Out of pocket

CMA appellants argue the FDs expose them to the fundamental risk of being unable to attract capital. It is very difficult in just a few pages – and at the time of writing, just a few days since the Statements of Case (SoC) were published – to offer a robust account of what the PR24 Competition and Markets Authority (CMA) appeals are all about. But the shaded section provides an overview of the high-level (not technical detail) grounds cited by the five appellants.

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The story so far

Ofwat has made the five referrals. Thames has paused its appeal for the meantime. The CMA has appointed a five-strong panel to hear the appeals. This is chaired by career civil servant and former Treasury finance and commercial director, Kirstin Baker. It also comprises consumer policy specialist, Ashleye Gunn; former general counsel and director of competition at the Office of Rail and Road, Juliet Lazarus; founding partner of the Competition Economists Group, Paul Muysert; and chartered accountant and former Ofcom director of competition and regulatory finance, David Thomas.

The authority said a timetable would be published as soon as possible; the references from Ofwat specify a six-month schedule, but this can (and seems likely to be, given the number of companies involved and spread of topics) be extended by a further six months. Perhaps mid-December at the latest might be targeted, to give firms time to build any changes into the second year of the AMP.

Ofwat’s positioning

As might be expected, in its introductory submission to the CMA, Ofwat set out that is determinations support record levels of expenditure by water companies, “including a quadrupling of investment,” providing the opportunity for performance transformation but also – on cue with the Government’s new instruction to regulators (see p10) – economic growth. The process, it said, had been robust and engagement extensive (formal engagement listed in an annexe).

Beyond that, Ofwat sought to pre-empt – and cast a shadow of doubt over – what it anticipated companies might say. Two things stand out.

• Financebility focus – First Ofwat anticipated that financeability will be companies’ key focus, but argued that it – as the regulator – has to pay heed to all its statutory duties, plus take affordability and deliverability into account. With one-in-five struggling to afford their bill, the need to ensure “allowed costs were efficient, that customers had not already paid for them, and that investor returns were fair” was paramount. On delivery, it pointed out that all five appellants are among the 11 that have underspent their enhancement allowances (by between 16% and 28% 2020-24); that Anglian, Southern and South East are ‘lagging behind’ on performance; and that all are subject to ongoing enforcement activities. On financeability, Ofwat argued its determinations are financeable for an efficient company with the notional capital structure – and that deviation comes at companies’ own risk, with four of the five with gearing above 70%. It also highlighted that Southern and South East are classified as 'action required’ under its financial monitoring regime, while Northumbrian and Wessex are of 'elevated concern’.
  

• Company-specific framing – Ofwat preemptively challenged special pleading, arguing “our determinations are based on interlinked 'building blocks’…[and] given the comparative nature of how we set expenditure allowances and performance commitment (PC) levels across the sector, adjustments to one company's determination can often also impact other companies’. … Therefore, while individual companies may narrowly frame issues as company-specific, these issues may require consideration on a cross-cutting basis.”

Observations

The SoC summaries speak for themselves, but some overall observations are:

• Ofwat is right that financeability – the risk/return balance and insufficient return – is the common thread running through all cases. This is unsurprising given how fundamental it is to all companies that shareholders have been instrumental in pressing for the appeals, and that all have to attract an enormous amount of capital for the foreseeable future. It is a fundamental challenge to Ofwat’s decisions, albeit companies have some different (as well as some common) ideas on what the corrections should be. Anglian is the most frank about the need to raise capital being the most pressing issue.

  
  

• Other issues raised by multiple companies are a) resilience (most urgently raised by South East, given its whole appeal is on the basis of water security jeopardy); and b) asset health/capital maintenance, where both Anglian and Northumbrian in particular sound at the end of their tethers, having raised the matter for years with little change resulting. Both of these issues are also fundamental matters for the CMA to adjudicate on.

  
  

• For Southern and South East, not much at all about the determination seems to work. Wessex is in a similar boat, but – perhaps as a high performer with the ability to cope with more – has taken a different approach in picking its battles rather than going all out and asking for everything to change. Northumbrian and Anglian have decent totex allowances, so have narrower – albeit still critical – complaints. All companies will also be cognisant that the Cunliffe Review offers a bonus opportunity for fundamental change.

  
  

• In terms of tone, perhaps because they have ridden this rodeo before, Anglian and Northumbrian are the punchiest, coming out fighting (as has Ofwat with its multiple references to companies underperforming in its introductory submission). Wessex comes across as being polite. Southern and South East make a straightforward case for help.

Southern Water: turnaround turmoil

Southern Water fulfils Ofwat’s expectations and makes the most prominent case for being ‘different'. This is based on two planks: its inherent regional characteristics (coastline, chalk streams, water stress, etc); and that it is in a turnaround programme "facing generational investment requirements [£8.5bn business plan] against a history of regulatory underfunding”. Southern told the CMA:

“It is not in the interests of our customers or our environment for Southern Water’s refinancing and turnaround to fail. We ask the CMA to implement the remedies outlined in our seven areas of dispute and to act in support of our turnaround.”  

The seven areas are:

• Overall risk imbalance and financeability – “The FD subjects us to a level of risk that results in a materially negative outcome on an expected basis: the base-case median expected scenario results in -375bps of RoRE (£680m net penalties, 8.0% of AMP8 totex) and a plausible downside scenario results in -641bps RoRE (£1,164m of net penalties, 13.6% of AMP8 totex). 

• Botex funding allowances – these fail to account for company-specific circumstances or the actual health of the asset base. "This has led to systemic under-funding for the last 20 years, meaning we have had to invest £585m above our base allowance of £3.6bn in our wholesale water asset base to meet our statutory capital maintenance requirements. This is unsustainable.” It is £650m short in AMP8. 

• Enhancement funding allowances – “abbreviated or arbitrary assessments have been applied, resulting in significant unjustified funding shortfalls without any substantive engagement with or rebuttal of the evidence provided”. Southern is £300m short.

• Uncertainty mechanisms: Southern seeks an amendment to the Delivery Mechanism it (and Thames) is subject to.  

• Price control deliverables (PCDs): some aspects are “potentially unworkable”; Southern seeks to amend the time incentive and non-delivery PCDs. 

• Operational targets and incentives: “Ofwat’s failure to capture company-specific risk factors in its calibration of PCs and ODIs disproportionately exposes Southern Water to outsized risk.” 

• Allowed returns – significant new capital is required, but the allowed return on equity fails market tests and is based on erroneous parameter estimates; and the allowed return on debt does not reflect the sector average company’s actual debt costs and fails to take account of factors outside of company control. The reduction to notional gearing (60% to 55%) is not supported by evidence. Ofwat’s allowed return is 3.97% and Southern’s estimate of the WACC is 5.15% – a £596m (nominal) difference in total over AMP8. In asked in addition for downside asymmetric risk to be compensated for by a 0.52% premium on top of its cost of equity estimate (or 0.21% on top of its WACC estimate). This amounts to an additional c£100m (nominal) in total over AMP8.
  

Southern suggested a novel idea to limit the impact of its proposals on bills: that the CMA consider the use of cash flow levers (PAYG rates and RCV run-off), to delay more of the burden of bill increases into future periods; and that ODI penalties be reallocated it boost the company social tariff so eligible customers “benefit from a meaningful discount, rather than the general customer base receiving a negligible bill reduction”. This would enable a further 11% (17,750 customers) to access the help and cut the number in water poverty by 2029-30 from 6.5% to 4.7% based FD allowed revenue; or from 7.8% to 5.9% based on the SoC request.  

South East Water: unacceptable water security risks