New guidance published by water industry regulator Ofwat today on key financial parameters that it will apply in setting price limits for AMP6 look set to cut the rate of return below the levels proposed by the water companies in their draft business plans.

The business plans, submitted on 2 December 2013, form the basis for Ofwat's price review to set customer charges for water and sewerage services for the next five-year regulatory period from 1 April 2015 to 31 March 2020 (AMP6).

The guidance forms part of the current 2014 price review process. Following Ofwat’s initial testing in December of the companies’ views on risk and reward in the plans, the regulator said “it was clear that these were not in alignment with market evidence” and that it would therefore issue further guidance on risk and reward, including on the level of the weighted average cost of capital (WACC) and other key financial parameters.

Today’s guidance bears out comments made by Ofwat's Chief Regulation Officer, Sonia Brown in November 2013 that the WACC should "start with a 3". Ofwat’s figures specify a mid-point of 3.85% within a range 3.6% to 3.9%, compared with a proposed industry average of 4.3% and an industry range of 4.1% to 4.9% in the water companies’ business plans.

In December credit ratings agency Moody's said that the comments indicated that Ofwat believed the range for the allowed return on the regulatory capital value (RCV) of wholesale activities proposed by the companies was too high, commenting:

“Given public remarks by Ofwat's Chief Regulation Officer, Sonia Brown, in November 2013 that the WACC should "start with a 3", it seems the rate of return allowed by Ofwat may fall significantly below the level proposed by companies.”

Moody’s also said at the time that the changes to the price review process announced by Ofwat would be credit negative for the UK water sector and put highly leveraged companies like Anglian Water, Thames Water, Yorkshire Water and Southern Water under negative ratings pressure.

Ofwat’s own view is that, on balance, the changes being introduced do not change significantly the overall balance of risk and reward that companies face – and some enhance their ability to manage their own risks. Ofwat said its proposals also include new complementary tools designed to mitigate significant risks faced by companies.

“Plans provide little incentive for outperformance and depend on higher WACCs to provide investors’ returns”

Commenting in the Guidance, Ofwat says that the overall level of return (based on companies’ expected performance) directly impacts customer bills. For example, a 0.5% increase in allowed weighted average cost of capital (WACC) increases annual bills by around £10. The guidance states:

“The risk and reward proposals in company business plans currently provide little incentive for outperformance and consequently depend on higher WACCs to provide investors’ returns. This means the proposed balance of risk and reward is not sufficiently aligned with the best interests of customers.”

“We do not expect to change our view on the allowed return unless there is a substantial shift in capital markets – or other unexpected events which meant that the risk and reward package needed to change.”

The water companies will now have to consider whether or not to accept the guidance. Under the Price Review process, Ofwat will ‘pre-qualify’ companies in March that have outstanding business plans which pass its tests for outcomes, costs and affordability, and which have demonstrated robust Board assurance.

There is now likely to be considerable pressure on the companies to accept the regulator’s guidance. The companies that ‘pre-qualify’ will need to consider whether to adopt Ofwat’s risk and reward guidance – and any ‘pre-qualified’ companies that choose to adopt Ofwat’s risk and reward guidance will then benefit from a fast-track approval process.

The guidance explains that enhanced status will confer a number of benefits on customers and companies, including:

Customers

• will benefit from the incentives being put in place for companies to deliver an excellent business plan and to minimise the costs of regulation. 

Companies  

• will gain certainty earlier in the price control process (through a draft determination in April 2014)
• early start gives enhanced companies a greater opportunity to deliver for their customers and outperform during the price control period.
• will also obtain financial benefits in the form of an enhanced cost performance (totex) menu
• all pre-qualifying companies will gain reputational benefits in capital markets and from customers

For companies who gain enhanced status and a draft April determination the regulator has already confirmed that a ‘do no harm’ principle will apply. This means that Ofwat would amend companies’ allowed return in line with any upward adjustment for other companies if there were to be a substantial shift in capital markets – or other unexpected events which meant that the risk and reward package needed to increase.

In April, Ofwat’s Board will announce its decision on the quality of all other companies’ plans. Business plans requiring some intervention will go through a standard process, while any company whose plan has significant shortcomings will be asked to resubmit its plans.

Key dates in the process are as follows:

• 10 March Announcement of pre-qualified companies.
• 17 March Deadline for pre-qualified companies to accept risk and reward package and provide revised business plans.
• 4 April Announcement of results of RBR for all companies.

Sonia Brown, Ofwat’s Chief Regulation Officer said:

“It is important for companies and customers that risks and rewards are appropriately shared between them. This helps companies keep customers’ bills  as low as possible and deliver the services that customers need both today and  tomorrow. It will be important for boards of water companies to consider this guidance carefully.”

Click here to download Risk and Reward Guidance