Experts last week lined up to provide comment on the draft PR19 methodology published by Ofwat on 11th July with a common message: the review would be tough on companies. Key commentators included consultant PwC and ratings agency Moody's.
In a report entitled Raising the bar, PWC concluded: “We consider that many companies will find it a much more challenging price control process.” Among the factors it cited in explanation were: the higher standards Ofwat is demanding, paired with a more complex process; and lower cost of capital with greater exposure to performance risk. It advised water companies to:
capitalise on their strengths and identify the weaknesses they need to overcome to ensure a high business plan categorisation
emulate best practice from outside the industry
treat resilience in a holistic way and acknowledge this adds a new layer of complexity to business planning
be ready to implement plans quickly.
The report categorises how challenging Ofwat’s key proposals are, together with how much change there has been since PR14. It lists the most challenging aspects as: producing high quality, ambitious and innovative plans; stepping up on customer engagement and engaging on resilience; common performance commitments; the absence of an ODI cap; delivering on resilience expectations; Ofwat’s approach to benchmarking wholesale costs and efficient retail costs; cost adjustment claims; funding unconfirmed environmental requirements; and lower cost of capital.
Full PwC analysis is HERE
Moody’s concluded the draft proposals will be credit negative and may require companies to take remedial action: “A lower allowed return will reduce companies’ financial flexibility, and coupled with measures that increase the potential for cash flow volatility, will be credit negative for the sector as a whole. Pressure will be exacerbated by Ofwat’s proposed upstream reforms, which aim to open various elements of the value chain to market forces, although the impact of these may only be felt beyond 2025. To maintain credit quality, companies may need to adapt financial and dividend policies to create additional headroom in the run-up to a significant regulatory challenge for the period 2020-25.”
Moody’s sector comment: Ofwat signals challenging price review highlights signals from Ofwat of a likely cut returns for PR19. It reminds us that Ofwat's methodology paper cites PwC's estimates of nominal market returns at 8 to 8.5% which implies a cost of equity range of 6.7 to 7.4% compared with PR14's 8.6%. That, according to Moody's, would be equivalent to a cost of equity range of 3.8-4.5% (real), compared with 5.65% at PR14, and a weighted average cost of capital of 2.3 to 2.6% (vanilla, real). Moody's goes on to argue:
absent outperformance, companies could see a material weakening in their cash flow based metrics;
assuming a differential between RPI and CPIH of around 100bps and an initial 50:50 split of the return on RCV, could suggest a blended RPI-CPIH return of around 2.8-3.1%
Likelihood that financial flexibility across the sector will decline post the price review, plus “if interest rates remain low beyond PR19, the impact on allowed returns could be significantly more pronounced at future price reviews”.
Moody’s analysis is available only to Moody’s subscribers HERE