Imrecon

For a few years now, we have witnessed network regulators Ofgem and Ofwat mounting some rather untidy arguments around the cost of capital.  Most importantly, they have dismissed the persistent evidence that the stock market sees these shares as rather lower risk than average.  But the accumulating evidence has made these arguments more awkward to maintain.  So, this summer, the initial proposals/draft determinations published by the two regulators do signal a change.   

The regulators have moved from their old positions, but they have not moved far.

Just one per cent

I have recently completed a report for the Consumer Council for Water on the cost of capital.  The report can be seen on the CCWater website.  The report draws from some of the insights I mentioned before on these pages ('Paradigm shifts' and 'Better off without Beta'). 

I argue in the report that a cautious assessment of the cost of capital may be a full 1% lower than Ofwat assessed for its draft determinations.  This would represent a massive reduction in the vanilla figure (the impact on reported profits) from 5.1% to 4.1%, but still in the middle of the range suggested by Ofwat's own advisors, Europe Economics.  The difference is £500 million annually on water bills.

But it's needed for finance, isn't it?

The real reason for regulatory inertia is that lenders have got used to healthy-looking financial indicators and companies have structured their balance sheets assuming that high profit allowances will continue.  If those allowances now fall, the financial indicators will no longer look as healthy, the companies will look over-geared and borrowing new money could be difficult.  This could conflict with the regulators' statutory duties to maintain financeability.

The choice looks like it is between consumers paying too much but at least getting continuing investment, or consumers paying the right amount but triggering an investment drought that will impact adversely on service levels.  Regulators might reasonably opt for the former.

Where are the risks?

But it is not that simple.  It seems to me that a big challenge for regulators is to play a more active role in analysing and understanding the risks in their sectors.  They are well placed to develop and maintain an authoritative account of how the commercial risks and regulatory regimes interact, going well beyond the financial indicator rules of thumb that currently pass as risk analysis. 

These are decidedly low risk businesses, and I do not believe they are generally over-geared.  But regulators, companies, shareholders, lenders and raters may need a more sophisticated understanding of the regulation and risk environment to reframe expectations for the low-risk reality.  That understanding will have to come from the regulators.

Ian Rowson
7 October 2009