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Ofwat: Testing the waters

An initial analysis of the draft determinations indicate that the water companies appear to have been dealt a very tough hand of cards by Ofwat, says Terry Povall of EC Harris.

Sector experts within EC Harris have looked at key elements of the draft determinations and have had discussions with many utility clients and institutional owners to formulate a view.

Overall, Ofwat has drawn a significant line in the sand on prices, Weighted Average Cost of Capital (WACC), capital efficiency and operating efficiency.

To what extent Ofwat may move in the next phase before it confirms the final determination on 26 November 2009 − is far from certain.

The water companies business plans asked for price rises of between 0% and 27% per annum above inflation between 2010 and 2015. Ofwat has proposed increases of between 14% to 0% per annum above inflation for the same five years. For most companies the cut back is about a 12% swing, but for some it is as much as a 32% swing.

data table

FBP Final Business Plan; DD Draught Determination; WACC Weighted Average Cost of Capital CIS CIS is Capital Incentive Scheme and the figure represents the variance for that company against an Ofwat baseline of 100. The companies are rewarded or penalised for variances in performance against this figure. The closer to the Ofwat baseline, the greater the level of reward.

What is the impact of reductions in requested price increases?

The price rises are only about the income tariff basket for a water company which are then reflected in the make-up of their final bill to customers.

The three significant elements of the price review that utility owners, executives, strategic partners and commodity suppliers need to be focused on in this price review process are:

  • Prescribed capital investment levels over the next five years
  • Prescribed operating costs over the next five years
  • Prescribed WACC over the next five years

In facing these challenges, the critical question for the owners and executives of any utility company is: “Can the business successfully operate to the regulator’s required high performance levels and yet still achieve the efficiency savings the same regulator is demanding?”

If a company has doubts about the sustainability of the determination then they may consider an appeal to the Competition Commission. However, this puts a business in suspension, diverts a lot of management focus and leaves owners or the stock market jittery on the outcome. Critically the Competition Commission can re-open any and all elements not just those a company appeals against.

How tough is the challenge set by the draft determinations?

Ofwat rightly demands exceptional service and performance standards. It also rightly expects lean efficient performance. In general, good benchmarks are now available to show what leading and frontier performance can be in world-class utilities.

There are undoubtedly some world-class utilities in the UK, however, the variances between upper quartile and lower quartile indicates there is still much to go at.

EC Harris estimates that there could be a 30% difference between upper quartile and lower quartile performance on capital delivery in the water sector as demonstrated in its £ in the Ground Analysis.

Overall the water companies’ final business plans asked for £27bn in the next five years and they have been given £21bn − these appear dramatic cut backs, but they are not all about approving efficiency. Companies have to justify their proposed investment plans on approved service standards. These standards are often based on cost benefit analysis and some of these reductions are Ofwat not accepting the scope justification.

However, one must wonder whether Ofwat in particular might be pushing some frontier companies a step too far? Or indeed, if Ofwat has set average and poor companies a mammoth task to catch up on capex and opex efficiency in one, five year review period?

Can the supply chain deliver these efficiencies?

Strategic partners and commodity suppliers will welcome the continuing size of the capital programmes. However, recent press comments by some suggest they may have not yet spotted how tight things will be going forward. Current delivery models will need to be challenged in spades by utility companies, if they are to achieve the regulator’s efficiency targets and yet still provide excellent performance and service standards.

If the delivery models we have seen over the last five to ten years have been successful, then where and how is the future efficiency to be achieved? Aren’t we told often enough that “If we always do what we have always done we will always get what we have always got?” The change in work mix as we move to increasing numbers of smaller maintenance type projects, adds to this need for different delivery models

Some water companies have had their capex proposals cut by 25% up to even 40% for some of the smaller water companies. Allowing for scope modifications, this still represents a significant capital efficiency challenge.

Interestingly, Ofwat CIS baseline scores do not show any company near or below a CIS baseline of 100. At 100, this would represent Ofwat’s view of what a normal company would expend on capex in that region.

There must be some doubt of the Ofwat methodology given this range and no doubt some companies will be challenging Ofwat hard in the next few weeks.

Does the efficiency challenge look even more significant on operating costs?

Water companies near the bottom of the Overall Performance Assessment league table have seen a double hit on opex with penalties for the existing poor performance and then large operating cost efficiencies for the next five years. For some companies, the catch up to average operating costs requires 15% savings and then to get to today’s frontier requires a 20% saving.

But even the frontier companies are being asked to continue operating reductions by Ofwat, albeit that the rules allow them to hang on to some of the extra savings.

Will the cost of capital impact on funding availability?

WACC at 4.5% for water and sewage companies and 4.9% for water only companies is at the lower end of city analysts expectations. This will impact on the returns that existing investors may receive from their existing investment in the business.

However, just as critically it impacts on a company’s ability to raise new debt in the market or new equity through rights issues to keep funding these massive multi-billion investment programmes. Any such delays in funding availability may cause some early projects to be deferred.

Some have argued for a two tier WACC approach with a lower WACC being applied to the existing regular capital value with a higher WACC being applied to new assets to reflect the difficulties of raising finance in the current and foreseeable markets.

The safe bet is that the debate on WACC with Ofwat is far from over. The regulators have an absolute statutory duty to ensure that these appointed licenced businesses have ongoing financial sustainability. Conversely with banks no longer being safe investments for pension and sovereign fund investments the market may eventually settle for a lower WACC, providing they believe the capex and opex efficiencies do not present a financial risk.

In summary…

The price cuts proposed are reasonable for end customers and certainly politically welcome, yet appear tough for some if not all water companies.

Looking at the variances in performance levels across the sector, the capex and opex challenges companies now face can certainly be achieved. Nevertheless radically different approaches both internally and in the appropriate engagement of the supply chain are essential.

These challenges plus a sustainable WACC may also lead to structural change, change of ownership, take over and mergers across the sector.

  • Terry Povall is a partner and head of utilities at EC Harris and has been involved in all the AMP determinations of the last 20 years

Power comparisons

Ofgem appears to have offered more flexibility in that its draft determinations are not yet fully baked and they appear to be open for discussion.

Ofgem has proposed price rises of between -4% per annum to +9% against 12% quoted in May 09. Again this is considerably down on what the Distribution Network Operators (DNO) electricity companies were looking for in their final business plans.

The least efficient DNOs are 26% above industry average for capex.

A drive towards delivery of capex and opex programmes at national average performance levels could deliver £1bn of value to the bottom line in these sectors.

Ofgem has not closed on where WACC should be. It has proposed that it be between 3% and 4.85% WACC.

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