Investors express alarm at CMA U-turn

Investors have rallied in response to the Competition and Markets Authority (CMA)’s intention to change its approach to the cost of capital in the redetermination of four water companies’ PR19 final determinations.

Infrastructure investment groups, many of which represent UK pensioners, warned that decisions made now will have repercussions beyond AMP7, with one suggesting the redeterminations brought the sector “perilously close to the edge” of not being attractive to investors.

They were responding to a novel methodology to setting debt, capital and equity costs released by the CMA earlier this month. This was part of the watchdog’s investigation into the appeals by Anglian, Bristol, Northumbrian and Yorkshire Water of Ofwat’s final determination on their 2020-2025 business plans.

GLIL Infrastructure, which invests UK pension funds in Anglian, was one of those warning of risks to future investment in the next AMP and beyond.

“We would argue that we are perilously close to the edge, which itself is hard to define, leading to a negative cycle of low investment, poor returns, inability to attract and motivate strong management teams, and greatly reduced incentives for institutional investors to invest time and capital to pursue upsides, an outcome which would play out through AMP7 and over future regulatory periods.”

GLIL said the concern over too low a weighted average cost of capital (Wacc) may not immediately cause investment to collapse because regulatory commitments would still be fulfilled in AMP7. However, it warned it could start a “negative cycle” that is hard to reconcile with risks from climate change, population growth and targets to lower abstraction. It said the risks of setting the cost of capital too low should not be underestimated and found Ofwat’s focus on reducing the scope of investment to be at odds with government calls to invest in the future.

Global Infrastructure Investor Association (GIIA), the membership body for institutional investors, said the CMA’s provisional findings were better aligned with current and future customers’ interests than Ofwat’s, but warned the revised proposal on capital and debt would “significantly dampen” incentives to invest in the UK.

GIIA said private investors seek regulatory stability and clear policy frameworks that incentivise investment alongside a fair and merits-based appeals system. With that in mind, GIIA said the revised approach did not strike the optimum balance and urged the CMA to reconsider.

IFM Investors, another Anglian investor, warned that Ofwat’s assumption of there being limited risk of capital exiting was founded on incomplete evidence.

It said investor confidence had been rocked by PR19 and while the provisional findings by the CMA restored some of it, the consultation had cast doubt on the stability and long-term attractiveness of the sector.

IFM warned that unexpected changes to how regulators determine the cost of capital would erode investor trust and confidence. It said the proposed recalculations by the CMA “signals a worrying trend for future AMPs.”

Dalmore Capital, another investor in Anglian as well as the wider sector, raised a concern that changing the cost of equity undermines one of the CMA’s stated reasons for aiming up: “to promote long-term investment in the water sector and address the risk of an exit of capital”. It said change would create a situation where companies that took long-term financing in the early 2000s – in line with regulatory guidance at the time – would now be penalised with “an assessment applied with the benefit of hindsight”.

Ofwat remains firm

For its part, the water regulator’s submission maintained the low risk of investor exit in the 2020-25 period as an argument against the CMA’s aiming up approach to cost of capital.

Ofwat said arguments made to the CMA are “likely to have been from investors that seek to protect their existing valuations” rather than concern for future investment. Ofwat noted the significant global demand for investment in infrastructure as a factor driving lower expected returns and suggested providing early signals about allowed returns for PR24 to dispel concerns for future returns.

This, Ofwat asserted, would be a much more cost-effective way of alleviating concerns about a low cost of capital at PR19 and be more relevant to investors than the previous price review.

Appellant concerns over backtracking

Northumbrian noted that this is the first water redetermination that has featured a second round of consultations following the provisional findings, and that the scale of change is equally novel.

Anglian said the proposed approach to cost of equity contains “implausible assumptions” and criticised the CMA’s approach on cost of debt as a departure from the benchmark-led approach in the provisional findings.

The company’s response questioned why the CMA believes there to be less uncertainty in the cost of equity now compared to four months ago and said the approach is not supported “by sound reasoning nor by robust evidence”.

Yorkshire argued customers’ wishes were better represented in the CMA’s provisional findings than Ofwat’s final determination, however the revised approach puts any benefits to customers at risk by making plans less financeable once more.

Meanwhile Bristol, as the only water-only company, said it was “very surprised and seriously concerned” by the absence of the relevant cost of capital to itself as a small company and the departure from the provisional findings without adequate justification. The company’s response said it would not be financeable without an embedded cost of debt of c.4.9 per cent and a company specific adjustment on the cost of equity that reflects its position as a smaller company with different risks.

Submissions to the consultation remain open until next Wednesday (27 January), just a few weeks before the estimated mid-February publication date for the CMA’s final findings.