Consumer Council for Water

This report has been prepared for the Consumer Council for Water (CCWater). Its main purpose is to highlight the key issues involved in the calculation of the cost of capital for the water industry in England and Wales. It therefore also embodies our views on the appropriate levels of the components of this important metric. The report has been written with an intelligent, non-expert in mind. In this section of the report we simply summarise our main conclusions.

• The current economic environment is not a very conducive backdrop for capital raising, for companies or for governments. Although there are tentative signs that the worst aspects of the credit crunch with respect to financial market prices have passed, many financial market indicators remain at “distressed” levels. Cost of capital estimates calculated in such an economic environment will almost certainly be higher than those that would be calculated in more settled financial market conditions. We therefore urge extreme caution in using current financial market information to estimate the cost of capital for any corporation.

• However, when more settled financial market conditions do return, probably towards the end of this year, the global economy will not return to the levels of activity that accompanied the credit bubble. In most developed economies, and particularly here in the UK, taxes and public sector debt servicing costs will both rise and public spending will fall. As a consequence, economic growth will be commensurately lower over the next decade compared with the previous decade, while inflation and interest rates will, on average, be higher. In this sort of economic environment companies with regulated, inflation-proofed revenues, and that have a significant degree of market power will tend to be favoured by investors – particularly by the UK’s pension fund industry. The debt and equity of the UK’s regulated utilities will be in demand, in much the same way that technology stocks tend to be in demand during times of economic excess. Indeed, there is already evidence of an increase in the demand for water utility securities.

• One of the key components for calculating the cost of capital for water utilities is the real risk free rate of interest represented by the yield on index-linked gilts. These yields have been ‘depressed’ for some time now. But in our view rather than being likely to rise, longer-term index-linked gilt yields will remain around their current levels (around 1.0%) in the short term and are unlikely to rise sustainably above the 1.25% to 1.50% range over the medium term. Yields will be held down at these levels, because of the enormous structural demand for inflation-proof income from the UK’s Defined Benefit pensions industry, and because of the uncertainty now surrounding the outlook for inflation. For the purpose of cost of capital calculations we recommend using a figure of 1.25% as a representation of the real risk free component of the cost of corporate debt (and a figure of 4.75% to represent the nominal risk free rate).

• Corporate bond spreads have increased substantially since August 2007. For nominal debt the spread is approximately 2.5%, for real debt it is around 2.0% on average. However, prior to August 2007 the difference in spreads between one water company and the next was fairly narrow; today it is quite wide. Therefore this component of the WACC should be treated with some caution. Nevertheless, despite the dispersion of spreads across water company debt recent developments in the corporate bond market underline the intuitively plausible idea that water companies are viewed as being lower risk compared with other types of business, and also that the market continues to favour investing in such low risk companies. As credit conditions gradually return to normal over the next year or so we expect the spreads to narrow on water utility debt by more than on equivalently rated debt issued by other non-financial companies.

• Of far more importance than the cost of raising debt now however, is the fact that only around 12% of existing water utility debt needs to be refinanced between 2010 and 2015. The cost of financing existing debt is both lower than would be the cost of financing new debt and lower than was anticipated in the 2004 Price Review. As such we believe that the regulator should adopt a weighted average cost of debt approach to this issue. That is, it should use an appropriately weighted combination of the actual, real cost of issued debt and the cost of debt that is likely to apply over 2010-2015 for any new debt.

• The equity risk premium for any company comprises two components: the price of equity risk and the quantity of equity risk. The price of equity risk – the market’s equity risk premium – has almost certainly risen recently. We believe that it is probably at the level last seen in the recession of the early 1990s, and equivalent to its average level of the 1970s. In our view 5.0% would be a reasonable estimate of the ‘price of risk’, or the market risk premium at the moment.

• The quantity of equity risk embodied in any equity is often represented by ‘beta’. The beta of an equity is a measure of how much the return on that equity covaries with the return on the market. The intuition is simple. If the return on a given equity moves in such a way as to exaggerate any move in the market return, then investors will require a higher risk premium to hold that equity, and its beta will be greater than 1.0. By contrast, if it tends to move in such a way as to dampen any move in the market return, investors will require a lower risk premium to hold that equity, and its beta will be less than 1.0. Utility companies are perceived as being less risky than the average UK equity. This seems intuitively sensible. These are companies with a steady income stream that is protected by law and which is inflation-proofed. And in times of economic uncertainty investors place an even greater value on income streams of this kind. We have used various methodologies to calculate estimates of beta for the UK’s water utilities, but whichever method we have used the beta for the UK’s water companies tends to be significantly below 1.0. In our view it is probably closer to 0.5, and certainly no greater than 0.75.

• For a water utility with a beta of 0.5 the appropriate equity risk premium to apply for the purposes of calculating the cost of capital is 2.5% (0.5 x 5.0%).

• Financeability remains a key concern with regard to the financial health of the water industry. However, we believe these concerns are not as significant as the industry would have us believe. First, the recent move in water utility bond yields relative to the yields on similarly rated bonds, indicates that the market has recently ‘upgraded’ water utility debt; furthermore some are anyway comfortably within the investment grade universe. Second, since PR04 it seems that water utilities have put financeability at risk with some aggressive payout policies and by increasing leverage. The increase in leverage at a time when debt was cheap simultaneously reduced the actual cost of capital below the regulated level set in PR04, supported high dividend payouts and put financeability at risk. We believe this issue should be addressed with cuts in dividend payouts. Indeed this is exactly the kind of economic environment that tends to be supportive of such moves. Many UK companies have cut their dividends. And recently the insurance giant Aviva, saw its share price fall when it maintained its dividend this April. Furthermore, a less aggressive dividend policy, other things equal, would tend to improve a company’s credit rating.

• Finally, the issue of the cost of capital has significant implications for millions of UK households. As a simple rule of thumb, from any given starting point for every increase in the cost of capital of 1.0% the average, annual UK water bill would increase by £20.

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