A question of finance, risk – and regulation
The financial crisis demonstrated the speed at which conditions can change. Derek Holt and Suzanne Rab reflect on how the UK water sector's long-term financial viability may be best secured in the challenging years ahead.As water companies focus on the challenge of delivering the significant investment programmes agreed at the recent periodic review (PR09) to time and budget, the rather arcane debates about cost of capital, frontier shift and financeability may perhaps fade for a time into the background.
But given the depth of the recent financial crisis, and the questions this raises regarding leverage and refinancing risk, it is opportune to reflect on how the sector's long-term financial viability may be secured. In particular, the sector is likely to persist in its cash negative profile, and the potential changes to the regulatory framework in order to facilitate competition could create a need for a new perspective on the financing of functions duty.
And, while the sector's financial profile has generally stood up to the challenge of the crisis, albeit with firms paying higher spreads for credit and achieving shorter maturities, it should be noted that conditions can change significantly within relatively short spaces of time.
This article identifies the main factors that are likely to influence the debate on financeability in future water sector regulatory determinations. Following a brief recap of the salient features of the current approach taken by Ofwat, it reflects on questions such as how financeability is dealt with in other sectors, what risks firms should bear, the role of credit rating agencies, and how future challenges in the sector, including changes in the market structure, could impact on financeability testing.
Price limits Financeability is a primary duty for the UK water regulator. Specifically, Ofwat has a duty to secure that companies holding appointments as relevant water and water and sewerage undertakers "are able (in particular, by securing reasonable returns on their capital) to finance the proper carrying out of the functions of such undertakers".
Ofwat's approach to financeability at PR09 represents an evolution of the procedures it had established in previous reviews to ensure that the price limits it was setting were sufficient to allow efficient companies to finance their functions. It has also been well trailed, with an early decision on the overall framework set out in 2008 based on the results of the joint consultation exercise undertaken by Ofwat and Ofgem on the subject of financing networks in 2006.
The essential components of the approach are as follows:
· A cost of capital (4.5% post-tax) was set uniformly for WASCs, with some adjustments for WOCs in relation to the higher cost of debt they face
·To test whether the proposed price limits were financeable, Ofwat examined the profile of five financial ratios including cash interest coverage, gearing and cashflow:debt ratios, checking these are consistent with retaining an A-/A3 credit rating
·A "notional balance sheet" approach was taken, modelling companies' financial position based on a notional gearing level of 57.5% rather than taking account of a particular financing structure put in place by individual companies. A proportion of this debt was assumed to be index-linked, consistent with broad industry trends
· A dividend yield of 5% was used, reflecting the treatment of the sector as an "income" stock while incorporating a proportion of retained income as a means to resolve financial constraints. In the case of three companies - Thames Water, Bristol Water and South East Water - equity injections amounting to 20%, 10% and 5% of initial notional equity were made in order to resolve financial constraints. In these cases, there was an allowance for the transactions costs relevant to issuing this amount of equity
· While no further financeability issues were identified in the modelling, Ofwat had previously set out in its financial framework a policy view which indicated that, in the event of any adjustments being required, these would be dealt with in a manner that was NPV neutral
The financeability debate has been addressed in a number of industries, although there have, to date, been relatively few situations in which significant interventions have been required. Some exceptions include adjustments made to reopen price controls in the event of major disruptions or changes in circumstance.
NATS received a RAB adjustment and had depreciation allowances brought forward as part of a response to the 9/11 volume shock. Similar revenue adjustments were made by the Office of the Rail Regulator following the financial problems suffered by Railtrack as a result of the Hatfield accident, and subsequent to the setting up of Network Rail.
Against a different regulatory framework, Postcomm has provided for a "glidepath" to take account of the pension deficit cash funding requirements of Royal Mail. Most regulators carry out a similar exercise involving modelling the financial profile of firms and checking that the proposed price limits will be consistent with reasonable financial indicators. In the energy sector, Ofgem's application of this approach has not led to significant adjustments being required, although in part this may reflect that cash returns on new investment had been accelerated relative to underlying asset lives, mitigating the impact of such investment on financial profiles.
Regulator challenges There are essentially two key questions that need to be considered in relation to the financeability duty. First, how should it be tested for; and second, what mechanism should the regulator adopt to mitigate or manage financeability problems?
In relation to testing, the standard approach, as noted above, is to assess financial ratios and compare these to thresholds consistent with maintaining investment grade credit ratings. There has been a debate about the dangers of regulatory "capture" by the ratings agencies. However, regulators must surely adopt methodologies or assumptions that are consistent with the credit indicators most valued by the market as these determine the ability to raise finance in the real world.
The latest round of water reviews did not identify any firms for which an adjustment is required. This is not entirely surprising given the following:
· The assumed starting balance sheet, with gearing of 57.5%, is relatively conservative
· Higher levels of retentions have been assumed in the modelling
· Ofwat is somewhat more flexible in terms of how it interprets breaches of the ratios. Depending on their number and magnitude, breaches do not necessarily trigger a "failure" in the test
· A seemingly flexible amount of equity injections can be assumed to address any remaining challenges. Three companies that faced the highest growth in RCV were assumed to make equity injections to offset the deterioration in financial position that this would otherwise cause
One interpretation is that testing for financeability is a technical exercise, but which serves little purpose. After all, if contortions of the type described above can be adopted, why not simply reject the basis of financeability as being irrelevant so long as companies can earn returns equal to the cost of capital?
On the other hand, the equity injections assumed did have a real impact, in that the associated costs of equity issuance were built into the allowed revenues. And, in different circumstances, the test might show that the required equity injection is very significant, which could lead to costs both in terms of market reaction and direct issuance costs. In such cases, alternative measures to address the financing gap may be preferred.
On the question of how to address a financeability concern should it arise, there are two issues to consider. The first relates to how the overall regulatory framework might be designed to enable companies to mitigate financing risks, while protecting the interests
of consumers. By creating a balance of risk between customers and companies, while signalling commitment to the RCV through consistent and transparent decision-making, regulators can set conditions that enable creditors and equity investors to invest in the sector. In principle, mitigating risk exposure would seem appropriate where companies do not have the ability to manage risk through prudent management.
Many companies argued during PR09 that the balance should move toward greater risk sharing with customers. This occurs already through mechanisms such as interim determinations in relation to notified items or relevant changes in circumstance that allow a price control to be revisited. There remains uncertainty regarding how such re-openers will operate in practice.
Risk-sharing tools Sutton and East Surrey, which requested a price limit change in 2008 to reflect the effects of increased power purchase costs and lost revenue from reduced consumption by metered customers, saw its appeal fail in front of Ofwat and the Competition Commission (CC). While all parties agreed that the materiality threshold had been met, and the CC agreed that the effects could not have been avoided through prudent management, Ofwat and the CC determined that the overall financial position of the company was robust enough to be able to carry out the financing of its functions. This indicates that, while the sector has a wide range of risk-sharing tools, the operation of some of these remains at the discretion of the regulatory authorities.
Secondly, options for providing increased financial headroom to address situations where the credit rating might otherwise be threatened must be assessed. Regulators facing such situations have approached this issue differently, in some cases providing revenue uplifts; in others changing the profile of cash through depreciation allowances. The latter approach is currently in favour given it is NPV neutral, but there remains a risk that this may generate further problems down the line (when depreciation allowances will inevitably be reduced). This highlights the importance of taking a longer-term view, including a greater commitment and increased transparency over several price control periods. A number of factors suggest that the issue of financeability will continue to play an important role in the water sector. The emergence of competition raises important questions about how the RCV will be allocated across business units, and what extent of separation of business activities will be required over time.
Not only might this have repercussions in relation to debt covenants measured against RCV, but questions may be raised about what thresholds should be relevant for financeability testing for the wholesale activity and how the increased risk of stranded assets may impact on the cost of capital for the sector. In such a situation, options for increased headroom, risk transfer, or cashflow adjustments may be required to ensure that a stable financial structure for the sector can be preserved.
Derek Holt is director at Alix Partners; and Suzanne Rab is counsel at Hogan Lovells