Board note - WSH draft determinations - 27 May 2014

Note to Ofwat’s Board – update on
draft determinations for Dŵr Cymru
1. Background
On 15 May the Board reviewed the assessment of Northumbrian Water’s and Dŵr
Cymru’s resubmitted business plans. Consistent with the approach taken with the
enhanced companies, Board agreed to delegate authority to the Chief Executive and
Chief Regulation Officer to determine the quantum of any outstanding interventions,
and to confirm the draft determinations for both companies. It was also agreed that
the draft determinations would be published early (around the end of May) as
opposed to the original date of 25 June.
In delegating authority the Board requested that that a summary of the draft
determinations be circulated to Board members covering each company’s revenue
requirements, ‘K’ factors and average bills over the period. It was also agreed that
the delegated authority would remain in place apart from in the event that any Board
member wished to discuss a particular issue, or that no new material issues arose.
2. Purpose
The purpose of this note is to provide Board with the information it requested in
relation to Dŵr Cymru (the note on Northumbrian was circulated on Friday 23 May).
We have also provided Board with an update on the outstanding issues and our
financeability assessment. In light of the different timeframe associated with these
determinations, we have adopted a template specific to these circumstances. We are
not intending to replicate this template for the remaining draft determinations.
The information in this note can be summarised as follows:




revenue requirements;
‘K’ factors;
average bills; and
update on outstanding issues.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
We ask that the Board respond to the Board Secretary
([email protected]) at the earliest possible time, with the cut-off time
for comments being 9:00am Thursday 28 May.
3. Dŵr Cymru
3.1 Draft determination – financial model outputs
In the table below we have set out the allowed revenues, k factors and average
customer bills associated with our draft determination.
Table 1 Draft determination K’s, allowed revenues and customers’ bills
2015-16
2016-17
2017-18
2018-19
2019-20
262.4
263.1
262.0
260.7
259.6
1,307.9
Wholesale water – K (%)
0.00%
0.26%
-0.33%
-0.66%
-0.61%
-
Wholesale wastewater –
allowed revenues (real)
(£m)
351.8
352.4
351.2
349.4
348.7
1,753.5
Wholesale wastewater –
K (%)
0.00%
0.18%
-0.25%
-0.70%
-0.39%
-
Retail household allowed
revenue (£m)
56
54
53
51
51
265
Retail non-household
expected revenue (£m)
180
180
177
175
173
-
Average customer bill –
water (£)
180
180
177
175
173
-
Average customer bill –
wastewater (£)
251
250
247
244
243
-
Average customer bill –
combined (£),
409
407
403
398
396
-
Wholesale water –
allowed revenues (real)
(£m)
Total
In the above table we have illustrated that the average combined bill will fall by £13
in real terms over 2015-20. Accordingly, we do not expect this draft determination to
give rise to any particular handling issues.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
As with the enhanced draft determinations, the average customer bill illustrated
above reflects a notional allocation (by Ofwat but based on the company’s split of
household and non-household) of the overall revenue requirement across Dŵr
Cymru’s customer base. In practice companies will have some flexibility about how
they recover the revenue requirement from different types of charges. We will shortly
be publishing a consultation on the new charging rules.
3.2 Update on outstanding issues – inputs into the financial model
When we presented the recommendations to Board, there were outstanding issues
in relation to: (i) outcomes; (ii) retail; and (ii) legacy adjustments. Below we explain
the decisions we have reached and provide an update on financeability.
Outcomes
We identified two issues with Dŵr Cymru’s outcomes, which necessitated
intervention. Below we set out the issues and the action we have taken.

Outcome delivery incentive (ODIs) – for the majority of ODIs with rewards
the company has not set the level consistent with our methodology. Instead
the company has used judgement not calculation to determine the reward. We
have intervened and recalibrated the reward by reference to willingness to
pay information.

Transferred assets – the company did not sufficiently justify why it did not
include transferred assets in its performance commitments. We have
therefore intervened and included these assets in the performance
commitments.
The consequence of these interventions is to change the potential return on
regulatory equity (RoRE) the company can earn (as opposed to the revenue
requirement for the draft determination). In particular, the interventions reduce the
upside from service outperformance. That said, we expect the company will address
these issues when they respond to the consultation on our draft determination.
Retail
We explained to Board that we were still assessing the company’s proposed
adjustment to the average cost to serve (ACTS) for (i) bad debt; and (ii) debt
management costs.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
We have since reviewed the evidence and, in particular, assessed the econometric
modelling supporting the bad debt adjustment. We have concluded that Dŵr Cymru
has satisfied our requirements. In particular, it has demonstrated that bad debt costs
due to deprivation are (i) material; (ii) beyond management control; and (iii) affect it
in a different way to other companies. Accordingly we have made an adjustment to
the company’s cost to serve. However, we have intervened and reduced the size of
the adjustment from £41 million to £38 million over the control period to reflect Dŵr
Cymru’s own econometric model.
We have also considered the proposed adjustment relating to debt management
costs. However, we have not accepted this adjustment.
The impact of these changes is that we have increased the allowed revenue for retail
household.
Legacy
We have identified only minor issues in relation to Dŵr Cymru’s legacy adjustments.
These changes have the effect of reducing the revenue requirement. These
adjustments can be summarised as follows.


Wholesale water: changed from -£31 million to £-32 million (in customers’
favour).
Wholesale wastewater: changed from -£18 million to £-19 million (in
customers’ favour).
Financeability
Under our approach to assessing financeability we assess the notional company
structure.
In relation to our assessment of Dŵr Cymru, since the Board meeting some of our
financeability ratios for the notional company have tightened while others remain
strong (there is not an issue with the financeability of the actual company). When we
assess financeability using the average interest cover ratio (which is used by
Moody’s) we get results which are consistent with a good investment grade rating.
However, when we make our assessment using the primary ratio adopted by
Standard & Poor (S&P) (funds from operation to debt ‘FFO/debt’) our assessment
produces ratios that are lower than we have previously accepted. Our calculations
suggest a FFO/debt of 7%. For comparison the FFO/debt ratio of Northumbrian
Water is 12% (compared with Affinity Water’s 12% and South West Water’s 10%)
based on the notional capital structure.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
This issue arises because of the use of the pay as you go (PAYG) and RCV run-off
levers by Dŵr Cymru. In particular, the company has chosen to run off its RCV over
38 years (compared with 16 to 24 years for Northumbrian, South West and Affinity),
with the result that it is taking less cash in-period and instead growing the RCV by
7% over the control period. We set out the issues below which give rise to both risk
and comfort with Dŵr Cymru’s numbers.
Risk
Comfort
Ofwat has never
previously gone below
10% FFO/debt.
The FFO/debt rating falls with the 6-9% band which S&P classifies
as ‘Aggressive’ and consistent with a BBB+/BBB investment grade
rating.
In the recent Ofgem
gas distribution
decision the lowest
FFO/debt was around
8.5% over the period
(with minimum target
of 8%).
S&P has indicated that an FFO/debt above 6.0% is sufficient to
maintain a BBB (flat) rating on the class B debt for Thames and
Anglian (which are both securitised). S&P has confirmed that the
class B debt is rated on essentially the same basis as a nonsecuritised corporate.
Dŵr Cymru has provided additional assurance that it considers it
would have an investment grade credit rating from S&P given this
ratio. In particular, it has previously had actual FFO/debt ratios of
5.4% in 2012 and 6.8% in 2013 and maintained an ‘A’ grade
investment rating from S&P. Dŵr Cymru shared its business plan
with S&P in February and S&P considered that it would maintain
an ‘A’ grade investment rating.
On that basis, we consider that Dŵr Cymru’s business plan under
notional structure is consistent with an investment grade rating
from S&P.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
Risk
Some licences require
water companies to
maintain an investment
grade credit rating from
each of the rating
agencies (Moody’s,
Standard and Poor’s
and Fitch).
Comfort
Using Moody’s Average Interest Cover ratio we get results that are
consistent with a good investment grade rating.
The notional financeability test is taken in the round. The view of
the Competition Commission in the Bristol Water determination
was:
“Rating agencies adopt a variety of quantitative and
qualitative techniques to assign credit ratings. They do not
use a mechanistic approach to assign credit ratings on the
basis of an observed or predicted credit ratio in a particular
year. It would therefore be in appropriate to place too much
emphasis on the value of particular credit ratio, particularly
when considering forecast values based on financial
estimates.”
We have gone back to Dŵr Cymru to obtain additional assurance
and evidence that, in its opinion, S&P will continue to have an
investment grade credit rating for the company (S&P will not give
an opinion on a notional company). This higher level of assurance
is consistent with the approach we would take if we had concerns
with the ratios of an actual company.
To address this issue we could intervene and require Dŵr Cymru to take more cash
in-period instead of growing the RCV. An intervention to arrive at an Ofwat FFO/debt
ratio of 8.5% would require an increase in customer bills of an average of about £8
per household over the control period. Dŵr Cymru research found that 94% of
customers supported the December business plan, with the May business plan likely
to increase acceptability due to lower bills (due in large part to a lower cost of
capital). We accepted Dŵr Cymru’s plan in terms of current and future affordability
as part of our risk-based review.
Our position is that we will not intervene.
We are still comfortable with the financeability of the plan submitted by Dŵr Cymru,
particularly since it has worked with the credit rating agency to assure itself and us
that its business plan is financeable. In addition, our draft determination effectively
provides very similar ratios to those from Dŵr Cymru’s business plan as the draft
determination gives Dŵr Cymru 99.98% of the revenue it requested.
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Note to Ofwat’s Board – update on draft determinations for Dŵr Cymru
4. Next steps
We are seeking to publish the draft determinations at 7 am on 30 May. We ask that
Board members respond to the Board Secretary at the earliest possible time, with
the cut-off time for comments being 9 am Thursday 29 May.
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