A bridge over troubled water: how do we pay for it?

• The UK water sector faces a sustained period of unprecedented expenditure to improve performance and address underinvestment of the past.  
• Ultimately, customers will pay – but there will be a continuous and significant demand for new equity across the sector, to provide the upfront capital.  
• This marks an important shift. Previously water companies were cash generative. From here – for the foreseeable future – they will not be. 
• This will have many consequences. Some investors may look to exit if the sector no longer fits their desired profile. Also, decision makers will change – the ongoing call for new equity will shift the balance between operating and holding company boards. 
• For Ofwat, signals from capital markets are growing in importance. At present market valuations suggest a weaker investment proposition than has been on offer in the past. Can a one size fits all approach to regulation attract the finance that is needed across the sector? 

Plan to spend 

Earlier this month, the seventeen English and Welsh water companies published their PR24 business plans. These set out what each company proposes to spend and deliver from 2025 to 2030. Ofwat will spend the next seven months assessing the plans. It will then publish its draft determinations in mid-2024 and final determinations in December.  

So far, so normal. But one does not have to look hard at the plans to realise that this time is very different. After over a decade of flat or declining prices, companies are all proposing price increases. On current plans, average bills will be around 20-30% higher than in the current regulatory period. 

Even more striking is the amount companies are proposing to spend. In PR19, Ofwat allowed the companies £59bn. In PR24, the companies are asking for £96bn. If the companies get what they are asking for, their collective Regulatory Capital Value (RCV) will on average grow by 6% per annum in real terms. 

The plans land at challenging time for water companies, regulators and the government. Rarely has a sector been more consistently lambasted by the media, politicians, and consumer groups. Noisy argument around cause, responsibility and solutions is set to continue.  

Through the noise however, informed observers will recognise the basic proposition that a massive boost to investment is necessary, and that while investors may provide the finance, the bill must ultimately be picked up by UK water customers. 

The question for Ofwat is how to make that happen. 

The regulatory economic model 

Investment in water is underpinned by a regulatory commitment. Private investors put money in, and the regulator promises that customers will pay them back over the functional life of the assets – often many decades. 

Within their annual bills, customers pay for “wear and tear” of the assets. They should also pay a fair return on the original investments, reflecting the risks borne by investors. In the regulatory vernacular the RCV reflects the outstanding value of investments made, and the Weighted Average Cost of Capital (WACC) reflects the regulator’s assessment of the fair return. 

We often see claims that this system of private investment, financed at a risk adjusted rate of return (the WACC) can be abolished and replaced by something that promises cheaper capital and lower risk. These claims should be viewed with caution and can be a distraction. They typically reflect sleight of hand, with risks being shuffled around the system (often onto government, and hence the taxpayer) in a way that has no overriding benefit. Worse, the accompanying regulatory changes may add to future risk rather than reduce it. 

In our view, this means that the RCV/WACC mechanism – or something equivalent – will remain, with investment capital, risks and allowed returns consistently aligned. There may be different flavours: the UK tends to favour incentive regulation where companies bear performance risk in exchange for potentially higher returns; the US has traditionally adopted a rate of return model where more of the risks are borne by consumers. But the basic model is likely to persist. 

From cash generation to cash consumption 

This is not to say that the system is stable across all fronts. PR24 marks a significant shift of the investment proposition in UK water. A previously cash generative sector will now become a cash consumptive one: 

• Until now, investment levels have generally been financeable from operational cash flows. Ofwat’s WACC and allowances for depreciation of old assets have more than covered needs. Under these conditions, companies have been able to flex dividends up or down to leave sufficient cash to cover expenditure on new or replacement assets.  
• From now, as a general rule¹, the equivalent operational cash flows will no longer be sufficient. For the foreseeable future – investors will be expected to open their collective wallets and stump up sizeable amounts of new money for infrastructure investment – and a swiftly growing industry RCV. 
• Customers’ bills will go up to reflect this investment, in due course. But in the near term the new cash must come from investors. 

Whose Board is it anyway? 

In theory, this “flip” into cash consumptive territory should make little difference to investment decisions, which in the corporate finance textbook are based on cash flow forecasts and technical analysis (of, for example, risk). 

The new reality will be different. The ultimate decisions on capital programmes and investments – previously made in company boardrooms where shareholders have at Ofwat’s insistence become a minority voice – will move more firmly into the domain of equity holders who also now face a longer wait for a cash return on their investment. These are two important changes: the RCV/WACC model is becoming back-end loaded and the balance of power among decision makers is shifting.  

As a consequence, we expect a renewed focus on the robustness of the RCV/WACC mechanics and incentives. If equity investors believe that the regulatory model provides for a fair (or better) expected return on investment, and are confident in its eventual cash crystallisation, then they will continue to invest. If not, there is risk that they will wish to avoid or minimise further financial commitment. In some cases, the changed dynamics may prompt a shift in the composition of the investor base.  

Lessons from the capital markets 

Debt and equity markets can provide useful information on how well the regulatory regime is working – a clue as to whether investors are getting a good overall deal.  

The information is easier to find for the quoted companies – Severn Trent, United Utilities and Pennon in the water sector – for whom market values of equity can be directly observed. Market value of debt is less easy to track but can still be observed and interpreted. 

A frequently referenced metric is the “Market to Asset Ratio” (MAR²) which is the market value of the business (the sum of both equity and debt) divided by the RCV. For an economic regulator, MARs can provide a valuable indicator of market perceptions about the regulatory regime. 

If the MAR is above 1, then the value of the business in the eyes of investors is bigger than the RCV. Put another way, the market places a higher value on investments than amounts spent by investors. 

This might be extrapolated by investors to suggest that a change in market value of the business resulting from a new (Ofwat supported) investment will justify the associated new equity injection. If so, all is good – for investors, and for investment, with customers getting what they need. The concern for a regulator is that if MARs are too far above 1, there is a risk that customers are overpaying. 

On the other hand, if the MAR is below 1, then investors may keep their cheque books in their pockets, for now at least. The sector will suffer from under-investment to the detriment of consumers. 

Unhelpfully, the capital markets are unstable. A MAR of more than 1 today may turn into a MAR of less than 1 tomorrow, and vice versa. This means that if MARs are above 1 but only by a small margin, investors may be reluctant to commit funds or face distorted choices³. 

Problems also arise if MARs are above 1 for some companies but (estimated as) below 1 for others. Investment in higher performers may make sense, while equity holders in poorer performers may wish to hold fire on new capital – despite it being in the interests of customers. 

This is the simple view. In practice, investment incentives should depend on the marginal return of a specific project whereas MARs are an indicator of average returns.  

Until recently, MAR values for quoted water companies have generally held above 1. The chart shows the available data for the quoted companies based on snapshot values for the closing month of each financial year. Values derive from book value of debt – as reported by the companies.

As the chart shows, MARs have declined sharply over the last eighteen months – even for acknowledged strong performers – and they are close to 1 for all three listed companies. The true picture is probably worse. We estimate that using market values of debt would further reduce today’s MARs by as much as 5%. 

The reasons for declining market values may appear obvious, but their consequences may be unhelpful. What should investors make of this information? 

Is there a “right” level for MARs?  

The suggestion that MARs should be equal to 1 skates on thin theoretical ice. A pragmatic regulator would more likely accept that MARs should consistently sit above 1. This kind of reasoning would, for example, link to the CMA’s PR19 re-determinations, which “aimed up” on the cost of capital. 

Such a position involves a trade-off between price implications for customers and many other factors, for example:  

• An evaluation of consumer harms associated with over- or under-investment. 
• An understanding of the consequences for investor behaviour and choices. 

• Consideration of capital market volatility, and how this may create “in flight” uncertainty. 
• Evaluation of incentives and behaviours across companies, including underperformers. 

These issues are complex and are compounded by estimation and interpretation challenges. Equity market values are only directly available for three companies and estimating equity values for non-listed companies is either non-trivial or not possible. A proper assessment should use the market value of debt but this is not always easily observed, and swaps or derivatives can complicate matters.  

Because of these challenges and complexities, regulators have generally adopted a light touch approach, using MARs only as a “cross check” of whether their assessment of the WACC is sensible. With the increased need for new equity across the sector, we think MARs deserve greater attention. 

The implications for Ofwat 

We know that Ofwat is thinking more about MARs and their implications. Notwithstanding the measurement challenges, we have a strong sense that there is both a wide spread of MARs across the sector and that for many companies MARs may well be close to if not below 1. That is a serious and profound conclusion. If it is indeed the case, Ofwat seems to have two broad choices. 

Simplistically, it could adopt generic measures to increase investment incentives across the sector. It would be possible to boost investment incentives by aiming up on the WACC, or by easing generic performance targets. While straightforward, this may be taken to represent a softening of the overall regulatory regime at customer’s expense – challenging for the regulator. 

Alternatively, Ofwat could move away from the “one size fits all” approach that has characterised recent changes to regulation of the sector. By recognising the very wide range of actual and prospective performance across companies, investment incentives might be maintained through targeted measures. 

Failure to take one or other of these approaches presents a serious problem for less well performing companies. If the conditions are not right, investors will not put money in, and those companies may fail. The latter approach seems more proportionate and effective. 

That does not mean that the right approach is to move away from the RCV / WACC model. Rather it means that the regulatory model needs to take greater account of each company’s starting position. If comparative regulation is to survive, it needs to adapt. 

This blog was written by partner Mark Caines and specialist partner Craig Lonie. Mark leads our competition and regulatory team and works across a broad range of sectors, including infrastructure, tech and media. Craig draws on over three decades of experience in the utility infrastructure, communications and media sectors. For more information on the topics discussed in this blog, contact us.