Water watchdog urges Ofwat to set ‘record low’ cost of capital

CCWater recommends Wacc should be between 1.8 per cent and 2.5 per cent

The Consumer Council for Water (CCWater) has called on Ofwat today (4 December) to “stick to its promise” to set the lowest-ever cost of capital for the water industry for the 2019 price review, PR19.

An independent study by Economic Consulting Associates (ECA), on behalf of the water watchdog recommends the regulator should set a weighted average cost of capital (Wacc) between 1.8 per cent and 2.5 per cent.

The Wacc is the assumption Ofwat makes on the cost water companies will incur in raising capital to fund investment in assets like pipelines and treatment works.
CCWater describes it as “one of the biggest building blocks” in the regulator’s price settlement for the five-year period from 2020 to 2025.

The study looked at the financial markets, cost of capital decisions made in other regulated sectors, and water companies’ financial performance, including historical data and future forecasts.

CCWater said returns to investors and interest and debt repayments can have a “significant impact” on customers’ bills. A 0.1 per cent increase in the cost of capital could add around £2 per year to the average bill, it suggested.

Tony Smith, chief executive at the Consumer Council for Water, said: “Striking the right balance on the cost of capital is a difficult challenge for the regulator but Ofwat must ensure that water companies do not continue to make generous returns at the expense of customers. This independent study reinforces our view that there is an opportunity for Ofwat to set a much lower cost of capital that will help to hold down bills.”

Ofwat set the equivalent cost of capital for this current period (2015 to 2020) at 3.74 per cent. CCWater claimed had the regulator applied a cost of capital of 2.5 per cent for this period, it would have reduced customers’ bills by about 7 per cent.

The ECA study shows Ofwat “could set a lower cost of capital” at PR19 due to evidence of both lower costs of equity and debt financing, and a lower assumption of risk in the sector than previously assumed.

Cathryn Ross, the outgoing chief executive of Ofwat, has acknowledged the regulator has set too high a Wacc in previous years.

In a speech in October, she said: “As the regulator we can and should ensure that companies and shareholders make money by doing stuff that benefits the customers by aligning their interests.

“Over the past few years we have consciously taken steps to improve this alignment and there is no doubt for example with the benefit of hindsight that it has been too easy for companies and their shareholders to make money by gearing up and outperforming the Wacc rather than by improving operating efficiency, innovating and delivering for customers.”

Ofwat has already signalled the cost of capital will be a historic low in the next price review, reflecting the economic environment and ensuring value for customers. Ross has suggested the weighted average cost of capital in PR19 “will likely” begin with a two.

The regulator is expected to announce its decision on the cost of capital on 13 December, when it publishes its methodology for PR19.