Why do the companies need to make profits?
Water and sewerage companies implement large-scale investment programmes to maintain their assets and meet their legal environmental and quality obligations. But the companies do not collect from customers all of the money they invest in the year in which they spend it.
So, companies must fund a large proportion of this investment from the competitive financial markets, either through borrowing (debt) or through investment from shareholders (equity).
Just as mortgage providers for homeowners expect a return on the finance (or capital) they lend, water companies must provide a reasonable return to providers of capital. This means that they must make a profit to reward their investors.
Although the water and sewerage companies are largely monopoly service providers they must compete for capital with other companies. If they do not offer comparable returns to other companies, after taking into account relative risks, they will be unable to secure the capital they need to finance their investment programmes.
The cost of capital is not intended to guarantee shareholders’ returns. A poorly managed water company might earn a lower return because it underperforms our assumptions, for example on efficiency savings. On the other hand, outperformance of our efficiency assumptions will increase returns. This is important for preserving incentives for companies to deliver services efficiently.
Does Ofwat regulate profits?
We have no formal powers to control profits. We set price controls, which control the revenue the companies can collect from their customers in bills. In setting price control we must make a judgement on what is a reasonable rate of return on the capital investors have provided. This return must be sufficient for the company to attract investors and lenders to finance the investment programmes. The water and sewerage sectors have a large volume of infrastructure to maintain and are required to make new investment to meet European Union Directives, quality standards and to improve the balance of supply and demand.
As the economic regulator of the water and sewerage sectors in England and Wales we have a statutory duty, under the Water Industry Act 1991, to make sure that companies are able (in particular by securing a reasonable return on their capital) to finance the proper carrying out of their functions.
In setting price controls our aim is to allow for a return on capital that is no more than necessary for an efficiently run company to get the funding they need from capital markets.
What is the balance between debt and equity?
The balance between debt and equity varies between companies.
Our approach to setting price limits seeks to create conditions where the funding for additional investment can come from either debt or equity.
We do not decide on the capital structure of the sectors, but we think it is important that each company’s structure is sustainable in the long term.
Do Ofwat control dividends?
We have no formal powers to control dividends. But each company’s licence requires it to declare or pay dividends only in accordance with a dividend policy which has been approved by its Board and which complies with both of the following principles.
- The dividends declared or paid will not impair the ability of the company to finance the regulated water and sewerage business.
- Under a system of incentive regulation, dividends reward efficiency and the management of economic risk.
We require the regulated companies to report any dividend paid to their parent company in their regulatory accounts. They must also explain the basis of the dividend.
We encourage the companies to explain to their customers, and to the public generally, what returns they have made in the regulated business and what they intend to do with them.
How do efficiency savings benefit customers?
We expect companies to be efficient. A regulatory system that gives incentives to companies to be efficient, and to make profits, is in the best long-term interests of customers.
Setting limits on prices rather than on profits (or rates of return) provides incentives to companies to pursue their objectives as efficiently as possible. Customers benefit from these efficiency savings when price limits are reset. We set price limits that assume all companies will continuously improve their efficiency. We expect less efficient companies to catch up with the most efficient companies, and at price reviews set targets to make sure they do so.
Is our approach fixed?
We carry out a detailed evaluation of our approach to ensuring companies can finance their functions at each price review. This allows us to modify aspects, incorporate new ideas and react to changing financial market conditions. Find out more in our price review section.