More institutional investors have made written submissions to the Competition & Markets Authority expressing their concerns in the current CMA inquiry into appeals by four water companies against Ofwat’s decisions on their AMP7 Business Plans.
Hari R. Rajan, Partner and Head of Corsair Infrastructure Partners, which manages 30.31% of the equity of Kelda, the owner of Yorkshire Water, on behalf of an international group of long term investors including public sector pension funds, insurers and sovereign funds, told the CMA:
“We have been concerned about the direction of regulation in the water sector for some time. Following Ofwat’s final determination for PR19, we concluded that the determination was not in the best interests of investors, customers or the environment, and we fully supported the Yorkshire Water board’s decision to reject Ofwat’s determination and seek a redetermination from the CMA.”
The submission said that Corsair, which has been invested in Kelda since 2007, and other investors placed a great deal of significance on the regulatory appeals regime under the CMA, as it “represents a key check and balance in the system”, describing the CMA’s approach to date as “rigorously independent and supported by evidence-based analysis.”
According to Hari R. Rajan:
“We were particularly encouraged that the CMA has upheld key principles such as a rigorous approach to financeability, and rejected dubious concepts such as Ofwat’s so-called ‘gearing outperformance sharing mechanism’, which was inconsistent with all regulatory precedent and principle.”
However, the submission goes on to express Corsair’s concern that taken in the round, the overall package set out in the CMA’s provisional findings, still appeared closer to Ofwat’s position than Yorkshire Water’s.
“In 2020, an unprecedented four companies have found it necessary to reject the regulator’s determinations"
In addition, the various working papers subsequently published by the CMA suggested that the CMA is considering material movement from the provisional findings, and “may be veering still further towards Ofwat’s position.”
Hari R. Rajan told the CMA:
“More broadly, we believe the risks for the sector in attracting capital are currently high. The UK’s reputation as a stable investment environment has been eroded in recent years. ….
“In 2020, an unprecedented four companies have found it necessary to reject the regulator’s determinations. Meanwhile, having now left the European Union, the UK is being watched closely by the global investment community as it redefines its investment proposition to the world.
“Foreign direct investment has been volatile in recent years and has declined for the last three years. The last equity transaction we are aware of in the unlisted water sector was nearly three years ago in early 2018 and more recent experience suggests that UK water assets are currently perceived as relatively unattractive compared to international peers.”
“The provisional findings went some way to addressing these risks and would have created a more positive environment for incremental investment in the sector. However, we do not believe the revised point estimate for WACC implied by the consultation would have the same effect.”
DWS Infrastucture - "concerning shift in the direction of regulation in the UK water sector in recent years”
Another major infrastructure investor DWS Infrastructure, also a long-standing investor in Kelda, the owner of Yorkshire Water, wrote separately to the CMA to say it had witnessed “a concerning shift in the direction of regulation in the UK water sector in recent years.”
DWS Infrastructure manages 23.37% of the equity of Kelda on behalf of investors – comprised of long-term UK and international investors, including public sector pension funds.
Describing Kelda as “a top tier, well-managed and continually growing company at the core of both UK infrastructure and of millions of households and businesses in the North of England”, the submission from Hamish Mackenzie, Global Head of Infrastructure says:
“We were therefore disappointed following Ofwat’s Final Determination. It was clear to us that Yorkshire Water’s high quality and evidence based approach to its AMP7 business plan had been overturned and replaced by a Final Determination that was not only flawed in methodology, but ultimately harmful to Yorkshire Water’s customers and damaging to the Company’s resilience.”
“ To that end, the Yorkshire Water Board concluded that this Final Determination was not in the long-term interest of its customers, Yorkshire or of the company – and as such, has sought this re-determination by the CMA. “
“Ofwat’s so-called ‘gearing outperformance sharing mechanism ….inconsistent with all regulatory precedent and principle”
As a cornerstone investor in Yorkshire Water, DWS said, “we reiterate our full support for Yorkshire Water’s pursuit of this re-determination from the CMA and rejection of the Ofwat Final Determination.”
Hamish Mackenzie went on to say that the CMA’s Provisional Findings and its understanding of the critical importance of financeability, recognition of an appropriate risk-return package to deliver long-term investment and the rejection of “tenuous concepts” such as Ofwat’s so-called ‘gearing outperformance sharing mechanism’ – which he described as “inconsistent with all regulatory precedent and principle” - marked a positive first step in the right direction.
"If actioned, the CMA’s latest consultation findings will set an irreversibly unattractive precedent which will extend far beyond AMP7"
However, he went on to express DWS’ concerns about the CMA’s working papers, saying:
“We were therefore disappointed to learn that, as signalled through the recently published working papers published, the CMA are engaged in an ongoing consideration around the reversal of some of the positive steps made in its Provisional Findings and leaning back toward the position of Ofwat’s Final Determination – with particular focus on both the WACC and totex allowances.”
“….The similar U-turn in potential leakage enhancement allowances, as seen in the CMA’s recent working paper on leakages, is equally disappointing.”
Referring to the recent roundtable discussion where DWS, CMA, Ofwat and Yorkshire Water were represented, he said:
“..we were disappointed to hear references were made stating the Ofwat Final Determination has no impact on investor interest in supporting the UK water sector. To put it plainly, we are at somewhat of an inflection point – where investor appetite in the UK water sector is now being held in the balance.”
“…..if actioned, the CMA’s latest consultation findings will set an irreversibly unattractive precedent which will extend far beyond AMP7. If the UK’s water sector is unable to attract future investment and finance itself appropriately, the consequences will be considerable.”
Bristol Water investor “deeply concerned”
iCON Infrastructure, the family of institutional funds that own 80% of Bristol Water plc, wrote to tell the CMA that in general, it had been” deeply concerned by, and sensitive to, positions taken by Ofwat in relation to Bristol Water during PR19, and now the CMA redetermination.”
iCON drew particular attention to Bristol Water’s position as a small water company, pointing out that in the course of the CMA’s 2020 redeterminations, Ofwat had raised the new contention that Bristol Water was not a “small” water company and thus should not receive any small company premium.
However, “this was never raised as an issue by Ofwat during the PR19 process for Bristol Water”, the submission says, and “…in fact, Ofwat relied on Bristol Water being a small company for elements of its PR19 determination.”
iCON goes on to point out that the South Staffordshire Water group, which was granted a small company premium, has higher total allowed revenues over AMP7 and serves more customers over a larger service area than Bristol Water.
Investors in non-appellant companies also express concerns
Institutional investors in water companies which chose not appeal Ofwat’s Final Determination on its AMP7 Business Plan have also written to the CMA to express their concerns.
HRL Morrison & Co, an active investor in infrastructure for over 32 years, was responding to the consultation as manager for the Utilities Trust of Australia’s (UTA) stake in South East Water.
The Morrison submission states:
“While South East Water elected not to appeal the Final Determination from Ofwat, this was a very challenging decision for our Board. Of significance, the cost and time that we felt would be needed to present our case was substantial for a smaller company….”
“ ….we do question why there has been such substantial movement between the Preliminary Findings and the further recommendations that are now being mooted.”
The letter says it supports a submission from South East Water which highlights the challenges that could be posed to other non-appealing companies (particularly smaller Water Only Companies (WOCs) from the recommendations presented in the Cost of Capital consultations.
“We note that the CMA decisions are likely to influence future regulatory settlements…”
“Our major concern at this stage is that there appears to be more limited consideration of the challenges posed to smaller companies, which do not have the same level of flexibility in their structures as the larger Water and Sewerage Companies (WASC’s) in their management of debt.”
…”We understand that this appeal is only applicable to the appellant companies but recognise that the CMA’s comments are likely to influence future regulatory direction and seek the CMA to consider how it delivers its final advice, and to be explicit about the types of companies for which this is considered appropriate.”
Morgan McCormick of Private Markets Group at OPTrust, which invests and manages one of Canada's largest pension funds, added his weight to the concerns. He was writing in his capacity as Managing Director of an equity investor in global infrastructure, which included a significant investment in Thames Water which his organisation held for over a decade and sold in 2017.
"Decision to exit equity interest in Thames Water ... in large part because of the direction of travel in regulation in the sector"
His letter says:
“We are aware of contentions raised in the course of the CMA’s 2020 redeterminations suggesting investors’ significant continuing appetite for investment in the UK water sector.
“We can only speak for ourselves but our decision to exit our equity interest in Thames Water was in large part because of the direction of travel in regulation in the sector, which we assessed resulted in materially increased risks combined with an outlook of insufficient returns on capital to warrant us maintaining our investment in Thames Water.”
“We hope that our data point provides at least a little more context for the important decisions that you will be making over coming weeks.”
USS - no equity investment in the water sector since 2017 "due to the perceived misalignment of risk and regulatory return“
The submission from USS Investment Management Ltd (USSIM) also told the CMA it had made no equity investment in the water sector since 2017 "due to the perceived misalignment of risk and regulatory return.“ USSIM administers the Universities Superannuation Scheme, the principal pension scheme for academic and senior staff in UK universities and other higher education and research institutions.
USS is one of the largest private sector pension schemes in the UK with more than £68 billion of assets under management as of 31 March 2020.
USSIM has maintained a longstanding interest in the UK water sector - USS is a 10.9% shareholder in Thames Water and has also made over £600 million in long dated loans to other UK water companies.
Mike Powell, Head of Private Markets Group at USSIM, wrote to the CMA:
“In our opinion, the CMA’s Provisional Findings regarding the cost of equity were a very welcome development given the support it gave to the general principle of “aiming up”. This seemed to us to reduce the risk that returns would be too low. We were encouraged by the approach adopted by the CMA which we felt provided a stable framework which could be used by all stakeholders going forward when thinking about the investment needs of the sector.
“However, the proposed downwards revision of cost of equity to around 0. 25% above the middle of the range has cast some doubt on this view….
“This…introduces a greater risk that returns will be set at too low a level and therefore acts as a strong disincentive to invest.”
“As a significant investor in the United Kingdom generally and in regulated businesses specifically….we believe that our long-term investment horizon coupled with our responsible investment focus makes USS an ideal steward for businesses which operate in the UK water sector. Investment in this sector represents an important part of our investment strategy……..”
He explained that given the benefits it could deliver to members, this made the sector one which could potentially account for an even larger allocation of USS capital. However, for that to be the case a number of things were required, including:
- The ability to receive a fair return for the risks to which USS is exposed; and
- Regulatory stability and predictability
He went on to point at that USS had a global mandate which allowed it to invest in markets outside of the UK and had made significant direct investments in Continental Europe, the US and Australia in recent years.
Mike Powell’s letter concludes:
“…. when assessing the suitability of any future investment in the UK, we will consider the prospects of that investment relative to similar investment opportunities in other jurisdictions.
“Further, the capital we could allocate to the UK water sector will also be assessed against a range of other UK investment opportunities in other asset classes. If the return level for the UK water sector is set below a fair level, it raises the prospect that capital which would otherwise be available for investment in the sector will be allocated elsewhere.
“We believe that this outcome would be undesirable given the need for significant future investment to deliver the network resilience and net zero carbon outcomes that customers rightly expect…..
“We would note that USS has not made an equity investment in the water sector since 2017 due to the perceived misalignment of risk and regulatory return.“
Click here to access the CMA PR19 appeals documentation and responses