CMA provisional determinations – summary and analysis

a) Summary (by Karma Loveday)

The Competition and Markets Authority (CMA) has made the following provisional determinations (PDs) in the PR24 price appeals of Anglian Water, Northumbrian Water, South East Water, Southern Water and Wessex Water.

Revenue

• Disputing companies asked for £2.7bn extra on top of the £26.6bn allowed to them by Ofwat.

• The CMA allowed £556m (21% of what was collectively sought).

• Table 1 shows total revenue impact by company. All companies benefit from an increase compared to their final determinations (FDs) but this falls far short of their requests in their statements of case. Wessex fares the best, securing over half of its requested uplift; the other companies secure between a tenth and a quarter. While all companies benefit from a rate of return increase, only three (South East, Southern and Wessex) also benefit from a cost allowance lift.

Bills

• The PDs add 3% to average bills on top of the 24% increase made by Ofwat’s FD.

• Table 2 shows bill impact by company. The uplifts range from 1.3% at Anglian and Northumbrian to 4.7% at Wessex.

• Chair of the CMA panel Kirstin Baker said: “We’ve found that water companies’ requests for significant bill increases, on top of those allowed by Ofwat, are largely unjustified. We understand the real pressure on household budgets and have worked to keep increases to a minimum, while still ensuring there is funding to deliver essential improvements at reasonable cost.”

Expenditure allowances

• Higher allowances granted for South East, Southern and Wessex; lower allowances determined for Anglian and Northumbrian.

• Base expenditure:

  • The CMA adopted a different, “simpler” approach than that taken by Ofwat, which it said better reflected different operating environments between companies. The models incorporated most of the cost drivers used by Ofwat and some (not all) of the cost drivers put forward by the companies. The CMA rejected all cost adjustment claims except differences in regional wages, economies of scale at water treatment works, and energy costs. It also changed the assessment of ‘what base buys’ which affected allowances for asset health improvement. This resulted in:

    • A higher catch-up efficiency challenge (where allowances for all companies are based on the expenditure of comparatively efficient companies) than Ofwat’s – the CMA said this was appropriate to ensure monopoly customers served by inefficient companies do not pay for poor operational performance.

    • A lower frontier shift (emulating efficiency improvements expected in competitive markets) expectation of 0.7%, down from Ofwat’s 1%. The CMA said that was in keeping with expectations of the wider economy. Companies requested 0.62%.

• Enhancement expenditure:

  • The CMA made changes to Ofwat’s modelling approach, resulting in changes to some modelled allowances, such as for phosphorous removal schemes.

  • The CMA largely rejected companies’ requests for higher allowances on the basis of insufficient evidence.

  • Where increases were allowed, these tended to reflect issues that matter to customers, notably addressing water supply interruptions, pollution and leakage, or where companies’ ability to invest had been underfunded.

  • Many increases are subject to an efficiency challenge, reducing allowances to 30% of what was requested.

  • Some enhancement schemes have been deemed too uncertain to provide a specific cost allowance for; the CMA said Ofwat’s gated process should be followed for these. That has reduced the enhancement cost allowance at this point in time, but offers the chance of allowances in future as more information becomes clear.

  • Frontier shift applied as for base.

Outcomes

• The CMA made limited adjustments only, citing the time and scope of the redetermination process in explanation. Funding therefore remains tied to defined outputs and levels of performance.

• Changes were made where Ofwat’s data was not deemed appropriate, or where penalties would disincentivise efforts to improve performance.

• The result is a slightly lower risk of underperformance for companies in some areas.

• CMA rejected companies’ argument that penalties for not delivering on time introduced excessive risk. These remain in place.

Risk & return

• The Capital Asset Pricing Model was used, but with updated market data.

• Cost of capital increased from Ofwat’s 4.03% to 4.29%. This reflected:

  • A higher cost of equity – driven by interest rate rises.

  • A lower cost of debt – driven by changes in expected inflation.

• More than half the change related to external market movements, the rest from targeted methodological changes.

• The CMA rejected companies’ argument that the PR24 FD as a whole would likely result in a significantly lower equity return than the specified allowed return – particularly given the downside risks of underperformance and subsequent penalties. It said its PDs offer a ‘fair bet’ — where the risks for an efficient company of earning more or less than the specified allowed return are broadly similar.

• Ofwat’s Aggregate Sharing Mechanism and Outturn Adjustment Mechanism retained.

Context

• The CMA said its decisions had been taken within the confines of the existing regulatory framework, but noted at some length the Independent Water Commission recommendations and wider reset agenda.

Next steps

• PDs open for comment until 6 November.

• The CMA will update its timetable after that date, noting the 17 March statutory completion deadline.

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b) Analysis (by Verity Mitchell)

Redressing the imbalance for Wessex

It was unsurprising that Wessex was the largest beneficiary of the CMA’s water redeterminations. Ofwat’s FD was 20% below Wessex’s enhancement totex business plan and 11% below its base totex business plan. This gave it the largest overall totex gap in the industry of 17%, compared to the sector average of 7%. The CMA has allowed 96% of Wessex's request for bill increases, which will be 4.7% higher than the AMP8 FD at £622. This will deliver £137m of extra revenue. Southern (11% FD shortfall) and South East (13%) will also benefit from a cost allowance uplift, receiving 89% of their redetermination request, and obtaining a 2.8% and 4.4% uplift to bills respectively.

For Anglian and Northumbrian, it appears to be the higher allowed return that is the primary driver of higher bills. These will increase by a further 1.3%, giving £117m and £52m of increased revenue respectively.

Cost of capital considerations

Investors will be pleased with the 26 basis points weighted average cost of capital (WACC) increase, to 4.29% from 4.03%. This reflected market movements since Ofwat’s cut-off date of September 2024. The CMA noted that yields on index-linked government gilts (ILGs) have increased by around 90 basis points and nominal corporate bond yields have increased by around 50 basis points. Updating for these market movements alone increases the WACC by more than 20 basis points. 

The CMA also made a departure from previous WACC calculations by assuming that the wholesale WACC is equal to the appointee WACC. It considered that there is no double counting of returns between the wholesale and the retail controls. This increases the wholesale WACC by a further 6 basis points, compared to Ofwat’s FD.

The 16% increase in the cost of equity to 5.9% from 5.1% has been partially mitigated in the overall WACC by a cut in the allowed return on embedded debt by 14% to 2.38%, based on the CMA’s long-term CPIH assumption of 2.4% (it used a balance-sheet led approach to deflate all nominal debt to produce a real CPIH cost). It has however increased both the assumption of the share of new debt and its cost so that the reduction in the allowed cost of debt falls by only 5.3%. 

The CMA noted though that in making its provisional decision, it had not been bound by the UK Regulators’ Network (UKRN) guidance that the WACC should be increasingly harmonised between regulated networks. It said it is “generally supportive of the general direction of travel towards greater consistency in cost of capital decisions”.

All five companies that appealed will need to raise additional equity to underpin their investment programmes. This new money will now command a higher return. Having all obtained higher allowances they may well consider that the CMA redetermination process was worth the effort.

Non-appellants and sector wide adjustments?

At PR19, the listed companies who did not appeal were criticised by their investors for missing out on incremental revenue from a higher allowed CMA return. Traditionally there is no recourse for non-appellants, their returns remain unchanged. With the ongoing need for equity issuance and significantly larger investment programmes in AMP8, should other companies be asking for these regulatory adjustments to be extended sector-wide?

What will now be more important is that all companies manage the risks to allowed returns from poor performance; gain Outcome Delivery Incentive rewards from achieving regulatory targets; and raise finance at competitive rates.

The CMA rejected requests to change both Ofwat’s Aggregate Sharing Mechanism and Outturn Adjustment Mechanism. Some efficiently financed companies ended up earning higher base returns than their peers, even with redeterminations in AMP7. The same looks likely in AMP8 as the listed companies' management have publicly indicated that they will maintain financing outperformance through the efficient cost of new debt issuance and the benefits of indexation.

What are the lessons for Thames?

Thames had the second largest totex gap at the FD after Wessex at 16%, so may consider that a CMA referral would be advantageous. Potential benefits include a regional wage uplift for the South East, a lower frontier shift and more investment funded explicitly for the benefit of customers. A higher allowed cost of equity would certainly be attractive as the board negotiates with new investors.

However, an 80 basis points uplift on the cost of equity for Ofwat’s 45% notional equity of Thames’ £21bn Regulatory Capital Value will have to be balanced with the CMA’s stringent evidence requirements. Thames could have schemes excluded from AMP8 funding if they are poorly articulated which would then need to be considered by Ofwat for later delivery under its gated processes.

The CMA has also set a higher catch-up efficiency challenge than Ofwat’s. It is strongly of the opinion that monopoly customers served by inefficient companies do not pay for poor operational performance. Under the current system, the whole determination is up for renegotiation. Not only might Thames be unrewarded by the CMA, but customer bills, even with a higher allowed return, could actually be cut compared to Ofwat’s FD. The Thames board must undertake a careful risk-reward assessment before the upcoming deadline of 22 October.