PR14 process grinds on

Ofwat has issued two more draft determinations, says Nigel Hawkins.

Back in 1984 when British Telecom (BT) was being lined up for flotation, the question of price regulation arose. As such, a basic RPI-formula was imposed to prevent BT racking up its prices.

Similar price regulatory formulae were applied to the ten water companies at flotation in 1989. In the intervening 25 years, Ofwat’s regulation of the (now) 18 water companies has become Byzantine in its complexity as increasing volumes of data are analysed.

The ongoing 2014 periodic review is undoubtedly the most complex as water companies are progressively played off against one another by Ofwat.

At least Ofwat has settled the paramount financial issue – its Weighted Average Cost of Capital (Wacc) assumption: its vanilla 3.85 per cent post-tax figure.

Of the 18 water firms, two “fast-trackers” – South West Water and Affinity Water – received their draft determinations in April.

Last week, two others – Dwr Cymru and Northumbrian Water – received draft determinations, thereby leaving 14 water companies outstanding; the latter should receive their draft determinations in August and final determinations in mid-December.

During a recent conference call, Ofwat updated City analysts and investors about the progress of PR14 and, in particular, the two latest draft determinations.

Ofwat chief executive Cathryn Ross confirmed: “We recognise that public trust and confidence is essential… These draft determinations will help maintain and build that trust and confidence.”

In Northumbrian Water’s draft determination, Ofwat is expecting broadly flat prices in real terms between April 2015 and March 2020: a £2.7 billion investment programme has also been factored in.

For Dwr Cymru, modest real price cuts are anticipated. Importantly, given Ofwat’s hitherto lacklustre approach to tackling leakage levels, Dwr Cymru is committed to reducing leakage by 8 per cent in the coming five years.

Within these two draft determinations, there are some significant variations – not least Northumbrian Water’s enhanced depreciation rate, which has a comparatively greater impact on its regulatory asset value (RAV).

Interestingly, the sector’s biggest hitter – and a one-time favourite to be a fast-tracker – is Severn Trent, which famously turned down a £22 per share bid last summer; its shares currently trade at 10-15 per cent below this figure.

At its recent full-year results meeting, Severn Trent confirmed that issues surrounding the Elan Viaduct, a key part of the Birmingham strategic water resilience project, were a central sticking point with Ofwat; there was also unfinished business on asset legacy issues.

After receiving its final determination in December, Severn Trent has confirmed it will address its dividend pay-out level. If new chief executive Liv Garfield is obliged to choose the dividend cut option, last year’s decision to reject the £22 per share offer will look very short-sighted. If, however, the dividend base can be held, with at least some annual increase, the shares should rally.

While United Utilities has recently been in the public eye – via its excellent Watermen TV programme – it still has major issues with Ofwat regarding the overall cost of its massive wastewater programme.

Given widespread deprivation, especially in industrial Lancashire, United Utilities is still negotiating with Ofwat about the supply costs of this retail base, where debt levels are higher than average. The dialogue, according to United Utilities’ chief executive Steve ­Mogford, remains “constructive”.

Like Severn Trent, United Utilities will also have to review its dividend base once a final determination is issued by Ofwat in December.

None of the remaining 12 companies is publicly quoted, apart from Dee Valley Water.

However, very considerable interest will fall on Thames Water, which currently has net debt of about £8.7 billion. Apart from its formidable ongoing capital expenditure budget, it is also vigorously promoting its £4.2 billion Thames Tideway scheme.

How this latter project is financed – assuming it proceeds as planned – is far from certain, although Ofwat has consistently argued that it should lie outside the current RAV regime.

Several water companies owned by private equity investors, with higher than average debt levels, will undoubtedly be concerned about the low Wacc figure assumed by Ofwat; furthermore, some of the current generous tax offsets could be pared back.

But the one certainty is that the finance and regulatory departments of the outstanding 14 water firms will have a busy summer.