Developments inthe allowed cost of capital

Moody’s 2017 UK Water Sector Conference

London, UK

Sahar Shamsi, Senior Consultant

17 October 2017

17 October 2017

Overview

The Ofwat PR19 WACC not only matters for the water industry, but has implications for allowed

returns across all UK regulated infrastructure

Given the importance of the WACC, there is a need to balance wider policy considerations

including legitimacy, value for money, investment incentives, operational incentives, and an

appropriate balance of risk and reward within the price control package

2

0 2,000 4,000 6,000 8,000 10,000 12,000 14,000

Dee Valley

Portsmouth

Sutton & East Surrey

South Staffs

Bristol

Affinity water

South East

Wessex

South West

Northumbrian

Southern

Dŵr Cymru

Yorkshire

Anglian

Severn Trent

United Utilities

Thames

RCV at 31 March 2017 in March 2017 prices (£m)

Setting the context

Illustrative scale of impact of reduction in WACC

17 October 2017 3

Total RCV value for

industry: c. £70 billion

Note: Light shading in chart denotes that the undertaking is a WOC 1This is based on the mid-point of the Ofwat/PwC indicative cost of equity range as published in July

2017 (i.e. 4.15%), and a cost of debt assumption based on interpolation of current forward gilt rates by Moody’s (i.e. 1.4%) 2 Using RCV values as at Mar 2017; with

expected growth over PR19, the financial impact will be higher for annual allowed revenues over time.

Source: Ofwat data on RCV values; Moody’s Investors Service (2017), ‘Ofwat signals challenging price review’, 17 July.

Assume an illustrative

decline in the PR19 WACC

(real, vanilla) of around

1.3%, relative to PR141

A 1.3% decline in the WACC

for PR19 would translate to

a reduction in annual

allowed returns of around

£900m across the industry2

Over a 5-year period, the

impact of an illustrative

1.3% reduction in the

WACC, on the industry’s

allowed revenues, is more

than £4.5 billion

Setting the context

The role of PR19 within the UK price control cycle

17 October 2017 4

Source: Oxera analysis and UKRN (2017), ‘Cost of Capital – Annual Update Report’, 31 May.

2018 2019 2020 2021 2022 2023

Ofcom—MCT,

WLA

ORR—PR18

Ofcom—LLCC

Ofwat—PR19

CAA—RP3,

H7 HAL

Ofcom—WBA

and Narrowband

Ofgem—

RIIO-T2 and GD2

Ofcom—WLA

Ofgem—

RIIO-ED2

Note: Figures are approximate; 1 Heathrow; 2 For total services where BT has significant market power.

Source: Oxera analysis based on data from UK regulators, company financial accounts and Office for National Statistics.

Setting the context

Extrapolating impact across UK regulated industries

17 October 2017 5

Airports1 £15bn

Wholesale/waste water £70bn

Gas and electricity transmission £22bn

Electricity distribution £23bn

Gas distribution £18bn

Telecoms2 £11bn

Industry Reduction in annual

allowed returns

£2.1bn

per year

Asset base

£160bnTotal

E

n

e

r

g

y

WACC -1.3%

c. £77 per

household

or

What happens to

cost of capital in the

event of

renationalisation?

80

85

90

95

100

105

110

115

120

Pennon Severn Trent United Utilities National Grid

Setting the context

Impact of Ofwat’s PR19 announcement on share prices

17 October 2017 6

Ofwat PR19

methodology

published

Note: Rebased to 100 on 2 January 2017.

Source: Oxera analysis based on data from Datastream.

Weighted average cost of capital

Focus on the cost of equity

17 October 2017 7

Weighted

average

cost of

capital

Cost of debtCost of equity Cost of equity is not observable and

can only be estimated using asset

pricing models.

Methodological decisions can have a

big impact on allowed cost of equity.

What are the key features of PR19

cost of equity evidence, which

underpin current policy debate?

Ofwat, 2004(7.73)

Ofgem, 2004(7.50)

Postcomm, 2005(6.93)

Ofcom, 2005(6.60)

Ofgem, 2006(7.00)

Ofgem, 2007(7.25) ORR, 2008

(6.75)

CAA, 2008(6.77)

Ofcom, 2009(7.00)

CC, 2009(6.64)

Ofwat, 2009(7.40)

Ofgem, 2009(7.25)

CC, 2010(7.00)

CAA, 2010(7.00)

Ofcom, 2011(6.40)

Ofgem, 2012(7.25)

Ofgem, 2012(7.25)

Ofcom, 2013(6.30)

ORR, 2013(6.75)

CAA, 2014(6.25)

CC, 2014(6.50)

Ofcom, 2014(6.30)

CAA, 2014(6.25)

Ofgem, 2014(6.50)

Ofwat, 2014(6.75)

CMA, 2015(6.50)

Utility Regulator NI, 2016(6.50)

Ofcom, 2016(6.10)

Utility Regulator NI, 2016(6.50)

Ofwat, 2017(5.30)

Utility Regulator NI, 2017(6.50)

01/01/2003 27/09/2005 23/06/2008 20/03/2011 14/12/2013 09/09/2016

0

1

2

3

4

5

6

7

8

9

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Pe

rce

nta

ge

po

ints

To update: update the source data, and then make sure the secondary horizontal axis has the same bounds as the primary one (maximum should be set at YE i.e. 31/12/YY), then make this white if

exporting to consultancy output

UK real equity returns Regulatory precedents on the market return

Cost of equity

Total market returns

17 October 2017 8

Source: Oxera analysis based on various regulatory determinations and historical estimates of real equity returns produced in annual publications of

Credit Suisse Global Investment Returns Yearbook.

Cost of equity

‘Lower for longer’ interest rates

17 October 2017 9

Source: Oxera analysis based on various regulatory determinations and Bank of England data.

Ofwat, 2004(2.91)

Ofgem, 2004(2.75)

Postcomm, 2005(2.50)

Ofcom, 2005(2.10)

Ofgem, 2006(2.50)

Ofgem, 2007(2.50)

ORR, 2008(2.00)

CAA, 2008(2.50)

Ofcom, 2009(2.00)CC, 2009

(2.00)

Ofwat, 2009(2.00)

Ofgem, 2009(2.00)

CC, 2010(2.00)

CAA, 2010(1.75)

Ofcom, 2011(1.40)

Ofgem, 2012(2.00)Ofgem, 2012

(2.00)

Ofcom, 2013(1.30)

ORR, 2013(1.75)

CAA, 2014(0.50)

CC, 2014(1.50)

Ofcom, 2014(1.30)

CAA, 2014(0.75)

Ofgem, 2014(1.50)

Ofwat, 2014(1.25)

CMA, 2015(1.25)

Utility Regulator NI,

2016(1.25)

Ofcom, 2016(1.00)

Utility Regulator NI, 2016(1.25)

Ofwat, 2017(-0.55)

Utility Regulator NI, 2017(1.25)

-4

-3

-2

-1

0

1

2

3

4

5

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Pe

rcen

tage

po

ints

Allowed risk-free rates Yields on 5-year IL gilts Yields on 10-year IL gilts

Yields on 20-year IL gilts 5-year average on 5-year ILGs 10-year average on 5-year ILGs

0.0

0.1

0.2

0.3

0.4

0.5

0.6

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Asse

t b

eta

Pennon Severn Trent United Utilities

Cost of equity

Asset betas for listed UK utilities

17 October 2017 10

Note: Two-year rolling daily asset betas are shown.

Source: Oxera analysis based on data from Bloomberg and Datastream.

PR14 final

determination

0

1

2

3

4

5

6

7

8

9

2010 2011 2012 2013 2014 2015 2016 2017

Yie

lds (

%)

Average of A and BBB iBoxx benchmarks

Cost of debt

Methodology

17 October 2017 11

Cost of embedded debt Cost of new debt

Note: Light shading in chart denotes that the undertaking is a WOC.

Source: Oxera analysis based on annual performance reports for 2016/17 and Datastream.

0% 2% 4% 6% 8%

South WestWessex

United UtilitiesSevern Trent

ThamesNorthumbrian

AnglianSutton & East Surrey

BristolSouthern

Affinity waterDŵr CymruSouth EastPortsmouthDee Valley

YorkshireSouth Staffs

Indicative average nominal interest rates

Winners

and losers

from

industry-

wide

embedded

cost of debt

Cost of debt

Financing duty?

17 October 2017 12

Ofwat’s primary dutiesOfwat’s secondary duties

(among others)

Protect consumer interests

Ensure that companies can finance

their functions

Ensure that companies properly

carry out their functions

Secure long-term resilience

Promote economy and efficiency

Contribute to sustainable development

Have regard to best regulatory practice

Ensure that there is no undue

discrimination

Overall WACC

Risk–return differentials across controls?

17 October 2017 13

Wholesale controls Retail controls

Water Wastewater Household Non-household

Total

revenue

control

Average

revenue

control

Average revenue per

customer control

(+ default tariffs)?

Return on capital Retail margins

Weighted average

revenue control

Unfocused

RCV

allocation

Focused

RCV

allocation

ResourcesNetwork

plusSludge

Network

plus

Source: Adapted from Ofwat (2015), ‘Water 2020: Regulatory framework for wholesale markets and the 2019 price review – explanatory document’, December, p. 164, Figure 29.

This also takes account of the subsequent decisions in Ofwat (2016), ‘Water 2020: our regulatory approach for water and wastewater services in England and Wales’ (decision

document), May, and the latest information provided in Ofwat (2017), ‘Delivering Water 2020: Consulting on our methodology for the 2019 price review’, July.

Total

revenue

control

Total

revenue

control

Retail margins

+ adjustment

mechanism

TOTEX Retail costsPAYG + non-PAYG + adjustments ?

Under review

?

Overall WACC

Balance of risk and reward

17 October 2017 14

2. Stylised outperformance

Efficiency

Innovation

Financial

ODIs, SIM

1. Headroom for uncertainty

To what extent would the reduction in the scope for financial outperformance

be compensated elsewhere in the price control?

WACC

Efficiency

Innovation

Financial

ODIs,

WaterworCX

Policy design

Trade-off: windfall gains/losses vs high-powered incentives

17 October 2017 15

Spectrum of possible regulatory response to

concerns regarding outperformance

Move towards greater cost

pass-through mechanisms

(e.g. true-ups and more

indexation) to reduce

outperformance and

windfall gains (or losses)

Higher-powered

incentives to reward

only the top-performing

networks could also

reduce outperformance

Less reliance on

incentives?

More reliance on

incentives?

Cost

pass-through

High-powered

incentives

Contact:Sahar Shamsi, CFA+44 (0) 20 7776 6624sahar.shamsi@oxera.com

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