Ofwat keeps up the pressure

The regulator's final determination could be interpreted as a partial victory for water companies. But they still see tough times ahead. Dean Stiles reports.

WATER COMPANY lobbying has paid off – after months of warnings of dividend cuts, job losses and lower capital spending, Ofwat has scaled back its requests for cuts to customer bills.

But Ofwat’s final determination will put pressure on water company contractors to deliver innovation and reduce cost. The regulator ruled that the water companies should lower customer bills on average by £3 over the next five years, retreating from its initial demand last July that prices should be £14 lower.

Ofwat also allowed capital expenditure of £22B, a billion more than the £21B in the original plan, but still short of the £24.2B the industry wanted. The cost of capital, a key measure for the rate of investor return and the ability to maintain dividend payments to shareholders, remained at 4.5%, below industry expectations. The increased capital expenditure includes an extra £250M earmarked for addressing sewer flooding, the regulator says.

Ofwat’s estimate of the weighted average post-tax cost of capital for the English and Welsh water and sewerage industry has not changed and remains at the 4.5% level proposed in July.

Some companies have complained that the figure – lower than that contained in the current five-year pricing framework – understates the real cost of financing their activities.

Water and sewerage bills will fall most for customers of Anglian Water, Welsh Water (Dwr Cymru), and Portsmouth Water by 7% over five years. Bills will rise by 13% for Essex & Suffolk Water customers, 7% for Bristol Water customers, and 6% for Northumbrian customers.

Water companies lobbied for a better deal when Ofwat released its draft proposals in July that suggested average household bill should fall to £330 over the five-year period. The final determination largely placates water companies and was positively received by investors.

Rights issues

Share prices rallied in early trading following Ofwat’s announcement with Severn Trent closing up 4%, Pennon by 1% and Northumbrian by 3%. United Utilities, which had warned of tough choices if the July review figures remained unchanged, also increased.

Speculation remains about rights issues for companies such as United Utilities and Severn Trent, the latter had gearing of 79% in September. The finances of both had been a cause of concern for analysts, but the price determination means they have more financial headroom, and are less at risk of credit rating downgrades.

In response to Ofwat’s decision Lakis Athanasiou, an analyst at Evolution, says Severn Trent and United Utilities were still likely to need to cut their dividends, but they have probably avoided a rights issue.

The 22 water companies have to study their individual price determinations, all detailed and highly technical documents, to decide the fairness of the report and indicate whether they will appeal.

None of the water companies has indicated that they will challenge at the Competition Commission. The four major listed water companies released statements saying that they were considering the drafts and did not rule out a challenge.

Pamela Taylor, chief executive of Water UK, says: “The companies’ business plans were based on 25-year direction statements and the biggest-ever consultation with customers. They took full account of both consumer priorities and the need to go on strengthening the infrastructure in the face of climate and demographic change.

“Ofwat has made changes to the draft determinations but doubts remain about the balance they have achieved. Companies must ask themselves if the settlement will allow them to meet the needs of their particular customers and local environments.”

She adds: “In the end it is the companies that take responsibility for the delivery of two of society’s essential services, not the regulator.”

Regina Finn, Ofwat chief executive, says the option to appeal was a welcome part of the consultatory process: “If they do not think they can step up to the [efficiency] challenge we have set for them then the Competition Commission is there.”

Richard Laikin, from Ernst & Young’s power and utilities team, says: “The devil will be in the detail of Ofwat’s rulings and although we expect some companies to move relatively quickly on this, for others the decision will be far more finely balanced.”

Tough targets

Jonson Cox, chief executive, of Anglian is critical of the tough settlement imposed on the company – a 7% cut in bills that was only slightly improved from the 8% in the draft price review. “This is a harsh determination from Ofwat and no one should be under any illusion that we will now have to make significant cost cuts and efficiency improvements to meet the tough financial targets we have been given,” he says.

Thames Water said it had not been funded to reduce leakage. “London’s pipes are so old that we have to work hard even to keep leakage level. But our systematic replacement of old mains will be much slower and only sufficient to stop the situation getting worse,” the company said in a statement.

Although the price decision largely placated the UK’s water companies and their investors, most water companies privately expressed the view that Ofwat’s decision was overly biased in favour of customers. Ofwat did not come close to matching any of the price rises that companies had requested as necessary to fund maintenance and expansion programmes.

Water companies face a more challenging economic climate with high levels of debt, from years of borrowing cheap money. Debt is more expensive and the companies face rising costs to build and repair infrastructure, alongside rising energy and pension costs.

Ofwat says: “We expect all companies to be more efficient and have challenged proposals for investment based on their scope and costs. We do not have a duty to support poorly run companies.”

The £22.1B investment in water services over the next five years is double the rate of pre-privatisation investment, says Ofwat.

But water companies will be forced to be more efficient if they are to ensure a return on investment for their shareholders. That will translate into greater pressure on contractors’ prices and demands for greater efficiencies.

Rates squeeze

This latest price review will probably be the last in the current form with the system most likely to change before the next round in 2014.

Ofwat and water companies agree that while the system of private companies operating within a strictly regulated environment works better than oversized public water monopolies, the flaws are apparent. Water companies feel they take the risk while Ofwat determines everything they do. Ofwat and the water companies lay great stress on providing incentives for innovation and greater efficiency, much of which is provided by contractors.

Philip Fletcher, chairman of Ofwat, says: “The system is trying to mimic markets, but it is not a free-market system. It has a lot to teach other utility regimes, but it is defective because of that element of natural monopoly.”

The 2005-10 pricing regime was generous towards water companies with bills allowed to rise more quickly than inflation, while interest rates were at lower levels than predicted in the price review, and investors were willing to buy shares.

Current trading conditions are very different and while Ofwat’s final proposals are not as severe as in the earlier draft, it will put pressure on water companies, especially stock exchange listed companies, to squeeze contractor rates, cut dividends, or cap pensions.

Andrew Hill writing in the Financial Times said: “The whole 20-year-old system needs replumbing. Ofwat is likely to review it. The next government should also look under the sink.

“No party wants to be accused of tinkering to increase water bills. Conservatives can’t make political capital from reform – as they have in attacks on Ofcom or the Financial Services Authority – because Ofwat was a creature of past Tory governments.

“But the current swings and roundabouts system needs to become more collaborative, more certain, less volatile and less complex.”

For contractors it will not reduce the pressure on price, or the need to innovate, but more collaboration and more shallow peaks and troughs in investment has to make planning and operations easier and more efficient.

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