Utility Week

8 | 9TH - 15TH MARCH 2018 | UTILITY WEEK Policy & Regulation Conference report H e's done it again. Every couple of years, since assuming the chairman- ship of Ofwat in 2012, Jonson Cox takes to the stage and makes a speech that sends shivers down water company bosses' spines. The first time, in the shadow of the Section 13 debacle just months aƒer his appointment, he set out a six-point plan for water company reform. In 2015, he set his view of a more fragmented, diverse and dif- ferentiated water sector, insisting "the logic of vertical integration no longer works". But this time was different. When Cox addressed the Water UK City Conference on 1 March, he was speaking not only of his own and Ofwat's concerns about corpo- rate behaviour in the sector, but also those of secretary of state for the environment Michael Gove. Gove hit the headlines earlier this year when he wrote to Cox decrying the use of opaque financial structures and excessive executive pay in the sector, promising to give Ofwat any new powers it deemed nec- essary to crack down on such behaviour. Cox, in turn, promised to respond to Gove by early April this year with a progress report and next steps – and this speech set out his thinking ahead of that deadline. Cox has long been critical of the practices of certain water companies – indeed, he took to the pages of Utility Week last year with an unprecedented public call for Thames Water to reform its corporate governance. Last week, he repeated those criticisms, insist- ing the current "crisis of confidence", as he called it, was "about corporate behaviour and aggressive financial structures". Cox reiterated the steps Ofwat is already taking to work with those companies that are highly leveraged – by which he means leveraged above 70 per cent: "We have said consistently that some companies must take action now to address apparently weak capi- tal structures to maintain resilience into the long term and an acceptable investment- grade rating. We continue to engage with these companies." Notably, he added that unless companies can meet financial stress tests, they may need to replace some of the equity that has been taken out of the business, asking: "Shouldn't that equity be unencumbered (that is, it can- not be debt at a higher part of the same cor- porate structure where the interest burden passes to the regulated company)?" In another challenge for highly leveraged companies, Cox plans to deploy one of his favoured tools – transparency. From the 2017- 18 financial year onwards, all water com- panies will need to publish a comparison of their actual returns on regulated equity versus what those returns would have been if they operated Ofwat's notional structure of 60 per cent gearing. Using the exam- ples of Southern Water and Anglian Water, Cox demonstrated how higher gearing can increase investor returns. He said: "A customer might well under- standably say that by having about a half of the equity that their customers pay for, both have flattered their equity returns and divi- dend yields by up to two times. There may be an element of outperformance on totex and performance incentives, but it appears a sig- nificant part derives from a thin equity struc- ture. Companies will have to explain this to their customers, who paid for the cost of a notionally financed prudent structure." Cox reiterated the importance of financial resilience in business plans for the upcom- ing price review, PR19. He warned that companies whose financial structure differs significantly from Ofwat's notional struc- ture will have to work hard to convince the regulator of their resilience, and held out the threat of the "significant scrutiny" business plan classification, with all the tough finan- cial consequences that entails. One of the most controversial financial issues water companies face is the level of dividends they pay out to their shareholders. Cox insisted that "aggressive dividends are at the heart of the public distrust", and said he has been talking with a number of "progres- sive" water companies about what an appro- priate dividend policy might look like: • A "gateway" to any dividend payout, that the company must be delivering what it promised its customers. Water sector must be 'reset' When Ofwat chairman Jonson Cox took to the stage at the Water UK City Conference, he gave the sector both barrels and demanded water companies clean up their act – or else. Ellen Bennett reports. • A base dividend set at about the level in Ofwat's notional structure – currently around 4 per cent – adjusted down- ward pro-rata if the company has higher gearing. • An additional outperformance dividend, set to ensure cash to investors is matched first by cash to customers in the form of bill reductions. • Strong regard to employee interests, ensuring that fair and appropriate pay- ments are made before the dividend to pension deficits, for example. The headlines didn't stop there. Cox turned to another of his recurrent themes: board leadership and corporate governance. Acknowledging the progress that has already been made on this issue, he raised a new suggestion – that independent executives should form the majority on the board. Summarising all of this action, planned and under way, on corporate behaviour as "Tier 1" activity, Cox went on to detail Tier 2 – more fundamental reform that will require changes to water company licences. These will be threefold – first, a new licence requirement on companies to put customers' and society's interest at the heart of their business. Second, a new requirement around resilience – financial as well as operational – which will oblige companies to maintain a standard investment grade credit rating. Last, but by no means least, Cox raised the prospect of changing the way in which Ofwat makes licence changes – the proposal that caused so much controversy five years ago, just before his term as chairman began. "We all know that the process for licence changes is clunky, and our board is consider- ing asking the secretary of state for support – which a number of companies indicated they could support five years ago – to rationalise and make simpler the process for bringing about licence changes," he said. In this multi-faceted programme of reform, there are many issues that at least some water companies will have difficulties with. But Cox was clear that, if they don't fall into line, stronger action could follow. He hinted that, long term, questions might be

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