|
|
|
| |  Philip Fletcher |
|
|
|
|
|
|
TALK SCHRODER SALOMON SMITH BARNEY STERLING BOND COMMUNITY CONFERENCE, LONDON
RESTRUCTURING – GLAS
Introduction 1. Thank you for inviting me to speak here today. These are interesting times for the water industry and I welcome the chance to hear your views. As Director General of Water Services I have a primary duty to ensure that companies are able to finance their functions, in particular by securing a reasonable return on capital. I therefore regard it as essential that there is a clear mutual understanding of our respective positions.
Ofwat's views on Glas 2. Much ink has been spilt on the issue of water company restructuring since my predecessor announced the current set of price limits in 1999. We have seen two attempts by licensed undertakers to restructure their businesses. The first by Kelda was, in my view, insufficiently considered, not least in response to the obvious first question – what is in it for customers? I agreed with Sir Ian Byatt's statement which in effect blocked that proposal. Last week I gave my views on the proposals by Glas Cymru to acquire Dwr Cymru / Welsh Water.
3. Subject to a number of conditions, I said I was content for Glas to go ahead and seek financing for their proposals – a conditional green light. Nonetheless concerns remain, in particular about the effectiveness of the incentive mechanisms and the long-term financial flexibility of the model. These are real concerns and I would therefore like to evaluate the experience before other companies rush to emulate it.
4. I will of course look at any proposals put to me but, as I said in my paper, it will not be easy to replicate the particular circumstances of Glas. These include the facts that the seller, WPD, wants to leave the water sector and is fully independent of Glas. The support of Welsh stakeholders, including the democratically accountable body, the Welsh Assembly and the Welsh Customer Service Committee is also relevant.
5. All this is set out in Ofwat's paper and I do not propose to dwell on the detail again today. Instead, I would like to focus on one apparent paradox revealed by the Glas proposals. That is, on the one hand, the markets' reported willingness to support Glas, as a very highly leveraged water and sewerage company and, on the other, the difficulty which other companies in the sector, with much lower leverage, claim to face in raising additional finance to meet their new investment needs, an issue raised last week by Lex in the FT.
Meeting future capital requirements6. The water and sewerage industry faces the need to finance substantial new investment to meet quality and environmental standards and to respond to growth in demand. Total net new investment 2000-2005 is estimated at around £15bn. The bulk of this will need to be raised from the markets.
7. Companies and others have expressed concerns that there may be difficulty in raising funds from public markets, citing poor investor sentiment, depressed share prices and widening bond spreads.
8. I take these concerns seriously. I need not only to ensure that appointees are able to finance the discharge of their functions but also to protect customers. It is therefore a key part of my role to ensure that the industry's financial costs, just as much as its operating and capital costs, are kept as low as is practical.
9. But, I must also ask whether these concerns are soundly-based. On the face of it, it seems odd that an industry which not so long ago was able to command strong credit and share price ratings should fall so far out of favour when there have been no significant changes in the market for water and sewerage services, in the structure of the industry, in its technology base, in input prices or in the regulatory regime.
What is behind negative market sentiment? 10. Some tell me that the culprit is 'regulatory risk'. If they mean by this a risk of unpredictable and arbitrary regulatory action, I emphatically reject the charge. My predecessor strove for a high standard of transparency and openness in the regulatory process, basing his decisions on empirical evidence and reasoned analysis, and I shall do the same.
11. But I don't think that is usually what is meant. When I press commentators for evidence, they generally point to such issues as: - the windfall tax;
- the proliferating environmental and social agenda; and prospects for statutory change;
- the alleged mismatch between five-yearly price limit reviews, which create uncertainty, and the long-term investment requirements of the industry – what one chief executive has referred to as the "fundamental disconnect" between the regulator's and the markets' perceptions of risk.
12. I want to come back to this last issue, because it is important to be clear what risks are entailed and how far they are or can be contained.
13. But first, let me just make the obvious point that Glas will be subject to these risks in just the same way and to the same extent as all other companies in the sector. So what is it that makes the difference?
Why may the markets finance Glas? 14. Here, you are the experts, not me. But particular elements of Glas' proposed financing structure, which distinguish it from the basis on which the industry has in general borrowed in the past include:- Mitigation of default risk through credit enhancement
- Elimination of diversification risk through restrictions in the articles of association and bond deeds
- Protection against subordination of existing debt.
15. These techniques would, as far as I can see, be available to other water companies without any need for ownership change. I am not pushing the companies in any direction. As Lex pointed out, it is a matter of management choice.
16. Before holders of bonds for existing holding companies rush to tell me that securitisation of operating subsidiary cash flows would exacerbate their structural subordination; that it is a much-feared example of event risk, and that the fear is one reason why the perceived quality of these bonds has been downgraded, let me say straight away that I recognise all this. Again, I am not pushing companies in a particular direction.
17. I regard it as primarily a problem for shareholders. By issuing bonds at holding company rather than operating utility level, managements have – presumably – sought to obtain greater flexibility, for the benefit of shareholders, enabling them for example to finance acquisitions without issuing equity.
18. Such flexibility is not costless. The ongoing needs of the utility must still be met. If Glas succeeds, it will suggest that these needs might in other cases also be met by borrowing at subsidiary level. But these advantages might not be available to a Group that is cavalier towards the interests of its existing bond holders, for in the longer run that would inevitably drive up its cost of capital. There is no reason why customers should be expected to pay the price for the earlier flexibility.
19. Management and their advisers will want to think carefully about these issues.
Difficulties caused by the regulatory cycle 20. I come back to the issue of the 'fundamental disconnect'. To minimise the uncertainty my predecessor established a regular five year pattern of reviews – I agree that this is the right period. There is always scope to improve the review process, to reduce uncertainty further.
21. But there is no getting away from the underlying principles. The basis on which I – and other regulators – approach the determination of price limits should by now be well understood. Revenues are set to recover the efficient level of operating and renewal costs plus depreciation plus tax payments plus a return on capital employed. In projecting the amounts of each of these components, Ofwat relies on data provided by the companies themselves and by the markets.
22. For example, efficiency targets are not set in an arbitrary fashion, but by reference to what the best performing companies have demonstrated is achievable, on a like-for-like basis. Depreciation is provided to ensure that, having due regard to current input price levels, asset replacement rates and the changing characteristics of a company's system, its operating capacity can be maintained. Tax is an arithmetic calculation. The cost of capital is estimated from empirical market data.
23. Of course, there are refinements from time to time. But none of this is new. The approach taken in 1999, in its essential elements, was the same as had been taken in 1994; it was also consistent with the approach taken by Ofgem in recent reviews. It should not have come as a surprise to markets that the reviews led to a downward adjustment to price limits – the evidence of companies' improving efficiency had been apparent from Ofwat's annual performance comparison reports, and it is axiomatic that the benefit of this is to be shared with customers.
24. Moreover, there are a number of important checks and balances to guard against inappropriate outcomes, especially the provision for interim determinations. These enable corrections to be made for over- or under-estimation of key input variables annually throughout the price control period. Financial checks are performed to ensure each company will remain 'bankable' under its revised price limits.
25. I consider that, generally across the whole piece, the outcome of the 1999 reviews struck a fair balance between the interests of customers and of capital providers. All but two small companies accepted their revised price limits. All are now indicating that they can live within these targets. Several are saying that they will outperform the targets, in many cases comfortably. Moreover, so far as the issues before it were generic to the sector, the Competition Commission in the MKT and SES references came to very much the same assessment of the cost of capital as Ofwat.
26. Price reviews are bound to put companies on their mettle. Some may not have the competencies, the culture or the motivation to drive their businesses as hard as is necessary to get to the top of the league. It is an essential feature of incentive regulation that it does not protect underperforming companies.
Assessment of the appropriate cost of capital 27. There is one respect in which I can see the 'mismatch' argument may have a point. This relates to the cost of capital. It is common practice among UK regulators, including the Competition Commission, to use at each price limit review a forward-looking estimate of the weighted average cost of capital. In deriving such an estimate, reliance is placed primarily on recent market evidence of the key variables – risk-free rate and risk premiums – as this provides the best information about the markets' expectations. But companies – especially infrastructure companies – do not finance themselves for discrete periods of five years at a time: they seek to match their financing structure to their cash flows, which in long-life asset-based businesses such as water arise fairly evenly over long periods of time. So does the regulators' approach not induce the risk of a mismatch in respect of long-term financing obligations?
28. There are several answers to this question. Perhaps the most helpful to this audience is: no, provided companies finance themselves efficiently. This is because I have a duty to ensure that the efficient companies can finance the proper discharge of their functions and to set price limits accordingly. This is where the 'bankability' checks come in.
29. We look to ensure, by reference to the key coverage ratios, that each company, provided it is efficient, will be able to sustain the kind of credit rating that, in normal market conditions, will enable it to raise additional finance readily and at reasonable cost. In some cases, the licences require companies to maintain an investment grade rating. This policy led us in the 1999 reviews to make special allowances for the embedded cost of fixed rate debt taken out when interest rates were at substantially higher levels, but it should not be assumed that we will always allow a pass through of high cost debt. In saying this it is certainly not our intention to prejudice appointees' ability to access the long-end of the market.
30. The key here is how efficient the company has been in structuring and managing its finances. In this context an efficiently-financed company would be one that retains the flexibility to respond to changing conditions; it would be likely to have a balanced portfolio of debt, with a mix of term and interest rate structures that diversifies its risks, including refinancing risk as well as interest rate, currency and inflation risks. Given the exceptionally long lives of system assets, this would suggest the need for a relatively long average duration and an interest rate structure aimed at maintaining a broadly stable real interest cost over time.
31. I hope that provides some clarity about the treatment of embedded debt.
Regulatory consistency 32. But, the Jeremiahs cry, how do we know you will not move the goal posts next time around? All I can say is that I need no persuading of the arguments in favour of regulatory consistency.
33. I reaffirm the point I made in last week's Glas announcement: I shall seek to ensure parity of regulatory treatment for all water companies, whatever their situation. In connection with the Glas proposals, I wrote last week to all water company Managing Directors (MD166) setting out a summary of the regulatory framework as it affects investors, with the intention that companies make such use of it as they will in providing information to investors, present and prospective. The text is on our website. I intend that this should help to reassure capital providers that we are indeed committed to maintaining an open, transparent, objective, fair and consistent approach, and that – although I shall always seek to keep customer charges as low as I reasonably can – regulatory risk in the water sector is no greater than it needs to be under our incentive-based system.
|
|
