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Price review 2009
PR09/03 18 October 2007 Dear Stakeholder PR09: RISK ALLOCATION, INVESTMENT INCENTIVES AND THE FINANCING OF REGULATED BUSINESSES We considered in the Financing Networks paper certain proposals for changes to the regulatory framework which addressed issues linked to risk allocation, investment incentives and the financing of regulated businesses. Proposals considered included the concept of the split cost of capital on new and past investment and lengthening the period over which the cost of capital is set as a method of improving regulatory commitment. We have considered the responses to the Financing Networks paper and we set out our conclusions on these issues below. In this paper, we consult further on the proposal discussed in the Financing Networks paper which is whether a component of the cost of capital could be linked to a market benchmark. Please send your views on this issue in your overall response to the consultation paper to Rhiannon McHugh (rhiannon.mchugh@ofwat.gsi.gov.uk) by 24 January 2008. A SPLIT COST OF CAPITAL Respondents, particularly investors, were strongly opposed to the split cost of capital proposal because it was considered to undermine investors' expectations of the returns they would receive on their investment. This might increase perceptions of regulatory risk. Respondents also raised concerns that such a fundamental change would diminish the role of equity and cited difficulties with distinguishing between and segregating the risks associated with growth and maintenance for the portfolio of assets that typifies a mature regulated water business. We note the points made, in the argument for a split cost of capital, between the average and marginal cost of capital. We do not think that there is evidence that there needs to be an increase in marginal returns to facilitate new capital investment. Neither do we agree that returns on 'sunk' investment should be lower than the average return for the reasons set out above. It is also questionable whether a split cost of capital would reduce the required level of return unless total risks were reduced. Taking account of these issues we have concluded that the concerns raised by respondents outweigh the potential benefits and we will not adopt a split cost of capital for PR09. We will however continue to consider the evidence arising from the continuing upward trend in gearing and the implication for our assumption on gearing and therefore for the allowed overall return in the cost of capital assessment. REGULATORY COMMITMENT The issue of regulatory commitment arises because of the timing mismatch between the five-yearly price setting cycle and the longer timeframe for financing regulated businesses. Uncertainty in the financial markets about future price reviews and the allowed cost of capital tends to increase the regulatory risk premium in the cost of capital. We recognise that steps to improve the predictability of price reviews and to reduce actual or perceived levels of regulatory risk may lower required returns. Ofgem, in its letter of 27 October 2006, has set out steps to reduce regulatory risk. We have already adopted these principles in the regulation of the water industry and we remain committed to the better regulation principles which ensure we minimise perceptions of regulatory risk. Other proposals for improving regulatory commitment discussed in the Financing Networks paper included setting the cost of capital for a longer period or setting allowed revenues in respect of depreciation and the cost of capital over the whole life of the asset within the RCV. We have already decided to set price limits for a five year period. However, we are committed to setting price limits within a long term context and we expect companies to set their five year business plans in the context of their 25 year strategic direction statements. To set a cost of capital for a period other than the 5 year price setting period would be inconsistent with our assessment of the rest of the package for the regulatory period and may pass undue risk to consumers. The proposal to set allowed revenues in respect of depreciation and the cost of capital in advance over the whole life of the asset within the RCV is more radical. It might create perverse financing incentives if companies reacted to reduce risk by locking in financing costs for a matched term and therefore ruling out future refinancing opportunities. Having considered these issues we have concluded there is insufficient evidence of any benefits to consumers for us to adopt a different regulatory approach. Our current approach allows us to consider the components of the price setting process every five years and provides the necessary flexibility for us to ensure the interests of consumers are protected. Nevertheless, there may be a case for adopting a different approach to certain projects that are individually very large, where the balance of project specific risks may be viewed separately from those facing the undertaker's business as a whole and where this could facilitate a cost-effective project-based approach to financing the related investment. Such an approach has been a feature of certain PFI/PPP structures. Were a longer-term approach adopted in any case, it would be important to ensure that the benefits of any refinancing that occurs, to take advantage of the lower risk profile generally seen after a major project has been commissioned, are shared with consumers. INDEXATION OF THE COST OF CAPITAL Background UK regulators of network industries set allowed revenues for regulated companies that include an allowed rate of return based on the risk-adjusted cost of capital, or weighted average cost of capital (WACC). The rationale for this is that the allowed return should reflect the risks facing the regulated entity, which are a function of the variability of its cash flows, and therefore enable an economic and efficient company to finance its business effectively. The allowed return has tended to be fixed ex ante for the period of the price control. This means that customers are protected against adverse movements in the underlying capital markets, leaving this risk with companies and providing companies with strong incentives at least to achieve the allowed rate of return. It also means that customers do not benefit from any favourable movements in the market. It has been argued that this approach has led regulators to take a relatively cautious approach to determining the allowed return (in particular the cost of debt) in order to limit the company's exposure to downside risk and there may be an argument for indexing a part of the allowed return to a pre-determined benchmark. Together with the Office of Rail Regulation (ORR), we commissioned Cambridge Economic Policy Associates (CEPA) to undertake a study to explore the rationale for indexation and to consider how indexing all or a part of the cost of capital could be implemented in practice. CEPA's report is available on our website. The study included:
In its paper, CEPA's conclusion is that there is a valid rationale for pursuing further the idea of an adjustment to the allowed cost of debt in the event that the actual rate over a five year review period falls outside of the range expected when the cost of debt was set. CEPA has also narrowed down on the mechanics of a suggested indexation mechanism and recommend that it should be applicable to incremental notional debt only(1) . CEPA argue that if indexation applies to the whole of the notional debt then the size of the 'gap' between the allowed and actual cost of sunk debt will change if the index is triggered. In this case there will be significant 'deadweight' effects' with shareholders winning or losing as a result of indexation. The CAA sought the views of the Competition Commission (CC) to consider the use of an indexation mechanism in its current price review. The CC's views were published earlier this month. The CC recommended to the CAA that it does not introduce any form of automatic adjustment of the cost of capital when implementing its current price controls. The CC concluded that the use of an indexation mechanism would start to erode a core foundation of the existing regulatory regime, such that shareholders are asked to manage cost risk for periods of five years at a time, without offering sufficient benefits to justify the apparently sub-optimal allocation of risk. The CEPA and CC reports were written independently of each other. CEPA's report was being finalised before the recent views of the Competition Commission were published. Ofgem considered the use of debt indexation for the Gas Distribution Price Control Review 2007 (GDPCR07). They considered that, whilst debt indexation may have benefits, it is complex and would require a separate consultation. They have decided that the GDPCR07 is not the appropriate context in which to make a decision about debt indexation, and will take this forward separately. ORR will be considering the findings set out in CEPA's report before setting out its approach on this matter in its February 2008 strategic business plan assessment document. There is no obligation on us to follow the views of the CC but we note the arguments set out by the CC. We acknowledge the benefit of consistency between regulators' approaches where the characteristics of their respective sectors allow. Considerations for respondents to this consultation Controllability, manageability and the allocation of risk. There are two very broad schools of thought on the adoption of a market benchmark for indexing a component of the cost of capital. Proponents suggest that companies have no more control over interest rate risk than inflation and as such companies should be protected against these risks through the adoption of an adjustment mechanism. This could then allow regulators to set a more aggressive WACC and reduce the extent of discrepancies between the allowed WACC and that materialising in the markets. Companies would be protected from adverse movements in the debt markets by transferring interest rate risk to consumers. Consumers could benefit from lower bills if actual interest rates in a five-year period were lower than the expectation when price limits were set, but could face higher bills if interest rates were higher than the expectation during the price setting period. The alternative argument questions whether it is correct to transfer interest rate risks to consumers. Whilst companies cannot control macro-economic variables such as the risk free rate, they are best placed to manage such risks through treasury management. In addition, it is argued that the indexation of price limits in line with RPI already creates a partial link between price limits and changes in economy-wide borrowing costs. Any automatic adjustment mechanism would have to be designed in such a way as to avoid any double counting. Therefore regulators should continue to assume that interest rate risks lie with companies, not consumers. In addition there is a view that provided the estimate of the cost of debt is set at a level which strikes an appropriate balance between the interests of consumers and the interests of shareholders, both sets of stakeholders should ultimately benefit from this form of regulation. The CC has stated that the guiding principle in price control design should be that risk is allocated to the party that is best able to manage it, either by reducing its size, its likelihood or both. The CC considered that companies rather than consumers are in a better position to manage the risk of changes in interest rates through the way in which they borrow. In its report to us, CEPA's view is that the argument about controllability and manageability is not really the point. CEPA conclude that the regulators approach whereby they allow headroom in the allowed cost of capital for future interest rate movements means that, without indexation, regulated companies are bearing very little interest rate risk in the forthcoming period but that consumers are bearing a very high 'insurance' premium as a result. We seek views on the extent to which financing costs are controllable or manageable (and the relevance of this issue to indexation of the cost of capital) and consequently the appropriate risk allocation between companies and customers. Benefit compared to the current approach The extent of the benefit arising from risk transfer created by an indexation mechanism is dependent upon what element of the cost of capital is indexed and whether it is applied to historic finance, future finance or both. The rationale for deciding these elements is dependent upon views of manageability, controllability and appropriate risk allocation. Our view is that any resulting benchmark should then be considered in light of the materiality of incremental improvements for customers over the likely base case. The base cases involve the continuation of our overall approach at price reviews ie an assumption that the WACC is fixed ex ante for the period of the price control. CEPA set out two variations to this base case depending on the weight placed by the regulator on longer term trends or spot/shorter term rates in determining the WACC. CEPA's analysis identifies theoretical benefits based on assumptions for the base cases attributable to the application of indexation. Its recommendation is that indexation should be applied to incremental notional debt only. It does not apply to the refinancing of existing debt. The extent of the benefits attributable to their approach are therefore dependent upon the extent of headroom that, under the base cases, is embedded in the ex ante assumption of the cost capital and could be removed due to the protection provided by indexation of incremental notional debt. This headroom would provide the potential for consumers to benefit from lower bills at the start of a price review. There is then some uncertainty over the price customers will ultimately pay once the impact of an indexation mechanism has been reconciled, which could be higher than under the current regime if interest rates were to rise in the price setting period. The CC have argued to the CAA that transferring interest rate risk from companies to customers results in a sub-optimal allocation of risk without offering sufficient benefits. We seek views on the potential benefits of indexation. Complexity, regulatory burden and regulatory intervention The composition and trigger levels of any benchmark would need to be assessed and monitored. This adds complexity to the regulatory methodology for setting and resetting price limits and would place additional burden on the regulator. In addition the composition of the benchmark and its trigger point might influence a company's financing strategy. CEPA acknowledges that regulatory burden is an important consideration when evaluating changes to the regulatory framework but see no major difficulties in designing indexation arrangements which impose an acceptable regulatory burden on regulators and companies and which remain fully within accepted approaches to regulation. CEPA also recognise that companies might use floating rate debt to maximise the protection provided by an indexation mechanism regardless of whether this was the optimal financing decision. However, the incentives for such behaviour are limited where an indexation mechanism is applied to incremental notional debt only. The CC argues that the assessment of an appropriate benchmark for an indexation mechanism would take the CAA much deeper into BAA's financing arrangements that it has in the past and could be regarded as unduly intrusive. We seek views on the costs of complexity, regulatory burden and regulatory intervention compared to the materiality of any benefits achievable from an indexation mechanism. Yours sincerely Keith Mason Director of Regulatory Finance and Competition (1) CEPA suggest the adjustment to the allowed cost of debt would be applied to the notional debt relating to the incremental RCV e.g. if there was £100 million addition to the RCV and the specified marginal notional gearing were 60% then the allowed cost of debt adjustment would apply to £60 million of notional debt.  |
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