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UTILITY WEEK | 11TH - 17TH MARCH 2016 | 17 Finance & Investment Analysis S hortly before water privatisation in 1989, three French companies – CGE, Suez and SAUR – launched bids for sev- eral statutory water companies, which had never been state-owned. CGE's acquisitions, boosted by subsequent takeovers, form the core business of the Hatfield-based Affinity Water, which is setting high standards in the UK water sector. In fact, Affinity's water supply area resembles a patchwork quilt. Most of its activities are on the edge of the north and west London suburbs, includ- ing the Colne and Lee Valleys and the town of Rickmansworth. Affinity's predecessor, Three Valleys Water, was built around these areas. In addition, Affinity has water supply operations in North Surrey and parts of East Kent, centring on Folkestone and Dover. In total, Affinity owns a 16,500km network of mains water pipes and supplies 3.6 million people. But it is not involved in the sewerage sector, unlike the ten large privatised water companies. In recent years, the key event for Affin- ity has been the 2014/15 periodic review, for which it was awarded the coveted "enhanced status" by Ofwat. As a result, it received a better overall deal than all other water companies, bar South West, which was also granted enhanced status. According to Ofwat, this status "means the company produced a high-quality busi- ness plan that stood apart from the other companies". Importantly, Affinity was allo- cated a weighted average cost of capital (Wacc) for its wholesale water business of 3.7 per cent, which is 0.1 per cent above the Wacc of non-enhanced status water companies. Ofwat has confirmed that this higher Wacc assumption is worth around £5 mil- lion. Furthermore, Affinity is protected – under the "do no harm" principle – against various regulatory downsides prior to April 2020. For the five years until 2019/20, Ofwat has agreed wholesale water revenues of an average £249 million: for last year, the out- turn was £268 million. On its website, Affinity lists several une- quivocal pledges, including a 14 per cent reduction in water leakage by 2020. This is a policy that Ofwat will surely welcome, hav- ing been persistently criticised for its lack- lustre approach to cutting leakage. Higher quality water, a more environ- mentally-orientated abstraction policy, an extended metering programme, a commu- nity-focused approach and a concerted "value for money" priority are also empha- sised – all are grist to Ofwat's regulatory mill. In terms of Affinity's water charges, these are set to fall from £165 in 2014/15 to £156 in 2019/20, a cut of just over 1 per cent a year. To achieve these cuts while protecting prof- its, Affinity will have to deliver much of its planned £106 million five-year efficiency savings. Importantly, there are key personnel at Affinity who know how Ofwat is pro- grammed and how to press the right buttons. Chairman Phil Nolan is a veteran of the epic 1990s battle of Transco between the former British Gas and Ofgas (now Ofgem), while Chris Bolt, a serial utility regulator, is a non- executive director. In terms of its finances, Affinity reported revenues of £291 million for 2014/15, an iden- tical number to the preceding year. Operat- ing profit was £93 million, compared with £84 million in 2013/14, as the already healthy margins were widened. Given its water-only status, compari- sons with Bristol Water are inevitable, even though the latter's annual revenues are just under half those of Affinity. The very differ- ent outcomes to their respective periodic reviews merit comment. Bristol chose to appeal to the Competi- tion and Markets Authority (CMA), whose eventual judgment fell well short of its opti- mistic expectations. Furthermore, its current relationship with Ofwat can be described as strained – at best. Affinity, by contrast, sailed through the periodic review, on the basis of being a fast- tracker. Such a scenario must have pleased Affinity's owner, a financial consortium in which Morgan Stanley – through North Haven Infrastructure Partners – plays the lead role with a 40 per cent shareholding. The other key shareholder, with a 35 per cent stake, is Infracapital Partners II: M and G Investment, a Prudential subsidiary, is the key backer. Two 10 per cent stakes are held by Veolia UK (a residual shareholding) and by a Chinese-backed investment business. Given the post-periodic review rumours about sector consolidation, there is bound to be speculation about an eventual sale. Of course, like every company, Affinity does face risks. Problems on the operating front could materialise, as United Utilities experienced last year with its cryptosporid- ium outbreak. Water shortages could also materialise, although this winter's heavy rains suggest this is unlikely for 2016. Later on in the regulatory cycle, drought condi- tions should not be ruled out. Financial setbacks are also possible, especially if there were materially adverse tax changes or interest rates rose substan- tially: Affinity's net debt is almost £800 mil- lion. And regulatory changes, oen driven by short-term political considerations, are risks that every utility has to accept. Even so, for now Affinity is in a very good state. Nigel Hawkins, director, Nigel Hawkins Associates Affinity sitting comfortably Having had a comfortable passage through the last periodic review, all the key numbers look good for Affinity Water – and look likely to stay that way. Nigel Hawkins reports . London Dover Clacton-on-Sea Affinity's supply areas