A KPMG report for Anglian Water, Affinity Water and Northumbrian Water has argued the regulator has made a “fundamental change” to the way it estimates the ‘total market return’ (TMR), a key component of the cost of equity. This relates to Ofwat’s use of a “a market based cost of equity, placing less weight on long-run historical average equity returns, and in fact places no weight on their estimates of actual, outturn historical returns”.
Based on PwC analysis, Ofwat’s market based approach has produced a cost of equity range of 3.8% to 4.5% on a real RPI basis, compared to 5.65% at PR14. KPMG pointed out: “PwC estimates a nominal cost of equity range of 6.7% to 7.4%, based on a nominal TMR of 8% to 8.5%, significantly below long-term market estimates of 10.3%. Ofwat’s own estimates for TMR in PR09 were 6.75% in real terms compared to their current estimate of 5.1%-5.5% TMR (real). This again marks a significant shift from their previous determinations of TMR.”
KPMG concluded: “Relying on short-term estimates would introduce substantial financial risk to the firms and investors on the basis of assumptions which cannot be relied upon.”
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