On 27 January 2014, Ofwat published its guidance on risk and reward as part of the price-setting process for 2015-20.

A key part of the guidance is Ofwat’s view of the cost of capital, which determines, in part at least, the level of returns that water companies are able to generate. Ofwat points out that a 0.5% increase in the allowed weighted average cost of capital (WACC) results in an increase to customer bills of approximately £10 per year.

In the business plans submitted by water companies to Ofwat in December 2013, the WACC estimated by each company ranges between 4.1% and 4.9%, with an average of 4.3%.

Ofwat’s view is that this level of WACC is not aligned with the financial markets. Ofwat states, “The risk and reward proposals in company business plans currently provide little

incentive for outperformance and consequently depend on higher WACCs to provide

investors’ returns. This means the proposed balance of risk and reward is not sufficiently aligned with the best interests of customers.”

Within the guidance document, Ofwat assesses the range to be 3.6% to 3.9%, and expects a notional company vanilla WACC to be no higher than 3.85%.

The companies must consider whether they accept Ofwat’s view, and whether their business plan remains financeable on that basis.

On 10 March 2014 Ofwat will notify those companies that have pre-qualified for enhanced status (i.e. the business plan has passed Ofwat’s tests in respect of costs, outcomes, affordability and board assurance), and invite them to adopt the risk and reward guidance. At that point, Ofwat will specify what the additional financial incentives from cost outperformance will be for those companies whose business plan is awarded enhanced status. Such companies will be expected to revise those aspects of their business plan that relate directly to risk and reward, by 17 March. If a pre-qualified company accepts the risk and reward package set out in Ofwat’s guidance and revises its business plan, the plan will receive enhanced status. On 4 April, Ofwat will announce the results of its risk-based review of all companies. This process clearly creates considerable pressure on the companies to accept Ofwat’s guidance.

Credit reference agencies have expressed the view that PR14 will be credit negative for the UK water sector, and in particular for highly leveraged companies.

Ofwat is unsympathetic. It considers that it is a management responsibility for each company to establish and maintain a financial structure that allows the regulated business to maintain an investment-grade credit rating, as required by the licence conditions of most companies’ licences, stating, “We do not expect to change our view on the allowed return unless there is a substantial shift in capital markets or other unexpected events which meant that the risk and reward package needed to change.”

All of which points to the need for companies to be ever more efficient throughout AMP6.