In an Expert Focus article for Waterbriefing, Colm Gibson, managing director of Berkeley Research Group's London-based economic regulation practice explores some key issues around the continuing renationalisation debate and Ofwat’s 2019 Price Review.

The renationalisation debate as the background to PR19

Colm Gibson: It’s been a tough couple of years for the water companies, exacerbated ominously by the Labour Party announcing its highly popular policy to “renationalise” the industry, and the Government’s / Ofwat’s subsequent response. The remarkable popularity of Labour’s policy looks like it has spurred the current Government to try and take some of the wind out of Labour’s sails on this issue, and be tough (and encourage Ofwat to be tough) on the companies in the PR19 price control.

Indeed, it is almost a year to the day (31 January 2018)¹ since the Secretary of State (Michael Gove) wrote to the Ofwat Chairman (Jonson Cox) encouraging Ofwat to be tough on companies (e.g. with respect to profits and dividend payments), and offering to beef up the regulatory framework if Ofwat’s existing powers didn’t enable Ofwat to be tough enough.

Mr Cox replied the same day, confirming that Ofwat was “pushing companies on a number of fronts”, including through the PR19 price control process, but noting that there was “more to do”. True to his word, Mr Cox expanded on this in subsequent correspondence, and Mr Gove, in return, promised that “if you find that water companies are not fully and promptly cooperating with your proposals, we are ready to revisit how government can give Ofwat stronger powers to amend licences, through legislation if necessary”.

The possibility of renationalisation may have reversed the general upward trend in value

Normally, whilst there are ups and downs in value, investors in regulated utility companies can expect a general upward trend in value. The possibility of renationalisation, at an uncertain price point (“Parliament may seek to make deductions for compensation on the basis of: pension fund deficits; asset stripping since privatisation; and state subsidies given to the privatised water companies since privatisation”)², combined with the threat of tougher than average price controls encouraged by Government, seems to have reversed this trend over the last 18 months.

Ofwat published the findings of its Initial Assessment of Business Plans (IAP) results on Thursday 31 January 2019. The results are interesting.

• No company achieved the coveted “enhanced” categorisation – it was probably always going to be politically difficult to have any company with enhanced status, given the points discussed above, and this may have dampened the incentive to try for it.
• The three companies ranked in the “fast track” category are the three listed companies (Severn Trent, South West Water (i.e. Pennon) and United Utilities). This protects the vast majority of industry shareholders (by number, but not by value) from the downsides of “slow track” or “significant scrutiny” classifications. Would the level of political support for Ofwat taking a tough approach be different, I wonder, if Severn Trent’s or UU’s many small shareholders were suffering as a result of Ofwat toughness?
• Most companies (ten) are categorised as “slow track”.
• Four companies (Thames Water, Southern Water, Hafren Dyfrdwy and Affinity) are in the “significant scrutiny” category.

The gap between Ofwat’s view of efficient totex and company plans is disturbing

Image: Ofwat Technical appendix 2 Securing cost efficiency - Table 4

Perhaps more significant than the IAP scores themselves, are Ofwat’s views on the efficient totex level that companies should be planning to spend, and the corresponding efficiency challenge that is implied by the difference between Ofwat’s view of efficient totex and company plans.

To my mind the gap is disturbing. Despite incentivising companies to forecast accurately, Ofwat has thrown down an efficiency challenge of stripping over £7bn from company plans whilst requiring them to deliver more stretching targets. Doubtless, much of this gap can be closed over time, if companies are able to provide more compelling evidence of the need for it – but companies should not underestimate the challenge this presents.

Dispassionate analysis is required

Whilst some companies will feel relief, I suspect that many companies, managers and investors will feel somewhat indignant at their categorisation (potentially, for good reasons). The price control teams of the 14 companies that have significant business plan reworking to do over the next 2 months would be forgiven for feeling a little daunted by the task and the deadlines. Naturally, there is some additional work that was always going to be required, and the companies I have spoken to are already progressing this.

The important thing, however, is to continue to remain dispassionate. Companies should, therefore, be checking that they really understand what is being said by the regulator. To the extent that it isn’t 100% clear (and my experience is that that this is pretty much all the time in price controls), companies should prepare a list of clarification questions. Only once they have received the clarifications and understood what Ofwat actually means, and why Ofwat believes what it believes, should companies firm up their action plans for resubmission, in the expectation that the truth will out before the Final Determinations in December 2019.

Investors should remain calm

To the extent that Ofwat ends up being tougher than it needs to be, it will reduce the value of the companies targeted for renationalisation. This would make it easier and more tempting to derive an even lower renationalisation price. The lower the level of compensation, the more significant the consequences for equity investors and potentially debt investors, too.

Such investors should already be investigating options for organising their holdings so as to maximise the benefits of any Bilateral Investment Treaties (“BITs”) that will allow them to seek compensation for this type of loss via some form of international arbitration. Such preparation, however, is only of value if investors have collated the economic and financial evidence needed to make such compensation claims.

Indeed, in my experience, arbitrators (and tribunals) are:

• inherently conservative;
• inherently sceptical; and
• are often presented with evidence that is not as clear or robust as it needs to be.

I have phrased this latter point more gently than I needed to, in the hope that it serves as a polite reminder that contemporaneous evidence is stronger than other types, hence collating an evidence file now will make a stronger case than trying to pull together the evidence in a few years’ time just in time for an arbitration or tribunal hearing. (Collating evidence now also avoids the problem that we’ve seen in similar cases where we have provided expert evidence, namely that once you’ve lost the company it can be much harder to get the information out of it to build your case.)

Investors should remain vigilant against unduly harsh PR19 determinations

Whilst major investors may well manage to protect value using BITs, it is important for all investors to remain vigilant against unduly harsh PR19 determinations. In economic terms, previous price controls were part of a “repeat game”, allowing the ups and downs of any given price control determination to be ironed out at subsequent price control reviews to some degree. Effectively, this diversified regulatory risk over time. There is a possibility, however, that PR19 is different, in that there is a material risk that investors will get cashed out before the PR24 determination is known.

To the extent that Ofwat’s current proposals don’t allow sufficient totex for companies to deliver what their customers want, companies need to strengthen their evidence and analysis, and ensure that it can be presented in a more persuasive way in time for the draft determinations.

Footnotes:

1. https://www.gov.uk/government/publications/water-industry-corporate-behaviour-of-water-companies.

2. “CLEAR WATER – Labour’s vision for a modern and transparent publicly-owned water system”, The Labour Party, September 2018, page 6

The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.

About BRG

Colm Gibson is the managing director of BRG’s economic regulation practice, based in London. This e-mail address is being protected from spambots. You need JavaScript enabled to view it

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