First blood in the Battle of Bristol Water

Nigel Hawkins gives an investor view of the CMA's initial findings on Bristol Water’s challenge to Ofwat.

The latest instalment of the Battle of Bristol Water – the utility sector’s most epic confrontation since the Transco saga in the 1990s – contained some good news for Ofwat and generally bad news for Bristol.

On 10 July, the Competition and Markets Authority (CMA) published its interim report on Bristol’s appeal against Ofwat’s final determination of the 2014/15 periodic review.

It was a tome of formidable length, no less than a thumping 286 pages.

With one notable exception, namely on base operating costs, Bristol emerged with relatively little to show for its years of labour to overturn Ofwat’s key numbers.

And, in terms of its appeal on some key investment plans, it received short shrift from the CMA, who found many of its arguments unpersuasive.

“With a more favourable M&A environment in the water sector, Bristol is undoubtedly exposed to possible bidders.”

Of course, the CMA’s final ruling, due by 3 September, could produce a very different outcome but it is most unlikely to veer radically from the interim conclusions.

Thereafter, Bristol’s options to pursue its case further are limited, although there could be an appeal to the Competition Appeals Tribunal (CAT).   

Nonetheless, Bristol’s chief executive, Luis Garcia – looking on the bright side – stated that “the provisional findings are positive in some areas”.

More specifically, the CMA’s interim conclusions contained various figures which warrant analysis; they are quoted on a 2012/13 real terms basis over the five-year 2015/16 to 2019/20 review period.  

Bristol’s overall total expenditure (totex) was assessed by the CMA at £429 million, compared with the £537 million that it submitted: Ofwat’s number was £409 million. Hence, the CMA’s provisional £20 million uplift still leaves a totex gap of well over £100 million.    

The CMA also indicated projected revenues of £529 million over the five-year period.  

As such, it envisaged average annual household prices of £159 (pre inflation) over the five-year period, compared with Bristol’s application for £187. The Ofwat figure was £155, just £4 below the CMA’s interim conclusions. 

Where Bristol has made some undoubted progress is on securing – at least provisionally – a higher operating cost base entitlement. The CMA remains sceptical that Ofwat’s bench-marking cost analysis has taken account of all relevant factors, some of which were particular to Bristol.

Consequently, it developed its own econometric model, which yielded a better outcome from Bristol in respect of its base operating costs.

The CMA provisionally concluded that these should be £346 million for the five-year regulatory period, compared with Ofwat’s determination of £318 million.

This provisional £28 million uplift was Bristol’s only real success from the CMA, although the new figure still remains £39 million short of Bristol’s business plan submission.     

Other water companies will surely study this preliminary conclusion and assess whether they too could benefit from possible flaws in Ofwat’s bench-marking; some may even consider submitting interim determination applications on the back of the CMA’s econometric analysis.    

Outside its proposed operating cost base enhancement, the good news for Bristol ends, with its Cheddar 2 reservoir project failing to pass muster with the CMA.  

On proposed enhancement expenditure, Bristol seems likely to come away virtually empty-handed. Like Ofwat, the CMA simply does not believe that a substantial chunk of the planned Cheddar 2 investment can be justified – at least on the evidence presented to date.

The figures are revealing. The CMA advocated five-year enhancement expenditure of £83 million, an even lower figure than Ofwat’s £91 million. Both were way below the £152 million submitted by Bristol. 

In terms of the weighted average cost of capital (WACC), the CMA stuck very closely to Ofwat’s debt/equity figures, which were decided after a long and painful process.

The CMA proposed a 3.65 per cent WACC, which compares very closely with the 3.60 per cent WACC that Ofwat had used: the former figure is miles adrift of the 4.37 per cent WACC that Bristol had advocated in its business plan.

In short, and as anticipated, Bristol received virtually no change to its allocated WACC. To have proposed otherwise, the CMA would have risked upsetting the entire periodic review apple-cart.

In presenting the CMA’s interim conclusions, Inquiry Group Chairman, Anne Lambert, confirmed that “we provisionally rejected several projects proposed by Bristol Water”. She added “we have provisionally agreed that a small increase from the Ofwat determination was necessary”. 

In the meantime, Bristol is facing other challenges. With a more favourable M&A environment in the water sector, Bristol is undoubtedly exposed to possible bidders, assuming that its key owners – the Canadian-based Capstone with its 50 per cent stake and Spain’s Agbar with 30 per cent – are potential sellers.

The Malaysian-owned Wessex is an obvious buyer, especially given its sewerage activities in the Bristol water supply area. It is well-placed to deliver operating savings, some of which could be passed back to customers through lower charges – grist to Ofwat’s mill.

Pennon, too, having launched its Bournemouth Water take-over initiative, is on the acquisition trail. It could comfortably absorb Bristol, especially since – as a fast-tracker – it had a comparatively generous periodic review.  

Assuming Bristol does retain its independence, its fraught relationship with Ofwat would need to be addressed.

It seems inevitable that various personnel changes, especially at the Ofwat-inter-face level, will be necessary – assuming the final outcome is close to the CMA’s interim views.

Slowly, but surely, conclusions are gradually being reached.

And, given the massive paper-work being generated by Bristol’s periodic review process, it is probably a good thing that some of the sector heavyweights, such as Thames and United Utilities, did not go down the appeal route.