19 December 2008
Financial Implications of Competition Models Water UK
Project Team Dr Bill Baker Dr Richard Hern James Grayburn Tomas Haug Mathieu Pearson Dominik Huebler Anthony Legg
NERA Economic Consulting 15 Stratford Place London W1C 1BE United Kingdom Tel: +44 20 7659 8500 Fax: +44 20 7659 8501 www.nera.com
Contents
Contents Executive Summary
i
1.
Introduction
1
2.
Competition Models
2.1. 2.2. 2.3. 2.4.
Overview of the Water and Sewerage Value Chain Retail- Wholesale Model Single-Buyer Model Wholesale Competition Model
2 2 4 6 7
3.
Implications for Existing Financing Arrangements
3.1. 3.2. 3.3. 3.4. 3.5. 3.6.
Existing Financing Arrangements Creditors and Existing Financing Arrangements Default and Trigger Events Materiality Key Implications Estimates of the Cost of Renegotiation/Refinancing
4.
Financial Parameters for Business Units in Models of Competition
4.1. 4.2. 4.3. 4.4. 4.5.
Retail Business Risks Network Business Risks Resource and Treatment Business Risks Capital Structure of New Business Entities Conclusions on Financial Parameters
5.
Financial Modelling of Stylised Water Companies
5.1. 5.2. 5.3. 5.4. 5.5. 5.6. 5.7.
Stylised Companies Business Unit Opening Values Financial Modelling of Business Units Modelling Results Single Buyer Models For Separated R&T units: Incremental Approach Wholesale Competition Models Conclusions About Financing Separated Business Units
6.
Conclusions
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19 19 22 24 27 28
30 30 32 34 35 39 41 44 48
Contents
Appendix A. UK Regulatory Precedent
49 49 49 54 56 57
A.1. A.1. A.2. A.3. A.2.
Introduction GB Gas Sector UK Electricity Scottish Water BT Openreach
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Executive Summary
Executive Summary Introduction NERA was commissioned by 15 water and sewerage companies in England and Wales to study the financial implications of approaches to separating, and introducing competition into, elements of the water and sewerage value chains. “Financial implications” include changes to existing financing arrangements, changes in the eventual cost of capital, and changes in the eventual feasible debt levels. We do not consider any other changes such as levels of expenditure by the business units or regulators or customers, or any wider effects such as changes in service quality, many of which would be important in any overall evaluation of the merits of such reforms. The study is motivated by current discussions of possible competitive reforms. Earlier in 2008 the water sector economic regulator for England and Wales - Ofwat - published a number of consultation papers on competitive possibilities, and set out recommendations including detailed review of a range of models.1 The UK Government subsequently commissioned an independent Review from Professor Martin Cave. During the course of our study Professor Cave published interim findings2 which among other things recommended reform of retail competition for large water users, and shortly afterwards the pre-budget report confirmed the Government’s intention to legislate for this step in 20093. Professor Cave’s final recommendations are expected in Spring 2009. In the course of our study we have undertaken interviews with water companies, investors, financial arrangers and rating agencies. We have reviewed the provisions of some existing financing arrangements and experiences and evidence from other sectors. We have assessed the risks likely to be borne by competitive business units and the associated cost of capital. In addition we have modelled the possible future financial positions of the business units implied by various competitive reforms applied to stylised water companies, using two approaches to determining the opening values of the business units. Competition Models We first make the enquiry more tractable by establishing a small set of possible competition models. In doing this we draw on Ofwat’s most recent competition consultation. We establish three standard models: §
Retail-wholesale competition: This involves the full separation of the retail business unit from the current integrated model, leaving an otherwise integrated wholesale business. Independent retailers compete in the market for all customers, paying the wholesaler a wholesale water and sewerage charge.
§
Single-buyer model: the single-buyer model involves the separation of water resources and treatment business units (and/or sewage treatment and disposal units), from the
1
Ofwat (May 2008) Ofwat’s review of competition in the water and sewerage industries: Part II
2
Cave, Professor M. (November 2008) Independent Review: of competition and innovation in water markets
3
UK Government (November 2008) Pre-budget report
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network business, and a single monopoly procurement agency (the “single buyer”) in each location. The single-buyer has responsibility for procuring capacity and production. In the electricity sector, a key characteristic of the single buyer model is that capacity is procured on the basis of life-of-plant contracts, and we also assume this, as well as that the single buying functions are undertaken by the network business which is under separate ownership from resources and treatment. §
A wholesale market model: Ofwat define the wholesale market model as “where multiple producers and retailers use bilateral contacts and/or trading platform, purchasing common carriage access to the network.”4 This appears to be Ofwat’s preferred model for water resources and treatment arrangements, and Ofwat has initiated market studies to identify geographic markets with a sufficient number of competing supplies to ensure competitive outcomes. Ofwat do not propose such a model for sewage treatment or disposal noting that these markets comprise very small relevant geographic markets, and there is limited or no scope for competition. Our version of this model assumes that all water producers are separately owned entities trading with retailers and facing market price risk.
These are the three basic competition models that we investigate independently and in combination. At the most disaggregated level we consider the financial implications of retail competition, combined with the single-buyer model for sewage treatment and disposal, and with competitive wholesale markets in water resources and treatment; i.e. a six business unit model. We also consider some incremental models. Existing Financing Arrangements Water companies’ balance sheets are characterised by a high level of gearing. For example, the average gearing level for water and sewerage companies (WaSCs) is 66% of regulated capital value (RCV), and for water-only companies (WoCs) this figure is 61%. The gearing levels are higher for structured finance companies, where most WaSCs and WoCs have levels in excess of 70% of RCV. Much of the debt is long-term - nearly half the existing bond finance matures after 2030 and a fifth matures after 2050. A lot of the debt is covenanted, heavily so for the structural finance or “whole business securitisation” (WBS) companies. The covenants include extensive lists of general default and trigger events as well as a set of financial covenants focussing on credit metrics (e.g. adjusted interest cover ratio, RAR = net debt/RCV). The covenants vary from arrangement to arrangement though are similar in all the WBS arrangements we have seen. The exact implementation route for the separation and competition models is not clear. However it does not seem plausible that the single-buyer or wholesale market model could be implemented without substantial change to legislation, to the Licence, to the set of legal entities providing service, and to the prospective RCV of the current appointed businesses. These steps appear5 to cut across the trigger and default events. Consequently it does not seem plausible that these competition models could be implemented without revisiting the
4
Ofwat (May 2008) op. cit., p.68.
5
NERA does not provide legal analysis or advice.
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existing financing arrangements. The implementation of a fully separated wholesale-retail model seems likely to lead to the same position. There is very little published evidence on the treatment of debt in reform or restructuring situations. The competitive reforms in other UK sectors are for the most part of no relevance to this question because the structural reform took place under government ownership or because the companies were far less geared than the water companies, with less restrictive covenants. In one case – the separation of Openreach from the rest of BT via undertakings to ensure equivalent access – the separated elements remain divisions of the licensed company. Whether the default or trigger events are implicated will ultimately be a legal question, and the fundamental change in creditor security may or may not be particularly relevant. We see a risk that adjustment negotiations with bondholders and other creditors will be needed even where there is little or no change to creditor security. To the extent that the change in creditor security is relevant, then “smaller” competitive reforms have fewer implications for existing financing arrangements. For example, retail activities form a small proportion of water and sewerage operating costs and involve a tiny proportion of water and sewerage company asset values on a modern equivalent basis (MEAV). Also, there are several situations where water and sewerage companies in England and Wales have delegated retail activities under contract, without any apparent negative effects on financing. Arguably, a continuing regulated wholesale business with an RCV which is not appreciably reduced should be able to provide creditor protection which is not notably poorer – and possibly better depending on the regulatory treatment of bad debts. Similarly, purchase of required new water production from an entrant would arguably have little effect on prospective credit security of many ongoing integrated businesses – bulk water purchases today have little or no effect on overall financing costs as far as we are aware. However, many interviewees suggested to us that creditors would react to the whole expected or possible path of reform, not just the first incremental step. Estimating the Cost of Redeeming or Re-Negotiating Current Bonds The costs of revisiting existing financing arrangements if this is necessary are best seen as a one-off, transitional cost, not related to change in the ongoing financing cost of the sector due to change in non-diversifiable investor risks. The creditor protection in the existing financing arrangements varies from arrangement to arrangement and company to company. The bonds include varying provisions for the issuer to pre-pay or redeem them (call them), or to buy them back in the secondary market for cancellation. Any eventual revision cost necessitated by competitive reforms would no doubt be the result of negotiations between companies and bondholders. We calculate benchmark figures for redemption costs to illustrate the importance of the issue. Many of the sterling bonds, including many of those inside WBS structures, provide a standard form of call protection whereby the issuer may only make an early voluntary redemption by making a payment to the bondholder according to the “Spens” formula. We have calculated today’s Spens value (November 2008) for a sample of the largest water company bonds, with coupons and terms ranging similarly to those of bonds as a whole, and NERA Economic Consulting
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found that the average premium is 35% over latest posted market value. The gross cost of redeeming all sterling-denominated bonds were this Spens premium to be applied to all such bonds today is approximately £27.9 billion, while their market value is approximately £20.7 billion, a net cost of £7.2 billion. An alternative benchmark envisages redeeming debt at par, the standard approach in the event of default. Paralleling our notional Spens calculation we calculate a 9% premium as the cost of redemption of the current outstanding principal of our sample at par, minus the latest posted market value of that debt. Applied to all sterling bonds today, this equates to a net cost of £2 billion. Not all bonds contain the Spens provision and any premium paid will be the result of negotiations. Table 1 links the possible redemption cost to the proportion of bonds redeemed. For example, if 25% of all outstanding bonds needed to be redeemed at Spens and 75% needed to be redeemed at par, the transitional financing costs to the sector would be around £3.3 billion at today’s values. These cost estimates ignore the transactions fees as well as the feasibility questions and practical difficulties in redeeming and reissuing a sizable proportion of long-dated sterling denominated debt. They also ignore the equivalent costs for other forms of debt, which currently make up about 20% of total debt. Also, the latest posted market prices are probably overstatements of today’s market value for our sample because they are not all completely up to date, there is little trade at present and interest rates for corporate issuance have risen. Allowing for this would probably increase both benchmarks. However, repeating the calculation in future using different current market values will of course give a different result as well. Table 1 Refinancing Costs at Spens and Par For Sterling Bonds Proportion of bonds redeemed
Net Cost (£bn) Repaid at Spens Repaid at Par
10% 25% 50% 75% 100%
0.7 1.8 3.6 5.4 7.2
0.2 0.5 1.0 1.5 2.0
Source: NERA analysis of November 2008 Bloomberg data on a sample of water company bonds
The benchmarks clearly show that transitional financing costs could be large relative to current debt levels. Financial Modelling of Stylised Companies We also analyse the non-transitional financing implications of the new business entities under different competition models, and under two different approaches to opening values/RCV assignment: focussed and unfocussed. Under the focussed approach contestable businesses are established at their market value, e.g. as established at auction, and businesses that are subject to continued regulation (e.g. the network business) are allocated a residual value, such
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that the sum of all business units’ opening values equals the RCV. This latter constraint approximately ensures that the initial values do not increase prices to final customers. As our proxy for the market value we use net MEAV at the business unit level. The difficulty faced in the water sector in England and Wales with this approach is that the total industry RCV is approximately 20% of the total industry net MEAV, i.e. there is a large capital value discount. This leads to a high proportion of the RCV being adopted as the opening values of the contestable units, leaving relatively small and even negative residual capital values for non-contestable network business units depending on the competitive model. The alternative unfocussed approach assigns opening values to each business unit proportionally to their net MEAV values, and summing to RCV. This rule ensures that the network business retains a larger capital value (relative to the focussed approach), but the assigned values may not be sustainable without ongoing regulation and may raise questions of compatibility with genuinely competitive arrangements. The business units which operate in competitive environments are subject to risks to their earnings stemming from demand or volume shortfall, input price risks and events. The risks are not passed back to final customers by regulation or by contract to the same extent that they are passed back under the integrated business. Some risks are introduced by competition. The risks will not be able to be fully hedged or diversified within the business or by investors; i.e. there is an increase in the market or beta risk for these business units, relative to the integrated regulated business. Overall, businesses are carrying more risk, and customers less. This leads to an increase in the cost of capital for the competitive business units, and overall, in our competitive models. Drawing on market evidence and analyst reports in other sectors, notably the electricity sector, but also gas, oil, rail, mobile phones, water and PFIs, as well as our discussions with investors, we estimate that new resources and treatment business units operating in contestable markets will face increased cost of capital of between 100bps (in long-term contract single buyer situations) and 400 bps (in wholesale markets) relative to the regulated integrated business. We consider that all ongoing regulated businesses should be treated as having the same WACC as the integrated regulated business, and for this figure we adopt 5.1% real post tax, as used by Ofwat at the last price review (PR04). We also adopt lower maximum efficient gearing for businesses operating in contestable markets, comprising 70% for businesses under a single buyer model and 50% for a business facing merchant risk. For the retail entity, we adopt a margin on revenues approach (EBIT/sales) of between 2% (under single buyer) and 5% (in wholesale markets) based on evidence from the GB energy retail sector. Table 2 summarises our WACC and gearing modelling parameters.
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Table 2 Real post-tax WACC and Debt/RCV gearing assumptions for different business units under different models of competition Retail - Wholesale WACC Max. Gearing Structured Network Corp Finance Network Retail Water Resources and Treatment Sewage Treatment Sludge disposal
2% margin
n/a
Single buyer Wholesale market WACC Max Gearing WACC Max. Gearing 5.10% 85% 5.10% 70% 2% margin n/a 5% margin n/a 6.1% 70% 9.1% 50% 6.1% 70% 6.1% 70% 9.1% 50%
We draw the following conclusions from our modelling work: §
Viability of new regulated businesses: The market or focussed approach to opening value/RCV assignation implies a high proportion of the existing RCV is assigned to the contestable business units, and consequently a relatively low value is assigned to the network or ongoing regulated business. In many cases (other than the retail-wholesale separation), the cost structure of the new regulated business is different to the integrated business, with a lower return element as a proportion of costs. This implies that the new businesses might not be financially viable, or at least might face higher financing costs than those we have assessed. In some cases, the focussed approach implies a negative RCV for the new regulated entity. These issues arise as a consequence of the capital value discount combined with the focussed approach and with treating the existing RCV as a cap on sector asset values in order to cap prices to customers. The capital value discount lessens substantially over time. However, our modelling of the single buyer model, which we assume is implemented in 2020, and the wholesale market model, implemented in 2025, shows that even with the lessening of this discount the full single buyer and wholesale market models result in potentially non-viable network businesses in many cases under a focussed approach.
§
Debt carrying capacity: The relatively low levels of capitalisation associated with the opening values assigned to the network or ongoing regulated businesses in a focused approach result in a reduction of their debt-carrying capacity relative to the levels carried in our integrated structured WaSC and WoC models. This implies that, irrespective of questions of feasibility of transitions and of change in the cost of capital, these companies would need to retire debt relative to current levels and/or debt would need to be migrated to higher risk (and therefore lower credit quality) entities. Under some models, the debtcarrying capacity summed over all sector entities after reform is lower than that we model the integrated business as carrying, implying that debt will need to be reduced across the value chain as a whole.
§
Increases in customer bills in the focussed approach: The more exposed to competition the individual units are, the more there are risks carried by investors which were previously passed back to customers by regulation. Under the fully separated models the investors in competitive elements will be bearing risks to earnings stemming from demand changes (including stranding risks), construction cost overruns, input price changes and so-on, without the opportunity to seek redress through an interim or periodic
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review of prices. The business units will have a higher cost of capital. We have drawn on evidence from other sectors on the returns demanded by investors (after diversification opportunities) in similar situations. Our assessment is that under the focussed approach the increase in the cost of capital leads to an increase in customer bills (ignoring all other effects of competition) ranging from around 2% under the retail-wholesale model and around 6% (resources and treatment single buyer), up to around 23% (wholesale market) and 24% (six-business unit separation). §
Increases under an unfocussed approach: The initial increases in customer bills, and the implied financial de-leveraging of the network or regulated businesses, are substantially less under an unfocussed approach to opening value/RCV assignation. The cost of capital increases then lead to bill increases of around 2% (retail-wholesale), 4% (single buyer for resources and treatment), and 14% (wholesale markets, and the 6-business model). As stated, these additional financing costs are gross of any benefits from competition and any other cost increases. However, they imply that under the focussed approach real benefits from competition will have to be found to ensure that consumers are not worseoff overall.
§
A challenge with the unfocussed approach: The unfocused approach leads to a design challenge as follows. If the unfocussed approach assigns less than market value to businesses in competitive situations, an ongoing regulatory or contractual mechanism applying to those businesses is needed to sustain this situation and prevent prices rising for “competitive” outputs and for final customers, while at the same time allowing those businesses and entrants to compete.
§
Partial or incremental approaches: Our competitive models assume full separation of elements of the integrated business. Partial models, such as retail competition for large customers only, or resources and treatment competition in only a few places where substantial new capacity is required, will involve similar effects but applying over smaller parts of the business (perhaps over very much smaller parts), and will therefore lead to smaller effects overall.
Conclusions Our investigation suggests that the financial implications of competitive reforms could be substantial depending on the competitive model that is adopted, and the approach that is taken to defining the business unit values and ongoing regulation. Firstly, it appears to us to be difficult to make any notable competitive reform without needing to revisit many of the existing debt financing arrangements. The cost of revisiting these arrangements would be determined by negotiations between the parties guided by law. We have shown that relevant benchmarks for these costs can be measured in billions of pounds. It seems to us that there is a danger that the transitional cost could be high even if the competitive reform were to be relatively benign in terms of fundamental impacts on creditor security. Secondly, our assessment is that the competitive reforms would place elements of the business outside the scope of regulation, leading to increases in the non-diversifiable risks borne by investors in those competitive elements, and a higher cost of capital. This
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rebalancing between investors and customers does not provide an offsetting reduction in the cost of capital for regulated elements, so increases in the cost of capital for the sector as a whole are to be expected. To reiterate, this is because the reforms place risks with the investors in the competitive elements; risks which were previously not present or were more fully passed back to customers by regulation. Because returns form a large part of water sector P&L costs, the cost of capital has important implications for sector costs overall. Ignoring all the other possible benefits and costs of competition, and assuming that increases in the cost of capital are all ultimately reflected in increases in the cost of water and sewerage services to customers, we assess the latter initial increases as ranging from about 2% given full competition in retail only, up to perhaps 14% under much fuller competition, if an unfocussed approach to business opening values can be applied. An unfocussed approach will require appropriate supporting mechanisms for competitive elements; the alternative focussed approach does not but leads to bigger immediate increases in financing costs and bigger financial viability questions for ongoing regulated business elements. The costs of incremental approaches to competition in retail for large customers only, or in only new capacity for resources and treatment, would also be smaller, probably much smaller. These substantial potential increases in costs make it important that the potential benefits of competition are clear before competitive reforms are adopted.
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Introduction
1.
Introduction
NERA was commissioned by 15 water and sewerage companies in England and Wales to study the financial implications of approaches to separating, and introducing competition into, elements of the water and sewerage value chains. “Financial implications” include impacts on existing financing arrangements, changes in the eventual cost of capital, and changes in the eventual feasible debt levels. We do not consider any other changes such as levels of expenditure by the business units or regulators or customers, or any wider effects such as changes in service quality, many of which would be important in any overall evaluation of the merits of such reforms.6 The study is motivated by current discussions of possible competitive reforms. Earlier in 2008 the water sector economic regulator for England and Wales - Ofwat - published a number of consultation papers on competitive possibilities, and set out recommendations including detailed review of a range of models.7 The UK Government subsequently commissioned an independent Review from Professor Martin Cave. During the course of our study Professor Cave published interim findings8 which among other things recommended reform of retail competition possibilities for large water users, and shortly afterwards the prebudget report confirmed the Government’s intention to legislate for this step in 2009.9 Professor Cave’s final recommendations are expected in Spring 2009. The remainder of this report is structured as follows: §
Section 2 describes the water and sewerage value chains and the competitive models we use to structure our study.
§
Section 3 outlines relevant creditor protections in the financing arrangements of the current integrated and regulated water companies, considers whether the protections might be inconsistent with steps to implement competitive models, and discusses possible costs of revising the financing arrangements.
§
Section 4 considers the risks associated with each of the business units in the competitive models and derives associated cost of capital (WACC) and maximum gearing levels for them.
§
Section 5 presents financial modelling results for stylised companies under competitive reforms, for both focussed and unfocussed approaches to defining opening values of the business units (sometimes referred to as “allocating the RCV”). We present results in terms of the cost to final customers, and the change in feasible debt levels.
§
Section 6 concludes.
6
As part of the study we interviewed six water companies, eight current or potential debt and equity investors and advisers, and three rating agencies, and we are grateful to them for sharing their views with us. We have also reviewed two recent commentaries by rating agencies: Moody’s (December 2008) UK Water Sector: Moody’s Comments on Competition Review; Standard and Poor’s (November 13 2008) Enhanced Competition Could Alter Standard and Poor’s Assessment of the UK Water Sector.
7
Ofwat (May 2008) Ofwat’s review of competition in the water and sewerage industries: Part II
8
Cave, Professor M. (November 2008) Independent Review: of competition and innovation in water markets
9
UK Government (November 2008) Pre-budget report
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Competition Models
2.
Competition Models
This Section reviews the water and sewerage value chains, as seen by Ofwat, in the course of identifying a set of competitive models to structure our study. The consultation and other papers we draw on, published in the last year, include: §
Proposals for accounting separation published by Ofwat in September 2008.10 Ofwat is currently working with a group of companies to identify the issues this will give rise to. The publication sets out Ofwat’s views on how best to identify discrete elements of the water and sewerage value chains. Ofwat identifies eight business units plus a retail unit. (We set these out in more detail below.)
§
One consultation paper published by Ofwat proposing reform of the current Water Supply Licensing (WSL) and inset regimes.11 Ofwat also published a second consultation paper discussing the contestability of elements of the water and sewerage value chains, and making recommendations for reforms.12 We draw on this second consultation paper as the basis for our set of possible competitive models.
§
The very recently published interim findings of the Government commissioned independent review by Professor Martin Cave of developing competition in the water sector, which recommended reform to retail competition for large users, with final findings due in spring 2009.13 The pre-budget report confirmed the Government’s intention to legislate for the retail reform. We have some regard to these findings and particularly Professor Cave’s indicative reform timetable in defining our competitive models.
2.1. Overview of the Water and Sewerage Value Chain Ofwat propose to establish a set of vertically separated businesses for accounting purposes, as a first step to competition in contestable parts of the value chain, and for greater cost transparency. In total, Ofwat identified eight different business units plus water and sewerage retail. The water business units comprise: 14 §
water resources;
§
raw water distribution;
§
water treatment;
§
treated water distribution; and,
§
retail services
10
Ofwat (September 2008) Accounting Separation: Consultation on allocation of activities between business units.
11
Ofwat (December 2007) Market competition in the water and sewerage industries in England and Wales Part one : Water Supply Licensing
12
Ofwat (May 2008) Ofwat’s review of competition in the water and sewerage industries, part II.
13
Cave, Professor M., (September 2008) The case for competition, Utility Week
14
Ofwat (September 2008) Accounting Separation: Consultation on allocation of activities between business units.
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Ofwat’s proposed sewerage service value chain business units are as follows: §
sewerage network;
§
sewage treatment;
§
sludge treatment;
§
sludge disposal; and;
§
sewerage retail.
Ofwat’s proposals are based on the principle of separating potentially contestable activities from natural monopoly elements.15 The full set of business units amounts to Ofwat’s current view of the maximum possible extent of vertical disaggregation of the integrated businesses. Figure 2.1 provides illustrative shares of asset values, on a modern equivalent asset (MEA) basis, in six business units which are a little more aggregated than Ofwat’s units, and for final customer meters. These shares are the average proportions in data provided to NERA by four water and sewerage companies (WaSCs) and four water only companies (WOCs), respectively. The asset value proportions very substantially from company to company. Figure 2.1 Net MEAV proportions of the elements of the value chain (Upper chain: WaSC; lower chain: WoC)
Source: NERA analysis of data provided by a sample of companies
Ofwat states that both the water and sewerage networks constitute natural monopolies and will not be subject to competition but will be subject to continued regulation. However, Ofwat considers that there might be scope to introduce competition for or competition in the market in each of the remaining business elements, namely water resources, water treatment, sewage treatment, sludge treatment, and sludge disposal, as well as retail services. Drawing
15
Ofwat (September 2008) op. cit., p. 10.
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on Ofwat’s May consultation, we define four competitive models as follows. We adopt these four models to span the competitive possibilities, to allow us to investigate the issues. §
A retail-wholesale model, which involves the introduction of competition in retail services only.
§
A “single buyer” model, which implies competition for the market for water resources and treatment, and/or sewage treatment and disposal, as well as competition in retail.
§
A wholesale market model which involves competition in the market for water resources and treatment, as well as in retail.
§
A “6 business unit model” for WaSCs that combines elements from the wholesale market and single buyer models. In this model there is competition in the markets for retail, and water resources and treatment, and there is competition for the market for sewage treatment and disposal.
The next sub-sections discuss our adopted models in more detail.
2.2. Retail- Wholesale Model Under the retail-wholesale model, retail activities are separated and opened to competition from new retailers, as has been implemented for non-household customers in Scotland. The retailers purchase water and sewerage services from integrated regional wholesale businesses which have responsibility for water and sewerage service production and distribution activities, and are subject to price regulation. Figure 2.2 shows the features of a retailwholesale model as envisaged by Ofwat. Ofwat has recommended that retail market competition be applied to both water and sewerage, with an initial eligibility threshold of 5 Ml and an extension to all customers at a later stage.16 They also recommend that the retail function is functionally and legally separated from the wholesale business under common ownership. 17 Professor Cave has also recommended an incremental approach. Ofwat’s and Professor Cave’s proposals also include reform of the current water service licensing (WSL) basis for charging for access - known as the cost principle - in favour of an alternative (as yet undefined) access charge determined by Ofwat. The objective of the reform would be to promote new up-stream entrants selling directly to retailers, and purchasing network access from the integrated wholesaler. Ofwat has also recommended unbundling of the current “combined supply” licence (which enables a retailer to develop a resource and convey the water through the network) into separate retail and upstream licences. 18 This would allow retail and upstream licensees to contract and trade with each other. Ofwat refers to this possibility as “regulated wholesale-minus”, and discusses possible ways of determining the discount element (e.g. based on the long-run marginal cost of resources in each zone). However, Ofwat also states that “such a model would be complicated to
16
Ofwat (May 2008) op. cit. p.54
17
Ofwat (May 2008) op. cit. p.57
18
Ofwat (May 2008) op. cit. p.55
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implement, and there would be considerable uncertainty as to whether it would deliver new benefits.” 19 The entry possibility under a “regulated wholesale-minus” framework is also shown in Figure 2.2 but it does not feature in our retail-wholesale modelling. Retail competition has been introduced for a range of utility markets elsewhere. As well as water and sewerage services for non-households in Scotland, energy supply in a multitude of countries is subject to retail competition, although this typically follows wholesale market reform (see Appendix A). On its own the retail business is a small fraction of the whole water and sewerage value chain. As set out in Figure 2.1, the value of the assets employed in the retail sector of a stylised WaSC is very small as a proportion of net MEAV, at around 0.1%. Based on the data supplied to NERA by eight companies, retail operating and capital maintenance expenditure averages approximately 9% of total opex and capital maintenance, but the reported proportion varies substantially across the companies. An unresolved issue is whether metering should be located with the network business or the retailing unit. Although the importance of metering is likely to grow with the widespread introduction of household metering we show in Figure 2.1 the current net MEAV associated with meters is very small at less than 0.2% of the total net MEAV. Finally, regarding the timing of the introduction of the retail-wholesale model, for the purposes of our modelling we assume this occurs in 2012, in line with Professor Caves’ recommendations for early steps in this area, though we assume full separation and competition for all retail customers. Figure 2.2 Retail- Wholesale Market Structure
Source: Ofwat (May 2008) op. cit., p.71.
19
Ofwat (May 2008) op. cit. p.70
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Competition Models
2.3. Single-Buyer Model Ofwat’s description of the single-buyer model involves separation of water resources and treatment, and/or sewage treatment and disposal, from the network business, and the creation of a single monopoly buyer/seller. The single-buyer would buy from producers and sell to competitive retailers. Ofwat does not include a detailed description of the actual contract arrangements. We need to clarify these arrangements to model this scenario. To do this, we draw on the accepted definition of the single-buyer model from the energy sector which is described as:20 “single buyer – allows independent generators [independent water producers] to sell to a single (utility) buyer in each area on long-term life-of-plant contracts”. The key point here is that water resources and treatment capacity is procured under life-ofplant contracts. The cited publication goes on to explain the reason for this: without a long term contract, a would-be new generator or water producer is reluctant to sink a large amount of capital in a plant, because they face the risk of being beaten back to variable costs in price negotiations with the monopsonist single buyer (having no alternative buyer) once the plant is completed. Thus, sellers look for life of plant contracts,21though these will not remove cost or volume risk to the same extent as regulation, and so will leave the producer with a greater degree of undiversifiable earnings risk. Our assumption that under single-buyer arrangements water producers require life-of-plant contracts has important implications for our assessment of the relative financing costs of the sector under different competition models, as set out in section 4.3. In our modelling we assume that the single-buyer is the network utility company, rather than assuming a separate procurement entity. This is a common arrangement, partly because the single buyer needs to have a robust credit rating to assume the liabilities under the long-term contract. However, this is not the only possible institutional arrangement – an additional separate procurement and sales entity may be created, buying network services from a network-only entity. Ofwat’s representation of the model makes this distinction (see Figure 2.3) Regarding the degree of separation, we assume that all water resources and treatment “production” assets and activities (and sewage treatment works and disposal, if the model is applied to the sewerage service as well) are under separate ownership from the network business. The single-buyer model might only be used to procure all additional incremental resources (a possibility Professor Cave discusses), or might be extended to pre-existing production facilities as well. In our modelling, we assume a single-buyer model applies to all existing resources and treatment; i.e. all these activities are contracted to the single-buyer under life-
20
Hunt, Sally (2002) Making Competition Work in Electricity, p. 58.
21
Hunt, Sally (2002) op. cit. p. 43.
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of-plant contracts. However, we also discuss the implications of Professor’s Cave’s incremental approach. Reform of the current abstraction regime is probably a necessary condition for efficient functioning of the single-buyer model. Otherwise, procurement of new or renewed supply contracts process would likely be restricted to those with current licenses to abstract in the area, favouring incumbents. Therefore, we assume the abstraction regime is reformed to facilitate offers from third-party new-entrants to the central procurement agent in each region when capacity is sought. As we have described the single-buyer model, this is a very common model worldwide in the energy sector (e.g. most US energy markets follow this structure) and also in sectors where there is energy and water joint production (e.g. in Gulf States). Scottish Water has also outsourced around 80% of its wastewater treatment plant capacity under life-of-asset contracts, and therefore is similar to a single-buyer for wastewater treatment services. Figure 2.3 The Single-buyer Model
Source: Ofwat (May 2008) op. cit., p.72.
2.4. Wholesale Competition Model Ofwat define a wholesale competitive market as being where22 “…multiple producers and retailers use bilateral contracts and/or a trading platform, purchasing common carriage access to the network.” The introduction of a wholesale market will require the establishment of precise trading arrangements or market rules. As indicated in Ofwat’s definition of a wholesale market, 22
Ofwat (May 2008) op. cit., p. 68.
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there are two broad models based on either a centralised trading platform where the despatch of different water production units to meet demand is determined by a system operator (SO) using optimisation software, or a decentralised model, where production decisions are based on bilateral contracts between traders, and the role of the SO is minimised.23 Within the scope of this project, we do not need to consider the trading arrangements any further. The essential characteristic of the wholesale market irrespective of the precise rules is that water producers face market price risk and volume (stranding) risks, leading to earnings uncertainty which they are unable to hedge completely and which is not completely diversifiable. This has implications for their financing costs and other financial parameters such as their maximum gearing. We discuss these issues in Section 4.3. Ofwat’s recent publications suggest that they favour a form of wholesale competition model for water resources and treatment, although Ofwat acknowledge that the feasibility of this model might be limited by whether there are geographic markets of sufficient size to ensure effective competition. Ofwat appears to rule out wholesale competition in sewage treatment and disposal because sewerage systems are more localised and there is limited or no scope for competition between treatment works. Thus, in our modelling we restrict the wholesale market to resource and treatment entities. Regarding the degree of separation, as with the single-buyer model, we assume that all water producers in the wholesale market are under separate ownership from the network business. As with the single-buyer model, we assume the wholesale competition model is supported by reform to the abstraction regime to facilitate new-entry. Figure 2.4 Wholesale Market Model
Source: Ofwat (May 2008) op. cit., p.69.
23
For a detailed description of different trading arrangements, see Hunt, Sally (2002) op. cit. p 127-160.
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Implications for Existing Financing Arrangements
3.
Implications for Existing Financing Arrangements
3.1. Existing Financing Arrangements The integrated water companies are characterised by high levels of gearing, dominated by long-term bond financing instruments. The current average gearing for a WaSC appointed company is 66% (debt/Regulated Capital Value or RCV), and for the set of WoCs it is 61% of RCV. The structured finance WaSCs and WoCs (also known as “whole business securitisation” or WBS companies) usually have much higher RCV gearing ratios with an average of around 75% for both WaSCs and WoCs. Figure 3.1 shows the composition of debt by value for WaSCs and WoCs under corporate finance and structured finance models. This shows that in three of the four categories, sterling bonds account for 80% or more of the value of debt, while for corporate finance WaSCs the proportion is 52%. The remaining important debt instruments comprise finance leases and loans, of which a high proportion are European Investment Bank (EIB) loans. Figure 3.1 Debt Composition For WaSC and WoC Under Both Structured and Corporate Finance Models
Source: NERA analysis of Bloomberg data (November 08) and FY07/08 company accounts
The water company debt is also relatively long-term. As set out in Figure 3.2, around half of all existing bonds by value will still be outstanding in 2030. More than 20% by value are dated beyond 2050.
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Figure 3.2 Percentage of Current Outstanding Bond Value Maturing by Year
2008 Debt Already Retired
100% 80% 60% 40% 20% 0% 2008 2013 2018 2023 2028 2033 2038 2043 2048 2053 2058 2063 Structured WaSC
Corporate WaSC
Structured WoC
Corporate WoC
Source: NERA analysis of Bloomberg data (November 08).
3.2. Creditors and Existing Financing Arrangements NERA does not provide legal analysis or advice. The following limited commentary on the position of creditors is based on public knowledge, suggestions made by interviewees, several lists of the key creditor protection provisions provided to NERA by water companies, and examination by NERA of excerpts from a small sample of draft and final water company bond documents. The current Instruments of Appointment (Licences) of the water and sewerage companies of England and Wales include ring-fencing provisions which limit the allowed disposals of physical water and sewerage assets. The current legislation sets out Special Administration provisions which govern the outcome for ownership of the Licence and the assets should an appointed water and sewerage company be in financial difficulty. The creditor protection in the existing water and sewerage company financing arrangements varies substantially between and within the loans, leases, bonds and WBS arrangements. Some water and sewerage company bonds, especially those issued longer ago, have few covenants. Some bonds issued by water and sewerage companies which maintain a lowergeared corporate (as opposed to higher-geared WBS) financial structure have “standard industrial” covenant provisions which list a limited number of default events and specify procedures for accelerated intervention by the Security Trustee in default cases. The WBS financing arrangements have been applied by several companies since 2000. This arrangement pre-defines structured tranches of issuance with various degrees of security, all within over-arching common creditor terms and an inter-creditor agreement, and is associated
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Implications for Existing Financing Arrangements
with higher overall gearing. The arrangements specify long lists of default events and trigger events. Trigger events include all default events as well as further events which would be expected to be reached in advance of a default event. Occurrence of a trigger event leads to a defined standstill period – typically eighteen months - during which, among other things, the Security Trustee may seek a remedial plan and in some cases a new business owner, in consultation with Ofwat. If no remedy for the trigger event has been found the standstill period is augmented unless the necessary proportion of bondholders vote for it to end, in which case the procedures for default become operative if relevant. The necessary voting proportion declines as the standstill period is successively added to. After conclusion of a standstill period if default applies then defined procedures are followed by the Security Trustee in search of a remedy. If the default cannot be remedied the issuer (and in turn any guarantee parties) must pay the holder the outstanding sums of principal and interest as defined by the terms. Where the Licence and assets are taken into Special Administration, eventually there may be payments for these to the previous owners and in turn to their creditors including the bondholders. The existing water and sewerage company bonds also include varying provisions for the issuer to pre-pay or redeem them (call them), or to buy them back in the secondary market for cancellation. As we discuss further below, many of the existing sterling bonds, including many of those inside WBS structures, include a standard form of call protection whereby the issuer may only make an early voluntary redemption by making a payment to the bondholder according to the “Spens” formula.
3.3. Default and Trigger Events Many different default and trigger events are listed in the documentation for loans, leases, bonds and WBS arrangements. This project is concerned with the financing implications of reforms to separate the currently integrated water and sewerage value chains and to introduce competition into elements of it. Depending on how and to what extent those reform proposals are pursued by the government and Ofwat, they have the potential to lead to default or trigger events. We envisage that reforms would be implemented by changes to regulation (e.g. regulatory accounting guidelines, lower limits on eligibility to be a water supply licensing customer), the Licence (e.g. form of tariff control) and legislation (e.g. definition of entities in the sector, their duties and powers, and constraints on ownership). The reforms would have consequences for the scope of the current integrated businesses and potentially for their financial parameters (e.g. their cashflow and their regulatory capital value or RCV). The default and trigger events in existing arrangements which appear to us to be most relevant in this context are listed below. They are drawn from different agreements and written in our descriptive terms as opposed to legal language. We do not claim this list is exhaustive, and in particular we have drawn on only a small number from the full population of agreements.
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Potentially relevant default events include: §
§
§
§
Loans: the borrower shall repay the loan on demand if: –
Any legislation is passed or generally any event occurs which is likely to jeopardise the ability of the borrower to service the loan or adversely affect any security for it
–
The borrower loses the Licence over 15% or more of the geographic area as measured by revenues
–
A material adverse change occurs.
Corporate bonds: events of default: –
If the issuer ceases or threatens to cease to carry on its business or a substantial part of its business
–
If a put event occurs (meaning repayment is required), where put events include –
Licence termination
–
Restructuring events including those following from material changes to the Licence or legislation
–
If any material subsidiary ceases to be wholly owned
–
Rating downgrade by one full category or to below investment grade and an IFA certifies this is materially prejudicial to the interest of bondholders.
Finance leases: default occurs if: –
The lessee ceases or threatens to cease to carry on its business; or
–
Transfers a substantial part of its assets; or
–
A substantial part of its assets are appropriated by a government authority adversely affecting the lessee’s ability to perform its functions.
WBS default events include: –
EBITDA ICR for various classes of bonds falling below a set level
–
Regulated Asset Ratio (RAR = defined Debt/RCV ) exceeding a set level
–
Change of control
–
Nationalisation, compulsory or not, compensated or not, where likely to have a material adverse effect
–
Changes to Memorandum or Articles, or to nature of business or business identity
–
Suspension or abandonment of all or a material part of the appointed business
–
Disposal of any part of the undertaking, or revenues, or assets (above de minimis levels)
–
Creation of any new subsidiary, de-merger
–
Agreement to Licence change which is likely to have a material adverse effect.
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Implications for Existing Financing Arrangements
Potentially Relevant WBS Trigger events include: §
Any default event
§
EBITDA ICR, post capital maintenance ICR, or RAR outside set limits (less stringent limits than for default events)
§
Rating for set classes of bonds falls to minimum investment grade, or falls below investment grade, or falls two notches or more (there are variations)
§
Receiving Notice of Licence termination
§
Six months after an announcement with clear proposals from Ofwat, not since reversed, for modification or replacement of the Licence which is expected to form a material adverse event
§
Circumstances which would be likely to lead to a Special Administration order
§
Commencement of legislation which would lead to a breach of the (default) financial ratios; (variously) commencement of the final reading in the House of Lords or House of Commons of such legislation.
Cross-defaults within appointed company arrangements are likely to mean that a default situation on one instrument implies a wider default.
3.4. Materiality The statement of some of the trigger and default events involves the test that the situation also constitutes a “material adverse event” (or adverse effect or adverse change or other similar wording). Often the occurrence of a material adverse situation is as well stated to be a qualifying event in itself. In a few cases independent certification of the material adversity of the event by an IFA is specified, but generally the statements rely on a definition of the term in the documents. One definition drawn from a current water and sewerage company arrangement is that: §
A material adverse effect means the effect of any event or circumstance which is materially adverse, taking account of the timing and availability of any rights or remedies under the Water Industry Act or the Licence, to: –
The financial condition of the appointee, the issuer, the within-group guarantor, or the financing group as a whole
–
The ability of any member of the financing group to perform its material obligations under any finance document
–
The validity or enforceability of any finance document or the rights and remedies of any secured creditor under them
–
The ability of the appointee to perform or comply with any of its material obligations under the Licence or the WIA.
Notwithstanding the clarity of this definition, it is difficult to be sure how the various materiality tests will limit the reform events which qualify as triggering events or events of default under existing water and sewerage company financing arrangements. Our
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understanding is that a likely rating downgrade, or a likely inability to be able to get an investment grade rating, is a good example of a material adverse effect. We understand that as a practical matter successful use of a stand-alone “material adverse change” clause to force a renegotiation of bond terms has been limited, outside underwriting situations. However many of the default and trigger events above are stated in a way which does not require material adversity to be shown. We also note that: renegotiations of bond terms are frequently required in restructuring situations; some holders of water company bonds have recently required payment to induce them to adopt revised and apparently more favourable security terms; and many of the people we interviewed for this study told us that if bondholders consent is required, then this will have a price.
3.5. Key Implications The exact implementation route for the separation and competition models we have outlined in section 2 above is not clear. However it does not seem plausible that the full single-buyer or wholesale market model could be implemented without substantial change to legislation, to the Licence, to the set of legal entities providing service, and to the prospective RCV of the current appointed businesses. These steps appear to cut across the trigger and default events listed above. Consequently it does not seem plausible that these competition models could be implemented without revisiting the existing financing arrangements. The existing financing arrangements are long-dated. Also, the industry has substantial projected capex needs and is projected to remain cash negative, so debt reaching maturity will need to be renewed and added to. This means that the need to revisit the financing arrangements will not be substantially lessened in the next twenty years without special steps. The implementation of a fully separated wholesale-retail model seems likely to lead to the same position. If retail activities are to be the preserve of a separately owned organisation then this seems to require that the definition of the appointed businesses will need to be narrowed to cover wholesale activities only, and revisiting that definition appears to us to be a default event under the WBS arrangements at least. The most obvious routes for creating a retail entity (new subsidiary with subsequent disposal or demerger) also appear to involve default events. Revision of Licence Condition B to reflect wholesale charging seems to us to be unavoidable, and solely-wholesale cashflows will be narrower than the current integrated cashflows, both of which seem likely to qualify as WBS trigger events at least. A thorough revisiting of the legislation to separate retail would implicate covenants in many existing financing arrangements. Whether the default or trigger events are implicated will ultimately be subject to legal test, and the fundamental change in creditor security may or may not be particularly relevant. To the extent that this is relevant, then “smaller” competitive reforms will have fewer implications for existing financing arrangements. For example, retail activities form a small proportion of water and sewerage operating costs and involve a tiny proportion of water and sewerage company MEA asset values. Also, there are several situations where water and sewerage companies in England and Wales have delegated retail activities under contract, without any negative effects on financing as far as we know. Arguably, a continuing
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Implications for Existing Financing Arrangements
regulated wholesale business with an RCV which is not appreciably reduced should be able to provide creditor protection which is not notably poorer – and possibly better depending on the treatment of final customer bad debts. Similarly, purchase of required new water production from an entrant would arguably have little effect on the prospective situation of many ongoing integrated businesses - bulk water purchases today have little or no effect on financing costs as far as we are aware. So reforms concerning incremental capacity only may not notably reduce creditor security.
3.6. Estimates of the Cost of Renegotiation/Refinancing The costs of revisiting existing financing arrangements if this is necessary are best seen as a one-off, transitional cost, not related to change in the ongoing financing cost of the sector due to change in risks, which we discuss in later sections. In this section, we set out benchmarks for the cost of revisiting existing debt arrangements, should this be made necessary by competitive reforms. In any specific case we envisage that the actual costs will depend on many factors affecting the negotiating strengths of the company and the debt provider, including the nature of the proposed reform, the creditor protection in the arrangement concerned, the year and hence remaining duration until maturity, and the prevailing capital market conditions including volumes and yields of competing issuance. We consider three benchmarks: §
Firstly, in the case of voluntary early call of many sterling-denominated bonds there is a specified approach to payment, known as the Spens clause.
§
Secondly, in the case of involuntary early repayment (i.e. in case of put or default events), companies may need to redeem debt at par.
§
Thirdly, for traded instruments the market price will be more or less observable depending on liquidity, though companies may not be able take advantage of this.
The Spens clause was established as a safeguard for investors against early call of a bond following interest rate changes. In the case of early termination the investor is compensated by receiving the higher of: 24 (i) the foregone coupon (interest) and principal payments, discounted at a rate equal to the redemption yield of a gilt of comparable maturity; or (ii) the outstanding principal. These rules protect the lender from interest rate changes since the time of debt issue. To take a simple example, if a water company has an existing bond issue on which it is paying a coupon rate of 6%, whereas gilt yields for the same maturity are 4%, early redemption will involve paying a substantial premium to the par value of the bond. The investor could reinvest the whole of the repaid funds in gilts and receive the same value in payments as before, while enjoying lower risk. The same premium would need to be paid to the investor if the water company wishes to redeem this bond in advance of its maturity date to avoid a default situation expected to arise under forthcoming competitive reforms. 24
See for example HMT(2006): Guidance on Application of the Spens Clause to PFI Transactions
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Implications for Existing Financing Arrangements
The formula above sets out the gross cost of Spens. The net cost of Spens redemption is the gross cost minus the market value of the redeemed asset. However, the Spens clause is not used for all sterling bonds. For example, it is not typically used for subordinated or short-term issues. Neither is the clause used where debt is denominated in other currencies, though Euro or dollar issues are likely to be covered by other call protection clauses requiring payment of a premium for early redemption. Also, the clause does not apply in cases of put or default events. The benchmark typically applying in cases of default is redemption at par. When financing costs have risen since issuance, the market value of a bond will be less than par. However redemption often cannot be at a market value less than par either because the terms prohibit companies from buying back their bonds in secondary markets, or because the bond holders are not willing sellers at a “market” price notably less than par when default circumstances – specifying repayment at par - are approaching. We made estimates of the Spens and par premiums using current market prices for the twenty-three traded sterling bond issues above £300m in size where coupon and maturity evidence was available. This choice of sample was driven by two considerations: on the one hand we wanted to base our estimate on as large a share of total issue volume as possible. On the other hand small bonds are potentially illiquid, resulting in out-of-date market values. Choosing a cut-off of £300m bases our estimate on the largest 10% of outstanding sterling bonds, which make up about a third of total outstanding sterling bond value while also limiting illiquidity effects25. Using information on these bonds we ran two thought experiments. §
Assume the water sector buys back all or sample of traded sterling bonds with outstanding principal above £300m and has to pay Spens on them. Then assume that all these bonds are re-issued into the current market with exactly the same term structure and coupon rates. Ignoring any problems related to transaction costs and the feasibility of reissuing, the difference between the amount notionally paid when redeeming at Spens and the notional sales proceeds from issuing the same sample of bonds at market prices is 35% of the market value of those bonds.
§
The second thought experiment assumes the sample is redeemed at par and then bonds with exactly the same coupons and maturities are re-issued at market prices. In this case the difference between the two amounts is 9% of the market value of the sample. Again this is ignoring any questions about the transaction costs associated with or the feasibility of such an undertaking.
We use the percentages above to estimate benchmarks for the possible overall transitional refinancing cost, though of course in the event this would be the result of negotiations. Summing the par values (from Bloomberg) of all outstanding sterling bonds in November 2008 provides a total figure of £22.7bn. Thus, if all sterling bonds were bought back at par
25
Our sample is reasonably representative of the whole population of bond issues with respect to the coupon and remaining term, so our sample-based calculation of Spens provides reasonable guidance on the cost of Spens if more widely applied.
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Implications for Existing Financing Arrangements
the cost to the water companies would be equal to £22.7bn. Our calculations outlined above suggest the market value of this debt is currently 9% below its par value26. Consequently a subsequent re-issue of that debt with the same coupon and maturity conditions would (ignoring feasibility) only fetch £20.7bn, resulting in a refinancing cost of £2bn. If all sterling bonds were subject to Spens the net refinancing cost to the sector (ignoring feasibility) would be 35% of the market value, resulting in an estimate of a net Spens cost of £7.2bn. Table 3.1 sets out our estimates of the cost of revisiting water company sterling bonds under different assumptions about the percentages of bonds incurring Spens or par redemption. Table 3.1 Sterling Bonds Refinancing Costs (November 2008) Par value Market value Spens value
Total Water Industry Sterling Bond Debt (£bn) 22.7 20.7 27.9
Gross Redemption Cost/ Market Value of Debt (%)
Repaid at Spens
Repaid at Par
35%
9% Net Cost (£bn)
Proportion of bonds redeemed 10% 25% 50% 75% 100%
at Spens 0.7 1.8 3.6 5.4 7.2
at Par 0.2 0.5 1.0 1.5 2.0
Source: NERA analysis of Bloomberg data(Nov 08) and company financial accounts for 2007-08.
Table 3.1 allows combined estimates. For example, if 10% of sterling bonds were redeemed at Spens, the net cost would be around £700m under today’s parameters. If 25% of sterling bonds were redeemed at par before being re-issued at market prices the cost would be about £500m. If 25% of all outstanding bonds were redeemed at Spens and 75% were redeemed at par, the cost would be around £3.3 billion. In all cases, the figures above suggest that transitional costs could be very substantial if existing financing arrangements must be revisited due to competitive reforms. In establishing this we have been conservative. We have not added sums for renegotiation of bank loans or finance leases. We have not considered whether it would be feasible for water companies to refinance such large amounts of debt in current or prospective market conditions. We have assumed that retired debt can be re-issued at market, whereas it is not clear that wrapping and index-linking capacity is now or prospectively will be available to the necessary degree. Our calculation here has not allowed that the onset of competition makes it likely that in the future more stringent covenants and/or higher coupon rates or shorter maturities will be required, 26
The average coupon on the outstanding sterling (non-IL) bonds in November 2008 is just under 6%. A market value 9% below par value (as observed for our sample, but probably not completely up to date in today’s volatile conditions) is consistent with application of a discount rate of approximately 7% to the time-stream of coupon and principal payments.
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Implications for Existing Financing Arrangements
further increasing the cost of re-issue. We have not added sums for transactions costs. Allowing for these and the points listed above would add further to the already substantial transitional financing costs.27 Finally, we have not allowed for any necessary revisiting of financing arrangements at holding company level.
27
As an example of the transaction costs associated with refinancing utility businesses, the NAO reports that the transaction costs associated with refinancing of National Air Traffic Service (NATS) following the September 11th 2001 terrorist attacks were around £20million. The negative shock to traffic and revenues resulted in NATS unable to finance its activities. As a percentage of the total bond issue refinanced of around £600 million, the transaction costs equate to around 3% of debt issue. Source: NAO (2004) Refinancing the Public Private Partnership (PPP) for National Air Traffic Services (NATS) p. 11.
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Financial Parameters for Business Units in Models of Competition
4.
Financial Parameters for Business Units in Models of Competition
This section sets out the financial parameters we associate with the various business units within each of the competition models identified above. Specifically, to enable our modelling framework we assess: §
the cost of capital, based on the undiversifiable risks, of the business units present in each of the different competitive models;
§
the expected maximum financial leverage of the businesses; and,
§
any other key assumptions about financing (e.g. for retail, there is evidence that the businesses operate on a margins approach rather than the standard WACC return on assets).
In making our assessment, we have no reliable water precedents to draw on. We draw on evidence from comparable utility sectors that have been restructured, especially the energy sector, as well as the responses from interviews with investors and rating agencies undertaken during the course of this study. Our assessments feed into our quantitative modelling in Section 5. The section is structured as follows: §
Section 4.1 presents evidence on the expected financing costs of a retail business;
§
Section 4.2 presents evidence for network financing costs.
§
Section 4.3 presents evidence for the financing costs of water resource and treatment businesses, which we also take to be relevant to sewerage businesses operating under the single buyer model.
§
Section 4.4 considers the capital structure of the new business units.
§
Section 4.5 draws conclusions.
4.1. Retail Business Risks As set out in Section 2.3, a prospective water retailer will have a cost structure which is characterised by a high-level of bought-in-costs (i.e. payments to a wholesaler under the retail-wholesale model, to the single-buyer model under that model, or to resource and treatment and network entities under a wholesale market). However we expect them to have a relatively low level of capital employed, reflecting the integrated companies’ asset value proportions, which show that the retail assets form around one-tenth of one per cent of an integrated company’s net MEAV. There is compelling empirical evidence from the GB energy retail sector that businesses with such a cost structure will target an EBIT/sales margin rather than targeting a rate of return on capital employed. For example, Ofgem has recently published the initial findings of its probe
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Financial Parameters for Business Units in Models of Competition
into the functioning of competition in the GB electricity and gas retail supply markets for domestic customers and Small and Medium Enterprises (SMEs).28 Ofgem’s evaluation of retailers’ profitability focuses exclusively on their margin on revenues. Ofgem reports that energy retailers earned a pre-tax margin on sales of 2% over the period 2005-2007, which is below their expectations over the business cycle of 5%: 29 “Based on suppliers’ submissions, we estimate the average pre-tax margin on sales in energy supply between 2005 and 2007 (inclusive) was around 2 per cent. Evidence from business plans suggests that this was below companies’ expectations, although compensated for by higher profitability in electricity generation and gas production. Several companies cite a “through the cycle” supply margin of 5 per cent as an appropriate benchmark for the retail energy sector, based on public comments by Centrica, owners of British Gas. “ UK energy sector regulators have also adopted a margin on revenues approach to setting price controls for regulated retail entities which are subject to a price cap prior to full retail market contestability. For example: §
The 1993 Electricity Supply Price Control Proposals for GB Regional Electricity Companies (RECs) set out controls on prices in the “franchise” market for sales to retail customers. The regulator (OFGEM) set a 1% profit margin on turnover. 30
§
In 1995, the then Monopolies and Mergers Commission report on Scottish Hydro stated that a sales margin of 0.5% was adequate for first tier electricity supply.
§
In setting price controls in 1998, Offer and Ofgas considered a margin of 1.5% on sales was commensurate with the risks faced by investors.
These decisions relate to continued regulated markets rather than competitive retail markets and so indicate a floor on the margin that a water and sewerage retail entity would require in a competitive market. The rationale for targeting a margin on revenues is that retail businesses have potentially volatile earnings streams: a negative revenue or cost shock will result in significant negative returns to investors. For example, competitive water and sewerage retailers will face input cost-risks, differing with the competitive model. They will also face demand risks from macro-economic factors and from retail competition. These risks are unlikely to be passed to customers to the same degree as in the integrated regulated model, and are unlikely to be completely diversifiable. Though this issue has not been substantially discussed as yet, it also seems most likely that competitive retailers will be required to assume final customer bad-debt risk to a greater degree than the regulated integrated companies – there will be fewer regulatory mechanisms to claw-back the associated costs from customers as a whole. This risk is likely to correlate to macro-economic factors and have an undiversifiable element. Depending on the treatment of disconnection rights, water retailers might face higher bad debt risks than energy retailers. For an integrated water company a cost or demand shock or 28
Ofgem (6 October 2008) Energy Supply Probe – Initial Findings Report.
29
Ofgem (6 October 2008) op. cit., para 8.6.
30
Offer (1993), Supply Price Control Proposals, Paragraph 4.27.
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bad debt might constitute (say) 1% of revenues, and therefore be a relatively small risk as a proportion of overall returns constituting one-third of revenues. However for an independent retailer the same risk will constitute a much larger share of their expected returns after input costs – and no regulatory redress will be available. Negative shocks therefore have a much greater impact on the retail company’s earnings. In reflection of this investors expect retailers to target a margin on revenues which is greater than that implied by the WACCbased returns an integrated entity is expected to earn on the few retail assets. The water sector in Scotland introduced non-household retail competition in April 2008. The regulator (the Commission) has set out default retail tariffs that Licensees must offer as part of their Licence conditions, as well as wholesale charge caps that apply to the Scottish Water wholesale business. 31 The Commission has stated that: “The wholesale charges scheme allows for a 11% retail margin across the whole retail market in 2008-09. Crucially, we have determined that a minimum retail margin of 4.5% should exist between the wholesale and retail tariffs for specific customer groups, with some margins up to 60%.”32 However, these regulatory figures are gross margins – i.e. calculated before the retailer’s sales costs – and are not comparable to the net (EBIT/sales) margins of 2% to 5% cited in the energy sector above. Comparable net margin figures have not been published for retail water in Scotland by the regulator. As retail competition opened in Scotland only in April 2008 there is as yet no market evidence on the net margins required or earned by competitive retail entrants. We have also reviewed evidence from other comparable sectors. For example, the Competition Commission’s approach to setting charges for connection charges for mobile phone operators in 1999 was based on a margin on revenues approach of 1.5%.33 There is also comparable evidence from the UK rail franchising sector where train operating companies (or TOCs) target margins on revenues of between 4% and 6%.34 A retailer in a wholesale market will have a trading function, and will need to make complex decisions on how much of its water purchases it should contract forward (i.e. hedge), and how much to purchase at spot. By contrast, in a regulated or single buyer environment, all retailers face the same wholesale price for water, and the more regulated or contracted environment implies lower cash-flow volatility. In conclusion, we believe that a margin on revenues between 2% (the current margin in GB energy retail) and 5% (the target margin over the business cycle) is an appropriate range to
31
See: (i) Water Industry Commission for Scotland (2007) Summary of 2008-09 Default Retail water tariffs; and (ii) Water Industry Commission for Scotland (2007) Summary of Scottish Water’s 2008-09 wholesale water charges.
32
Source: The Water Industry Commission (02 August 2007) Retail and Wholesale non-household charges for 2008-09, p.2. The margin of 11% is also confirmed in the wholesale charging scheme: Scottish Water Draft Wholesale Charges Scheme for the Financial Year 2008-09, Effective From 1 April 2008, p.5.
33
Ofgem (6 October 2008) op. cit., para 8.19-20.
34
In Great Britain, bidders participate in auctions for the franchise to run train operating companies (TOCs). The TOCs have high revenues and high operating costs, but are able to lease many of their assets, so their financial position is arguably comparable to a retail entity. The revenue margin included in bids is around 4%-6%. See NERA (2006), Implications of Amending Franchise Agreements: Final Report for ORR, July 2006, page 4. This document is available at http://www.rail-reg.gov.uk/upload/pdf/incentives-nera.pdf.
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consider for a water and sewerage retailer. We adopt the lower bound of 2% for a competitive retailer buying from a wholesaler or a single buyer/seller, and the higher bound for a retailer operating in a wholesale market which faces greater cash-flow volatility.
4.2. Network Business Risks In identifying the relative financing costs of the continuing regulated businesses – covering the networks and any other activities remain regulated in our models - we take the cost of capital of the integrated business as our starting point and consider the factors which might be different under the new competitive models, as follows. In the retail-wholesale model, because the retail activities are a small proportion of the integrated business, we expect the regulated wholesaler to be similar to the integrated regulated business in respect of most risks and their diversifiability. Competitive retailers are likely to be required to assume final customer bad debt risk, risk which the integrated regulated business was previously able to largely pass back to customers as a whole, so the competitive reform will transfer some risk from customers to retail-investors. Whether the wholesale business now faces less or more risk than did the integrated business depends on its regulation, notably the extent and regulatory treatment of the wholesaler’s bad debt risks (from bankruptcy of retailers - there have been such bankruptcies in both GB energy and water in Scotland) and in particular the wholesaler’s ability to recover such costs from network charges. The wholesaler’s risk position will also be affected if the wholesaler has retailer–of-last-resort duties with costs which cannot be completely passed through. The wholesaler’s risks can be mitigated by requiring the retailers to pre-pay the wholesaler as in water in Scotland. Overall, the risk profile of the new wholesale entity will depend on the detail of its regulation and on the precise retail market operating and market codes. The wholesaler’s non-diversifiable risks could be higher or lower than those an integrated business currently faces. Network businesses acting as the single-buyer will face contract risk and exposure as the counter-party to long term water and sewerage treatment contracts. In the electricity sector, and where these contracts exist in water and sewerage (e.g. in the case of the PFI in Scotland), it is generally intended that the buying entity’s prudent procurement costs would normally be passed-through to its customers in the same way as the costs of an integrated regulated entity would be. As for an integrated entity, intended pass-through does not leave the singlebuyer’s investors without risk - the regulator might not pass-through all costs, for example if the regulator determines ex post that the network has not procured new resources at least cost or has not achieved least cost despatch. It has been suggested to us that a water network business may be less risky than an integrated business because the risks associated with the water companies’ sizeable capital expenditure programmes are not relevant for the network business. However Figure 4.1 shows that over the period 2000-01 to 2006-07 the network elements had a higher exposure to construction risk – as measured by the proportion of capital expenditure relative to total expenditure – compared to other business elements. We are not aware that companies’ capital expenditures patterns across the business elements are likely to change significantly going-forward. There is also no evidence we are aware of to suggest that capex risk is lower for the networks than other businesses because of the type of projects undertaken. On the contrary, the difficulty
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with observing the network asset condition and therefore estimating the expenditure necessary to achieve minimum service levels or quality improvements implies higher risk.
Percentage of Total expenditure
Figure 4.1 Capex Exposure of Different Business Units 80% 70% 60% 50% 40% 30% 20% 10% 0% Retail
Water Network
Resources & Sewage Treatment Treatment
Enhancement over total expenditure
Sludge Disposal
Sewerage Network
Capex over total expenditure
Source: NERA Analysis of June Returns data for all WaSCs, 2000-01 to 2006-7
In the specific case of water and sewerage in England and Wales the RCV is a small proportion of the MEAV, and the network assets form a high proportion of the MEAV. If competition is introduced then the opening value for the network business might be significantly smaller than the current integrated RCV, with higher operating leverage meaning that given cost and demand shocks have a larger impact on earnings (as discussed for retail above) than for the current integrated business. The relatively small network business value is the outcome of a number of our modelling scenarios applying a “focussed” approach to setting opening values (see Section 5.4). Depending on the geographic consolidation and other diversification opportunities, the reduction in size of the network business unit may also directly limit access to some finance sources. In our interviews with sector investors and rating agencies, the narrowing and size effects and their possible direct and indirect negative implications for financing costs were highlighted by a number of our interviewees. In conclusion, there are different factors which might be expected to reduce and to increase the cost of capital for a regulated network business compared with an integrated network business. The eventual outcome will depend on the detail of the regulatory and competitive framework. On balance we consider the most appropriate assessment to be that all the network or broader continuing regulated businesses, including the wholesaler, under all our competition models, have the same cost of capital as the integrated regulated business. In other words our best assessment is that the capital market or “beta risk” for all these regulated entities is the same. NERA Economic Consulting
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For the purposes of our modelling we assume this WACC is equal to the headline allowed rate of return of 5.1% (real post-tax) adopted by Ofwat for the regulated integrated businesses at PR04.35
4.3. Resource and Treatment Business Risks In this Section we evaluate the relative risk of resource and treatment businesses operating under a single-buyer model and a wholesale market model. (We apply the same reasoning for a sewage treatment business contracting with a single buyer.) As described in Sections 2.3 and 2.4 above, we expect the risk exposure of a water-producing business operating in a single buyer environment to be very different from the exposure of a business operating in a wholesale market environment. Under single-buyer procurement, generally some form of auction is held to determine the lowest cost offering, and the singlebuyer signs long-term life-of-plant contracts with the independent power producers (or IPPs), the term used in the energy sector, or independent water and power producers (IWPPs) for co-generation producers. The single-buyer model requires long-term (life-of-plant) contracts because investors are reluctant to sink large amounts of fixed capital in plant if they run the risk of being beaten back to running costs by the single buyer once the plant is complete. The design of singlebuyer contracts in the energy sector and for co-generation facilities worldwide invariably includes at least two-part payments comprising: §
A fixed annual fee to cover the independent producer’s fixed costs. The fixed payment is often linked to the producer’s declared availability to provide energy/water, and is referred to as an availability payment. The fixed payment structure can be designed to incentivise plants to make themselves available, i.e. to reduce planned and unplanned outages.
§
A variable cost designed to cover the costs when the producer provides energy/water. This term might be indexed using indices that are intended to proxy the producer’s change in input costs over time, while leaving an incentive to outperform.
Independent resource and treatment plants are likely to involve substantial risks for their investors, even with a long-term contract with a creditworthy counter-party. These risks stem from construction cost overruns, operational performance problems, and the chance of ongoing capital and O&M costs that are higher than those contemplated by the contract, e.g. from new compliance risks. They also face risks of possible changes in availability of inputs or changes in demand or quality requirements, or introduction of wholesale markets that open up bilateral re-contracting risks and stranding risks. Our assessment it that these risks will be left with investors to a greater degree than they were left with the investors in the integrated business after the operation of regulation. Similarly, and to a greater extent, a plant operating in a wholesale competitive market (or “merchant” plant) faces wholesale market price uncertainties without the benefit of a long term contract to provide comfort that the producer will recover its fixed costs, or of regulation 35
Ofwat (2004) Final Determination, p. 219.
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to increase the certainty of returns. Instead, the producer’s results depend on potentially volatile market prices and input prices. For example, demand in the plant locality (which may be much narrower in geographic scope in water than for energy grids) might fall away, resulting in excess production capacity, lowering market prices and creating a short-fall in recovering fixed costs.36 Demand and input cost factors are likely to be correlated with macro-economic factors and so lead to volatility of the producer’s earnings which is not transferred or mitigated by contract or regulation, and is not diversifiable by investors owning a portfolio of such plants. That is, we expect the market or beta risk for water producers in wholesale markets to be notably higher than that of an integrated regulated water business, and also notably higher than that of producers operating under single-buyer arrangements. In order to assess the expected difference in the WACC between producers under a single buyer and wholesale market model, we reviewed equity market research papers. In particular, a research note by Credit Suisse sets out estimates for the difference in the market or beta risk WACC between contracted and merchant electricity plants in the US, Australia and Europe of between 370 bps and 410 bps for International Power (IP). Research notes on IP provide a useful comparison of risks for different market models because it has a substantial portfolio of both contracted and merchant plant, and is a “pure-play” generator. A research note by Morgan Stanley set out a lower premium, of 150 bps, for the worldwide set of IP’s contracted plants relative to merchant plants, although the research note implies a higher merchant plant WACC where plants face higher commodity or technology risks.37 In such cases, the implied premium for merchant plants relative to contracted plants is around 250 bps.
36
In the energy sector, merchant plant typically seek to sell capacity forward in order to lock-in prices and revenues. For example, Drax, a large coal-fired merchant electricity generator, seeks to sell two-thirds of its capacity forward in short and medium term markets. In the GB energy sector, there has also been a trend towards integration of supply and generation in order to hedge wholesale market risk. These hedging strategies reduce short/medium term cash-flow volatility but do not eliminate all market risk.
37
Morgan Stanley identifies Drax, a coal-fired plant, and British Energy, the owner of the portfolio of nuclear energy plant, as facing higher risks.
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Figure 4.2 Merchant Plant WACC Premium Relative to Contracted Plant WACC38 Merchant WACC Premium Relative to Contracted WACC (%)
4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00%
North America
Europe
Australia
IP
Credit Suisse
Credit Suisse
Credit Suisse
Morgan Stanley
We also need to consider the relative risk of contracted plant relative to a regulated integrated or network business. US energy regulators have considered the cost of capital of producers under a single-buyer model to be higher than that of a regulated utility business because of the contract risks set out above, e.g. construction risk, plant availability and O&M costs which might not be recoverable under the contract. For example, the Californian Public Utility Commission (CPUC) concluded that the contracted plant WACC fell “somewhere between that of a merchant generator (selling into the market without a long-term contract) and a utility”.39 The Morgan Stanley publication cited above also estimates an asset beta for contracted plant, of 0.6. Assuming an asset beta of 0.4 for a network utility (the implied asset beta adopted by Ofwat at previous reviews)40, this implies a WACC premium for contracted plant of 100 bps (on a pre-tax basis). We have sought to cross-check this premium against the internal rates of return (IRR) earned on long-term PFI contracts in the water sector, taken as a proxy for plants under a singlebuyer model on the presumption that PFI contracts might share similar characteristics to any eventual long term offtake agreement between an independent water producer and a singlebuyer. There is little publicly available evidence. However HMT state that the margin
38
Sources: Morgan Stanley (December 2007), "Higher for Longer Commodity Prices: Buy Generators Focus on Clean Energy", slide 11; Credit Suisse (May 2006) "International Power", p. 19.
39
See: http://docs.cpuc.ca.gov/published/Comment_resolution/54445.htm
40
At PR99, Ofwat set an asset beta of 0.35- 04. See NERA (2004) UK Water Cost of Capital, A Final Report for Water UK, p. 28-30. At PR04, Ofwat did not explicitly state an asset beta, but the implied asset beta based on equity beta of 1 and gearing of 55% is 0.45. See Ofwat (2004) Final Determinations, p.222.
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earned on PFI contracts relative to a standard utility WACC was around 170 bps - although their report notes that this estimate is sensitive to key assumptions.41 In conclusion, our assessment is that resources and treatment plants operating in wholesale water markets would face higher non-diversifiable risks and so involve a WACC 300 bps higher than plants under a single buyer model with long term contracts. This premium is the approximate mid-point of estimates set out in the two equity research notes cited above. For a water producing plant under a single buyer model with a long term contract, our assessment is that the contract with a creditworthy buyer allows the producer to transfer much of the output price risk to the buyer. But the independent producer still retains substantial contract risks, including construction cost overruns, operational performance problems, and possibilities that ongoing capital and O&M costs are higher than those originally contemplated, e.g. from new-compliance costs. There is less redress than under regulation. Consequently we consider that non-diversifiable risks for investors will be a little higher than in the regulated integrated business – accordingly we consider the WACC will be 100 bps higher than that of the regulated integrated business.
4.4. Capital Structure of New Business Entities To fulfil our brief of investigating the financial implications of the competitive possibilities, and in particular the possible implications for the gearing of the sector, we need to assess the maximum efficient capital structure for each business element. Our assessments are based on observed company gearing decisions for regulated network businesses, a research note by S&P which sets out maximum gearing for generators operating in wholesale markets,42 and comments by interviewees. Drawing on this evidence base, we reach the following conclusions regarding gearing: §
For a regulated network business adopting structured financing, we apply a maximum gearing ratio of 85% based on observed achieved appointed business gearing levels.
§
For a regulated network business adopting corporate financing (e.g. with listed equity) we apply a maximum gearing level of 70% based on observed achieved appointed business gearing.
§
For a water production entity in a wholesale competitive market with a minimum efficient credit rating of BB we consider that feasible gearing could fall into the range of 35% to 50%. To achieve a BBB+ rating a merchant water production company would need to have no more than 35% gearing. In modelling we apply 50% as our maximum.
§
For a resource and treatment entity under a single buyer structure with a long term contract, we assume the feasible maximum gearing is equal to 55% to 70% based on our understanding of the risks relative to regulated network activities, and for modelling purposes we adopt a maximum of 70%.
41
For example, the estimate is sensitive to the authors’ assumption regarding bid costs. See HMT (2003) PFI: Financing Costs p126.
42
Standard and Poor’s (September 2001) International Utility Ratings and Ratios
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4.5. Conclusions on Financial Parameters Table 4.1 summarises our real post tax WACC and maximum gearing assumptions for the different business units under our competitive models. Our starting point is to set the regulated or network WACC equal to 5.1% (Ofwat’s post-tax WACC for an integrated business at PR04), and then add our assessed WACC premia. Table 4.1 Real Post-tax WACC Assumptions for Different Business Units
Source: NERA calculations on the basis of considerations above Note: Regulated elements always include the network
These modelling parameters represent our expectations about the relative levels of financing costs of the various business units over the long-term, and not the absolute levels. As set out in Table 4.1, the weighted sum of the new business units’ WACC is greater than the existing integrated company’s WACC. This is for a simple reason that we have stated a number of times already: the risks borne by new investors in the contestable markets are currently largely borne by customers under the current regulated price cap regime. That is, the separation of the integrated business and the associated financing costs of these businesses is not a zero sum exercise, because it involves a change in the overall relationship between the service providers (and therefore their investors) and the customer. We ignore here any transient increases in the cost of capital of the current integrated business or later separated businesses which could result from uncertainty about the reform process, though we note that they could be substantial. For example, Standard and Poor’s recently placed Nuon, an integrated Dutch energy utility, on creditwatch negative following the announcement of mandatory unbundling of regulated distribution operations from unregulated generation and supply businesses by December 31 2010.43 The issues and uncertainties that S&P highlighted as negative risk factors would also be relevant were similar unbundling reforms to be pursued for the England & Wales water sector: 44 §
“the strategy of the unregulated businesses” (e.g. with regard to acquisitions or partnerships)
§
“the financial policy of the regulated businesses. The regulator is considering putting in place minimum credit metrics for the regulated businesses [which might affect the financial risk profiles]”
43
Standard and Poor’s (July 18 2008) Dutch utility Nuon placed on creditwatch negative on unbundling of regulated operations.
44
Standard and Poor’s (July 18 2008) op. cit., p. 3.
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§
“the allocation of debt between the unregulated and regulated businesses.”
§
“any one-time costs and/or liabilities resulting from the unbundling.”
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5.
Financial Modelling of Stylised Water Companies
5.1. Stylised Companies We have analysed the financial implications of separation of the integrated business units under different competition models initially with respect to four stylised water company models as follows. We model the financial implications for a stylised WaSC and a stylised WoC. The WaSCs are substantially larger than an average WoC - for example, the average WaSC has an RCV about 17 times the size of the average WoC – and they undertake sewerage services. These differences mean that the financial implications of different competition models may be different. For our stylised WaSC and WoC, we also analyse separately the financial implications for a structured finance and a corporate finance company. The starting values of debt vary considerably according to the financing structure, and this has implications for the ability to carry the existing levels of debt under the new competitive structures. They also have different compositions of debt instruments, as set out in Figure 3.1 above. Of course, a change in the capital structure may be the efficient and appropriate reaction to competitive reforms – here we seek to identify if such a change appears to be required. Table 5.1 below shows the categorisation of each company in the sector according to our four stylised models. Table 5.1 Company Categorisation by Stylised Model
WaSC
WoC
Structured Anglian Dwr Cymru Southern Thames Yorkshire Bournemouth & W Hants Bristol Dee Valley Portsmouth South East South Staffs Sutton & East Surrey
Corporate Northumbrian Severn Trent South West United Utilities Wessex
Cambridge Folkestone & Dover Tendring Hundred Three Valleys
Source: NERA analysis
Table 5.2 presents average net MEAV, RCV and gearing ratios for our stylised companies, used in setting starting values in our financial models.
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Table 5.2 Net MEAV, RCV and Gearing by Stylised Company WASC WOC
Net MEAV (£m) 21,526 1,180
RCV (£m) 4,333 220
Gearing - structured Gearing - corporate 75% 57% 76% 34%
Source: NERA analysis, Ofwat analysis of company financial performance 200845
Figure 5.1 shows net MEAV per business unit for the year 2008 for our stylised WaSC and WoC. Figure 5.1 Net MEAV By Business Unit for Stylised WaSC (Upper Level) and WoC (Lower Level) all figures £m for 2008
Source: NERA analysis of data provided by a sample of companies
Figure 5.2 shows the starting values for operating and capital maintenance expenditure for each business unit for our stylised WaSC and WoC.
45
Ofwat (25 September 2008): Financial performance and expenditure of the water companies in England and Wales 2007-08
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Figure 5.2 Operating and Capital Maintenance Expenditure By Business Unit for Stylised WaSC and WoC (all figures £m for 2008)
Source: NERA analysis of data provided by a sample of companies
5.2. Business Unit Opening Values The implementation of competitive models will involve the establishment of initial asset values for all separated business units. In our modelling of the financial implications for the sector, we adopt two principal rules to obtain opening values. The first rule we refer to as the “focussed approach” (borrowing from the terminology used by Ofgem, where they have addressed similar issues).46 The principle governing this rule is that we should calculate asset values for the different assets to avoid any stranded costs (or windfall losses) or stranded benefits (windfall gains) compared with the initial integrated situation. We do this by: §
Setting the value for the new businesses in contestable markets equal to the market value. In practice this might be established at auction, but the proxy we use for modelling is the net MEAV (loosely speaking the replacement cost) of the assets falling into that business unit.
§
Setting the value for the remaining businesses in non-contestable markets (e.g. network businesses) equal to the RCV minus the value of contestable businesses.
This rule is consistent with continuing to recognise the whole of the RCV asset value built up by an integrated regulated water company. The difficulty with this rule in the water sector is that the total industry RCV is only approximately 20% of the total industry net MEAV, i.e. there is a large capital value discount. Under the focussed approach, this potentially leads to a very high proportion of the RCV being taken up by the contestable units, and a relatively small and potentially negative opening capital value remaining with the non-contestable business. If the latter receives a 46
See Appendix A for a discussion of regulatory precedent.
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regulated return based on a positive opening value, our approach ensures that the NPV of returns (discounted at the WACC) always equals the opening value. However, is this is a small opening value, the business as we have modelled it will probably not have sufficient financial strength to attract the capital it needs (recalling that the companies are projected to be cash negative). In such circumstances a different approach will be required. One approach is to try to establish a higher WACC which is consistent with financing the business on a lower capital base, but we have not explored this route. An alternative rule, the unfocussed approach to RCV assignation47, aims to avoid non-viable non-contestable business units by establishing opening values for each business unit equal to a share of RCV proportional to the net MEAV shares. Applied in England Wales this rule ensures that the water network business retains a larger opening capital value (relative to the focussed approach). A potential difficulty is that the assigned opening values of the assets in the competitive sectors are then not equal to the market asset value, or in other words, not equal to the cost of the best new entrant (BNE). As regulation is lifted from contestable units we would expect output prices to gravitate to competitive levels, lifting prices to end customers and creating the opportunity for windfall gains (known as “stranded benefits”) to be made by the owners of the newly competitive units. On the other hand, if the contestable unit values and prices are held down at the unfocussed level below the BNE level, that might be expected to stall new-entry and competition. To avoid these potential effects of the unfocussed approach, the challenge is to design accompanying regulatory or contractual mechanisms to remove stranded benefits while not undermining the efficiency properties of the new contestable markets. (The flip-side situation is where opening asset values are set higher than new entrant levels, so that assets are undercut, prices fall, and stranded costs result unless these are covered by regulatory or contractual mechanisms.) Figure 5.3 illustrates the very different outcomes for the opening values of the different business units under the focussed and unfocussed approach for a stylised WaSC. This shows that: §
Today the water and sewerage network have asset values of £6,238 million and £11,513 million respectively, comprising approximately 82.5% of the total net MEAV for an average WaSC.
§
Under the unfocussed approach, the network businesses would be valued at £1,256 million and £2,318 million respectively, i.e. at a discount of around 80% compared to net MEAV.
§
However, under the focussed approach, where we assign net MEAV to the contestable businesses – in this example, water resources and treatment, retail and sewage treatment and disposal – the implied water and sewerage network opening asset values are only £196 million and £362 million respectively, or a discount of around 97.5% compared to the net MEAV.
47
Again, drawing on terminology used by Ofgem. See Appendix A.
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Figure 5.3 RCV Allocation Under Focussed and Unfocussed Approach: Stylised WASC (£ million)
Source: NERA calculations based on data provided by a sample of WaSCs
The following sections set out the implications for financing costs and the financial viability of the new entities under the focussed and unfocussed allocation rules and under different competition models.
5.3. Financial Modelling of Business Units We have constructed a simple set of integrated financial accounts which models both an integrated business (as our “control”) and all possible structural separations required for the set of competition models we investigate. The financial outcomes under the different competition models can then be compared to the integrated model. The model runs over the period 2008-2030. We analyse the financial implications of the competition models for our four stylised companies under our three different competition models – retail-wholesale, single-buyer and wholesale market, as described in Section 2 – and for the focussed and unfocussed RCV allocation approach. The starting values, the net MEAV for each business unit, RCV, operating costs, and capital maintenance costs are set equal to the average values for our stylised WaSC and WoC as set out in Section 5.1 above. Depreciation and IRC are set equal to capital maintenance costs. Regarding the financial structure of our four stylised models, we assume opening debt levels
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equal to the current WaSC and WoC values for both the structured companies and corporate finance companies as set out above. In addition, we assume the stylised structured company has two tiers of debt. Senior debt has a cost of debt which is 75% of the total cost of debt and is limited to comprising a maximum of 60% of total debt. In assigning initial debt to the new business units, we assign as much as possible within the total carried by the integrated business, and within the maximum gearing assumptions for the new business units, beginning with the non-contestable business units. In modelling total financing costs, we apply our estimates of the WACC for each of the business units (see Table 4.1) to the modelled capital base. We base our estimates of capital enhancement programmes on the proportion of RCV these form in companies’ latest draft business plans. The average share for WoCs is 8%, with 6% for WaSCs. We assume companies continue capital investment at this proportion for the first two asset management plan periods (AMP) in our modelling period, i.e. from 2010 to 2020, before reducing capital enhancement as a share of RCV to 4% and 3% respectively until 2030. We also assume that new enhancement expenditure incurs the same operating expenditure per asset value as the existing assets. The key questions our modelling framework addresses are as follows: 1. Under what modelling scenarios do we have a very low - or even negative - RCV for noncontestable elements, which might generate insufficient returns to make the modelled regulated businesses financially viable at the WACC we have assessed? 2. What is the P&L structure of each of the new business units? In particular, how do the network business unit’s returns compare to those of the integrated company under different scenarios? 3. What is the change in overall sector costs, including financing costs, and therefore customer bills under each competitive model, relative to the integrated company? (Remembering that we ignore all benefits and all costs of competition apart from financing costs.) 4. How much debt can the non-contestable businesses, and the new sector businesses in total, carry under different modelling scenarios, relative to the current integrated model? Is it likely that de-levering will be required?
5.4. Modelling Results This section presents a selection of results from modelling the stylised companies at various stages of separation. We present a limited set of cases that emphasize the major issues. 5.4.1. Retail-wholesale separation Figure 5.4 depicts the outcome of a retail-wholesale separation for our stylised structured WaSC using the focussed approach to RCV allocation. We assume this model is adopted in 2012. The retail business represents both water and sewerage retail for households and business customers (i.e. we have not modelled a retail business for a smaller defined set of eligible customers).
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Figure 5.4 Retail-Wholesale Separation: Structured WaSC, Focussed Approach
2012
847
869
§
The top left-hand quadrant of Figure 5.4 presents initial MEAV proportions by business unit, and RCV or opening value arrangement by business unit, under our designated rule (in this case, a focussed approach). Under this approach, the retail business is allocated its entire net MEAV. However, as the figure shows, the net MEAV of the retailer is very small, and the retail business value forms a negligible proportion of the total sector RCV approach even under the focussed approach.
§
In the top right quadrant we present information on the P&L structures of the different business units. This shows that a very high proportion (>90%) of the retailer’s costs constitute bought-in-costs, that is payments to the wholesaler. The quadrant also shows that the cost structure of the new wholesale business is very similar to the integrated business.
§
The bottom left quadrant sets out the increase in costs – annual P&L costs - per stylised company under this competition model. This shows that overall sector costs increase from £847 million to £869 or around 2%, i.e. equivalent to our input assumption on the margin required by the competitive retailer based on the empirical evidence from the GB energy sector.
§
The bottom right quadrant shows the capital structure of the individual business units. Since the retailer has a negligible capital value the new network business looks almost identical to the integrated business. Therefore, our analysis indicates that the new network business has the same debt carrying capacity as the existing integrated business (although, as we set out in Section 3, this does not imply that existing debtholders would migrate to the new network business, or if they do, that there are no up-front transaction costs). Our modelling simply considers debt-carrying capacity.
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The outcomes for the other three remaining stylised company models are similar in implications to the structured WaSC so are not shown here. 5.4.2. Single buyer models for separated R&T units Figure 5.5 describes the effects of the introduction of a single buyer model for treated water for our stylised structured WaSC. Under this scenario both the retailer and the water resource and treatment units are separated from a regulated water network plus integrated sewerage service business, which we assume occurs in 2020. Figure 5.5 Separate R&T business Under a Single Buyer Model: Structured WaSC, Focussed Approach
2020
1,026
1,085
We note the following key points: §
Under our focussed opening value assignation rule, the R&T business has a net MEAV share of about 10% but receives nearly 40% of RCV to bring it to our assumed BNE level. As a consequence the residual value remaining with the network and sewerage business is proportionally low (top-right quadrant), and this translates into a lower return element as a proportion of revenues of around 25% compared to the integrated business proportion of 40% (top-left). This structure might not be strong enough to attract capital into the cash negative network and sewerage business at our assessed WACC.
§
The bottom right-hand quadrant shows that the new licensed water and sewerage business cannot accommodate as much debt as the integrated case. Effectively the new regulated business will have to be de-levered by £1.6 bn (referred to in all Figures as “Debt difference 1”) relative to the integrated business. As a whole, the new sector entities can accommodate as much debt as the integrated business is carrying in 2020, but the new
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water resource and treatment businesses have different risks from the existing licensed business, which might imply a different set of debt investors. §
As modelled, P&L costs for an average structured WaSC increase from £1,026 million per year to £1,085 million per year, or by around 6 %. The increase is larger than under retail-wholesale separation because of the higher cost of capital we associate with the R&T business (bottom-left quadrant).
Figure 5.6 below sets out the same single-buyer competition model for an outlier WoC. In particular, we depict the case of a WoC with a high proportion of net MEAV in R&T. For this particular company, the results show that the net MEAV associated with the R&T business is equal to more than 100% of the total RCV. This implies a negative residual value for the network business (top-left), which as a consequence earns no return (or really a negative return) and has no debt carrying capacity (top-right and bottom-right). This competition model and the opening value/RCV assignation rule, taken together, clearly result in a non-viable situation - a different approach will be required. Figure 5.6 High Net MEAV R&T Under a Single Buyer Model: Outlying WoC, Focused Approach
2020
97 83
If the competition model were to apply, then one alternative is to re-consider the opening values, for example by adopting an unfocussed approach. The results are set out in Figure 5.7.
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Figure 5.7 High Net MEAV R&T Under a Single Buyer Model: Outlying WoC, Unfocused Approach
2020
83
86
This shows that: §
Under an unfocussed allocation rule, the asset value of the network business is a much higher proportion of the RCV.
§
As a consequence, the cost structure of the new network business is similar to the integrated business, although the return element has fallen from around 30% of revenues for the integrated model in 2020 to below 25%.
§
With a lower opening value for the R&T business (maintained at less than BNE levels by some notional ongoing regulatory or contractual mechanism), the total increase in customer bills due to our assumed financing cost changes is around 4%.
5.5. Single Buyer Models For Separated R&T units: Incremental Approach In the Section above, we considered the financing implications of models assuming that all existing R&T capacity is placed under long-term contracts.
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In his recent interim findings, Professor Cave stated that:48 “Bearing in mind the difficulty with focusing the regulatory capital value, and the potential consequences of doing so on an incumbent’s ability to maintain and finance its networks, I would propose allocating the regulatory capital value proportionately on a cost basis across the value chain. Given the regulatory capital value discount, I would therefore expect the local incumbent to supply existing capacity. Ofwat would regulate this activity. […] New entrants would compete with incumbents to supply new capacity to the independent procurement entity.” In short, Cave states a preference for a unfocussed approach, where his solution to the risk of creating standards assets or benefits is to leave all current capacity under the operation of incumbent water companies, and regulated by Ofwat. Such an approach would introduce competition to R&T in a very gradual way. This is because there is very limited investment in new incremental resources, although there are a few exceptions in the South East. Assuming a depreciation asset life for a water treatment works in the range of 20 to 40 years (although in practice the economic life might be longer), this implies that only 2.5 to 5% of existing capacity will be subject to the new competition arrangements each year. However, this probably overstates the extent to which competition will be introduced given the difficulties of designing auctions for all plant at the end of their economic life. 49 Such an approach would clearly substantially reduce the initial sector cost increase due to financing costs set out above of around 4% (single-buyer model, unfocussed) because most of the capacity would be retained by the incumbent under regulation and be financed at the regulated business WACC. Hence, there would be limited impact on sector financing costs in the short-term at least because of the very limited introduction of competition. However, an incremental approach to introducing the single-buyer model would still result in a cost increase of 4% (as we estimated in Section 5.4.2) for those plant procured using this method, relative to contracting incremental plant under the current system of regulation. That is, the model does not lead to reduced non-transitional financing impacts on a unit basis. We reiterate that there is no evidence to suggest that the increased financing costs for the plant procured under a single-buyer model will be off-set by a lower WACC for the licensed business. As set out in Section 4.3, the procurement of plant under a long-term contract leaves greater risk with the service provider than plant procured under the current regulatory model, implying a higher overall sector WACC.
48
Cave, Professor M (November 2008) op. cit., p.10.
49
For example, it might be difficult to hold an auction for the replacement of all existing capacity where a high proportion of the existing asset might continue to be used (e.g. the civil works aspects of the plant). In such cases, the procurement agent will need to design a contract to mitigate incumbency advantage regarding the asset conditions.
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5.6.
Wholesale Competition Models
Figure 5.8 shows the effects of introducing a wholesale water market when opening values are assigned according to the focussed approach. We do not expect such an arrangement to come into place before 202550 and we model the change in that year. Figure 5.8 Separate R&T business Under Wholesale Competition: Structured WaSC, Focussed Approach
2025
1,346 1,118
Compared to the scenarios presented above, we observe two issues: §
The debt-carrying capacity of the sector is lower, so different capital structures involving more equity will be needed. There is a reduction in the debt carrying capacity of £1.4 billion for the new water network plus sewerage licensed business (compared to the integrated business). In addition, the merchant risk borne by the R&T business in this scenario decreases the maximum gearing it can efficiently bear. As a result, the debt carrying capacity summed over all the new entities is £176m less than the integrated business is carrying in 2025 (this is referred to in all Figures as “Debt difference 2”).
§
This scenario increases business risks for retail and R&T units, which leads to higher costs of capital for the R&T business and a higher required margin for the retail business (which now has assumed a trading function). As a result, customer bills under a separated water supplier are 20% higher due to changed financing costs, compared to an integrated business. This cost increase is much higher than the 6% we observed for the long-term contracts and single buyer models (focussed), because of the higher financing costs associated with a R&T business in a wholesale market.
50
Ofwat (May 2008) op. cit., p69
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The magnitudes by which wholesale market R&T separation increases financing and customer costs are similar for all other stylised companies. The debt difference is similarly large for the structured WoC. The detailed results are not shown here. Adopting an unfocussed approach can substantially mitigate the adverse consequences outlined above by allocating a larger share of the asset base to the network, provided the departure from BNE levels can be maintained with a mechanism which does not distort competition. Figure 5.9 Wholesale Competition: Structured WaSC, Unfocussed Approach
2025
1,259 1,118
As set out in Figure 5.9: §
Under the unfocussed approach, the opening value proportions are equivalent to the MEAV proportions. The diagram shows the 2025 position.
§
As a consequence the cost structure of the new network and sewerage business is similar to the integrated business and the new network and sewerage business has just enough gearing headroom to carry the same level of debt as the integrated business is carrying.
§
The total P&L cost increase due to financing is 13% compared to 20% under the focussed approach, ignoring all other benefits and costs of competition.
5.6.1. Further Separation In our final model, we consider a more disaggregated notional structure: splitting the stylised WaSC into six different business units. This involves: §
Water and sewerage retailer
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§
Wholesale market competition in R&T;
§
Single-buyer model for sewage treatment and sludge disposal;
§
Separation of the network business into water and sewerage.
Figure 5.10 presents the results. Figure 5.10 6-Business Unit Model: Structured WaSC, Focussed Approach
2025
1,456 1,184
This shows that: §
The assignment of BNE opening values proxied by net MEAV, to contestable elements results in a very low remaining residual RCV value for the network businesses (top-left). As a consequence, for the sewerage network business the return element as a proportion of total costs is just over 10%, which implies it might not be financially viable (or not at the existing integrated business cost of capital). The return proportion is particularly low because the sewerage network has a high proportion of bought-in-costs due to its role as the single buyer of sewage and sludge treatment and disposal.
§
The new licensed businesses – the networks for our stylised WaSC - can carry £3.2bn less in debt than the integrated business. The business units as a whole have a lower debt carrying capacity of £628m;
§
The higher financing costs of the sector entities result in an increase in sector P&L costs of 24% relative to the integrated model, ignoring all other benefits and costs of competition.
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As with the other models, the viability issues and cost increases from separation are substantially lessened under an unfocussed approach to opening values, if a mechanism can be found to sustain opening values below market level for businesses in competitive markets. Figure 5.11 6-Business Unit Model: Structured WaSC, Unfocussed Approach
2025
1,350 1,184
As set out in Figure 5.11: §
By using an unfocussed approach to assign more capital to both networks the sewerage business now has a cost structure closer to the existing integrated business, although its return margin at 28% is still well below the integrated business value and possibly inconsistent with our assumed WACC.
§
Inconsistencies aside, the amount of debt that cannot sit with the licensed business is now around £1.3bn. The overall debt bearing capacity of the combined separated units is just enough to carry debt at the level of the integrated business in 2025.
§
The total increase to consumer bills due to financing alone is still high at 14%, although this is much lower than the 24% set out above under the focused approach.
5.7. Conclusions About Financing Separated Business Units We draw the following conclusions from our modelling work: §
Viability of new licensed businesses
The market or focussed approach to opening value/RCV assignation implies a high proportion of the existing RCV is assigned to the contestable business units, and consequently a relatively low value is assigned to the network or ongoing regulated business. In many cases (other than the retail-wholesale separation), the cost structure of the new
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regulated business is different to the integrated business, with a notably lower return element as a proportion of costs. This implies that the new businesses might not be financially viable, or might face higher financing costs than we have assessed. In some cases, the focussed approach implies a negative RCV for the new licensed entity. These issues arise as a consequence of the capital value discount combined with the focussed approach and with treating the existing RCV as a cap on sector asset values in order to treat investors and customers fairly. The capital value discount lessens substantially over time. However, our modelling of the single buyer model, which we assume is implemented in 2020, and the wholesale market model, assumed implemented in 2025, shows that even with the lessening of this discount the single buyer and wholesale market models result in potentially non-viable network businesses in many cases under a focussed approach. The unfocussed approach substantially assists with this issue. §
Reduction in debt-carrying capacity
The relatively low levels of capitalisation associated with the network or ongoing regulated businesses result in a reduction of their debt-carrying capacity relative to the levels carried in our integrated structured WaSC and WoC models. This implies that, irrespective of questions of feasibility of transitions, these companies will need to retire debt relative to current levels and/or debt will need to be migrated to higher risk (and therefore lower credit quality) entities. Under some models, the debt-carrying capacity summed over all sector entities is lower than what we model the integrated business as carrying, implying that debt will need to be reduced across the value chain as a whole. This issue is greatly eased under the unfocussed approach.
% Debt Not Sitting with Network / Any Business
Figure 5.12 Debt-Carrying Capacity
60%
40%
20%
0% R-W
SB SB focussed unfocused
Wh. Comp.foc
Wh.comp. Full Sep. - Full Sep. - unfoc foc unfoc
Source: NERA calculations, Note: Average across all four company models weighted by total debt. Figures for year scenario is introduced
§
Increases in customer bills
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The more exposed to competition the individual units are, the more there are risks carried by investors which were previously passed back to customers by regulation. To the extent the risks are non-diversifiable the business units have a higher cost of capital. Our assessment suggests that this leads to an increase in customer bills (ignoring all other effects of competition) ranging from around 2% under the retail-wholesale model, through 4%-6% for the single buyer models, up to 14%-23% for a wholesale resources and treatment market, with very similar figures for our most disaggregate model (6 business units). In all models the lower figure is for the unfocussed approach. These ranges are also taken over the four stylised company results, and they hide potentially important single company differences. Figure 5.13 Increases in Customer Bills
Total Cost Increase to consumer
25% 20% 15% 10% 5% 0% R-W
SB SB focussed unfocused
Wh. Comp.foc
Wh.comp. Full Sep. - Full Sep. - unfoc foc unfoc
Source: NERA modelling, Note: Unweighted average across all four stylised types. Figures correspond to the year scenario is introduced: Retail- wholesale (RW), 2012; Single-buyer (SB), 2020; Full separation (2025).
As stated, these additional financing costs are gross of any benefits from competition and any other cost increases. However, they imply that genuine benefits from competition will have to be made to ensure consumers are not worse-off. The following Table sets out the cost reduction which would be required to outweigh the increase in sector financing costs. Table 5.3 Required Benefits From Competition to Off-set Increased Financing Costs Competitive Model
Increase in Sector Costs from Financing alone (Unfocussed/Focussed)
Required Reduction in Contestable Market Opex and Capital Maintenance, to outweigh financing effects alone
Retail-Wholesale split
2 – 3%
48 – 70% (Retailer alone)
Single-buyer in R&T
4 - 6%
17 – 44% ( Retailer & R&T)
14 – 23%
53 - 158% (Retailer & R&T)
Wholesale market in R&T
Source: NERA calculations. The figures reflect the range for the four stylised models under the focussed and unfocussed approaches, and for the first full year after implementation of the competitive model.
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§
The unfocussed approach:
The initial increases in customer bills due to financing costs alone, and the implied financial de-leveraging of the network or regulated businesses, are both substantially less under an unfocussed approach to opening value/RCV assignation. However, as set out above, the unfocussed approach would result in the new businesses in competitive environments having opening values below market values, suggesting that output prices would gravitate upwards with knock-on effects on final customer prices, increasing the business value in the process. These effects could perhaps be addressed through so-called stranded cost/benefit mechanisms –ongoing regulatory or contractual arrangements. The challenge is to design these so they are consistent with establishing competitive arrangements in the relevant business units.
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Conclusions
6.
Conclusions
In this study, we have investigated the possible financial implications of the implementation of competitive models for the UK water sector. Our investigation suggests that the financial implications could be substantial depending on the model that is adopted and the approach that is taken to defining the business unit values. Firstly, it appears to us to be difficult to make any notable competitive reform without needing to revisit many of the existing debt financing arrangements. The cost of revisiting these arrangements would be determined by negotiations between the parties guided by law, but we have shown that relevant benchmarks for these costs can be measured in billions of pounds. It seems to us that there is a danger that the cost could be high even if the competitive reform were to be relatively benign in terms of impacts on creditor security. Secondly, our assessment is that the competitive reforms would place elements of the business outside the scope of regulation, and add new risks, leading to increases in the nondiversifiable risks borne by investors in those competitive elements, and to a higher cost of capital. This rebalancing between investors and customers does not provide an offsetting reduction in the cost of capital for regulated elements, so increases in the cost of capital for the sector as a whole are to be expected. To reiterate, this is because the reforms place risks with the investors in the competitive elements; risks which were previously not present or were more fully passed back to customers by regulation. Because returns form a large part of water sector P&L costs, the cost of capital has important implications for sector costs overall. Ignoring all the other possible benefits and costs of competition, and assuming that increases in the cost of capital are all ultimately reflected in increases in the cost of water and sewerage services to customers, we assess the latter initial increases as ranging from about 2% given full competition in retail only, up to perhaps 14% under much fuller competition, if an unfocussed approach to business opening values can be applied and sustained. An unfocussed approach will require appropriate supporting mechanisms for competitive elements; the alternative focussed approach does not require these mechanisms but leads to bigger immediate increases in financing costs and bigger financial viability questions for ongoing regulated business elements. The financing cost implications of incremental approaches to competition in retail for large customers only, or in only new capacity for resources and treatment, would also be smaller in proportion. These substantial potential financial effects of competitive reforms make it important that the potential benefits of competition are clear before reforms are adopted.
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Appendix A
Appendix A.
UK Regulatory Precedent
A.1. Introduction In this section we present some examples of regulatory precedent for the treatment of financial issues that have arisen during the separation of the elements of vertically intergraded regulated businesses. The key issues that are covered in our review are: §
The allocation rules used to separate the RCV51 between business units;
§
The implications for financeability from the separation of the vertically integrated businesses, if any, and how these issues were dealt with; and
§
Regulatory remedies for changes in financial risk arising from the separation of the integrated business or from the introduction of competition in elements of the regulated business (for example the risk of stranded assets);
This section focuses on UK regulators as these are the most directly relevant examples for E&W Water. Below we present the following examples: §
GB Gas Sector;
§
UK Electricity;
§
Scottish Water; and
§
BT/Openreach.
For each of these examples we provide a brief overview of the process of unbundling. We then discuss, where they are relevant, each of the key issues identified above as they in the context of each example.
A.1. GB Gas Sector In this section we present the example of the gas market in Great Britain which includes England, Wales and Scotland; it excludes Northern Ireland where the history and regulatory arrangements are somewhat different. A.1.1. Overview The history of British Gas after privatisation in 1986 is one of progressive unbundling of the regulated network businesses from the competitive ones. In the early 1970s, the gas industry in Great Britain (GB)52 had been largely consolidated into a single integrated entity – British Gas Corporation. In 1986 the British Gas Corporation was privatised and became British Gas plc. British Gas’s dominant position as a vertically integrated monopoly in the gas industry
51
Note that we use the term RCV as a universal term to refer to regulatory asset value in the examples that we present in this section, although some regulatory bodies may use a different term.
52
This describes the situation in the gas market in Great Britain which includes England, Wales and Scotland; it excludes Northern Ireland where the history and regulatory arrangements are somewhat different.
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was maintained after privatisation. Key milestones in the process of unbundling the regulated business are outlined below. §
The Gas Act 1985 - The act provided for the incorporation of the publicly-owned British Gas, established a regulator (Then Ofgas now Ofgem) whose duties included the duty "to secure effective competition" in the gas industry and set down the main principles governing the regulation of the GB gas industry.
§
1988 MMC Inquiry –Investigated the sale of gas to large customers with recommendations to improve the accessibility of gas supplies and transparency within the gas market. At the same time the first agreement for common carriage was negotiated.
§
1991 Office of Fair Trading investigation - Required British Gas to sell some of its contracted gas supplies to competitors to encourage new entrants.
§
1993 MMC Inquiry – Investigation into the structure of BG. Recommended abolishing BG monopoly on supply to customers below 2500 therms per year and the strict functional separation and eventual ownership separation of gas transportation and storage from gas trading.
§
The Gas Act 1995 – Introduced separate licensing for gas transporters, shippers and suppliers with requirement that transport licence must be held by a separate legal entity from that which holds the other two. Provision for future separation from transportation licence of other activities that may be conducted on a competitive basis, e.g. storage, metering and new connections.
§
1997 Price Control for Transportation and Storage – The price controls for transportation and storage are unbundled paving the way for separate regulation of these functions.
§
1997 MMC Inquiry – BG appeal against Ofgas August 1996 proposal for 1997 price control.
§
1997 British Gas restructuring – This included the de-merger of trading activities into a separately listed company – Centrica.
§
Gas Act 1986 (Exceptions) Order 1999 Deregulation of gas storage, removal of requirement for gas transportation licence for storage facilities with regulation by general competition law. BG Storage Rough and Horsea facilities deregulated but facilities at five LNG terminals are not.
§
2000-2002 Further restructuring of British Gas – BG restructured into two separated listed companies, the Lattice Group which owns the transportation assets (Transco) and BG Group which owns the exploration and production assets. In 2003 Transco merged with the National Grid Company to create National Grid Transco.
§
2003 Separation of Transco’s price control– Transco’s 2001 price control was separated out for each of the eight local distribution zones (LDZ’s) this was followed by granting of separate gas transportation licences for the LDZ’s and the eventual sale by Transco of four of the LDZ’s.
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A.1.1. Discussion of key issues §
Allocation of RCV between business units
Allocation of RCV between production, transportation activities and storage used an ‘unfocused’ approach’. Allocation of RCV between BG’s business units (including production & exploration, transportation, storage, metering and retail) was based upon a methodology adopted in at the 1993 MMC inquiry. An initial market value at privatisation was established for BG and this was then rolled forward. Pre-privatisation assets were included in the RCV at a discount based on the ratio of the market value of BG in 1991 to the current cost accounting (CCA) value of its assets (the market to asset ratio or MAR). The MAR was judged to be approximately 60% based on the observed market values of BG throughout 1991. The MAR discount was distributed across business units using what was termed an ‘unfocused’ approach. This approach spread the discount proportionally to the CCA value of the pre1991 assets attributed to each business unit.53 The method of RCV allocation is contrary to the notion of a “level playing field” and could lead to windfall gains for shareholders in the event that the activities of a business unit are deregulated and it is then sold at a price that that is greater than the RCV attributed to it. Allocation of transportation RCV to local networks based on RCV implied by total distribution charge network within each network area. Allocation of transportation RCV to the eight LDZ’s was undertaken prior to the granting of separate licences to each of these networks. The Network RCVs were calculated on the basis of forecast distribution charge revenue for each network for the year 2002/03 (based on the 2001 Transco price control). The RCV for each network was calculated as that which was “required to generate allowed revenues for 2002/03”.54 §
Financeability of the separated business units
Size of RCV available at unbundling left sufficient RCV in the production, transportation and storage business units to ensure the financeability of each. The unbundling of the production, transportation and storage business units resulted in very little consideration by the regulator of the financeability of the separated units. The main reason for this would appear to be that the available RCV and the unfocused allocation rule ensured that the RCV remaining within these businesses was sufficiently large. At separation of transportation price control each LDZ was assessed as being having a prospective investment grade credit rating on basis of allocations of RCV and costs. The issue of financeability was given more serious consideration when the price control for the Transco networks was separated out in 2003. It was determined that there were no
53
See para 2.149, MMC (1993) ‘British Gas plc: Volume 1 of reports under the Gas Act 1986 on the conveyance and storage of gas and the fixing of tariffs for the supply of gas by British Gas plc’
54
See para 2.14, Appendix 2, Ofgem (2003), ‘Separation of Transco’s distribution price control: Final Proposals”
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financeability issues raised by the separation after consultation with credit rating agencies. This consultation indicated that each network would qualify for an investment grade credit rating and therefore be able to secure future finance on reasonable terms.55 §
Regulatory remedies for changes in financial risk
During the 1993 inquiry the MMC decision included compensation for the financial implications for BG of introducing competition in gas supply (retail) which they considered may adversely affect the supply of capital to the industry. However, the MMC did not support a claim by BG for a loss in the value of storage assets resulting from prospective competition, considering the impact of competition in this area to be uncertain. During the 1993 MMC inquiry the commission recommended an adjustment to the BG tariff formula from RPI-5 to RPI-4, this was done “by reason of the future effects of the introduction of competition in supply to users of between 2,500 to 25,000 therms a year, subsequent to the introduction of the formula, which may, in our view, be expected adversely to affect the supply of capital to the industry particularly for the financing of new investment.”.56 Following the unbundling of the price controls for transportation and storage BG requested compensation for a loss of value in its storage assets from prospective competition in gas storage. The request formed part of BG’s appeal against the Ofgas decision for the 1997 transport and storage price control. The basis of the request was stranding of storage assets that might occur if, as was intended, competition was introduced in gas storage. The MMC agreed with Ofgas that compensation would not be justified “given the lack of precision of the commercial values that can currently be ascribed to storage, and to the broad approximations used in determining the regulatory value.” 57 The MMC went on to say that “as no one can predict with certainty how competition in storage will develop, it is not certain that any stranding would occur: indeed it is possible that the assets could increase in value.” Ofgem in a later determination on LNG storage prices interpreted the 1993 MMC decision on compensation for stranded storage assets as suggesting that all of this risk should be left with the incumbent operator (then National Grid Gas - NGG). However, following representations from NGG Ofgem set storage prices that took account of some historic costs, thus mitigating the risk of stranded costs. NGG operates four Liquefied Natural Gas (LNG) storage sites. The four sites provide a mix of commercial storage services to gas shippers through periodic auctions and price regulated services to NGG National Transmission System (NTS) in its role as System Operator (SO) and to the Scottish Independent Undertakings. Ofgem sets a minimum price for use of these storage facilities, with NGG able to charge the maximum of the minimum price and the market price (determined by auctions of available capacity), with the latest price controls set
55
See para 3.17. Ofgem (2003), Op. cit.
56
See para 2.165, MMC (1993) ‘British Gas plc: Volume 1 of reports under the Gas Act 1986 on the conveyance and storage of gas and the fixing of tariffs for the supply of gas by British Gas plc’
57
Para 2.27, MMC (1998) ‘BG Plc: A report under the Gas Act 1986 on the restrictions of prices for gas transportation and storage services’
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in December 2007.58 Ofgem’s initial proposals for this price control were to base the minimum price on ‘efficient forward looking capital and operating costs’59 and stated that any historic investment or decommissioning costs were the responsibility of NGG. This view was based upon the MMC’s 1997 with regard to possible stranding of assets with respect to BG storage facilities. Ofgem stated that from the MMC judgement it:“was clear that the commercial risk that BG (Ref 6) failed to recover up to that cap [the revenue cap for BG storage assets] due to commercial pressures was to be borne by BG. It also stipulated that the risk that future development of competition impacted (positively or negatively) on the value of the BG’s storage assets (at that time comprising Rough, Hornesa and the LNG sites) - the ‘stranded asset’ risk - also resided with British Gas given the ‘unfocused’ basis on which the combined regulated business was valued for regulatory purposes.” NGG objected to Ofgem’s position arguing that the MMC judgement was less clear cut and suggested that the MMC did not necessarily rule out stranding as a point of principle but centred on whether any stranding was likely to arise.60 In their final proposals Ofgem changed their position so that the minimum price would guarantee NGG a return on the proportion of the historic asset base that is used to provide regulated services, but did not make any provision for decommissioning costs.61 In a recent determination on metering Ofgem acknowledged the principle of stranded cost recovery, but found that the long term metering contracts (metering service agreements or MSAs) used by NGG artificially restricted the rate at which NGG meters could be replaced. The provision of gas meters has been deregulated in the UK. The provision of gas meters for customers is the responsibility of gas suppliers (retailers) who are able to source meters from a meter operator of their choice. NGG as the incumbent meter operator owns a stock of legacy meters installed prior to deregulation, which are rented to suppliers on long term contracts (legacy MSAs). These MSAs define a schedule for the numbers of meters due to be rented by a supplier over a number of years (either 18 or 7 depending on the type of meter). If the number of meters replaced by suppliers exceeds that specified in the glidepath then the MSA requires a supplier to either pay: §
A full meter annual rental charge for each meter the supplier was scheduled to rent, rather than for the actual number it rents if, following meter replacement, the remaining stock of legacy meters is between 90% and 100% of meters the supplier was scheduled to rent under the glide path. No allowance is made for the costs NG avoids when it no longer provides or maintains the meter; or
§
If the gas supplier replaces enough NG meters for the remaining stock to fall below 90% of the glidepath “allowance”, the supplier must pay a premature replacement charge, per meter, on the shortfall between the level of its remaining stock and 90% of the glidepath
58
Ofgem (December 2007), ‘LNG Storage price control - Final proposals’
59
See page 2, Ofgem (December 2007), Op. cit.
60
National Grid (September 2007), a letter to Robert Hull the Director of Transmission, Re: “LNG Storage price control – Initial thoughts” consultation
61
See page 2, Ofgem (December 2007), Op. cit.
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allowance. This charge is the same irrespective of the age of the meter or when the meter was installed. Ofgem finding was that “The Authority does not consider that the charges NG levies under the MSAs can be objectively justified. NG has argued that the contracts are a legitimate way of protecting their historic sunk investment in long lived meter assets. But the Authority has shown that there were (and are) other ways that NG could seek to recover any customer specific sunk costs that are less restrictive of competition. One way would be the use of a simple, transparent age-related premature replacement charge for all meters without the need for any glidepath allowance, take or pay charges or other financial penalties.”62 The findings of Ofgem are subject to an appeal to the Competition Appeals Tribunal. By February 1997, when British Gas de-merged its gas trading activities, “stranded” high priced take or pay obligations, which after the advent of retail competition left BG with a projected surplus of gas, had become a major problem for British Gas. The opportunity was taken to assign these contracts to Centrica, along with sufficient production assets to cover the attendant liabilities. Centrica plc markets gas in Great Britain under the name of “British Gas” through its British Gas Trading subsidiary.
A.2. UK Electricity A.2.1. Overview The privatisation of the electricity sector in the UK followed the Electricity Act 1989. At privatisation the E&W electricity industry was already substantially more unbundled than GB the gas sector, with generation, transmission and distribution and supply already established as separate business units. In Scotland, however ScottishPower and Scottish Hydro-Electric were privatised as integrated companies with substantial assets in generation and transmission as well as distribution and supply. We outline the key milestones in the process of unbundling of the UK electricity sector below. §
Gas Act 1989 – this paved the way for privatisation and established a regulator (then Offer now Ofgem)
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1990 Privatisation of regional electricity companies (RECs) – government sell an initial tranche of shares in the 14 E&W electricity distribution and supply businesses.
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1991 Flotation of PowerGen and National Power - sixty percent of the generation companies are sold on the stock market.
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1991 Flotation of ScottishPower and Scottish Hydro-Electric – Integrated Scottish generation, transmission and distribution and supply businesses sold off.
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1995 Flotation of National Grid Company – The England and Wales Transmission network owner and operator is sold.
62
See Summary Section, (Ofgem February 2008) “Competition Act 1998, Decision of the Gas and Electricity Markets Authority Investigation into National Grid (formerly known as Transco)”, (Case CA98/STG/06), Ref: 27/08
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§
Utilities Act 2000 – Introduces legislation that provides for separate electricity distribution and supply licences and provide that these licences must cannot be owned by a single legal entity.
§
2000 + attempts to introduce competition into aspects of distribution– Ofgem have made attempts to introduce competition into aspects of the distribution business including new connections, network extensions and metering.
A.2.2. Summary of key issues §
Allocation of RCV between business units
The UK distribution companies RCV was set at the flotation values plus an uplift. The retail assets owned by the companies were assigned an asset value of zero. For the RECs the initial RCV for the distribution businesses was set equal to their floatation values less the value of the companies’ shareholdings in the National Grid Company.”63 Some adjustments were made to this value “to avoid going back on the prospects held out by investors at flotation and, this amounted to an upgrade of around 15%. The value of the RECs other businesses (supply, appliance retailing, and in some cases generation) was assumed to be zero.64 In Scotland generation, transmission, distribution and retail assets were still owned by vertically integrated companies at privatisation. The generation assets (which could potentially be open to competition) were allocated an RCV equivalent to an estimate of their market value (i.e. a focused allocation). For the ScottishPower and Scottish Hydro-Electric the initial RCV was also based on their initial floatation values. Determining the how to allocate the RCV between the business units was more complicated in this case than for the RECs because these two companies owned substantial generation and transmission assets in addition to their distribution assets. For generation the assets were valued by applying to them a MAR equivalent to that observed for the National Power and PowerGen (approximately 51%) at the time of their flotation. The remainder of the RCV was allocated to the distribution and transmission businesses. §
Financeability of the separated business units
The allocation of RCV to the REC’s produced high RCV to CCA asset values ratios for all companies, ensuring their financeability. At the time of the 1995 distribution price control, after the initial RCV had been adjusted for new investment and deprecation, the ratio of the RECs RCVs to their CCA asset values ranged between 75% and 90%.
63
See para 11.7, Offer (1995), ‘The Distribution Price Controls: Final Proposals’
64
See para 11.4, Offer (1995), Op. cit.
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After the focused approach to the allocation of RCV to Scottish generation assets there was an RCV left with the distribution and transmission businesses that was very similar to the CCA value of the assets.65
A.3. Scottish Water A.3.1. Overview Scottish Water is now separated into Scottish Water Wholesale (“SWWH”) and Scottish Water Business Stream (“SWBS”). SWWH provides wholesale water and sewerage services to SWBS which provides retail water and sewerage services to all non-household customers. In preparation for the introduction of non-household retail competition in April 2008, the Commission at the last strategic review of prices in 2006 (SR06) set out indicative nonhousehold retail charges for SWBS, and set out wholesale charge caps which limit the wholesale charges made by SWWH to SWBS and eventually to other retailers. A.3.2. Summary of key issues §
Allocation of RCV between business units
RCV allocated to SWBS in proportion to fixed assets associated with retail operations. SWBS allowed revenue included a current cost depreciation (CCD) charge of £2.4 million in 2006/07. The CCD charge is based on an estimate of the initial gross asset value associated with the non-household retail business of £10 million, and an asset life of 5 years. The Commission assumed that the assets were half way through their economic life, and therefore recognised an opening retail regulatory asset value of £5.1 million.66 §
Financeability of separated business units
SWBS revenue allowance included financing costs for RCV and working capital transferred from wholesale business. Transfer of assets to SWBS was very small compared to whole Scottish Water asset base, and therefore did not raise any concerns regarding financeability of SWWH Financing costs of £8.8million in 2006/07. The financing costs relate primarily to the costs of working capital which the Commission assumed would be equal to 25% of total nonhousehold water and sewerage revenue (or £86.8 million67) and the value of fixed assets (£5.1 million). The Commission assumed a cost of equity of 12%, and a cost of debt of 5.6% (nominal post-tax figures), and a capital structure of 76: 24 debt:equity. This equates to a nominal post-tax WACC of 7.2%.68.
65
See para 4.11, Offer (1995), ‘The Scottish Distribution and Supply Price Controls: Proposals’
66
Source: Water Industry Commissioner for Scotland (2005) Final Determination, p. 368, Figure 35.3.
67
Source: Water Industry Commissioner for Scotland (2005) Final Determination, p. 367
68
WACC = 0.24*12% + 0.76*5.6% = 7.2%.
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A.2. BT Openreach A.2.1. Overview The government sold 51% of BT’s shares in 1984 following the Telecommunications Act 1983. Since privatisation there has been gradual de-regulation in the UK telecommunications sector with the scope of BT’s activities for which tariffs are subject to price control substantially reduced. However, BT still retains significant monopoly power in certain areas of its business, particularly in relation to its national copper access network (these are the assets that connect telephone exchanges to users of telecommunications services). Over time the access network has been increasingly separated from the other elements of BT’s business. §
Accounting Separation - In 1995 BT’s licence was changed to require BT to divide its accounts between its various business units. This change facilitated the setting of interconnection charges (the price at which other operators could access BT’s network), an important step in opening up BT’s network to alternative telecommunications providers. In 1996 interim interconnection charges were set by Oftel, with a separate (from retail and wholesale) network price control being introduced in 1997. The details of the accounting separation required of BT has evolved over time. The current regime is based upon the requirements first outlined by Ofcom on 22 July 2004 in ‘The regulatory financial reporting obligations on BT and Kingston Communications’. The key focus of these reporting requirements is on providing transparency in areas of BT’s business where it is deemed to have significant market power.
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Functional Separation - The functional separation of BT was enacted by a series of undertakings from the company to Ofcom under the Enterprise Act 2002.69 These undertakings were put in place to deal with issues relating to the workings of the competitive market in the provision of telecommunications services. In particular they were intended to ensure that all operators (including BT) had equality of access to BT’s network. The legally binding undertakings were accepted by Ofcom instead of a Competition Commission referral. The undertakings required the complete functional separation of the management of the access network. In January 2006 Openreach was created as a stand alone business unit of BT Group with a separate staff and headquarters. The undertakings also required BT Group from 2006/07 to separately present the results of Openreach in its regulatory accounts.
A.2.2. Summary of key issues §
Allocation of RCV between business units
Current cost asset allocations to the various parts of BT, including specific allocations to all areas where BT is deemed to have significant market power, are reported in BT’s audited regulated accounts. These allocations are the basis of the regulated asset values for the areas of BT business where price controls are set.
69
Ofcom (September 2005), ‘Undertakings Given To Ofcom By BT Pursuant To The Enterprise Act 2002’
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There is no formal regulatory determination regarding the distribution of the RCV between Openreach and the other BT business units. Paragraph 5.31 of the undertakings requires: “With effect from the start of BT’s financial year 2006/2007, the regulatory financial statements of BT will also separately present the financial results of AS [Openreach]. The form, content and basis of preparation of the financial results of AS will follow those used in the preparation of the regulatory financial statements of BT except where differences are agreed with Ofcom and properly disclosed in the financial statements and related documentation. Information about the financial results of AS will include the following: headline revenue, cost of sales (or gross margin), SG&A, EBITDA, depreciation, operating profit and capital expenditure, revenues broken down into the broad product groups that the AS provides and further split between internal and external sales, separately identified payments to other parts of BT for products that form inputs to AS products (e.g. electronics); and a commentary that explains any changes in the basis within which the above figures are presented. BT’s regulatory financial statements will reconcile AS’s revenue and operating profit (and other such items as may be agreed between BT and Ofcom) with information about AS shown in BTGroup plc’s annual report and accounts. The independent audit of BT’s financial statements will include AS.”70 This above requirement is additional to those set out in Ofcom’s 2004 direction which requires BT to separate out its accounts in areas where it is deemed to have significant market power. The methods used by BT to allocate assets and costs between its business units are set out in BT’s “Detailed Attribution Methods”.71 As we discuss above significant proportions of BT’s activities are unregulated, almost 70% of BT’s assets are allocated to the areas of the business that are deemed to have significant market power. 72 Of the assets allocated to the regulated areas of BT’s business the vast majority (over 80%) are distributed to Openreach. §
Financeability of the separated business units
The financeability of the separate business units has not been an issue for Openreach and the remainder of the BT group. This is because: 1) the RCV of Openreach is approximately equal CCA value; and 2) the financing of Openreach is not ringfenced and therefore the vast majority of BT’s debt is held at the holding company level and is secured against all of the assets of BT Group. §
Regulatory remedies for changes in financial risk
Ofcom’s approach to valuing BT’s assets for regulatory purposes is consistent with the principle of full cost recovery.
70
Ofcom (September 2005), Op cit.
71
A copy of this document can be found on BT’s website.
72
NERA Analysis of CCA mean capital employed from BT’s 2008 regulated financial statements.
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Ofcom states that it “does not believe it is right to reduce BT’s valuation to account for spare 73 and surplus74 network assets”.75 This approach would appear to include the recovery of the costs of assets that have been stranded due to competition.
73
Defined as “Additional capacity provided within network infrastructure against future demand and maintenance requirements.”.
74
Defined as “Additional capacity provided within network infrastructure beyond what is required to provide sufficient spare capacity”.
75
Ofcom (2005), ‘Valuing Copper Access: Final Statement’.
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