Blog: Cost of capital – striking the right balance for consumers

Over-generous or value for money? Steve Hobbs, our Senior Policy Manager for Regulation, explains why Ofwat’s assumptions on how water companies are financed should be a concern for customers.

CCWater has always called for the views and expectations of customers to be at the heart of the price-setting process in the water industry. So far in the 2019 Price Review we have seen water companies rising to the challenge to engage more effectively with customers to develop their business plans for 2020 to 2025. This process should deliver outcomes that provide the service customers expect at a price they both accept and can afford.

But one of the biggest building blocks in Ofwat’s five-year price settlement for water companies has a considerable impact on customers’ bills – the assumption the industry regulator makes on the cost water companies will incur in raising capital financing to fund investment in assets like pipelines and treatment works.

Ofwat’s cost of capital assumption carries with it great implications for customers and is a potential source of controversy.

Why is it so important for customers?

It’s a bit like taking out a mortgage to buy a house. Water companies rely on raising equity finance from shareholders and borrowing from lenders to build the assets that are essential for delivering the resilient and reliable water and wastewater services customers expect. Water companies raise capital finance and repay it over many years.

Within its five yearly price determinations, Ofwat makes an allowance for investors to make a return on their capital investment. As water is such a capital intensive sector, these returns can take up as much as a third of the average customer’s water bill. That’s why Ofwat’s assumption of the cost of capital is so important for customers.

Which brings us on to why Ofwat’s assumption of the cost of capital may also be controversial.

When it makes its assumption of what companies need to finance their investments, Ofwat has to balance two conflicting interests. Firstly, the water sector needs to be attractive to investors and lenders to raise finance. Secondly, Ofwat should ensure that customers’ bills reflect efficient costs and give value for money.

In the past, Ofwat has overestimated this cost at customers’ expense, arguably failing to deliver the value for money customers expect.

Since the water industry was privatised in 1989, water companies listed on the financial markets have generated returns for their investors that have been significantly higher then the average rate of return on the FTSE share index.

This has been seen most starkly between 2010 and 2015 when water companies were able to make windfall gains of around £1.2 billion by raising capital finance cheaper than Ofwat assumed when setting prices in 2009 – money that customers have effectively overpaid in their bills.

Since 2015, Ofwat has been criticised by CCWater, the National Audit Office and the Parliamentary Public Accounts Committee for its over-generosity to the industry. While Ofwat had a lower cost of capital assumption when prices were last set in 2014, water companies’ financial performance since 2015 shows they are still raising finance at a cost lower than their regulator assumed.

In December Ofwat will publish its assumption of the cost of capital for 2020 t0 25. We have called consistently for the regulator to ensure it avoids the level of over-generosity seen in the past.

While greater customer influence in the price-setting process could increase public trust and legitimacy in the sector, this progress could be undermined if customers once again see water companies making large returns at customers’ expense.

We will see in December how far Ofwat will go to meet this key challenge – and we’ll be working to influence the regulator to help it make the right decision for customers.

Categories: Blog, Price Review