Ofwat, the regulator for the water sector in England and Wales, is due to publish the 2024 Price Review (PR24) Final Determination (FD) on 19 December 2024. This will set the parameters for the industry for the regulatory period 2025-2030. Below, we set out our thinking ahead of the release and how we have been positioning within the sector.

What is the Final Determination (FD)?

This is the conclusion to several years of consultation and sets out the regulator’s view and the parameters in which companies in the industry should operate. It is important because water is a regulated industry and natural monopoly, so water companies have to operate within certain constraints. These ensure consumers are protected from excessive prices but necessary infrastructure spend takes place to keep the water and sewerage systems functioning well.

The relevance for investors

The return that investors can earn depends on the performance of the companies as well as reflecting the risks they take and the level of investments. Ofwat was subject to considerable pushback at the time of the Draft Determination (DD) released in July 2024, which was seen as challenging and based on some wrong inputs. Ofwat has acknowledged some of the criticism and water companies have provided evidence to support their requests, so the market is anticipating an improved determination for the sector. Furthermore, the drama surrounding Thames Water, which has the most stressed balance sheet in the sector, has drawn further attention to the FD. This is because it is seen as a test of whether capital returns will be permitted at a level that encourages new and existing capital (both equity and debt) to be invested in the industry.

Likely outcomes

While the FD will release a substantial amount of documentation and financial spreadsheets, which will take time to be fully absorbed by the water companies, rating agencies and markets, we believe there are three key parameters that markets will focus on:

ALLOWED COST OF CAPITAL

The regulator permits an allowed real return (deflated by the Consumer Prices Index including owner occupiers’ housing costs or CPIH) on capital. This can be thought of as the real Weighted Average Cost of Capital (WACC). The actual return capital holders may achieve may be slightly higher or lower depending on how efficient the company is and the economic environment over the course of the five-year regulatory period.

• History:  The PR24 Early View of the weighted average cost of capital (WACC) as of December 2022 was 3.29% (cost of equity 4.14% and cost of debt 2.60%, assumed gearing of 55%) using September 2022 data. Using the same methodology, Ofwat updated the DD WACC (using market data to April 2024) to 3.72% (cost of equity 4.80%, cost of debt 2.84%, 55% gearing).
• Our expectation: We think WACC will come in around 4.1% (cost of equity around 5.2%, cost of debt around 3.15%, 55% gearing). We believe this level will be broadly neutral to slightly positive for bond spreads for most water companies. Anything meaningfully below this would be a negative catalyst. We expect that FD WACC will be higher than DD WACC because:
  • Borrowing costs for water companies have risen because of higher perceived risks in the sector, including the Thames Water debacle. Water companies have argued that new debt issuance (c25% of total debt) could cost up to 30-45bps more even though Ofwat might argue that spreads might recede once the FD is settled.
  • Ofwat uses iBoxx £ Non-financials A and BBB 10-year+ indices but this is harder to justify given Moody’s downgrade of the business risk of the sector and potential for further rating adjustments. The A versus BBB indices exhibit a spread of around 25-30bp so switching from a A/BBB mix to fully BBB would result in a cost of debt increase of c15-20bps.
  • Cost of equity is more difficult to predict as it is less observable but it is likely that any increase in cost of debt will lead to a higher return on equity as well. Looking across at the regulated UK gas and electricity industry, the regulator there (Ofgem) has proposed an early view real return on equity of 4.57% to 6.35%. Ofwat’s cost of equity is at the lower end of Ofgem’s range despite water now seen as more risky, reflecting the political and public scrutiny, financial distress, environmental scandal and high investment needs.
• Impact: A WACC of around 4.1% would align with the requests of most water companies, although fall short of that requested by Thames Water and Southern Water (4.5% to 4.6%).

ALLOWED TOTAL EXPENDITURE

Companies propose the amount of expenditure they wish to undertake in business plan submissions. This is then reviewed by the regulator. There is a risk that expenditure could be excessive as consumers ultimately foot the bill, so the regulator seeks to ensure that water companies provide value for money. Allowable total expenditure allows water companies to deliver a good level of service to customers (base expenditure) and allow for improvements in service quality and resilience, eg new pipelines, equipment upgrades, new reservoir build (enhancement expenditure). Together, these two reflect allowed total expenditure (totex).

• History: Under the PR24 business plan submissions, UK water companies requested a combined totex of £105bn, almost an 80% increase on the previous plan. Ofwat’s Draft Determination (DD) allowed £88bn of totex, i.e. an average cut of 16% across the industry, although with significant variations across the different companies, ranging from single digit percentage cuts for Northumbrian / South West / Anglian to close to 25% – 35% cuts for names such as Wessex / South East / Thames.
• Our expectation: We think the gap between the company requests and the FD will meaningfully reduce because:
  • Historically, at the FD the regulator has tightened the gap between the regulated companies’ business plan totex submissions and the DD totex allowance. During PR 19, Ofwat reduced the initial DD totex cut from -11% to -5% at the FD.
  • Unlike in previous submissions, water companies have since increased their totex requests in updated representations post their original business plan submissions. They are now requesting totex of £113bn, up 8% on their original request. Water companies argue that the latest representations are based on more robust cost evidence and the increase reflects better understanding of statutory investment requirements. Ofwat’s latest comments seem to support the industry claims.
• Impact: Totex adjustments will be uneven across companies, leading to differentiated reactions. In principle, the higher the outstanding gap, the worse the issuer will be positioned, as the company will either incur totex underperformance or won’t be able to carry out all the intended investments to improve the infrastructure.

OUTCOME DELIVERY INCENTIVE (ODI)

The ODI regime is a set of regulatory measures and rules that can either award a financial reward to a company that meets or outperforms its selected operating key performance indicators (KPI) or impose a penalty if the company fails to deliver on its targets.

• History: This was a key area of industry pushback with companies emphasising the downside skew of the current regime.
  • Companies evidenced that Ofwat was using an incorrect starting point for the calculation of ODI penalties / rewards, as the regulator assumed that companies have achieved their performance targets for the 2019-2024 period.
  • Current ODI targets are unrealistic as they don’t allow sufficient investments to meet the regulatory expectations.
  • Lack of caps and collars creates material risk, especially considering increasingly severe weather events e.g. penalties from flooding causing sewerage overflow.
• Our expectation: Ofwat has partially acknowledged the shortcomings of its proposal and requested feedback on the introduction of a new Outturn Adjustment Mechanism (OAM), a new regulatory feature which intends to rebalance the ODI penalty exposure by assigning a 0 incentive / penalty value to a sector median performance. The regulator should also be able to better calibrate the new starting points as it will receive another year of published performance data from the companies.
• Impact: The OAM will further overlay an already complicated regulatory mechanism and it will be difficult to quantify as it will be applied retroactively. Rewards won’t be known until the end of the regulatory period and will depend not only on individual company performance but the whole sector. Sector outperformers could see their rewards reduced although penalties should be less severe for underperformers. Proper calibration will be critical.

Positioning

Spread widening typically occurs around the regulatory review, but has been more pronounced this time. A reasonably supportive FD could lead to a risk-on mood and spread outperformance for most of the names in the short run, since the likely 1-2 notches negative rating actions have been more than priced in and confirmation of equity support from shareholders could still prevent some of the downgrades.

Nonetheless, we expect spreads to remain volatile and not fully compress back to pre-price review levels. This reflects ongoing high public and political scrutiny of the sector, expected regulatory changes following the recently launched UK government consultation into UK water, higher investment needs coupled with less predictable regulation leading to higher risk of penalties and underperformance, possible CMA referrals, high leverage and high issuance needs in an atmosphere of frail investor confidence and risk of rating downgrades.

Additionally, the Thames Water restructuring process remains an overhang while Southern Water and South East Water face credible prospects of downgrade to high yield, which could lead to further sector contagion. Given the rather speculative nature of equity bids for Thames Water presented so far, the possibility that the UK government will need to step in and impose a Special Administration Regime, which would lead to lower creditors’ recovery versus current market expectations, remains a possibility.

Overall, this situation continues to warrant a selective approach and active management of the UK water sector. Our favoured exposure remains bonds issued by Anglian, Severn Trent, Pennon and Dŵr Cymru Welsh Water, which we see as more resilient names. These higher quality water companies received less punitive DDs, which should enable a more workable final determination, while benefiting from lower leverage and/or stronger operating track records.

Our preference for these names reflects our expectation that the FD should be more constructive for the sector than the DD and could drive risk appetite in the water space in the short run. Our preference for higher quality names, however, also reflects low conviction around the FD outcome and possible contagion risk from the Thames Water overhang. We also expect sector issuance early in the new year and believe that the upcoming supply window could offer an opportunity to top up exposure if the FD provides sufficient comfort around sector developments.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.