Five firms criticised for short term financial viability outlook
Ofwat singled out five companies for criticism last week when it published its second annual Monitoring Financial Resilience report for failing to provide Long Term Viability Statements looking at least five years ahead.
It said Thames Water, Severn Trent, Bristol Water, Dee Valley Water and SES Water had only looked forward as far as the end of the current control period, despite a regulatory challenge last year to consider financial viability under a set of stress tests at least five years into the future. Ofwat senior director, Aileen Armstrong commented: “Looking ahead to 2020 doesn’t qualify as long-term planning for businesses whose assets last hundreds of years.”
Ofwat also noted there was significant variation in the detail companies included about the approach and assumptions they have made in preparing their Long Term Viability Statements. “We expect all companies to follow best practice and we will be working with them to make improvements in the clarity of their reporting in this area,” it said.
Monitoring financial resilience seeks to lay bare companies’ ability to avoid, cope with and recover from disruption to finances. Among other key messages to emerge from the report, which considered data for the year to 31 March 2017, included:
Investment grade ratings – Most companies’ licences include a requirement with respect to maintaining an investment grade credit rating. Ofwat said: “Where necessary, companies should act to address issues, and we note that Yorkshire Water’s financial restructuring resulted in Moody’s moving it from negative to stable outlook in July 2017.”
Gearing – there were no significant changes in gearing in the year, and therefore no increase in risk from this metric.
Pension liabilities – The majority of the water and sewerage companies have significant pension deficits. The deficits fluctuate, but the overall increase this year is £1.25bn, principally due to the reduction in market based discount rates. The regulator said: “As we have previously set out, we have capped the level of funding from customers for pension deficits, with the majority ending by 2025. The remainder of the deficits are the responsibility of company shareholders. Water companies have long term licences and relatively predictable cash flows (compared with other sectors) which should help them manage these deficits. We would however expect to see the treatment of pension deficits being considered by companies as part of their work on long term viability statements.”
Return On Regulated Equity – there was a wide spread in performance between companies and across the different areas (expenditure, financing and service incentives) that affect the level of returns against regulated equity. Overall, the average annual RORE varied from 3.9% to 11%. Ofwat noted: “What comes through clearly from the RORE figures is that there is opportunity for outperformance (or indeed a risk of underperformance) across all the activities companies undertake.” In detail:
There was an average outperformance on regulatory cost allowances by 0.7%. Ofwat said: “This totex outperformance is the main reason the sector is achieving a 6.22% return (compared to the base equity return set at PR14 of 5.65%). We will take company performance against our cost allowances into account when we set cost benchmarks at PR19.”
Reported performance for financing varies from -2.27% to 1.9% (average -0.35%), with 12 companies underperforming in respect of financing costs. However according to the report, rising inflation levels mean that fewer companies are expected to underperform in the next financial year.
Reported performance relating to ODIs ranged between -0.6% and 1.05% (average 0.14%). Ofwat observed: “At PR14 companies considered they faced more downside than upside risks on their ODIs, although our view was that a notionally efficient company’s risks should be neutral on its ODIs overall. However, the majority of companies have managed to rise to the challenge of delivering more for their customers and, so far in this price control period, are reporting net outperformance payments.”
The regulator concluded: “We will continue to review whether reporting can be improved, in particular in relation to the transparency of group structures and payments between group companies to ensure that we and other stakeholders have clear information about how companies are managed.”