Customers and financeability dominate final submissions in markets watchdog review

Financeability, together with defining what exactly constitutes customers’ best interests, dominated the final submissions from Ofwat, Yorkshire Water, Bristol Water, Anglian Water and Northumbrian Water to the Competition and Markets Authority (CMA). These come ahead of the final redeterminations being issued within the next few weeks.

Ofwat

In a covering letter from chair, Jonson Cox, Ofwat made a last ditch plea for the CMA to reintroduce some kind of gearing outperformance sharing mechanism; this was scrapped in the Provisional Findings (PFs). Cox said: “We are not precious about the form of our mechanism to address gearing. If you can improve on it, we’d be really pleased. We also note that removal of the mechanism may be taken by investor interests as CMA approval for equity withdrawals, high gearing and complex structures.”

Cox also reiterated Ofwat’s earlier argument that the customer voice had been “drowned out” in the face of highly technical arguments and low resourcing compared to the deep pockets and expertise of the companies and their investors. And he argued there is evidence of ongoing investor appetite for the sector under Final Determination (FD) conditions – not least by citing additional green recovery investment proposals recently put forward by some firms.

As part of the final submission itself, Ofwat insisted it was “at least as concerned about resilience as the companies themselves. The difference between us was the importance we placed on efficiency and avoiding unearned returns. This point remains fundamental”.

It said that a year in to the price control period, “all the evidence from non-disputing companies suggests that PR19 is driving the right behaviours, working for customers, and maintaining the sector as an attractive proposition for high quality, long term investors”. This included that cost allowances are sufficient; outcomes are achievable “with growing evidence of companies expecting significant outperformance over the AMP and in year one”; listed companies trading at premia to RCV that are high by historical levels; and the allowed return being “sufficient and potentially generous” in light of falling returns since late 2019.

The regulator also set out its final stance on the subjects covered by the CMA’s January working papers, and called for the firms to be made to share details of their process costs. It said: “It is remarkable, indeed unacceptable, that the disputing companies are resisting Ofwat having sight of their costs in this process so that we can, as requested by the CMA, assist you in considering their efficiency and proportionality. In that way, we aim to help the CMA to ensure that customers do not pay for any excess costs from the representation of the companies’ interests without adequate scrutiny or challenge. We have confidence that the CMA will see this for what it is. The CMA is being urged by the companies to do something that not only lacks procedural fairness, but that would be indefensible in the court of public opinion.”

Anglian Water

Chief executive Peter Simpson in his covering letter recalled why Anglian had decided to seek a redetermination in the first place. He said: “At the heart of this matter is the approach that Ofwat had taken to PR19 and reflected in its FD which Anglian’s Board considered to be fundamentally at odds with the purpose of the company, as enshrined in our Articles of Association, to bring environmental and social prosperity to the region we serve through our commitment to Love Every Drop. And, we believe, the FD seemed to have been driven more by a focus on maximising short-term bill reduction, and attacking securitised structures, rather than a proper balancing of Ofwat’s duties. That includes the new resilience duty."

Specifically: “We were faced with an FD with a totex gap of £744m, that underfunded the resilience investment needed to avoid our region running out of water, and that ignored the clear priorities of our customers who asked us to address the growing risks from drought and flood.”

Simpson boiled the situation now down to two central issues that the redetermination must resolve: ensuring that the notional company is financeable; and ensuring that sufficient funds are available to safeguard security of water supply for Anglian customers.

He commented: “On the first, I am reassured by the commitment given by the CMA in the working papers that it will ensure that the financeability test is met, which I assume will require the overall balance of risk and return in the redetermination to be consistent with notional company financeability, on the same basis as set out in the PFs.

“On the second, we have evidenced to you that the urgency of addressing risks to the security of water supply in our region has increased, even during the redetermination process. Critically, the only tools we have available to address this during AMP7 are to reduce demand, as supply-side options will only bring benefits from AMP8. To do this, we need the funding in leakage base costs we specified in our cost adjustment claim, and the timely investment in smart metering. This is why these issues are so important to address in your redetermination.

“Further, we have also evidenced that the only realistic prospect of completing the Strategic Interconnector in time to avoid security of supply issues biting at the end of the AMP is for the scope of DPC [direct procurement for customers] to be limited to the Elsham treatment works.”

Northumbrian Water

Acknowledging time is “running down”, Northumbrian Water chief, Heidi Mottram, urged the CMA to focus on three areas ahead of its final decisions.

• “Addressing the clear mistakes in the allowed return and ensuring that the final package remains financeable: we have identified a range of mistakes in the theory and arithmetic underpinning the CMA’s recent consultations on the allowed return. These need to be corrected and the CMA should continue its focus on ensuring that the final package is financeable and allows us to maintain a strong investment grade credit rating.
  

• “Closing the outstanding cost gap: our business is one of the most efficient in the sector overall and provides some of the best service levels to our customers. In our submissions we have set out evidence which shows a gap of about £83m between your provisional cost allowance and our anticipated efficient costs for AMP 7. It demonstrates that there are cost items outside of our control that are rising beyond inflation, and that there are aspects of the determination that include double-counting, for example in relation to growth allowances. The latest information at a sector level also confirms that the cost allowances provided are too low, by a comparable amount to the gap highlighted. Providing these allowances will help to address the clear asymmetry in the package and reduce the cost overruns we expect in AMP 7.
  

• “Providing further funding for our sewer flooding investment: these investments, widely supported by customers and stakeholders, will help us to avoid one of the worst service failures that customers can ever experience. Our proposed sewer flooding programme addresses the clear and escalating risks from climate change and urban creep, which are further underlined by new evidence we provide in our submission and demonstrates a very strong benefit for that associated investment. There is also headroom in bills to make these investments which is unlikely to continue into future price reviews.” Northumbrian’s submission included an alternative overall package reflecting these changes. The company said it could still deliver a massive 21% bill reduction with leading affordability support and stretching service standards, but which allowed for £150m more to be invested in resilience.
  

Yorkshire Water

Yorkshire Water argued ensuring financeability was imperative. It recalled the PFs reestablished the balance missing from the FDs, but lamented the CMA’s January working papers backtracked “to such an extent that the notional firm is highly unlikely to be financeable”.

It called for this to be addressed through the WACC and by correcting risk/return asymmetry. Yorkshire warned: “To fail to do this will lead to increased costs for customers over the longer term, and will exacerbate already existing concerns about investor confidence in the UK water sector.”

The company also passionately refuted Ofwat’s assertion that companies and investors had supplanted the customer voice, arguing rather: “The views of YWS’s customers were not properly reflected by Ofwat and that will also be true of the CMA if it does not reverse the positions taken in the January working papers.”

Bristol Water

Bristol’s redetermination case centred around the fact that Ofwat set the cost of capital too low to support efficient financing for it as a small water only company (WoC). In light of the latest developments, Bristol said: “Based on its more recent response to the cost of capital working papers, Ofwat’s main point appears to be that Bristol Water is no longer small. This argument does not hold up to any scrutiny.”

It called for the CMA to focus on the overall cost of debt for a small WoC, “which is a minimum of 4.9%”. On cost of equity, it pointed to the 2015 CMA precedent that small WoCs required a higher cost of equity. It observed: “The evidence for a company specific adjustment (CSA) on the cost of equity is now stronger for this determination than it was in 2015, given the clear sector water service underperformance in AMP6 and the asymmetry in water service ODIs that is not diversifiable for investors in small WoCs. Including a CSA uplift on the cost of equity, a cost of equity for Bristol Water of c7.8% is fully justified.”