Utility Week

UTILITY WEEK | 12TH - 18TH JANUARY 2018 | 17 Policy & Regulation The financial markets digest the implications of Ofwat's tough stance on the Wacc. W hile Ofwat's latest 259-page tome on PR19 is wide- ranging, for most water company executives, leading sharehold- ers and utility analysts, it is the chapter on the sector's finances that will be most scrutinised. In particular, details of Ofwat's latest thinking on its assumed weighted average cost of capital (Wacc) – a pivotal figure – were set out. Following much specula- tion about Ofwat's initial Wacc assumption, it has now been confirmed that in RPI terms it is 2.4 per cent – a reduction of 1.3 percentage points from the 2014 price review. This initial headline figure was tougher than most forecasts, but whether it will endure at the final determina- tion remains to be seen. Furthermore, there are strong Wacc-based premium incentives to secure Ofwat's coveted "exceptional" or "fast- track" status. With a much tighter Wacc already discounted by the market, shares in the three quoted water stocks – Severn Trent, United Utilities and Pen- non – were down marginally on release of the document. Severn Trent's shares have fallen by 17 per cent since their May 2017 peak. With Ofwat's latest Wacc assumptions now in the public domain, the focus of the water companies will move increas- ingly to their long-term busi- ness plans. Outside the water sector, other utilities – including the regulated electricity compa- nies – will take note of Ofwat's aggressive Wacc stance, as will their respective regulatory bodies, including Ofgem. Furthermore, the Treas- ury will closely monitor the response of the credit rating agencies to Ofwat's tough Wacc announcement given that the water companies need to preserve their treasured investment grade status. It may be that the sector is being used as a stalking horse by the Treasury to ascertain whether regulated companies can absorb a more aggressive Wacc. Undoubtedly, over the next few months, consider- able debate will ensue about Ofwat's Wacc range – and the extent, if any, to which its financial analysis is flawed. Aside from financial issues, it should be added that the sector will not welcome Ofwat's more aggressive leak- age stance – reductions of "at least 15 per cent" are being sought. This will be a seriously big ask for some of the urban- based water companies. Overall, it was not a good morning for water sharehold- ers, although customers will welcome the projected £15 to £25 annual price cuts. Nigel Hawkins, director, Nigel Hawkins Associates Column Nigel Hawkins financial rewards for cost savings and out- performance. "Ofwat has also increased incentives for companies to improve their plans," Laikin adds. "Poor performers, how- ever, will face greater financial challenges." He acknowledges companies are likely to focus on Ofwat's early view of the cost of cap- ital. "With much to do before the September 2018 business plan submission date, it will be a challenging time ahead for water and wastewater companies. Pressure is ramping up to create effective and robust plans in line with the methodology and deliver the quality of evidence Ofwat is looking for." This year will certainly be busy for water companies – and did we mention they may find it "tough"? What's changed since the draft methodology? • Revised list of common metrics – Ofwat says it will challenge compa- nies to achieve forecast upper quartile performance each year, rather than 2024-25 upper quartile performance from 2020-21. The regulator has also replaced the common performance com- mitment on non-infrastructure asset failures leading to pollution incidents with one on treatment works compliance, and amended the definitions of three others. • Amended resilience principles – Ofwat has amended its resilience principles to make the treatment of the natural environment more explicit and make it clear that companies can use natural capital approaches where appropriate. The regulator has also emphasised it expects companies to con- sider water efficiency and recovery and response as smart resilience options. It has also amended the definition of several of the common perfor- mance commitments to better reflect resilience, and has added text to make explicit reference to the need for companies to adopt systems thinking and consider the interdependencies between different parts of their business and the wider system in which these operate. • Five-year retail controls – Ofwat has ruled out three-year controls for retail and will instead set five-year price controls for all market seg- ments and encourage water companies to tackle gap sites and voids. • Cost efficiency – the regulator has strengthened its cost-sharing incentive and higher cost adjustment claim materiality thresholds. • Aligning risk and return – Ofwat has revised the financial incentives for the initial assessment of business plans and the totex cost-sharing rates, and has provided an early view on the cost of capital. • Securing confidence and assurance – the regulator has revised its data requirements, definitions and guidance, and will publish the 2018 company monitoring framework assessment alongside the initial assessment of business plans in January 2019. Ofwat has also introduced a new initial assessment test, requiring board assurance that the company's plan enables customers' trust and confidence through transparency and engagement on issues such as its corporate and financial structures. • The initial assessment of business plans – "exceptional" and "fast- track" companies will receive an amount equivalent to, respectively, a 20-35 basis points and 10 basis points addition to the return on regulated equity (RoRE). For these companies, Ofwat says it will also apply an "early certainty" principle to specific components of the early dra determination.

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