Ofwat needs to move on returns but underperformers can’t have a free ride

A leading analyst has said Ofwat must give more ground on the cost of equity in the PR24 price control so that it “becomes a facilitator rather than a blocker”.

Martin Young told Utility Week that as “the regulatory game is played out” in water this year there “absolutely has to be a shift” on the base level of return. However, he stressed that this was a case of fair calibration and that “equity should rightly face the risk of underperformance”.

Ofwat has yet to confirm an updated cost of equity for the 2025-2030 asset management period but its early view was 4.14%, with cost of debt at 2.60%. Based on a notional gearing level of 55%, these rates would translate to a weighted average cost of capital (WACC) of 3.29%.

Several companies proposed higher rates in their draft business plans last October, with some going as far as saying their plans would be unfinanceable under the regulator’s current approach.

Young told the latest Utility Week Horizons that utilities regulators have a vital role in the global competition for capital. He pointed in particular to the cost of equity rate cases agreed in the US last year, at 9.6% for electricity and 9.64% for gas, albeit in nominal terms.

He said Ofgem’s accelerated strategic transmission investment (ASTI) framework, which fast-tracked 26 projects worth £20 billion, was a “shift in the right direction”. However, he said the successful appeals to Ofwat’s PR19 determinations and the success of the transmission and gas distribution networks in repealing the outperformance wedge in RIIO2 all highlighted regulators “could have done more in the past to encourage anticipatory or enhancement investment”.

He pointed to particular challenges facing Ofwat as it approaches the 12 June draft determination deadline.

He said: “With the exception of Welsh Water, each of the water and sewerage companies suggested higher WACCs in their PR24 business plans. Thames and Wessex ended up deviating completely from Ofwat’s methodology in their submission.

“Granted, Severn Trent was able to raise £1 billionn of new equity last September, but at a premium to its regulatory capital value of only c.3%. And this for a company that is best in class on ODI (outcome delivery incentives) performance, and an outperformer on finance too. Taken in the round, investors were willing to inject fresh equity, but net off the outperformance components and one can argue that the base level cost of equity is insufficient.

“Indeed, with Ofgem’s current cost of equity at 4.91% CPIH real for a 55% geared notional company, my view is that Ofwat needs to move so it becomes a facilitator rather than a blocker. That said, it is about fair calibration and not offering a free ride. Equity should rightly face the risks of underperformance.”

During the session earlier this month, Young went on to discuss wider investment and affordability challenges, including his views on the future of the price cap, which he also covered in this recent comment piece.