Ofwat’s Risk and Reward Guidance – Gambling on Innovation

Economic and Financial Consulting

March 4, 2014

On 27 January Ofwat published its much anticipated ‘risk and reward guidance’, laying out its views on cost of capital (WACC), retail margins and the package of rewards and penalties English & Welsh water companies face for under or out-performing their price controls. With Ofwat’s announcement of which companies have pre-qualified for ‘enhanced’ status just days away, companies and investors will be weighing up the merits of Ofwat’s guidance. However, the headline WACC of 3.85% (real, vanilla) announced by Ofwat implies a rate of return that the sector’s investors will presumably not be happy with (given the difference between business plans and Ofwat’s guidance), suggesting the industry will be considering a combination of:

  • Is there a case for a higher WACC?
  • Are there other ways to enhance returns over and above the allowed WACC? and/or
  • Is now the right time to start preparing to appeal to the Competition and Markets Authority (CMA)?

Is there a case for a higher WACC?

On the face of it, a WACC lower than any company in the industry proposed – and significantly below what most included in business plans – must surely be open to challenge. But on what grounds? And what are the chances of success?

Ofwat argues that the Competition Commission’s (CC’s) Provisional Findings for Northern Ireland Electricity (and related cost of capital decisions and consultations from CAA and Ofgem) only served to reinforce their own internal views, so the battle would appear to be to convince Ofwat that its analysis isn’t appropriate (rather than to tackle the CC’s proposals, a topic which hundreds of pages have already been devoted to). However, Ofwat’s analysis appears to be in line with other recent regulatory pronouncements and some analysts have suggested the guidance is “reasonable”, though all of Moody’s, Fitch and S&P have noted the guidance would put negative pressure on credit ratings (with Fitch going further and placing the industry on negative outlook).


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