Counting the cost of capital

Water regulator Ofwat this week published guidance that suggests a weighted average cost of capital much lower than most companies would like – and they may struggle to adjust. Conor McGlone reports.

A regulator and the regulated often have different ideas about what is reasonable, and the water sector is no different. One such difference of views was bought into stark contrast this week when Ofwat published PR14 guidance on risk and reward and, most importantly, on the weighted average cost of capital (Wacc).
The regulator found that the Wacc should be no higher than 3.85 per cent, significantly lower than the sector’s average proposed figure of 4.3 per cent, and a world away from the current Wacc, set in 2010, of 5.1 per cent.
Water companies have until 17 March to submit revised Waccs, but the regulator will have the final say and it looks likely it will set a 3.85 per cent level in December.
Mat Stalker, principal economist at Ofwat, says one reason for the lower Wacc is the rebalancing of rewards to place greater emphasis on cost and outcome-driven performance, which the regulator estimates could be around 1.0 per cent to 1.7 per cent on the cost of capital.
How have the markets reacted to Ofwat’s guidance? In December, when Ofwat trailed the announcement, ratings agency Moody’s warned that highly leveraged water companies could face downward ratings.
Market reaction was muted. United Utilities climbed 1.9 per cent to close at 713.50 pence after the announcement on Monday. Severn Trent rose 1.3 per cent to 1,700 pence. Pennon Group, owner of South West Water, was almost unchanged at 678 pence.
Deutsche Bank said the new guidance is “a reasonable overall package of proposals” and should allow at least the listed water companies to earn an attractive return on their Retail Asset Bases. Peter Atherton of Liberum Capital agrees: “I can’t see any numbers that are unreasonable.”
However, Atherton warns that some companies – particularly those that are highly leveraged – will struggle with the adjustment.
“You have a situation where you are currently earning the equivalent of 5.1 per cent and most companies will have to adjust down to a new level of 3.85. This can create considerable pain for companies but that doesn’t mean the regulator is wrong.
“Companies have enjoyed a cost of capital which was perhaps correct when it was set back in 2009. The companies also benefited from above-expected inflation. It might be painful but that doesn’t mean it is not the correct number,” he says.
Despite the significant difference, Ofwat says good companies “might not have to change their business plans a lot”, to adjust to the difference. “They might now just be able to raise capital more cheaply,” says Stalker.
Also, the regulator says that if companies outperform by bringing in services below the costs set by Ofwat, they can keep a proportion of their savings.
Ofwat has been hinting at a lower Wacc for some time. Chief regulatory officer Sonia Brown said last year that she hoped to see business plans in which the Wacc began with a 3. None of them did (see box, below left).
According to the guidance, companies that ‘pre-qualify’ in March for having outstanding business plans can then choose to adopt Ofwat’s latest guidance, which will enable them to benefit from an “enhanced” fast-track approval process.
 “In this area none of the companies met our expectations,” says Giles Stevens, portfolio director at Ofwat. “We are now providing this extra opportunity for companies to reconsider their business plans, in their customers’ interest.”
So is the fact that Ofwat has had to issue extra guidance a signal that its new light-touch approach is not working as expected?
Ofwat said the business plans submitted were solid in a number of areas and that this latest intervention was “pragmatic”. After all, it says, PR14 is new and susceptible to a few teething problems, and they can be solved with a tweak here and there. It remains to be seen whether investors in the water sector will agree.