16/03/09
In setting price limits for water companies for the next five years, Ofwat will need to make a judgement on the cost of capital to allow the companies. Recent and continued turbulence in capital markets has made this a particularly challenging task for the regulator.
To assist, Water UK commissioned independent economic consultants NERA to provide an expert assessment of the appropriate level. The findings of their report, published here, were recently presented at the Water UK City Conference on 26 February. This report updates an earlier report produced in June 2008, and is based on data up to the end of December 2008.
NERA's assessment at the present time is that the appropriate range for the industry average cost of capital 4.6 to 5.1, post-tax. This is 0.2% higher than their estimate of a year ago, and reflects the deterioration in credit markets and increase in the cost of debt since then.
Cost of debt
NERA’s estimate of overall cost of debt (3.8%-4.3%) takes account of:
a) the costs companies are likely to face in raising debt now to re-finance existing debt and raise new debt; and
b) the significant volume of debt raised when it was available at very cheap rates and has been locked in by companies for the long term.
In this way, the approach passes on to consumers the benefits of cheaper long term debt raised during the benign market conditions preceding the credit crunch.
Cost of equity
The cost of debt is relatively straightforward to estimate - it can be directly observed in the market, although the persistence of the credit crunch cannot be readily predicted. The cost of equity (or appropriate return to shareholders) on the other has always been harder to estimate.
The task has been made more difficult by distortions and volatility in capital markets that have meant it is no longer possible to rely on traditional ways of estimating the risk free rate* using yields on index-linked government bonds.
NERA's approach has been to refeence the risk free rate estimate to data on interest rate swaps. The results are strongly corroborated by international evidence.
NERA’s overall cost of equity estimate is a range of 7.4-8.2% based on an assumption of 60% gearing. This is broadly similar to Ofwat’s allowed cost of equity at PR04, which is consistent with the fact that the regulatory framework, and hence the riskiness of the industry, has not fundamentally changed over this period.
Judgement and decisions
Nonetheless estimating a cost of capital to fix for the next 5 years for water companies, in the current economic and financial turmoil, remains a matter of judgement.
NERA have provided an estimate of the appropriate range, but it will still be for companies and the regulator to consider where in that range it is appropriate to set the single point estimate required for setting price caps.
The rate must take account of risks to customers of paying higher bills than necessary (if the estimate turns out to be too high); and risks to investors and ultimately market confidence and investment of setting it too low.
In arriving at its conclusions, the regulator will have access to the latest Investor Survey, commissioned by Water UK and carried out by Indepen in December 2008 (and also reported at the City Conference). The survey provides an up-to-date view of how investors see market conditions and the prospects of investing in water.
What happens now
Water companies submit final business plans to Ofwat on 7 April 2009. Each will will make an assessment of the cost of capital appropriate to them. This will take account of their attitudes to risk and the specifics of their own investment history and capital requirements for the next five years.
Ofwat will review these submissions and will announce their draft determinations of price limits at the end of July. This will contain the regulator's first public pronouncement on their view of the cost of capital. It is expected that they will set a single cost of capital for the industry as a whole. Following this, Ofwat publishes Final Determinations in November, including their final assessment of the cost of capital.
The length of time between now and publication of the Final Determinations means much could change. Markets have already changed since the cut-off date for the data on which the NERA report is based. If anything, these changes suggest a worsening of conditions, particularly in terms of equity investors' forward-looking perceptions of risk, as Dr Richard Hern of NERA noted at the City Conference.
Ofwat will need to incorporate an evolving view of the markets and cost of capital, and to that end Water UK will be asking NERA to provide a further update on the cost of capital later in this year.
* Risk free rate - a fundamental parameter from which the cost of equity is built up.
NERA report: Cost of Capital for PR09
January 2009, 208pp
Executive summary 12pp
For more information please contact:
Water UK Communication
020 7344 1809 (out of hours 07833 450544)
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