Drawing a line under PR19

The publication of the Competition and Market Authority(CMA)'s water redeterminations justify why a record four companies sought an appeal. With gains made on all sides Utility Week explores what has been won and lost.

The much-anticipated findings by the CMA were published this week after months of back and forth between the four appellant companies, the water regulator and the appeals body.

Anglian, Bristol, Northumbrian and Yorkshire all rejected Ofwat’s final determination, which was criticised as permitting insufficient spending and offering rates of return that would deter investment when it was needed most.

One commentator suggested the confrontational language seen in the written submissions meant the process had to end with “a winner and a loser”. Despite the shift since the provisional findings were published in September, there looks to be more in favour of the appellants than the regulator.

Ofwat criticised the CMA’s earlier findings for putting investors before billpayers and it was clear from the regulator’s response it was deeply unhappy at that stage in the proceedings. The CMA listened and consulted on alternative approaches, or as former Ofgem chief executive Dermot Nolan put it: “Ofwat threw its toys out of the pram and the CMA reacted”.

The result included some gains for Ofwat but contains much for the appellant companies to be satisfied with. One commentator told Utility Week the findings “shot through many key principles of PR19”.

Yorkshire said the redetermination meant a line could be drawn under the process and it could focus on delivering for customers. Its reasons for requesting the redetermination have largely been addressed.

Good outcome, bad experience

Mel Karam, chief executive of Bristol, which was appealing its third consecutive price control, told delegates at Utility Week’s Investor Summit that the company was very pleased with the outcome that “pretty much” reinstated its business plan in its entirety.

“We got 99 per cent of our cost base in our business plan approved. We have 95 per cent of our cost of capital approved by the CMA. Almost all of our performance criteria and outcome deliveries were signed off by the CMA.”

But he said the process was neither easy for the business nor reassuring to investors: “The whole conduct of the way things are done, and I have heard this directly from the investor community, has definitely shaken the confidence of investors in water.

“On a personal level, I have no triumph about this at all. It’s 18 months of my life, and my team’s life. It was a diversion from the running of the company. I’m here to run the company and deliver our business plan.

“There’s no prize for having wasted 18 months on something where we shouldn’t really have been there in that place.”

He added it had been quite damaging to the way investors see the process, becoming more complex  with the continuity and the principle of regulation not being supported. Overall he said the outcome was good, but the experience was not good to go through.

How did Ofwat do?

The regulator has clawed back some points since the provisional findings, and ground was conceded by the CMA on the contentious cost of capital. Compared to the provisional findings returns are reduced from just over 3.5 per cent to 3.2 per cent.

Although it remains 0.2 percentage points above Ofwat’s, the closer alignment suggests a shared view that returns must be earned and there is no given right for profits from water services, which has been an important message from the regulator throughout the process.

The appeals body followed structure and models used by Ofwat in much of its work, “including in areas of contention”. Service targets and financial incentives were largely untouched.

The voice of consumers was included: written and oral evidence from representative groups was put forward, something Ofwat and the appellants all pushed for. Despite the inclusion, CCW raised the issue of whether customers had sufficient voice in the process, something to be considered in the RIIO2 appeals.

More spending has been permitted for infrastructure projects, which had been a central point for rejecting Ofwat’s ruling. Customer support for such projects was used as evidence by companies that resilience schemes were not only necessary but popular with billpayers.

An additional £75 million of spending was permitted by the CMA for company-specific projects. The appeals body acknowledged, based on extra evidence, that the spending was justified and the projects essential for resilience.

This significant revenue back to the companies is not the only point that Ofwat was overruled on.

A novel approach was taken by the appeal body towards the gearing mechanism. It’s now gone. One commentator suggested this signals a return to more conventional regulation and a departure from “tinkering” with revenues to finance projects.

The gearing outperformance sharing mechanism (GOSM) was described in the CMA’s decision as “not well-designed”. It said it could even reduce the financial resilience of companies rather than enhancing them. It’s come as no great surprise the GOSM was removed but the CMA proposed no alternative. It said there was insufficient evidence that such an intervention was required.

The weighted average cost of capital (WACC) became a contentious point through the proceedings. The new rate may have unsettled companies and investors that accepted their determinations in 2019 with a lower WACC.

Colm Gibson, managing director at Berkley Research Group (BRG) said: “Companies that didn’t challenge Ofwat may want to ask Ofwat to adjust their own price controls to align them more closely with the CMA’s position and will be evaluating the options for doing this.”

Despite the new WACC only applying to the appellants, companies that feel aggrieved could trigger an interim determination, which if rejected by Ofwat, they could make an appeal for to the CMA. The impact of Covid-19 on future levels of bad debt could be significant enough to warrant a request and the cost of capital could be addressed within that process.

A crucial difference between Ofwat’s final determination in December 2019 and the CMA’s decision is time. The CMA had access to information that was not available to Ofwat including the blind year data from 2019/20 and data on leakage, the cost of debt and the cost of equity. The consultations in January on each of those topics, therefore, could be viewed not so much a change of methodology as a chance to include new evidence.

The word from the CMA showed recognition that achieving the frontier level of enhancements to service necessarily cost more than base costs so the allowances should be greater, hence the increased allowances. Ofwat had pushed the companies to find greater efficiencies in both capital and operational spending to cover the costs. The review was designed as a challenge after what had been perceived as soft regulation and overly generous returns to investors at previous price reviews.

The final document from the CMA is due to be published in two weeks. The companies and regulator will then have an opportunity to accept or take the appeal process to a higher power. Early indications from appellants suggest they are pleased with the outcome, even if the process has been all-consuming.

It was also costly. In total, all four companies forked out £25.9 million and Ofwat spent £2.8 million.

For smaller company Bristol, the CMA ruled it can recover 50 per cent of its costs, while the three larger companies will be permitted to recover 25 per cent.

Wider impacts

As the process draws to a close, the effects will be felt by the wider utility sector, not least the network companies that chose to appeal part of Ofgem’s RIIO2 determinations. The ruling on returns will restore confidence to investors, which according Gibson may open the door to acquisitions: “The CMA’s decision will provide greater certainty for investors in the utilities sector, potentially paving the way for a number of deals.”

The has already been the announcement that National Grid acquired WPD the day immediately after the CMA published its decision. The certainty is likely to restore confidence in further activity. There have been no acquisitions in the water sector since Pennon Group added Bournemouth Water to its portfolio in 2015 but Gibson suggested the climate would now be more attractive for both sellers and buyers. Since selling its waste disposal business, Viridor, last year, Pennon declared its intentions to acquire another UK water business.

With so much conceded to the appellant companies it seems likely the redeterminations will be accepted which will bring to a close the tumultuous chapter of warring with the regulator. But they also raise questions about what Ofwat will take from the experience into PR24 to push the sector without facing a second revolt.