Comment: Verity Mitchell’s early reflections on the FDs

Positive movement in the companies’ favour

Ofwat has improved many aspects of PR24 in its final determinations (FDs), but there remain areas of challenge, not least to deliver the step up in investment required to improve environmental outcomes. There have been positive movements upwards on allowed returns, some easing of performance requirements and extra allowances for costs that exceed normal inflationary expectations. Allowances for power and business rates, and network reinforcement costs to facilitate economic growth, have mitigated some of the £8bn of what Ofwat called "unjustified costs”.

As is normal in price reviews, extra expenditure has been allowed for schemes where additional information on customer benefits have been provided. Compared with previous price reviews, Ofwat has also had to include investment mandated by other government agencies which has pushed the totex even higher since the draft determinations (DD).

Financeability concessions

From a financeability perspective, Ofwat has been obliged to take note of Moody’s revised, more stringent financial ratios. Regulatory uncertainty has led not only to the erosion of a water ‘halo’ effect of cheaper debt issuance relative to the relevant debt indices, but a reversal into a risk premium in the pricing of recent water bond issues. Ofwat has been forced to reflect this by adding a 30 basis points premium, driving up the cost of capital above 4%.

There might also be more easing of cashflow constraints as Ofwat is looking at the mid-period, interim determination process in early 2025. Lower thresholds and the ability to open a price review for new obligations will share cashflow uncertainty risk with customers.

Ofwat has also revised its approach to the financeability assessment for the final determinations to include a base dividend yield of 4% (up from 3% in PR19). “RCV growth will need to be financed by new debt and equity, and we support the provision of additional equity [which may need to be as much as an additional £12.7bn, it estimated] by providing an allowance for equity issuance costs.” Ofwat added that "companies will log-up certain PR19 reconciliation adjustments to the value of nearly £4.2bn to the RCV ahead of PR24. Across the sector this will reduce gearing by 2.5% at a notional level, within a range of 0.3% to -6.1%.” 

Those with adequate cashflows to fund accelerated investment such as United Utilities and Severn Trent will be rewarded.

Layering on further complexity 

Ofwat has done nothing to reduce regulatory complexity. On performance commitment levels (PCLs), it uses caps, collars, and deadbands to mitigate the effects of extreme under- or out-performance. Caps and collars apply to over 75% of all performance commitments, up from just over 60% at draft determinations. A number of PCLs now have lower starting and endpoints.

There is the also the new ‘in-period’ adjustment, the Delayed Delivery Cashflow Mechanism (DDCM), which Ofwat said “brings payments linked to service delivery closer in time to when customers experience a given level of performance”. Finally, the Delivery Mechanism for Southern and Thames is a contingent budget which will only be released if these companies can provide evidence that they can spend the money on a year ahead basis.

On Price Control Deliverables (PCDs), companies will be required to publish delivery plans, setting out their PCD targets and six-monthly updates on those plans. The Outturn Adjustment Mechanism (OAM) has also been introduced following pressure from companies that the incentives and penalties in the DD were skewed to the downside. Ofwat has now conceded that recalibration needs to be undertaken on annual basis rather than at the end of the AMP as originally proposed.

Ofwat said the OAM is intended to trigger in the rare circumstance that there is a significant shift away from anticipated sector level returns. If the median performance of the sector passes an equity return trigger threshold of +/-50 basis points, it will apply an adjustment to all companies calculated as the difference between the median OAM benchmark and the trigger threshold. A company could benefit from OAM recalibration but at the same time be penalised with revenue clawback from delays in delivering enhancement expenditure in the first two years of the AMP, with further uncertainty on PCL thresholds. Regulatory complexity will no doubt be addressed in the upcoming reviews of water regulation.

Winners and losers

Ofwat has been keen to point out that it remains focused on value for money for customers. While some water companies will deem their determination challenging but fair, for others, recourse to the Competition and Markets Authority (CMA) might be worthwhile.

If a company has a large totex shortfall and stringent targets; is unprepared for the ramp up of investment into AMP8, making it likely to incur penalties or be subject to the DDCM; and is raising debt at a premium to Ofwat’s assumptions, an appeal may be attractive. Any company that will have to raise significant amounts of equity may look to the 250 basis points’ spread between the allowed cost of debt and cost of equity offered to companies by the CMA at PR19, compared to the c200 basis points equity to debt spread that Ofwat continues to assume in its cost of capital assumptions.

Wessex has a 17% gap in terms of cost challenge. Ofwat said this is the result of an expensive capital maintenance cost adjustment claim, which it found was not well justified. On enhancement, the company requested far higher phosphorus removal costs than other companies.

Ofwat does admit though, in discussing ‘aligning risk and return' that Thames Water will be "the only company (to earn) significantly below our allowed return... it projected amongst the greatest level of underperformance against the draft determinations outcomes package and also has the largest cost gap in our final determinations. We do not agree that an efficient company would incur these costs, or that its expectations on performance reflect an efficient company.” The challenge leads to a 16% gap. With this assessment from Ofwat, Thames, in particular, may have nothing to lose from referring its FD to the CMA.