Imrecon

What profit should be allowed for in a price cap?  It is always an important question for a price review - very material[1] and symbolically significant.  Because most of us know what it is like to have a mortgage, we have an innate understanding of the cost of capital.  We also have a sense of the justice of it - if it is set too high, investors will get undeserved gains at the expense of consumers; if it is too low, they will suffer undeserved losses and important investment may not happen.  It is politically potent.

As a subject, it keeps adding layers of insight, shifting shape as we individually deepen our experience with it and with each cycle of periodic reviews, academic research and economic developments.  The agenda continues to evolve, and a key theme of the current phase of evolution is an increased focus on risk analysis as data from the stock markets dry up with so few listed regulated businesses left. 

This phase could prove particularly fertile, increasing regulators' understanding of risk, allowing better policy development and revealing discrepancies in the allowances across the sectors.

In this piece we look at the one sector where there remains a body of listed companies, water, as Ofwat's draft determinations were published on 23 July.   We consider the Modigliani & Miller insight in the context of the privatisation discount for water in 1989.  This suggests that, though the headline rate of return allowed for by Ofwat in PR09 is lower than it has ever been, in real terms the underlying level of allowance for risk may be at an all time high. 

The issues that arise suggest that, in this sector endowed with market data, the need for more bottom-up risk analysis still looks compelling. 

The new need for bottom-up risk analysis

Even in these turbulent times for the debt markets, the main risk component is about equity investors, about the Capital Asset Pricing Model (CAPM) and, conventionally, about beta[2].

Europe Economics, in its 21 July 2009 report to Ofwat[3], stated that:

"The starting point in thinking about the effect of gearing is the Modigliani-Miller insight . . . that the riskiness of a company depends on the riskiness of its real cash-flows - volatility in the costs and in the demand for its products."

I would go further to say that this is the starting point in thinking about the cost of capital: the driver of the cost of capital is the riskiness of a business's real cash-flows.  Equity markets implicitly consider that risk, because of its impact on future dividends, and it is reflected in share prices.  Regulators also implicitly consider that risk, because of its impact on the cost of capital, reflected in the price cap.

Markets can therefore inform the regulator; and the regulator could equally inform the markets.  The regulator is in a good position to gain insights into the risk issues and into how the regulatory processes impact on risk.  Understanding risk is arguably integral to understanding the impact of an incentive regime.

Sadly, perhaps, the flow of information on beta has been mainly from the markets to the regulators: the beta statistics in share prices have been a principal source of information for regulatory judgements.  While those statistics are available, regulators have not had to carry out their own bottom-up, qualitative or quantitative analysis of the risk issues. 

However, this is now changing as the population of UK businesses subject to economic regulation that are listed on a stock exchange has dwindled from 26 in 1995 to five[4].  Four of those are in water.

Outside water, as the evidence on beta degrades, regulators have to turn to bottom-up analysis.  The CAA did it to determine the relative betas for the three London airports and Ofgem to inform its gas distribution review and, currently, its electricity distribution review.  (ORR has also performed some bottom-up analysis for Network Rail's cost of capital, though its application to equity risk for a business with no equity is problematic.)  I would argue risk analysis is especially important for sparsely capitalised businesses such as Royal Mail and NATS.

Ofwat hasn't had to do it.  It published its draft water determinations on 23 July 2009.  Its proposed allowance for the cost of capital gives a useful insight into why bottom-up analysis might be useful.

PR09 - a tough one?

Ofwat's draft determinations provide for a post-tax 4.5% return on the Regulatory Capital Value (RCV).  This compares with returns of 5.1% in PR04[5] and 4.75% in PR99.  Going back even further, PR94 provided for a ‘glide-path' of returns from their giddy heights of 1992/93.

On the surface, the main reason for a lower assessment in PR09 is a risk free rate assumption of 2%, down from the 2.5% to 3.0% assumed in both PR99 and PR04, but whatever the reason, the assessment is lower than it has ever been.

The following chart illustrates these assessments (on a ‘vanilla' basis[6]). 

The scale of the ‘glide-path' allowance in PR04 (and the rates of return immediately post-privatisation) shown in the chart remind us of how much the world seemed to change in PR99.  The toughness of that review arguably propelled the industry into a damaging phase of lost investor confidence, low market values, increased gearing, de-listings and mutualisations, creating new risks for incentive regulation and water customers.

They were great returns, but on so little capital

Water is almost unique[7] in being privatised on a massive discount to replacement cost value.  The initial RCV was based on market values in the first 200 days after the 1989 privatisation and totalled some £12.5 billion in 2009 price terms.  The modern equivalent asset value of the assets employed by the sector at that time was £218 billion (also in 2009 price terms).  The industry was sold at a 94% discount, but Ofwat's regulation makes sure the benefit accrues entirely to customers.

In those early days, investors had paid a small stake for a very big sector but were exposed to all of the risks.

The following chart illustrates the small stake, and also shows how the RCV has grown with new investment - investors still have a small stake, it is just not quite as small as it was (the RCV has grown from 6% to about 20%).

Because the rates of return are computed on (and applied to) the RCV, the actual level of profits represented by those returns are somewhat tilted by the growth in that RCV. 

The level of profits in the first ten years still look high, but it isn't the absolute level of profits that really matter, it is the level of allowance for risk in relation to the quantum of systematic risk exposure.

A stealthy dynamic

To consider the quantum of systematic risk exposure, remember the quote from Europe Economics' report to Ofwat: "the riskiness of a company depends on the riskiness of its real cash-flows - volatility in the costs and in the demand for its products."

The report went on to say:

"The implication is that where there are no taxes, incentive or information problems, the way a project or firm is financed does not affect its value or its cost of capital - the market value of any firm is independent of its capital structure. This is because the overall risk on the company's asset base, the asset beta, does not change with the capital structure of the firm (i.e. the chosen combination of equity and debt)."

In essence, the Modigliani & Miller insight is that the profit required to compensate for risk is not affected by the size of the equity stake. Except in financial distress (and thus ignoring any debt beta), all of the risk attaches to equity.  The quantum of risk is not affected by changing the capital structure.  Likewise, the quantum of risk should not be affected by the level of privatisation discount[8].

My starting point for analysis is that, other things being equal, the level of risk in a business is likely to be related to the underlying size of the business, not affected by an arbitrary and artificial factor such as the privatisation discount.  It would therefore seem appropriate to relate risk allowances to fundamental measures of business size.  Two readily available examples are MEA values and levels of opex. 

The next chart shows those relationships.

The chart suggests that the underlying allowance for risk has been progressively increasing.  It is still not at the heady levels before PR99, but it is getting closer.

What about the markets?

What are the markets saying?  Surely, an all-seeing efficient equity market would tell us what's really going on.

So, the next chart shows two views of the market's assessment, the asset beta.  The RCV-based asset beta on the left is my estimated central line from a chart on page 31 of NERA's June 2008 report for Water UK.  The MEA-based asset beta on the right is computed from it.

The left hand chart looks like a rather variable RCV beta statistic between 0.2 and 0.5 that gives an uncertain picture but plausibly evidencing NERA's estimate of 0.35 to 0.45[9].

The right hand chart gives a different kind of picture.  It suggests a rather more stable MEA beta statistic between 0.04 and 0.06 until about 2004, followed by a relatively rapid doubling during the course of the current control period to nearly 0.1.  It looks less like a variable statistic around a mean and more like something dynamic.

This raises lots of questions:

• Has the underlying level of risk really doubled in recent years, and why?
• Or is it just that the market's perception of risk has doubled, in which case why and what is the real level of underlying risk?
• Or does it tell us that the market evidence is somewhat haphazard and really the market tells us very little?

It would be revealing to understanding what, if anything, lies behind the kick-up in the MEA beta since 2004 and, in particular, the fall in water share prices in the unnerving autumn of 2008, evidently rather more in step with the stock market than we might expect the supposedly low-risk water sector to be:

• What part of the regulated future profits and cash flows were investors worried about at that time?
• What could the regulator do to address that worry?

For example, does the sector's exposure to the debt markets, and the recent debt market crisis, imply an exposure to systematic risk (on a de-levered basis) and therefore evidence for an increased cost of equity?  Alternatively, to the extent that the stock market falls were investors anticipating a period of poor conditions for corporate profits, how did investors believe these conditions would affect water profits? 

Risk analysis would help both understand and, in due course, inform the market.  And maximise the information value for UK regulators of the few listed companies we have left.

Whatever the answers, it seems to me that there is a case for more bottom-up analysis of systematic risk issues, probably across the regulated sectors.  Even in the one sector where there are listed companies.

I do not know from this analysis whether Ofwat's cost of capital assessment is too low or too high.  Calling the equity beta 1.0 would seem arbitrary and unbecoming.  Calling it 0.9 does at least seem closer to the evidence base.

A separate study

My preliminary bottom-up analysis of profit allowances across the sectors suggests that there could be discrepancies in conventional thinking which would have big implications for regulation.  Do contact me for further information.

Ian Rowson
31 July 2009

[1] The cost of capital (pre-tax) represented 60% of regulated revenues in the last review of Heathrow's airport charges, 30% in the draft water determinations published last week

[2] In broad terms, CAPM acknowledges that a market discounts the value of future benefits arising from an asset, not just for the time value of money but also for the risk or uncertainty in those future benefits. Investors are risk averse, but because investors can invest in a portfolio of assets, they are less concerned about the generality of risks that can be expected broadly to balance out across a reasonably diversified portfolio.  Investors are rather more concerned about those risks that affect the market as a whole, which cannot be readily diversified away.  This kind of risk is called systematic risk.  The central insight of CAPM is that the market's discount rate for an asset, the way it is priced, will be driven by the amount of systematic risk in the associated benefits, e.g. dividends.  The measure of systematic risk is beta.  For regularly traded assets, such as listed shares, an estimate of beta can be statistically inferred from share price data. 

[3] Paragraph 5.3 on page 64.

[4] The energy networks, both gas and electricity, are now represented only by National Grid (Scottish & Southern is too diversified for its beta to be useful).  Future airport reviews will only have pre-2006 data on BAA.  A listed Railtrack is now ancient history and Royal Mail never was listed.  Water has Northumbrian, Pennon, Severn Trent and United Utilities.

[5] Slightly higher returns were provided for water only companies in both PR99 and PR04.

[6] The ‘vanilla' measure includes the cost of debt in gross terms, producing a slightly higher number than Ofwat's full post-tax measure but one that compares directly with current cost operating profits before tax.

[7] Railtrack is the other privatisation.  The discounts in energy sectors were rather less dramatic.

[8] For this piece, I am putting aside the question of whether there could be a systematic component in regulatory risk, which could make this statement incorrect.  Personally, I find the idea of systematic regulatory risk plausible but suspect it is unlikely to be large.  I am also discounting the fact that the privatisation discount directly affects regulated revenues.  Especially after PR09, with the proposed revenue correction mechanism, it appears the scope for systematic risk in revenues is limited.

[9] I would not necessarily concur with NERA's figures: I find Blume adjustments uncompelling at best.