Utility Week

16 | 12TH - 18TH JANUARY 2018 | UTILITY WEEK Policy & Regulation Analysis C ompanies knew to expect a "significant reduction" in the weighted average cost of capital (Wacc), but until 13 Decem- ber 2017, they couldn't be sure exactly how far it would fall. The regulator had previ- ously hinted the figure would start with a two, and companies have been hedging their bets since then as to what was most likely to follow the decimal point. Some companies will be disappointed it is at the lower end of the expected range, but there was plenty of warning that Ofwat was targeting a historic low. Now, whether they like it or not, they will need to get on with preparing their business plans for 2020 to 2025 accordingly. Ofwat has outlined what it expects to see from companies in its tome of a methodol- ogy, which stretches to almost 260 pages. The document includes an initial view of the cost of capital of 2.4 per cent in RPI terms, estimating that it could result in an average saving per customer of £15-£25 a year from 2020 onwards. The cost of capital is the allowance Ofwat makes within its price controls for the costs of raising debt or equity to fund infrastruc- ture improvements. The 2.4 per cent figure represents a material reduction of 1.3 per- centage points since PR14, which Ofwat says has been driven by lower expectations of the market cost of debt and equity. While companies themselves had been expecting a lower Wacc, industry analysts who spoke to Utility Week prior to the publi- cation of the PR19 methodology said the City was hoping for a minimum of 2.6 per cent. However, Ofwat says that having con- sidered the range of evidence available, it considers a more tightly-bounded plausible range for the Wacc is 2.2 per cent to a maxi- mum 2.6 per cent. Investors will no doubt be disappointed with Ofwat's decision. Direction of travel On the morning of the publication, David Black, senior director at Water 2020, told Util- ity Week the 2.4 per cent Wacc shouldn't be of significant surprise for the industry because Ofwat had signalled this was the direction of travel. "Obviously it is much lower than it was previously, but this does reflect the fact that they [water companies] can borrow for lower cost in the market, so we think there should be an appreciation that this is the world that we live in," he explained. Ofwat will review the cost of capital at the dra and final determinations. Final deter- minations will be set out in December 2019. Utilities analyst Nigel Hawkins says the ini- tial headline figure is "tougher than most forecasts", but whether it will endure at the final determination "remains to be seen" (see column opposite). Outgoing Ofwat chief executive Cathryn Ross says the next decade will see "profound changes" in customers' expectations and the regulator is pushing the water sector to be at the forefront. Less weight on history The industry has been embroiled in a row over the best way to set the cost of capital for months. Ofwat made little secret of its plans for PR19 and stressed its determination customers rather than investors should benefit this time round. In a speech in October 2017, Ross acknowledged the regulator has set too high a Wacc in previous years. "We expect to place less weight on history, which we have finally learned is not the best predictor of the future, and more weight on market observation and future expectations," she explained. This statement caused concern among water companies, who said if you can't base assumptions on what's happened in the past, what can you base them on? Richard Khaldi, water sector expert at PA Consulting Group, tells Utility Week: "The 2.4 per cent Wacc figure didn't come as a bolt from the blue. Some people may have been hoping it would have been at the higher end of general expectations, but we anticipate that most companies have modelled down to round about the 2.4 per cent level. "For companies not performing well now, they will have to catch up quickly," he adds. "There will be less revenue for them to start with, while the operational ask is increasing. They are likely to find themselves between a rock and a hard place." And water companies are already looking at what they can do to ensure they are in a good position, Khaldi says, citing as a prime example Yorkshire Water's announcement of a multi-million-pound package to trans- form its operational performance by tackling issues such as leakage and pollution. "Others will be looking at the way they operate too. What companies are realising is they can't continue the way they have been," he says, adding: "This is a complex price review, probably the most complex price review there has been." Khaldi should know, with ten years' expe- rience in economic regulation of the water sector, and having most recently worked as senior director of customers and casework at Ofwat prior to joining PA Consulting in May last year. "The methodology for PR19 has taken around 260 pages to explain it but companies will only have around 300 pages to do it, in terms of their business plan. It's certainly an interesting scenario," he says. "Some people have suggested investors will leave the sector, but there's not likely to be a massive flight of capital, although we may end up seeing a different kind of investor profile," he says. "Investments in the water industry have an RPI-linked cash return and not many investments do that." Financial challenges In October last year, Moody's Investors Ser- vice published a report suggesting lower returns will pressure credit quality from 2020, with highly leveraged companies "par- ticularly exposed". Water-only companies are likely to suffer the most, as their size makes it difficult for them to obtain capital at rates as low as those obtained by the larger companies. Meanwhile, PwC water sector leader Richard Laikin says Ofwat has "toughened its resolve" with its price review final meth- odology, and the "bar remains high" for companies preparing their business plans. The methodology will benefit the top per- formers, who will expect to earn higher Bar set high with low Wacc The water industry has been bracing itself for a tough price review since Ofwat published its draft methodology last July. Now it knows just how low the regulator is prepared to go, says Katey Pigden.

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