Yesterday’s eagerly awaited draft determination announcement by Ofwat, regarding the water pricing regime between April 2010 and March 2015, confirmed modest price cuts in real terms and a near £21 billion five-year capital expenditure plan. Good news for consumers.
Shareholders, though, were less happy as Ofwat chose a 4.5% post-tax Weighted Average Cost of Capital (WACC) figure, which was below market expectations. No wonder shares in the remaining publicly quoted water companies fell.
In today’s volatile markets, setting a credible WACC, which can endure until March 2015, is nigh impossible. Yields on water shares are closely correlated with gilt-edged stock; between March and June this year, the yield on 10-year government bonds rose by some 100 basis points.
Factor in, too, the planned issuance of gilts until March 2015, which could amount to an astonishing £800 billion, and it is clear that forecasting long-term yields is only for the brave.
In the event of its WACC figure being materially awry, Ofwat did offer some hope of financial restitution - through the ‘substantial adverse effects’ clause in the list of notifiable items by which interim price rises can be awarded.
In today’s announcement, Thames Water is an obvious loser. There is a near chasm between its own WACC assumption – close to 5.25% - and the 4.5% of Ofwat. A confrontation at the Competition Commission seems almost inevitable.
The tighter WACC being proposed by Ofwat is on the back of lower valuations of water stocks, which are now trading – in some cases - below their Regulatory Asset Value (RAV).
In reality, between now and November, when Ofwat publishes its final determination, expect considerable activity on behalf of the water companies to drive up Ofwat’s WACC assumption much closer to 5%. A lacklustre gilt auction before then would be very helpful.