Moody’s flags prospect of CMA appeals if PR24 risk/reward is not rebalanced

Ratings agency Moody’s has issued more analysis that underpins its continued negative outlook on the price review. In a new report, published in conjunction with its conference on 15 October, it said: “Public, political and regulatory scrutiny remains high amid serious concerns over the companies' operational and financial performance. There is a risk that this will result in a less favourable risk-return profile that could further weaken the sector's credit quality and make it hard to attract necessary funding.”

On Moody's analysis, operational underperformance, driven by total spending above allowances and performance penalties, has reduced operating cash flow and resulted in a weak adjusted interest coverage ratio. The sector wide cumulative achieved return on regulatory equity (RORE) is also low at 2.9%, below the average base allowance of 4.1%. Together with many other commentators, the agency considered that allowed returns may not be sufficient to attract investors. Moody’s said that updating Ofwat’s methodology with the latest market data on cost of debt and the risk free rate would indicate an allowed return in the range of 3.7%-4.1%. This compares with Ofwat’s Draft Determination of 3.66% and the average return of around 4.4% requested by companies (all wholesale weighted average cost of capital, CPIH-deflated).

Because of the perceived shortfall in totex allowances at £88bn (16% below companies’ request of £105bn), low allowed returns and the punitive Outcome Delivery Incentive regime, Moody’s observed that many companies are considering appealing to the Competition and Markets Authority if the risk return profile is not rebalanced.

At the Moody’s conference, Ofwat chief executive David Black reiterated that there needs to be continued cultural and performance improvement in the sector to regain trust from the public. He defended Ofwat by pointing out that it has allowed investment in the sector in the past, and has agreed to the considerable step-up to £88bn of totex for AMP8.

He also said Ofwat is listening as it considers the shape of the Final Determinations (FDs) and is committed to a fair balance at the FDs. Since the drafts, Ofwat has held over 80 meetings with investors and one-to-one meetings with company boards and NGOs.

The regulator has also highlighted that the new mechanisms – Direct Procurement for Customers and Specified Infrastructure Project Regulations – are catalysts for further major investment.

Ofwat continues to assert that rising returns and growth should be attractive to investors combined with inflation and other cost protection, and that equity investors should therefore step up to underpin financial resilience.