• Richard

GOOD NEWS for Customers! Ofwat’s Final Determinations PR19 Price Review

Ofwat, the economic regulator for England and Wales, reporting a planned £50 fall in bills, before inflation ($80). ‘This can be achieved as a result of our £6 billion efficiency challenge and lower financing costs, with the lowest allowed return on capital since privatization 30 years ago.’ Of course, depending upon inflation, customers might not actually see any of that reduction in bills – but at least index linked tariffs (though linked to a likely reduced inflation indicator from now on) support service providers when politicians resist the need for cost-reflective tariffs.

For an international perspective, a simple analysis of the reported prices for 2020 indicate an average cost of water of $2/m3 and an average cost of wastewater collection and 'bioresources' of $2.9, call it $3/m3. So, $5/m3 water and wastewater all in – remembering that in England & Wales this also pays for a significant proportion of surface water and highway drainage. I normally ‘quote’ an average cost-reflective tariff globally of $1/m3 for water, $1/m3 for sewered sanitation – this taking into account (in a guesstimate sort of way) the effects of ‘Purchasing Power Parity’. Perhaps I need to adjust it.

Back to the Price Review Final Determinations – it is fantastic news after all the work done in Consumer Council for Water in earlier Price Reviews (often with frustratingly limited effect). Because a large part of the reduction is due to the WACC (‘Weighted Average Cost of Capital’) being reduced significantly again; it makes such a difference to customer’s bills when there is an RCV (Regulatory Capital Value) of £75 billion ($100billion) or so. The WACC is now being quoted as 2.96% ‘vanilla’ ‘for the whole business’, this being in REAL terms, that is after (projected) inflation being accounted for. ‘Vanilla’ refers to the weighted average of the pre-tax cost of debt and the post-tax cost of equity. ‘This is the WACC typically referred to by Ofwat and is used because interest costs are paid before tax and returns on equity are paid after tax has been deducted' (ECA, 2014).

So the WACC Vanilla Real has come down from a way too high 5.83% real in the 2004 Price Review to a still overly high 2009 5.08% even in the midst of dramatically declining interest rates following the 2008 financial crash to a surprisingly good (to this stakeholder anyway) 3.74% in PR14 and now to 2.96% in PR19. Though thanks to a GWI explanation that is actually 1.9% in ‘old money’, that is using the RPI version of inflation to get to the real allowed rate of return rather than the CPIH measure which Ofwat is beginning to introduce during AMP 7 (that is the period of the 7th Asset Management Plan, each five years long). So in trying to understand what could be called ‘the allowable profit margin’ one has to understand not just the return on capital employed (and how you measure that capital employed in real terms) but also along with the WACC, the CAPM (Capital Asset Pricing Method), the ‘risk free rate’, the equity premium, the Beta factor for variation in profitability and risk between average businesses and utilities, the ‘tax wedge’, ‘vanilla’ and now the new measure of inflation to be used, CPIH. Good luck with that to any consumer representatives!

Along with this, something else CCWater tried to point out was that with Ofwat basing its figures on a notional 60% gearing some companies could (and did!) ‘leverage up’ to much higher (and cheaper to finance) debt levels, increasing the risk of failure and doing nothing for customers. So very pleased to see Ofwat saying: ‘We have introduced a gearing outperformance mechanism, which could mean companies sharing up to £210 million of financial benefits from gearing with customers in 2020-25.’

And making a rough and ready attempt to understand the ongoing CapEx (WASH is such a ‘capital intensive’ sector) my graph below shows that capital expenditure for capital maintenance* and for capital enhancement works (improvements over and above the base ongoing service levels) has increased again, all in real terms, to around $7.5 billion annually. Which is approximately $125 per person served CapEx and CapManEx ANNUALLY – which can be contrasted with the estimates for one-off investments to serve urban dwellers in low-income countries.

* Ofwat does not report directly on Capital Maintenance Expenditure as in the past, now that companies have to bid for ‘TOTEX’ based on ‘BOTEX’ and ‘Enhancement’, this to discourage capital intensive solutions (smart metering anyone?) which simply increase overall costs (WACC on the higher RCV) rather than optimising efficiency.

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