Developments in the allowed cost of capital

Transcription

1 Developments in the allowed cost of capital Moody s 2017 UK Water Sector Conference London, UK Sahar Shamsi, Senior Consultant 17 October 2017

2 Overview The Ofwat PR19 WACC not only matters for the water industry, but has implications for allowed returns across all UK regulated infrastructure Given the importance of the WACC, there is a need to balance wider policy considerations including legitimacy, value for money, investment incentives, operational incentives, and an appropriate balance of risk and reward within the price control package 17 October

3 Setting the context Illustrative scale of impact of reduction in WACC Thames United Utilities Severn Trent Anglian Yorkshire Dŵr Cymru Southern Northumbrian South West Wessex South East Affinity water Bristol South Staffs Sutton & East Surrey Portsmouth Dee Valley Total RCV value for industry: c. 70 billion Assume an illustrative decline in the PR19 WACC (real, vanilla) of around 1.3%, relative to PR14 1 A 1.3% decline in the WACC for PR19 would translate to a reduction in annual allowed returns of around 900m across the industry 2 Over a 5-year period, the impact of an illustrative 1.3% reduction in the WACC, on the industry s allowed revenues, is more than 4.5 billion 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 RCV at 31 March 2017 in March 2017 prices ( m) Note: Light shading in chart denotes that the undertaking is a WOC 1 This is based on the mid-point of the Ofwat/PwC indicative cost of equity range as published in July 2017 (i.e. 4.15%), and a cost of debt assumption based on interpolation of current forward gilt rates by Moody s (i.e. 1.4%) 2 Using RCV values as at Mar 2017; with expected growth over PR19, the financial impact will be higher for annual allowed revenues over time. Source: Ofwat data on RCV values; Moody s Investors Service (2017), Ofwat signals challenging price review, 17 July. 17 October

4 Setting the context The role of PR19 within the UK price control cycle Ofcom MCT, WLA ORR PR18 Ofcom LLCC Ofwat PR19 CAA RP3, H7 HAL Ofgem RIIO-T2 and GD2 Ofcom WLA Ofgem RIIO-ED2 Ofcom WBA and Narrowband Source: Oxera analysis and UKRN (2017), Cost of Capital Annual Update Report, 31 May. 17 October

5 Setting the context Extrapolating impact across UK regulated industries E n e r g y Industry Asset base Wholesale/waste water 70bn Gas and electricity transmission 22bn Electricity distribution 23bn Gas distribution 18bn Reduction in annual allowed returns 2.1bn per year or c. 77 per household Airports 1 Telecoms 2 Total 15bn 11bn 160bn WACC -1.3% What happens to cost of capital in the event of renationalisation? Note: Figures are approximate; 1 Heathrow; 2 For total services where BT has significant market power. Source: Oxera analysis based on data from UK regulators, company financial accounts and Office for National Statistics. 17 October

6 Setting the context Impact of Ofwat s PR19 announcement on share prices Ofwat PR19 methodology published Note: Rebased to 100 on 2 January Source: Oxera analysis based on data from Datastream. Pennon Severn Trent United Utilities National Grid 17 October

7 Weighted average cost of capital Focus on the cost of equity Weighted average cost of capital Cost of equity Cost of equity is not observable and can only be estimated using asset pricing models. Methodological decisions can have a big impact on allowed cost of equity. What are the key features of PR19 cost of equity evidence, which underpin current policy debate? Cost of debt 17 October

8 Percentage points Cost of equity Total market returns 01/01/ /09/ /06/ /03/ /12/ /09/2016 Ofgem, 2012 CC, (7.25) (6.50) To update: update the source data, and then make sure the secondary horizontal axis has the same bounds as the primary one (maximum should be set at YE i.e. 31/12/YY), then make this white if exporting to consultancy output Ofwat, 2004 (7.73) Postcomm, 2005 (6.93) Ofgem, 2004 (7.50) Ofcom, 2005 (6.60) Ofgem, 2007 Ofgem, 2006 (7.00) (7.25) ORR, 2008 (6.75) CAA, 2008 (6.77) Ofcom, 2009 (7.00) CC, 2010 CC, 2009 (7.00) (6.64) ORR, 2013 Ofwat, 2009 (6.75) (7.40) Ofgem, 2012 Ofgem, 2009 (7.25) (7.25) CAA, 2010 (7.00) Ofcom, 2011 (6.40) Ofcom, 2013 (6.30) Utility Regulator NI, 2016 (6.50) Ofcom, 2014 (6.30) Utility Regulator NI, 2016 (6.50) Utility Regulator NI, 2017 (6.50) Ofcom, 2016 (6.10) 5 4 CAA, 2014 (6.25) CMA, 2015 (6.50) Ofwat, 2017 (5.30) 3 CAA, 2014 (6.25) Ofgem, 2014 (6.50) Ofwat, 2014 (6.75) UK real equity returns Regulatory precedents on the market return Source: Oxera analysis based on various regulatory determinations and historical estimates of real equity returns produced in annual publications of Credit Suisse Global Investment Returns Yearbook. 17 October

9 Percentage points Cost of equity Lower for longer interest rates Ofgem, 2006 (2.50) Ofwat, 2004 (2.91) Postcomm, 2005 (2.50) Ofgem, 2004 (2.75) Ofcom, 2005 (2.10) Ofgem, 2007 (2.50) CAA, 2008 (2.50) ORR, 2008 (2.00) Ofgem, 2012 (2.00) CC, 2009 (2.00) Ofcom, 2009 (2.00) Ofgem, 2012 (2.00) Ofgem, 2009 (2.00) Ofwat, 2009 (2.00) ORR, 2013 (1.75) CAA, 2010 (1.75) Ofcom, 2011 (1.40) Ofcom, 2013 (1.30) Ofcom, 2014 (1.30) CC, 2014 (1.50) Ofgem, 2014 (1.50) CMA, 2015 (1.25) Utility Regulator NI, 2016 (1.25) Utility Regulator NI, 2016 (1.25) Ofcom, 2016 (1.00) Utility Regulator NI, 2017 (1.25) CC, 2010 (2.00) CAA, 2014 (0.50) CAA, 2014 (0.75) Ofwat, 2014 (1.25) Allowed risk-free rates Yields on 5-year IL gilts Yields on 10-year IL gilts Yields on 20-year IL gilts 5-year average on 5-year ILGs 10-year average on 5-year ILGs Ofwat, 2017 (-0.55) Source: Oxera analysis based on various regulatory determinations and Bank of England data. 17 October

10 Asset beta Cost of equity Asset betas for listed UK utilities PR14 final determination Pennon Severn Trent United Utilities Note: Two-year rolling daily asset betas are shown. Source: Oxera analysis based on data from Bloomberg and Datastream. 17 October

11 Yields (%) Cost of debt Methodology Cost of embedded debt South Staffs Yorkshire Dee Valley Portsmouth South East Dŵr Cymru Affinity water Southern Bristol Sutton & East Surrey Anglian Northumbrian Thames Severn Trent United Utilities Wessex South West Indicative average nominal interest rates Winners and losers from industrywide embedded cost of debt 0% 2% 4% 6% 8% Note: Light shading in chart denotes that the undertaking is a WOC. Source: Oxera analysis based on annual performance reports for 2016/17 and Datastream. Cost of new debt Average of A and BBB iboxx benchmarks October

12 Cost of debt Financing duty? Ofwat s primary duties Ofwat s secondary duties (among others) Protect consumer interests Promote economy and efficiency Ensure that companies properly carry out their functions Ensure that companies can finance their functions Secure long-term resilience Contribute to sustainable development Have regard to best regulatory practice Ensure that there is no undue discrimination 17 October

13 Overall WACC Risk return differentials across controls? TOTEX Retail costs PAYG + non-payg + adjustments? Wholesale controls Retail controls Water Wastewater Household Non-household Unfocused RCV allocation Resources Network plus Focused RCV allocation Sludge Network plus Under review? Total revenue control Total revenue control Average revenue control Total revenue control Weighted average revenue control Average revenue per customer control (+ default tariffs)? + adjustment mechanism Return on capital Retail margins Retail margins Source: Adapted from Ofwat (2015), Water 2020: Regulatory framework for wholesale markets and the 2019 price review explanatory document, December, p. 164, Figure 29. This also takes account of the subsequent decisions in Ofwat (2016), Water 2020: our regulatory approach for water and wastewater services in England and Wales (decision document), May, and the latest information provided in Ofwat (2017), Delivering Water 2020: Consulting on our methodology for the 2019 price review, July. 17 October

14 Overall WACC Balance of risk and reward 1. Headroom for uncertainty 2. Stylised outperformance WACC Efficiency Innovation ODIs, SIM Efficiency Innovation ODIs, WaterworCX Financial Financial To what extent would the reduction in the scope for financial outperformance be compensated elsewhere in the price control? 17 October

15 Policy design Trade-off: windfall gains/losses vs high-powered incentives Less reliance on incentives? More reliance on incentives? Cost pass-through Spectrum of possible regulatory response to concerns regarding outperformance High-powered incentives Move towards greater cost pass-through mechanisms (e.g. true-ups and more indexation) to reduce outperformance and windfall gains (or losses) Higher-powered incentives to reward only the top-performing networks could also reduce outperformance 17 October

16 Contact: Sahar Shamsi, CFA +44 (0) Follow us on Oxera Consulting LLP is a limited liability partnership registered in England and Wales No. OC392464, registered office: Park Central, 40/41 Park End Street, Oxford, OX1 1JD, UK. The Brussels office, trading as Oxera Brussels, is registered in Belgium, SETR Oxera Consulting LLP , registered office: Avenue Louise 81, Box 11, 1050 Brussels, Belgium. Oxera Consulting GmbH is registered in Germany, no. HRB B (Local Court of Charlottenburg), registered office: Rahel-Hirsch-Straße 10, Berlin 10557, Germany. Although every effort has been made to ensure the accuracy of the material and the integrity of the analysis presented herein, Oxera accepts no liability for any actions taken on the basis of its contents. No Oxera entity is either authorised or regulated by the Financial Conduct Authority or the Prudential Regulation Authority. Anyone considering a specific investment should consult their own broker or other investment adviser. Oxera accepts no liability for any specific investment decision, which must be at the investor s own risk. Oxera, All rights reserved. Except for the quotation of short passages for the purposes of criticism or review, no part may be used or reproduced without permission.