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20 | 12TH - 18TH JUNE 2015 | UTILITY WEEK Finance & Investment Analysis B ristol Water's battle with its regulator over its PR14 final determination rum- bles on this month with oral evidence being submitted by both parties. Their words will add dimension to the reams of written material already submitted, in particular by Bristol as it tries to promote its grievances to the Competition and Mar- kets Authority (CMA). First off there is an appeal document with 625 pages of tightly argued text and more recently a 177-page rebuttal of Ofwat's case. It is a furious skirmish of claims, parries and counter-claims which conjures memo- ries of the epic Battle of Transco, waged throughout much of the 1990s between British Gas and its then regulator. Then, as now, there was constant citing – typical of a PhD thesis – of detailed evidence and incisive conclusions from various learned authorities. However, Bristol's appeal to the CMA is by comparison quite simple. Unlike the other 17 water companies, who have all accepted their final determinations – in some cases, with qualms – Bristol believes it has been unfairly treated. To the outsider, Bristol may seem like the disenchanted squaddie on the parade ground, who cannot understand why every- body else is out of step. In its final determination, Ofwat required Bristol to reduce its average annual water bill from £197 to £152 by 2019/20: both figures are based on 2012/13 prices. In opposing Ofwat, Bristol's relation- ship with its regulator has hit rock-bottom. Bristol's regulatory director, Mike King, has openly accused Ofwat of using "flawed modelling" and the company has reacted badly to Ofwat's suggestions "that we [Bris- tol Water] have been factually inaccurate, glossed over evidence that might support our case, been inconsistent in our approach and that our business planning does not reflect good practice". Key points of dispute While there are many areas of dispute, there are three key financial issues that place Bristol radically at odds with Ofwat: the base total expenditure (totex); the enhance- ment totex – including the planned Cheddar Reservoir 2 project; and the weighted average cost of capital (Wacc) assumption, especially as it impacts Bristol. Importantly, Bristol has stated that "the most significant reason for seeking a re- determination from the CMA is the difference between our business plan and the 2014 final determination regarding the assessment of the appropriate level of costs". In its final determination document, Ofwat assumed a £288 million five-year base cost figure against Bristol's £359 million: both figures are on a pre-menu basis. Ofwat has also drawn the CMA's attention to Bris- tol's 50 per cent hike in base costs between 2010/11 and 2012/13, due in part to higher maintenance expenses. In its "glide path" extrapolation to 2019/20, Ofwat's base cost of £58 million for that year becomes closely aligned with that of Bristol's £56 million – assuming, hypo- thetically, that its recent cost-cutting can continue at the same 7.7 per cent annual rate projected between 2013/14 and 2017/18. The latter contention is decidedly spuri- ous, since ongoing cost reductions of 7.7 per cent per year will eventually yield base costs of next to nothing. Given this point, the CMA may concede some leeway to Bristol. But it is on the enhanced cost element that there is the largest gap between the two protagonists – accounting for around two-thirds of the difference in their PR14 calculations. The respective figures at the final determi- nation stage, prior to any menu allowances, were £152 million, as claimed by Bristol, and £91 million, as calculated by Ofwat – a vast gap to be bridged. Cheddar Reservoir 2 Central to this financial chasm is the deep- seated dispute over the plan to build a sec- ond reservoir at Cheddar and, if so, how Bristol should be remunerated before April 2020. In fact, the project has an estimated ten- year build time and is unlikely to be availa- ble for use before 2030, assuming it proceeds at all. Bristol argues that it is much needed to secure its long-term water supplies. But Ofwat is far more sceptical and argues that the investment case is simply not robust. In particular, it cites the SSE-backed Seabank 3 power station project, which may be supplied with untreated water from the planned reservoir: Ofwat describes Seabank 3's prospects as "highly uncertain" and it is certainly true that any cursory perusal of National Grid's database on new power station projects shows how many are either cancelled or simply "parked". Interestingly, Ofwat claims that it gave the benefit of the doubt to Bristol with respect to the algae removal programme at the Cheddar water treatment works. With respect to the Cheddar Reservoir 2 project itself, the CMA may give some finan- cial respite to Bristol, especially in respect of the various upfront costs, if it is clear that it has to proceed. In any event, the CMA may also com- mission further engineering studies as to whether the case for the Cheddar Reservoir 2 really is a compelling one or merely at the high end of desirability. Bristol's complaints on Ofwat's Wacc figure centre on both the cost of equity – its own assumption is 6.40 per cent against Ofwat's 5.65 per cent – and the cost of debt, for which the figures are 3.15 per cent and 2.59 per cent respectively. Importantly, Bristol's debt cost assump- tion is affected by its embedded debt for which it expects, perhaps optimistically, to receive special treatment: Ofwat has rejected this application. Overall, these figures produce a vanilla Wacc of 4.37 per cent, as calculated by Bris- tol, against Ofwat's 3.60 per cent assump- tion. In terms of valuation, the two figures represent a pronounced difference. However, it seems unlikely that the CMA will shi noticeably on Ofwat's overall Wacc assumption. To do so would risk upsetting the whole water regulation apple-cart. Ofwat and Bristol battle on With less than a month to go before the CMA voices its first thoughts on Bristol Water's dispute with Ofwat, Nigel Hawkins considers the lie of the land and precedents for resolution.