OFWAT price review 2009

Ofwat today revealed its draft determinations under the ongoing Price Review 2009 process proposing serious cuts to the level of planned investment while promising to cut consumers bills as a result. The key announcements were:

• A reduction in the average water bill by £15 to £330
• A recommended capital investment figure of £21 billion (£6 billion less than the draft business plans submitted by water companies and £3 billion less than their final business plans)
• Weighted average cost of capital (“WACC”) to be set at 4.5%, a figure lower than that set during the last review (PR04 in 2004)

In seeking a balance between suitable levels of capital expenditure and protecting the interests of consumers, this announcement will mean that some water companies will have their leakage and mains replacement, metering and other planned expenditure plans significantly altered as a result. The stock market’s response to the announcement has highlighted the effect of low prices on dividends as share prices of the water companies fell this morning.

The effect of a lower than predicted WACC (where average WACC proposals by water companies was 4.88%)will make it a challenge for the industry to secure the required funding, particularly given the continuing credit constraints. The figure is lower than the 5.1% figure allowed during PR04 and the industry will hope that it is revised upwards before the final determinations are released.

The final determinations are due in November and water companies will have the opportunity in the interim to lobby for changes to the recommendations. However water companies cannot rely on others to take the lead on this as it was confirmed that in the event of a successful Competition Commission application by one company, the review process would not be re-opened to the remaining water companies.

Changes to the Price Review process for 2009

PR09, which began with a consultation in 2007, has already seen the publication of draft business plans and price proposals, research into consumers views on the process and the issue of final business plans by the water companies. Following scrutiny of these plans and the draft price published today, the final price limits will be published in November 2009.

Prior to the last review (PR04), the process was led by Ofwat in discussion with other key stakeholders culminating in costed options being presented before Ministers. Following a revisal of the procedure, the PR04 process allowed for a more prominent role to be played by water companies in the form of the submission of a business plan to Ofwat for review. The business plan will ultimately set out what level of investment each company foresees in the following five years under its Asset Management Plan 5 (AMP5).

A further key inclusion in the PR09 process is the concept of a Strategic Development Plan (“SDS”) to cover the investment plans of each company for the next 25 years. The business plan content required by Ofwat was set out in an earlier consultation at the outset of the process and crucially provides that the SDS should inform as much of the business plan as possible with any derogations or inconsistencies with the SDS being identified and explained fully.

It remains to be seen how the five-year business plans will remain entirely consistent with such a broad 25-year investment strategy, particularly given the volatility of the economy at present, and indeed how Ofwat will attempt to effectively enforce adherence to the submitted plans.

Key issues for PR09

• The introduction of an SDS to be completed by each water and sewerage company to encourage a long term structure to water industry planning
• The use of a Capital Expenditure Incentive Scheme (“CIS”) in order to reward companies that set and then meet challenging investment targets
• The impact of the weighted average cost of capital (“WACC”) to be announced on potential investors in the water industry
• The impact of the price review on consumers

Strategic Direction Statement

PR09 has seen the water companies assume a greater role in the policy process in the form of the 25-year SDS which sets out what the company proposes to deliver in the long term (e.g. management of assets and innovation), what major risks they perceive going forward and how they will address these issues through financing.

The SDS should cover the future priorities of the company, giving an indication of what these priorities mean for bills and services. By encouraging companies to provide long term strategic plans based on certain assumptions, Ofwat will attempt to make future policy more inclusive of these aims.

Capital Expenditure Incentive Scheme

After reviewing the business plans already submitted, Ofwat will consider the proposed expenditure under these plans to maintain water and sewerage assets. A draft baseline is then deduced based on the level of investment needed and where the investment is required. Under the CIS water companies are able to retain any savings they make in delivering the investment they commit to at a cost below the baseline set by Ofwat. Another government regulator, Ofgem, is using a similar approach in its electricity distribution review.

By allowing companies to set their own targets through their business models, Ofwat is prepared to reward those companies that set challenging targets and succeed in meeting and surpassing those targets. Companies that set less challenging targets will therefore be rewarded at a level that is commensurate with what they proposed.

Capital expenditure and investment companies

21 water companies have already submitted their final business plans revealing a proposed capital expenditure of £27 billion between 2010 and 2015. In terms of the spread of investment across the industry, the ten largest water and sewerage companies account for 90% of this total. The exact level of investment by each company varies in its scope and this variety is primarily due to geographical location, climate, population size and economy. The state of the infrastructure and the capacity of the assets available to provide water will also determine the level of expenditure required in order to meet industry standards.

Of particular interest to potential investors is the weighted average cost of capital to be announced as part of the consultation process. The water industry has a traditionally high debt gearing and investors will pay keen attention to the predicted rate of return as formulated by Ofwat in order to assess future investment plans.

The publication of the final business plans saw an average proposed WACC increase by the water companies of 4.75% to 4.88% from the draft plans. Under PR04 Ofwat set the WACC at 5.1% a figure which some commentators suggested was too generous to investors, it is now proposed to be set at 4.5% for PR09. The key concern for PR09 will be the effect of the credit crunch on the availability of debt finance, if Ofwat responds to this by setting a low WACC potential investors may not see the reward they would hope to.

A further effect of Ofwat setting the WACC at too low a level could be a credit downgrade of the water company in question leading to greater financing problems as a result. It is possible that a Competition Commission application could be made by the company in order to review the regulator’s decision.

The effect of the slowing economy on the funding of the significant capital expenditure required to meet key customer service standards means that debt financing costs have become a much higher proportion of the value of the investment. Mitigating and off setting these costs will need to be balanced with the ongoing duty to the consumer under statute.