PR19 final determination – is Ofwat for turning?

Water company shareholders may have joined the fight against Ofwat’s proposed price cuts, but it might be too little, too late, says Nigel Hawkins.

While the talk may be all about elections and public ownership, nervousness will also be rising among water companies as another key date fast approaches – PR19 draft determination day.

Although likely to be overshadowed by the general election result a few days earlier, water firms will be worried about the outcome. It’s a concern that was highlighted not long ago, as the sector began a belated public relations fightback against Ofwat and its tougher regulation.

Reports revealed that shareholders were getting in on the act, with a meeting at the Treasury said to have been attended by various institutional investors.

One particular gripe seems to be the perceived political drive behind PR19, which is geared to delivering major price cuts – even if shareholders suffer heavily in the process.

Water sector shareholders have done well over the years. And shareholders in some private equity-owned water companies have done particularly well – leading Australian private equity investor, Macquarie, is one, for example.

Not surprisingly, the four water companies in private equity ownership, whose gearing levels are well above the sector average, are fearful of the outcome.

Aside from the impact on their operating cost base, it is Ofwat’s weighted average cost of capital (Wacc) figure of 2.4 per cent, which has been slashed by around one-third since 2014/15, that is causing real concern.

Compared with the massive Wacc-related debates of the past – think Transco and Ofgas during the 1990s – the water companies’ response to Ofwat’s very aggressive Wacc has been lacklustre at best.

No doubt, some have expressed trenchant views privately, but only Wessex seems to have put its head above the parapet – to be shot down by Ofwat in its test area assessment document.

Clearly, Ofwat wants minimal debate on this issue: “don’t go there” is the message.

Don’t forget either that water companies still have formidable capital expenditure programmes to be financed – and, conceivably, at far higher interest rates near the back end of the 2020/25 regulatory period.

Formidable price cuts

Ofwat’s aggressive response to regulating the water sector, which has been privately owned for 30 years, is reflected in the pronounced price cuts that it is seeking to impose.

Overall, the regulator is aiming to reduce average household bills by more than 12 per cent in real terms by 2025 – a tough ask.

In Northumbrian’s case, Ofwat has proposed a 25 per cent cut in real terms by 2025, approximately 80 per cent of which Northumbrian seems prepared – albeit with considerable reluctance – to accept.

The proposed cuts facing some of the heavyweight water companies are formidable. Ofwat is seeking real price cuts of more than 10 per cent by 2025 at Anglian, Southern and Thames.

By contrast, the regulator’s three fast-trackers – Severn Trent, South West (part of Pennon Group) and United Utilities – are rather better positioned. Indeed, their special regulatory status confers certain benefits.

In Severn Trent’s case, its outcome delivery incentives have protected the dividend. United Utilities is well placed, while Pennon Group’s shareholders will be hopeful that the planned initial public offering of Viridor will boost their returns.

However, the disgruntled water companies – perhaps up to seven in number – do have some cards left to play.

Although any public relations campaign is probably too late to have a major impact, retaining investment grade status is vital.

While the credit rating agencies, in the final analysis, did little for the crashed banking sector in 2008/09, their response to PR19 will be important.

Given their sizeable capital expenditure programmes, water companies need to retain investment grade status from the credit rating agencies. If over-aggressive price regulation pushed them near “junk” territory, they might struggle to raise funds at a decent rate.

Consequently, retaining investment grade status has acted as a regulatory floor, to the benefit of the highly geared water companies.

Accept or appeal?

After the final determination announcement, all ten water companies will have to consider whether to accept Ofwat’s ruling or to seek solace in a reference to the Competition and Markets Authority (CMA).

The track record of utility CMA appeals – and those to its predecessor, the Monopolies and Mergers Commission – is not good. Water companies have generally emerged with slim pickings as they seek to persuade the appellate body that Ofwat’s judgments are – in effect – misguided.

It can be safely assumed that the three fast-trackers will accept Ofwat’s rulings – and churn out the well-worn ‘tough but fair’ mantra.

Of the other seven, Southern and Thames, in particular, seem likely to end up at the CMA, while Anglian and Yorkshire might well follow suit.

It will be interesting to see whether Wessex pursues its Wacc case at the CMA. Dwr Cymru is clearly not happy either – there is a very large gap between its proposed price cuts and what Ofwat is seeking.

Northumbrian’s figures are now quite close to those of Ofwat and it may accept them.

Overall, it could be a rather busy time next spring at the revolving doors of the CMA, especially if Ofwat is “not for turning”.