Ofwat has launched a new consultation on its proposed approach to setting the cost of debt which the water companies will need to use in developing their  5 year Business Plans for the upcoming Price Review in 2019, together with alternative approaches for setting the cost of equity for PR19.

In previous reviews, Ofwat has set the cost of debt for the five year review period based on the historical cost of debt in the market and forecasts for the future cost of debt over the price review period.

In the consultation, Ofwat is asking if there is a way to set the allowed costs to better reflect the efficient cost of debt and to reduce the risk of inaccurate forecasts.

Ofwat’s preferred position is setting the cost of embedded debt based on evidence of efficient costs at the beginning of the price review period, indexing the cost of new debt to market benchmark interest rates, and making adjustments for changes in the cost of new debt at the end of the price review period.

New approach to cost of debt would be fairer and reduce bill volatility

According to the regulator, the use of an end of period adjustment would reduce bill volatility over the course of a price review period.

David Black, Senior Director of Water 2020 at Ofwat, said:

“We want to make sure that we keep incentives on companies to get the best deals possible on the cost of debt, but we also want to ensure customers benefit from sector outperformance against market benchmarks as well as minimise the risk of inaccurate forecasts for the cost of new debt.”

“We think our proposed approach will deliver these outcomes. It will be fairer, avoiding a process of resetting the cost of debt each and every year, which could see more volatility in bills. We are keen to hear what people think of these proposals.”

NAO: different approach by Ofwat for AMP5 would have lowered customers' bills

In 2015 a National Audit Office (NAO) study of economic regulation in the water sector highlighted that if Ofwat had used a similar approach to Ofgem’s indexation of the allowed cost of debt in the energy sector , total customers’ bills would have been lower over the period 2010-15.

A subsequent report by the House of Comons Public Accounts Committee report said over-estimating by the water regulator had led to the water companies making at least £1.2 billion in windfall gains during the period.

The water sector regulator set out in the 2014 price review that it would be looking at alternative approaches to the way that it could set the cost of debt allowance in future price controls.

Introducing the paper, Ofwat explained that the allocation of risk between companies, investors and customers and it sets allowed returns are central to determining customer bills and delivering good outcomes for customers. The new consultation sets out a range of options and Ofwat’s  preferred approach.

In previous price reviews, Ofwat set a fixed cost of debt allowance for the five year period of the price control, based on the cost of debt for an efficient notionally structured company. Companies are responsible for the risk that the actual cost of debt may be higher or lower than the allowance.

Over recent price review periods, the cost of debt has fallen faster than expected at the time the control was set, meaning that companies benefited during the control period.

Customers should not be responsible for funding inefficient financing structures

Ofwat is proposing to continue with the use of a notional capital structure approach to set the cost of debt allowance, commenting:

“This approach means that companies, their investors and management are responsible for their own financing and capital structure and bear the risks associated with their choices. Placing this risk with companies incentivises companies to minimise their debt costs and ensures that customers are not responsible for funding inefficient financing structures.”

The paper puts forward three options for setting the cost of debt allowance for the 2019 price review. Ofwat’s preferred approach is to index of the cost of new debt only, which means that the forecast errors from estimating the cost of debt for the forthcoming review period are corrected and that customers bear risk around changes in the market rates over the period.

Pain/gain sharing to be encouraged where appropriate

The paper also discusses whether further mandatory risk or pain/gain sharing with customers should be introduced, so that customers share in the differences between the company-specific cost of debt compared with the allowed cost of debt. Ofwat is not proposing to mandate risk sharing as this would weaken incentives to manage financing costs and could create perverse incentives for companies to increase gearing.

However, the paper says Ofwat is encouraging companies to consider pain/gain sharing, including around the cost of debt as part of their business plans for PR19, where this is in the interest of customers.

The paper also discusses some preliminary ideas about the approach to the cost of equity for the 2019 price review. In the 2014 price review, Ofwat assessed company business plans as enhanced or standard, with enhanced status awarded to plans that provided strong evidence that they were in the customer interest. The enhanced companies benefited from a financial reward, as well as procedural and reputational benefits.

Ofwat is now seeking views on an approach adopted by an Australian regulator, which provides for different levels of the cost of equity to "recognise the differences in ambition and risk inherent in company plans." It also incorporates a menu based incentive for companies to accurately self-assess their plans.

At this point, the regulator is not consulting on a preferred approach, but wants  stakeholder views on what are the potential advantages and disadvantages of a menu based approach to the cost of equity, compared with the approach adopted by Ofwat at PR14.

HoC Committee: water firms benefited from £1.2bn in windfall gains in 2010-15 due to over-estimating by Ofwat

Since economic regulation began in the water sector, over much of the period interest rates have been falling and since the 2004 price review, the cost of debt has been falling faster than the allowed cost of debt set in Ofwat’s  price controls. Consequently, in many cases, companies have outperformed the cost of debt allowance.

In particular, the 2010-15 control period saw a steep economy-wide reduction in interest rates. The cost of debt allowance for the 2010-15 period was set in 2009 at the start of the global financial crisis during significant market uncertainty.

In 2015 a National Audit Office (NAO) study of economic regulation in the water sector highlighted that if Ofwat had used a similar approach to Ofgem’s indexation of the allowed cost of debt in the energy sector , total customers’ bills would have been lower over the period 2010-15.

At the time the NAO Report said that Ofwat’s price cap regime did not balance risks appropriately between companies and consumers and was “not yet achieving the value for money that it should”, with customers failing to benefit from at least £800 million in net windfall gains between 2010 and 2015.

The NAO concluded that both Ofwat’s current fixed allowance approach and Ofgem’s indexation approach have advantages and disadvantages. While an indexation based approach directly passes on the benefits to customers of lower debt costs, it also passes on financing risks and higher bills when debt costs rise. The NAO also recognised that indexation increases the volatility of customers’ bills.

The subsequent House Of Commons Public Accounts Committee (PAC) review which followed the NAO report, recommended that Ofwat review its approach to setting allowances for the cost of debt, taking into account the methods used by other economic regulators.

In January this year Ofwat said it would “carefully consider the thoughts of the PAC”, following publication of the report which said over-estimating by the water regulator had led to the water companies making at least £1.2 billion in windfall gains over the last five years.

Following on from the consultation, finalised proposals will then form part of Ofwat’s price review methodology consultation, to be published in July 2017.

Deadline for responses to the consultation is 17 October 2016 – click here to download the consultation paper Water 2020: consultation on the approach to the cost of debt for PR19