Water firms claim PR24 equity returns will put off investors

Water companies have claimed that Ofwat’s current methodology for setting the cost of equity will provide insufficient returns to attract the massively increased investment needed during AMP8.

In their PR24 business plans released on Monday (2 October), multiple companies noted that the gap between the cost of equity and debt would be significantly reduced.

They warned that this would leave little incentive for investors to accept the inherently higher risks of equity investment at a time when the regulator is also seeking to bring down gearing levels in the sector.

In its final methodology for PR24 in December, Ofwat gave its ‘early view’ of the cost of equity and debt at 4.14% and 2.6%. Based on a notional gearing level of 55%, which the regulator is planning to reduce from the current level of 60%, these rates would translate to a weighted average cost of capital of 3.29%.

When expressed in nominal terms, Ofwat’s preliminary figure for the cost of equity is 6.22%. In its business plan for 2025 to 2030, Northumbrian Water pointed out that this is less than the 6.27% yield of the iBoxx index of non-financial corporate bonds with a BBB rating.

As of the beginning of the next regulatory period, BBB with a negative outlook will be the minimum rating companies will need to maintain to avoid Ofwat’s tightened cash lock-up licence conditions.

“The future returns proposed are well below comparative sectors that investors could choose to invest in with returns in debt markets above the equity return Ofwat has suggested,” Northumbrian stated.

It continued: “This raises an important question around why a rational investor would put substantial new equity capital into the sector when a higher return can be achieved in lower risk debt markets.”

Northumbrian chair Andrew Hunter said the company’s business plan is not financeable under the cost of equity proposed by Ofwat, adding: “When so much new private investment is required, we could not see how the return available could be less than that available in debt markets.”

The company also included a quote from its main investors, CKI and KKR, which said Ofwat’s decision on parameters such as allowed returns will “play an important role in how the investment committees of each shareholder will evaluate any such PR24 equity investment proposal.

“As global investors, the shareholders are not limited to investing only in the UK, nor just the water sector and have respective fiduciary duties to their ultimate investors with respect to return and yield which will be considered for any new commitment of equity.”

Northumbrian’s plan also cited a report produced by KPMG for Wessex Water, South East Water, Thames Water, Anglian Water, Southern Water, Affinity Water and South Staffs.

Ofwat’s preliminary figure for the cost of equity of 4.14% is based on data collected up to September 2022 and represents the mid-point of its estimated range of 3.67% to 4.6% in real terms.

KPMG said repeating Ofwat’s calculation with data collected up to June 2023, raises this range to 3.88% to 4.87%. The firm said this movement is primarily driven by a roughly one percentage point increase in the observed risk-free rate of return.

However, KPMG estimated the cost of equity range even higher at 4.96% to 5.56%, giving slightly different figures for all of the components in the calculation, including the risk-free rate, total market returns, and the equity beta. It also suggested applying an additional uplift of 0.15% to reflect uncertainties in the figures, pushing the range to 5.11% to 5.71%.

In nominal terms, Northumbrian said this equates to a range of 7.21% to 7.81%, and on this basis, suggested an allowed cost of equity slightly below the mid-point at 7.44%.

KPMG also produced a related report, which similarly to Northumbrian’s business plan, highlighted the reduced differential between the cost of equity and debt as proposed by Ofwat.

Based on the proposed notional gearing of 55%, KPMG said the differential between the cost of equity and the cost of new debt at PR14 amounted to 3%. It said this figure rose to 4.04% for the companies that successfully appealed their PR19 final determinations to the Competition and Markets Authority.

However, the firm said this differential was just 0.88% for Ofwat’s early view for PR24 and falls even further to 0.55% when recalculating the figures with more recent data.

KPMG said this is not consistent with corporate finance theory, which says there should be a substantial difference between the cost of equity and debt due to the “subordinated nature of equity claims”.

“It is a core principle of corporate finance that equity is inherently riskier than debt,” the report explained. “Both security classes represent contingent claims over a firm’s assets. In the event of an insolvency, debt holders have the priority claim over the firm’s assets for debt repayment, while equity holders could receive the remaining assets only once all outstanding debt capital has been repaid and if the remaining value of the firm is non-negative.”

It continued: “Similarly, as the payment terms of debt are fixed, debt is known as fixed income. If the company fails to make the required interest or principal payments, it is in default and debt holders can take control of the business.

“By contrast any dividends can only be paid to equity holders once fixed payments have been made to debtholders. As a result, debtholders are senior and equity holders are junior – they can only be paid after all debtholders are paid.”

KPMG said the “scale of the disconnect” between equity and debt pricing implied by Ofwat’s calculation of the cost of equity “may be indicative of a material miscalibration”.

This argument was also made by Yorkshire Water, which cited reports it commissioned from Oxera and First Economics.

Based on data collected up to July, the consultancies respsectively estimated the cost of equity at 4.66% to 5.67% and 4.39% to 5.37%. For comparison, Yorkshire said inputting data from the same period into Ofwat’s calculation produces a figure of 4.55%.

“The market data to July 2023 shows that the current yield on investment-grade BBB debt is 6.33%, or 4.25% on a CPIH stripped basis, assuming long-term inflation in line with the government’s target of 2%,” Yorkshire stated.

“Whilst current yields are expected to be inflated slightly by the current high inflation, it is clear that the yields on investment-grade debt are now comparable to the returns on equity being proposed by Ofwat.

“On this basis, we see little reason why a rational investor would choose to invest equity in water companies rather than buy investment-grade corporate debt.”

Wessex Water said the next regulatory period will require an “unprecedented increase” in investment. It said its annual capital expenditure has averaged 7% to 8% of its regulatory capital value over the past 15 years, but this is set to almost double to 13% over AMP8.

Of its £3.5 billion of planned capital expenditure, the company said more than a half (£1.8 billion) will be in “novel or ‘first-of-a-kind’ activities” that are likely to involve “new, untested, unfamiliar and untested methods of investment”.

It said: “The novelty, scale and often unclear legislation and guidance around these activities increases risks in several respects.”

Among the examples it gave were phosphorus removal whereby the company said it is being “asked to achieve limits that are technically achievable in theory but which have not previously been reached.” It also pointed to the rollout of smart meters and the prevention of discharges from storm overflows.

“At the same time, regulators are ratcheting up performance expectations and shifting more of the risks onto companies,” Wessex added.

“Companies are more exposed to systematic risks outside of their control, and asymmetric sector-specific downside risks that that make it more likely that investors will not achieve a fair return on capital.”

It said investors will be required to make “a significant equity injection and face the prospect of zero/depressed dividends over the next 15 years.”

As things stand, Wessex Water said PR24 “is not an investible proposition” and will fail to “encourage new investment and keep existing investors in the sector.”