Counting the cost of cutting
The Coalition’s spending plans have now been revealed. But what, asks Dean Stiles, will the cuts mean for the water industry?First there was the Comprehensive Spending Review (CSR), then the National Infrastructure Plan with the Government's strategy to promote economic growth. For the water industry the implications are mixed: water companies are sanguine about business prospects while contractors face more competition for existing work and price pressure.
Flood defence spending is cut £170M under the spending review, despite environment secretary Caroline Spelman's initial claim that Defra had prioritised the maintenance of front-line services, including flood defences.
Defra will cut £61M over the next four years in flood and coastal erosion defence maintenance budgets, and a further £110M in capital spending on new defences. The department will cut its resource spending by 29% and capital spending by 34%, with £2B allocated to coastal and flood defences over the four-year review period to 2015. This is less than the £2.15B commitment made in the previous three-year period, 2008-2011.
This £150M shortfall over the next four years could cost the public around £4.8B in the future, based on the Environment Agency's (EA) assertion that every pound spent on flood defences saves £8 of
future spend in terms of reduced damage.
Ring fencing £2B for coastal and flood defence each year is welcome, says David Balmforth, executive technical director with consultant MWH. But he is concerned about the effects of the spending review on the capability of local authorities to fulfil their flood risk management obligations set out in the recent Floods and Water Bill.
"Flooding is set to be one of the biggest threats the UK faces in coming years. So there is now even more onus on government to get the different responsible bodies working together more effectively," says Balmforth.
Balmforth, who leads the Institution of Civil Engineers' work on flooding, says it is vital to get better value from investment in managing flood risk given that public funding is decreasing in real terms. "We need to shift from a reliance on defence to building resilience. This requires new approaches and funding mechanisms and regulation that foster collaboration."
Christopher Digman, MWH senior principal engineer who specialises in urban drainage and flooding in the urban environment, calls for more innovatory ways of managing flood risk.
"We also need to reposition flood risk management in the general context of improving urban and rural communities. We need to demonstrate the delivery of multiple benefits to society, eg flooding and wider environmental benefits such as improved water quality and an increase in green infrastructure," he says.
At first glance it may seem that contractors to the water industry will remain unscathed by Chancellor George Osborne's spending plans for the next four years. Water company spending plans agreed with Ofwat remain in place and for construction companies generally transport and wider infrastructure spending fared better than many dared hope. But the detail behind his plans reveal the extent to which government is withdrawing spend. Capital expenditure as a proportion of GDP will fall from 4.9% to 3% from 2009/10 to 2014/15, the Construction Products Association says.
The predicted upswing in private sector work will not be sufficient to make up the industry's shortfall in work, sending construction into a second downturn. "The size of the cuts in the CSR means that there will be a double-dip recession in construction," said the association's economics director Noble Francis. Jonathan Hook, head of UK construction at accountant PricewaterhouseCoopers, forecasts a 5% drop in overall construction output.
Nor does the Government's infrastructure plan hold much hope for the beleaguered construction sector. Up to £200B is earmarked to upgrade the infrastructure, including roads, railways and utilities, over the next five years, but mostly with private investment: the plan is backed with less than £50B of state funding.
Most of the spending in the five-year plan would come from the private sector "where necessary, helped by suitable regulatory change", along with levies and state-imposed pricing rules in areas such as renewable energies.
The Government has placed a big bet on the private sector stepping in to fill the void.
The water industry, with its capital investment plans in place, under the current AMP is an attractive option for those many construction companies looking to fill the space left by the withdrawal of state expenditure. Water companies will be keen to exploit to the full the opportunities to reduce costs when work is put out to work-hungry contractors.
More than six months into the new regulatory period water company are more confident that they will once again be able to perform better in a range of areas than Ofwat had assumed. Shares in at least two water companies, Severn Trent and Pennon, are in demand as investors shy away from riskier assets into safer havens and UK water stocks have performed strongly, up 17% over 12 months.
A favourable economic environment with higher than expected inflation and low bond yields has made analysts increasingly upbeat about water companies' prospects. Market expectations for pre-tax profits in the year to the end of March 2012 at Severn Trent, for example, have risen by 24% since the start of this year, according to Bloomberg.
A year ago brokers were worried that water companies would struggle to deal with greater costs to build and maintain infrastructure as well as rising energy prices and pension expenditure, while keeping average household water bills broadly flat.
Some analysts say the credit crunch came at the right time for the water sector: debt markets are considerably healthier today than when the regulator was drawing up its plans. "If we hadn't had the credit crisis, I think we'd have seen Ofwat go to much lower allowed returns," says Lakis Athanasiou, at Evolution Securities. "Water bond yields are close to previous lows hit in 2005, while credit spreads over gilts have tightened to near pre-crisis levels, at about 100 basis points - implying the new pricing regime has had minimal impact on the companies' cost of borrowing."
Ofwat had assumed a weighted average cost of capital, equity as well as debt, of 5.1% for the period but brokers say that the "real" figure is in fact lower - Credit Suisse calculates the figure at 3.3%.
Ofwat, which sets price rises based on estimates of the retail price index, appears to have underestimated the resilience of inflation. Whereas Credit Suisse forecasts an RPI figure of 4.76% for next month, the regulator had assumed 2%. That produces huge revenue gains for most water companies.
"Water companies will welcome further reductions in gilt yields since it helps them outperform Ofwat's 4.5% weighted average cost of capital assumption," says Nigel Hawkins, director of Nigel Hawkins Associates, which undertakes investment and policy research.
Although a recovering economy should boost this positive trend, interest rates might need to rise to curb inflation. The resurgence of inflation generally benefits water companies because of the positive impact of the RPI-related pricing formula and their high operating margins,
But none of this will reduce the pressure that water companies face on costs. They have already taken out costs by reduced staff, making pension schemes less generous to employees and renegotiating contracts with third-party suppliers. Cuts in welfare payments could also see bad debts increase although this is one of the few areas Ofwat allows an increase in tariffs.
Ofwat has made it tougher for water companies to secure interim adjustments to their allowable tariffs in the five-year review period up to 2015. Companies can only claim such tariff increases for four items - increases in bad debts, increases in the environmental cost of water abstraction, costs driven by climate change, and costs associated with road-traffic permits. Ofwat changed the procedure for applying for such adjustments requiring applicants to involve auditors early and demonstrate that they have explained the need for the increase to their customers.
The "triviality" threshold, under which claims for extra costs are not considered, has also been increased from 1% to 2% of business's turnover.
After two decades of cost cutting since privatisation the remaining opportunities to do so may be modest, but work-hungry contractors are an easy target for driving down rates.
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