What to expect from CMA on PR19 appeals

As the CMA undertakes the mammoth task of re-evaluating four final determinations and taking tough decisions on the cost of capital, how much weight should be given to billpayers' views and the need to invest now for the future? Utility Week explores where there could be movement and what it may mean for those businesses and the regulator.

February saw a record four water companies rejecting the final determinations handed to them by Ofwat and requesting a referral to the Competition and Markets Authority (CMA). The CMA is now tasked with examining the determinations and deciding if the decisions made by Ofwat were correct.

So, what are the key areas to look out for?

All eyes on the WACC

One of the most contentious points of PR19 was the lowest-ever weighted average cost of capital (WACC), which was cut by around a third from the previous price review.  Ofwat insisted it wanted bills to come down in real terms and for customers to get more from their companies.

Analyst Nigel Hawkins believes it is “unlikely” the crucial WACC figure will be revisited. Several companies accepted their determination in February despite protestations that returns were too low and this could set a precedent.

Hawkins tells Utility Week: “Ofwat will take great comfort from – and draw attention to – the fact that 13 of 17 companies have accepted their determinations despite a much tougher WACC.”

However, if the CMA rules on adjusting the cost of capital for the appellants, it would not legally change the outcome for companies that have already accepted their determinations.

The CMA’s end result will be a K figure for each year, within which there will be many small adjustments. Noel Beale, director of competition and regulation at legal firm Burges Salmon explains that for each of the elements being examined by the CMA there will be an “up, down or stick decision” that will then be looked at in the round.

Historic precedent 

The history of water companies going to the CMA is not great. South West Water in 1995 made some gains as did Bristol Water at the previous two price reviews, but not to a significant degree.

Will there be strength in numbers this time around, with almost a quarter of companies covered by the price review claiming Ofwat got it wrong?

Conversely, 13 companies did accept their determinations -the first to do so being the publicly listed South West Water, Severn Trent and United Utilities. Each of these is in a stronger financial position than those financed through private equity with higher gearing.

Hawkins says: “It is very significant that in terms of ownership that the three quoted water companies are in a better financial position than several of the private-equity owned companies.”

Shift in ratings

Falling credit ratings could cause problems if agencies significantly downgraded water companies because the cost of capital was set too low.

Maria Fassakhova, senior director at Fitch, says the agency is currently assuming no upside or downside to rating cases for Anglian and Yorkshire Water from the appeals. “However,” Fassakhova says, “there is a risk that re-determined weighted average costs of capital could be lower than in the final determination, due to lower risk-free rates.”

Risk-free rates and interest have fallen since December when the determinations were published, and inflation is forecast to be slightly lower also.

Fitch set out some of the common issues across the cases presented by the appellants:

Individual cases

In recent years Bristol has challenged its determination at PR09 and PR14, making it a hat-trick for the water-only company. It is entitled to a slight premium on the WACC but argued this was not sufficient. The CMA may order for the risk premium to be slightly adjusted to reflect Bristol’s size and provide a bit more revenue.

The three larger firms – Yorkshire, Northumbrian and Anglian – each wanted a bigger allowance for investing in future resilience, which Ofwat rejected and said efficiencies must be found instead.

Other areas the appellants may see movement could include operational targets. Ofwat’s initial response to each of the appellants cases pulled no punches as the regulator staunchly defended its position that companies needed to demonstrate greater efficiency in delivering public services.

For Anglian costs have always been higher, partly because the rural spread of its region means costs of delivering services are higher than in towns and cities. However, Ofwat insisted the company was “fully funded to meet its requirements” and should raise its efficiency in line with others.

Northumbrian has been tasked with absorbing the largest bill cuts, which may be a point for negotiation to lower prices by less than Ofwat’s 25 per cent target.

For its size, cutting prices will have a disproportionate impact on Northumbrian’s operating profit so it may be given a lifeline by the CMA.

For Yorkshire there might be leeway on performance targets for flooding, sewage and in agricultural areas for phosphorous levels. One of the company’s major issues is around financial capital structure, which the CMA seems unlikely to move on.

Value of engagement

Customers’ views are at the heart of the appeals and the question of how much say customers should have in the final outcomes is crucial. Ofwat and CCW pushed hard for greater inclusion of consumer views in writing business plans, and more billpayers were consulted and involved than ever before.

However, doubt has been cast on how valid some of this engagement is, with a CCW study finding customers struggled to engage with the complexity of the business plans. The CMA may suspect a degree of unconscious bias and inability for billpayers to make a fair assessment in the round in the same way as a regulator with more information and expertise.

Beale says: “This is a difficult territory for Ofwat and even harder for the CMA to be operating in. Ofwat made some decisions where it hasn’t allowed companies things that they have customer buy-in for, which companies have challenged – particularly around ODIs. Granting such allowances could put water companies in very different positions from one another.”

This boils down to a judgement call and that is where there may be differences between Ofwat and the CMA.

Customer engagement was largely cited around the balance between investment now versus in the future. If within the re-determination the CMA ruled in favour of greater investment in resilience it would be making a statement that Ofwat got that balance wrong, which is exactly what the companies have been arguing.

“It’s obviously something that companies, their owners and investors feel strongly about. It would be a big step for the CMA and have some pretty compelling evidence that this was the most efficient way of meeting customer needs in the long term. And that they were persuaded that Ofwat either hadn’t seen such information or they had seen and discounted it. This is difficult for anyone.”

Judgement call

As an impartial decision maker, the CMA is looking for problems with the original decision and to ask itself whether the right calls were made, based upon all the evidence presented to them.

“There will undoubtedly be different outcomes to the Ofwat view because of the complexity of the problems,” Beale says. “Different mindsets will have different view when balancing a complex range of factors.”

With complex issues being considered – even without Covid-19 – this a tough task for the CMA and the customer viewpoint and future investment are both pretty big judgement calls. Beale concludes: “The safer thing to do is to go with what Ofwat said. The bolder, bigger thing that would have serious repercussions around the industry, would be to have significantly different opinions. That would be really interesting and cause Ofwat to do a major rethink about the way it is approaching these things. If they had a fundamental difference of view Ofwat would have to do something with that.”

Hawkins thinks it is unlikely Ofwat will be this bold.

“The CMA may well make a number of tweaks but Ofwat will still be pretty strong about the ground it’s standing on.

“The record of getting change from the CMA for water companies is poor, so the four appeals are unlikely to bring about a major overhaul.”