A report commissioned by Affinity Water, Anglian Water and Northumbrian Water has raised serious concerns about Ofwat’s approach to total market returns, suggesting that it could have serious implications for the financing of the 2020-25 upcoming AMP7 investment programme.

The scope of the review included an assessment of the robustness of the evidence and analysis provided by PwC, which "Ofwat has indicated it is minded to rely upon". The KPMG review warns:

“Relying on short-term estimates would introduce substantial financial risk to the firms and investors on the basis of assumptions which cannot be relied upon.”

The report - A review of Ofwat’s proposed approach to total market returns – was prepared under a private contract in August in response to Ofwat’s July consultation on its proposed methodology for the 2019 price review.

To support its proposed estimates, the water sector regulator commissioned a report from its advisors, PwC, to consider the implications of what it describes as a ‘lower for longer’ interest rate era on the cost of equity for PR19.

The water companies jointly commissioned KPMG LLP to independently review the PwC analysis of total market returns (TMR) and consider how Ofwat reflected the analysis in its consultation and could reflect it in its PR19 determination.

Ofwat’s consultation paper signals possible fundamental change to previous approach

According to KPMG, Ofwat’s consultation paper signals a possible fundamental change to the approach that Ofwat, as well as other regulators, have previously employed with respect to estimating a key component of the cost of equity: the total market return (TMR).

Specifically, Ofwat refers to the use of ‘a market based cost of equity, placing less weight on long-run historical average equity returns’, and “in fact places no weight” on their estimates of actual, outturn historical returns, the review says. Under the revised approach, Ofwat refers to a cost of equity range of 3.8% to 4.5% on a real RPI basis, compared to 5.65% at PR14.

Ofwat’s own estimates for TMR in PR09 were 6.75% in real terms compared to their current estimate of 5.1%-5.5% TMR (real). This again marks a significant shift from their previous determinations of TMR, according to KPMG.

Ofwat “effectively consulting” on transition from previous approach to full reliance on relatively new and untested approach

KPMG said that Ofwat appears exclusively to rely on PwC analysis and PwC’s estimates of TMR, and that the estimates appear to place no weight on historical outturn equity returns achieved by investors over the long-run or take account of the limitations and uncertainties associated with such estimates.

They also do not appear to take into account other important market evidence, the report says, together with the fact that the overall cost of equity may be influenced by sector-specific developments such as the introduction of competition in some elements of the value chain, changes to the regulatory framework concerning performance and corresponding financial exposure, as well as efficiency challenges.

The KPMG report states:

“TMR is inherently difficult to estimate because it represents market investors’ expectations of future returns; it is not therefore directly observable or measurable. …Ofwat is now effectively consulting on a complete transition away from the approach that was previously adopted based on robust long-term estimates in favour of full reliance on a relatively new and untested approach ignoring historical returns; this new approach yields a real TMR of 5.1%-5.5% according to PwC and Ofwat.”

Analysis underestimates TMR and has limited predictive power

PwC relies primarily on one approach to estimate the TMR—the dividend discount model (DDM) -  which does not take into account traditional, historical measures of TMR and, in effect, places all weight on one estimation method, the review says.

According to KPMG, this is “problematic when the approach in question suffers from considerable uncertainty and potential biases”, going on to suggest that “a more prudent approach when confronted with such uncertainty might be to rely on several approaches.”

KPMG also points out that the market to asset ratios (MARs) for the listed water companies used in the PwC analysis exhibit considerable volatility and says that the analysis has also omitted the impact of regulatory capital value (RCV) growth and non-regulated services on the listed water/wastewater companies’ valuations.

PwC’s sample of two companies in the water sector used in its analysis is unlikely to be representative of the broader economy since the listed water companies are considerably larger than the average company in the sector, the report warns.

PwC “lower for longer” approach to interest rates at odds with academic literature and empirical evidence

KPMG says that PwC has introduced the concept of ‘lower for longer’ to describe the expectation that interest rates will remain low for several years and explicitly suggested that the expectation of low future interest rates implies low future equity returns.

According to KPMG, the suggestion that ‘current market interest rate conditions in the UK, and as a consequence returns, are expected to diverge from long-run historical averages for an extended period of time' is at odds with academic literature and empirical evidence quoted by PwC itself. It also contradicted PwC’s own findings that the impact of low recent interest rates has been offset by increases in the equity risk premium (ERP).

The review states that the evidence on ‘lower for longer’ has shifted in the eight months since PwC did its analyses, commenting:

“For example, BoE Governor Mark Carney, in the most recent press conference discussing the Bank’s latest Inflation Report (August 2017) indicated that despite markets having increased its expectations of a rate rise, its current expectations are still “insufficient”.”

“This illustrates both the volatility of interest rates but also the risk of relying on short term estimates of interest rates for the purposes of a five year charge control.”

In KPMG’s view, the assumption that low forecast interest rates imply low equity returns is not supported by robust evidence, undermining a key justification for moving to such a significantly lower TMR.

The review also draws attention to the fact that PwC’s analysis implies substantially negative risk free rates (RFR) would constitute a major departure from past regulatory determinations of the real RFR - something which has also been recognised by other regulators.

“The lower bound of PwC’s range for the real risk free rate (RFR) is unprecedented historically at negative 1.3%”, the report says.

According to KPMG, the current real returns on UK gilts, which form the basis of PwC’s estimate, are due to highly unusual macroeconomic conditions, created, inter alia, by the BoE’s quantitative easing policy. “Little weight should be attached to these values as a proxy for the long-term real return required by investors in risk free assets.”

KPMG commented:.

 “Adopting a negative RFR, even implicitly, would constitute a major departure from past regulatory determinations of the real RFR. Indeed, this was recognised by other regulators. For example, in Ofcom’s publication on the upcoming wholesale local access (WLA) charge control it suggested that it would not, as a matter of principle, include a negative RFR in the regulated cost of equity, despite the current data on UK gilt yields.”

“Short-term trends do not provide robust evidence of lower return expectations”

The KPMG review also warns that short-term trends in outturn equity returns do not provide robust evidence of lower return expectations, saying that the premise of PwC’s report is that there has been a shift in investor’s expectations for returns on UK equities.

The review says that while there is some “cursory market evidence” that shows returns in the current period have been lower than the long-run past so that some reduction from the long-term trend might be justified, the high volatility of TMR over time makes it “difficult to conclude robustly that there has been a permanent shift in TMR.”

“There appears to be insufficient evidence to justify large changes in total market returns”

Adding that the average return over any sub-period over the last 20 years is statistically indistinguishable from long-run historical average returns since 1900, KPMG concludes that therefore “there appears to be insufficient evidence to justify large changes in total market returns.”

 The review warns that the TMR estimate is a fundamental input to the regulatory settlement which has significant implications for financeability and incentives to invest and that there is a risk of making a large reduction in TMR on the basis of weak evidence. A more appropriate TMR estimate for PR19 requires reliance on long-run data.

The review describes TMR as “inherently an unknown parameter, because its forward-looking estimation is trying to predict what investors’ expectations of returns will be in the future.”

KPMG has suggested that TMR for regulatory settlements should be based on long-run averages, in line with regulatory precedent. It also says that ”sole reliance on short-term market data, whilst not advisable”, should at least involve a correction for the shortcomings in PwC’s analysis, which results in a real TMR of approximately 6.5%.

The KPMG review paper acknowledges that Ofwat’s task is difficult in that it must strike the right balance, based on conflicting evidence in some cases. However, it concludes that:

“In relying on PwC’s current market (or spot rate) TMR estimate, Ofwat would need to be comfortable that there has been a very large, permanent reduction in TMR. However, there is no statistically robust evidence to support this. Relying on short-term estimates would introduce substantial financial risk to the firms and investors on the basis of assumptions which cannot be relied upon.”

Click here to download the KPMG Report A review of Ofwat’s proposed approach to total market returns