduction of com- petition along the water value chain could reduce cash flow predictability. For now, many of today's investors continue to like the low-risk, regulated nature of UK water companies. Indeed, recent underperformance by Pennon, United, and Severn is largely due UK deflationary concerns. However, longer-term holders will likely agree with Bank of England's February inflation report where the Monetary Policy Committee is choosing to look through the current low level of inflation as an influence on policy-setting for the medium term. Persistent M&A expectations will likely prevent significant sell-offs, and as we progress along 2015, we look ahead to what Ofwat has in store for us down the river. Maurice Choy, equity research analyst at RBC Capital Markets "The focus now is on the new methodology Ofwat is devising for how to regulate the different parts of the water value chain" Investor view Maurice Choy "The RCV may be split up among the various parts of the business" For the longer term, he has set up a stra- tegic review, which is due to report in the summer. By that time, prospects for the UK gas market may have become slightly clearer aer the general election, which will inevi- tably highlight the Ed Miliband-inspired 20-month energy price freeze, to which Cen- trica and SSE are seriously exposed. On the other hand, the uncertainty may endure, especially if the general election pro- duces a hung parliament. Thereaer, Centrica has other challenges to surmount. First, the Competition and Markets Authority report – and whether a new gov- ernment will implement its key recommen- dations – will loom large throughout 2015 and beyond. Splitting up Centrica's domestic gas busi- ness, which accounts for the overwhelming share of its 14.8 million UK customer base, may well be proposed. Second, there remains the oil price. Its recent gyrations have defied the projections of most experts. Importantly, neither BP's chief executive Bob Dudley nor his Shell counterpart, Ben van Beurden, expects a sus- tained recovery in oil prices for some time. Theoretically, Centrica could spin off its E&P operations and seek to emulate mining giant Glencore with its Lonmin stake. Cen- trica could then return to being a high-yield- ing utility. In fact, by grasping the dividend nettle, Conn has replicated the policy that Dave Lewis, Tesco's new chief executive, has pur- sued. Both companies have dominated their respective sectors for years – and recently both have faced buffetings on several fronts. Centrica's dividend may grow again from a lower base, but yield-chasing investors will have noted that neither BP nor Shell cut their 2014 dividends despite plunging oil prices. Undoubtedly, 2015 will be another challenging year for Centrica – it has already flagged lower underlying earnings. And they could be much lower than the market expects. Nigel Hawkins, director, Nigel Hawkins Associates Some key indicators were travelling in the wrong direction for Centrica this time around, sending its share price down 8 per cent on the day. £1,746m adjusted operating profit 35% down on last year 28% fall in adjusted earnings per share 30% cut in dividend £1.9bn impairment charge the big nuMbers ➟ ➟ ➟