Water UK, the body which represents the UK water and wastewater companies at national and international level, has flagged up a number of challenges for the regulator to consider in three discussion papers on financing the water sector’s AMP6 programme.

The industry body has commissioned three papers by First Economics and NERA Economic Consulting on key topics relating to financing the water industry for the 2014 price review (PR14).

Water UK said the purpose of the papers is to make a constructive contribution to PR14, to raise awareness and promote debate. Water UK’s ultimate aim is to ensure that decisions on financing are robust, sustainable and strike a reasonable balance between stakeholder interests.

The papers have highlighted a range of challenges and opportunities for both the water companies and for Ofwat to address during the upcoming price review to determine the investment programme for 2015-20. Although technical in nature, the papers have highlighted a range of issues which will need to be addressed in the upcoming Price Review which could have implications for the supply chain.

The main purpose of the paper on equity financeability is to show that there should be a limit on Ofwat’s ability to fix problematic financial ratios by assuming that a company will raise new equity. The paper by First Economics says that by compensating investors for the effects of inflation, regulators create short-term weakness in cashflow which is manageable when gearing is low but which causes rating agencies and lenders considerable difficulty when the RCV and gearing level has moved higher due to high levels of investment.

To give some sense of the scale of the issues this creates, First Economics has calculated that the water industry’s interest bill in AMP5 (i.e. the green line over years 1 to 5) was projected in PR09 to be approximately £8 billion and that the funding contained within AMP5 price limits for these payments (i.e. the blue line) is less than £5.5 billion. This leaves £2.5 billion of interest costs for companies to pay for out of equity returns/retained profits.The paper says that in a majority of cases this was just manageable, but in the case of three companies – Bristol Water, South East Water and Thames Water – interest cover didn’t quite meet the rating agencies’ benchmarks and Ofwat had to look for fixes to financeability issues.

First Economics said it was worth emphasising that the reason this outcome arises is because the regulator thinks in terms of long-term net present value, whereas lenders and rating agencies care at least as much about cashflow in the short and medium term, commenting:

“When these two worlds collide, a regulator can find it is unable to satisfy rating agencies’ ratios and is forced to assess what steps it should take to discharge its duty to secure that companies are able to finance their activities. “

The paper says this differs from Ofwat’s explanation of financeability problems in PR09 – where the regulator took the view that financeability issues are ‘brought about by’ continuing large capital programmes and the consequent rapidity in the growth of the RCV. The paper states:

“In this way of looking at things, companies with financeability issues have found that they have been unable to satisfy the requirements of rating agencies because they are growing their businesses too fast. Like all other firms, whether regulated or unregulated, the affected companies have discovered that there is a point at which their ability to finance new capex by issuing new debt runs out. When this point is reached, it quite naturally becomes necessary to fund the expansion of the RCV via other means. “

First Economics suggests that Ofwat’s approach gets the cause of a financeability problem back to front and that the root of the problem is in the regulatory framework rather than in companies’ balance sheets, commenting:

“Notwithstanding the challenges that large investment programmes present to the capital markets, water companies would not fail financial ratio tests if it were not for the way in which Ofwat sets returns. “

Looking ahead, the paper concludes that there is no reason to think that the issue will not be a feature again in Ofwat’s PR14 and that a combination of companies’ likely starting gearing levels and continued investment will continue to expose the real/nominal mismatch and put pressure on interest cover ratios in AMP6. It suggests that if anything, the financeability issues are likely to affect more companies than in PR09.

The paper is calling on the regulator to signal that it will not "treat equity injection as a free lunch" as Ofwat finalises its methodology for the 2014 review of water and sewerage charges,

Profits could rise as result of price control separation

Setting the Allowed Margin for Retail Price Controls examines the price limits that Ofwat sets at the end of PR14 will comprise separate price controls for wholesale activities and household retail services, plus default tariffs for non-household retail services. The paper says that when setting retail profit allowances it is important that Ofwat is able to explain how the risk that the business takes translates into reward. 

It suggests that before concluding that price control separation should be revenue and profit neutral, it is necessary to allow for the possibility that investors’ exposure to risk will change as a result of price control separation. This could be for two reasons:

a. volume risk – in the case of retail services sold to non-household customers, any reduction or removal of the threshold for contestability creates new volume risk – with higher risk normally thought to translate into a higher cost of capital.

The paper says it is therefore logical that Ofwat would have to allow for some increase in allowed returns to compensate investors for the higher risk that they face in the face of increased competition.

b. reallocation of risk by Ofwat – the paper says it also looks likely that Ofwat will change the way that it allocates retail cost risk between companies and customers with the proposed removal of two key protections from 1 April 2015 in both the household and non-household controls, thereby exposing companies to greater cost risk than previously. The reallocation of risk might therefore be expected to trigger an increase in required returns.

The paper states that “ ..we can see why annual profits in the sector should naturally increase following price control separation…..It should not therefore be surprising if total annual profits move higher when separate retail and wholesale price controls are established.”…..

“The conclusion that we draw is that Ofwat will hand companies a windfall profit if it provides in price controls for full ‘stand-alone’ retail profits and a full return on the RCV. If Ofwat is to stick to its policy of allocating 100% of the RCV to wholesale price controls, it needs to make some adjustment to its calculations to avoid double counting.”

Companies should be compensated for risk in bringing forward some investments

 The third paper Alternative Approaches to Estimating Cost of Equity by Nera Economic Consulting examines a number of approaches, including the possible application of Real Options Models. In economic literature a real option is an option arising in relation to a real investment decision, in which there is flexibility to take decisions in the light of subsequent information. 

Under the Real Options approach. the available options may involve deferral, expansion, contraction or abandonment of the investment. Real option theory is concerned with valuing such options, and ensuring that such values are taken into account in the investment decision. The paper states:

"Arguably, the water sector is facing unprecedented uncertainty that stems from the structural and regulatory reform as well as environmental challenges. This uncertainty together with the irreversibility of investments in water infrastructure mean that decisions available to investors, especially that of delaying capital investments, involve real options which have positive value. …"

"Real options can be used to support arguments for an uplift on the rate of return above the standard CAPM-WACC, in order to reimburse investors for investing earlier than is privately optimal for them in the face of uncertainty. Specifically, we believe that Ofwat should consider including a real option implied uplift on CAPM-WACC figures for investment with high social value or positive externalities, where delay would allow the company to make a more informed, lower risk decision or where there is a need to establish a level playing field with entrants who are not obliged to invest."

The paper says that if the regulator Ofwat does not allow a higher WACC for socially beneficial investments the companies will likely find it optimal to keep the wait and see option, by not investing today and waiting for new information to arrive. This will be the optimal deployment from the companies’ perspective, but it will be late deployment and loss of utility from the perspective of society. Similarly, it may be optimal to allow a CAPM- WACC uplift for projects where entry of competition will allow entrants to “wait and see” and cherry-pick only the most profitable areas.

Nera are recommending the use of real option implied CAPM-WACC uplifts by Ofwat in certain situations in order to reimburse the incumbents for giving up the real option and thereby level the playing field with entrants.

The paper says that as part of the industry structural and regulatory reforms a substantial portion of RCV (wholesale, retail, sludge, metering) may in future be subject to competition and that the future value of the assets that are subject to the reform will be influenced by uncertainty.

Nera conclude that unless Ofwat rules out the possibility of RCV erosion and stranded assets, then there may be a value from waiting before undertaking the investment until (some of) the uncertainty is resolved.

The paper suggests that Ofwat may find it socially optimal to incentivize the companies to invest early by compensating them for the option value they forgo when investing early and that failing to do so may lead investors to wait for uncertainties to resolve and so may postpone socially beneficial investments over prolonged periods of time.