RD 04/10: Regulatory capital values 2010-15

Dear Regulatory Director

1. Introduction

The regulatory capital value (RCV) is one of the critical components underlying price limits. This letter updates the RCVs for our determination in 2009 and changes in inflation.

Appendix 1 reconciles the opening and closing RCV and the average value by company, for the years 2010-11 to 2014-15. This is in the same format we used in RD06/09 last year. It also shows the movement between the closing RCV (at 31 March 2010) as set at the 2004 price review (and subsequently adjusted by interim determinations) and the opening value for 1 April 2010 which underpinned our 2009 determination.

2. The role of the regulatory capital value

The RCV has been developed for regulatory purposes and is primarily used in setting price limits. One of the elements we consider when assessing the revenues that the companies need is a return on the capital invested in the business. The value of the capital base of each company for the purposes of setting price limits is the RCV.

The RCV is remunerated through price limits at a cost of capital (on a real basis) that we set at each price review. The impact of inflation on the value of the RCV to investors and lenders is recognised by adjusting the value each year by RPI.

We introduced the concept of RCVs in our 1992 consultation paper ‘Assessing capital values at the price review’. It was developed during the MMC referrals for gas and water companies between 1993 and 1995. The RCV is now widely used by the investment community as a proxy for the market value of the regulated business and has, in some instances, become enshrined in bond covenants. We have published future RCVs (and updated them annually) since 2002 to provide transparency to investors.

3. Basis of calculation

We have set price limits at price reviews in accordance with our duties under the Water Industry Act 1991 (WIA91). One of our primary duties is “to secure that companies are able (in particular by securing reasonable returns on their capital) to finance the proper carrying out of their functions”.

There is no definition of ‘capital’ in the WIA91. The current replacement cost (modern equivalent asset or MEA) valuation of the companies’ assets at privatisation was about £224 billion (in today’s prices). The proceeds from privatisation of the water and sewerage companies was £9 billion (in today’s prices).

The RCV starts with a direct measure of the value placed on each company’s capital and debt by the financial markets following privatisation. This initial RCV is calculated as the average of the market value of each water and sewerage company for the first 200 days for which the shares were listed, plus the total value of debt at privatisation. A proxy for the initial market value was used for the water only companies that were not privatised in 1989 (and hence no market information was available). This initial value was taken as the opening value of the RCV for 1990.

This initial value is rolled forward each year. The RCV is recalculated annually in outturn prices. The closing value from the previous year is adjusted by the movement in RPI. This adjusted figure gives the opening value for the year.

Capital expenditure to enhance and maintain the network, which is assumed in setting price limits, is added to the RCV. Any capital grants or contributions towards the cost of the new assets are deducted. Current cost depreciation (based on the MEA value of the assets), which is assumed in setting price limits, is deducted from the RCV each year.

Expenditure in any one year to maintain and replace infrastructure assets (infrastructure renewals expenditure or IRE) is not directly added to the RCV, but compared with the infrastructure renewals charge (IRC). The balance, the infrastructure renewals accrual or prepayment, is added to or deducted from the RCV each year. This reflects the extent to which more (or less) money has been spent on maintaining the infrastructure asset base than assumed in price limits, thus increasing (or decreasing) the value of the capital base to be remunerated.

For the period 1990-95, the net additions to the RCV were based on the assumptions made by the Secretaries of State in setting price limits for the period immediately following privatisation. For all years from 1995 onwards, the movements in RCVs are based on the assumptions we make in setting price limits.

The assumptions about net new expenditure that we made at the 2009 price review (PR09) for each company are set out in appendix 1. They are split between:

• capital expenditure;
• infrastructure renewals expenditure and the infrastructure renewals charge;
• grants and contributions; and
• current cost depreciation.

4. Outperformance of regulatory assumptions

The companies have incentives to outperform our regulatory assumptions and earn a higher level of profit than we assumed when setting price limits. Within a five-year cycle, the companies had greater incentives to outperform early in the price review period and to keep the benefits of their efficiencies for longer, before these are returned to customers. This unnecessarily distorted the timing of efficiency savings.

At the 1999 price review we introduced a mechanism to provide incentives for each company to improve its efficiency and outperform our regulatory assumptions throughout the five-year price review period, as set out in MD145, ‘The framework for setting prices’ (March 1999). We retained this mechanism for the 2004 and 2009 reviews. This mechanism, the rolling incentive allowance, allows the company to keep the benefit of outperformance in any given year for five full years before it is passed on to customers, and hence removes the distortions caused by the cycle of price reviews.

The RCV is the mechanism used to reflect past capital outperformance and hence transfer the benefit of this to customers through lower price limits. In broad terms, the level of outperformance is assessed by comparing net actual capital expenditure and depreciation in the year with our projections. The outperformance adjustment is deducted from the RCV. The reduction in the RCV reduces the capital base on which investors earn a return, resulting in lower bills for customers. In effect, the benefits of the outperformance are passed on to customers five years after they have been made.

The outperformance adjustment is shown as a separate line for each company in appendix 1.

The outperformance adjustment is calculated by comparing the capital expenditure (excluding IRE but net of grants) actually incurred in a given year with that assumed in setting prices (plus any agreed logging up for new legal obligations – see section 5). This difference is then adjusted for depreciation using an average asset life for the industry. The difference between the infrastructure renewals expenditure actually reported in the year and that assumed in setting price limits is the final element of the calculation. The outperformance adjustment is calculated separately for the water and sewerage services.

Provided that in total the company’s capital expenditure was less than that assumed in previous determinations, we calculated the annual adjustments as set out above and then smoothed these to achieve the same Net Present Value (NPV) as the unsmoothed adjustments.

Where the total actual expenditure for the period exceeded that assumed in setting price limits, the actual expenditure over and above the amount we assumed is not automatically included in the RCV.

Where expenditure exceeded the projected level for the service but, at a company level, aggregate expenditure was less than projected, the company was required to explain why the additional expenditure (above the service level) should be included in the RCV. This explanation is needed to both justify the work carried out and to show that the costs involved would stand scrutiny in comparative analysis. Where expenditure exceeded the projected level for the company as a whole, then the company needed to provide clear and incontrovertible evidence to show why the additional expenditure should be included in the regulatory capital value.

Some companies underspent against the level of infrastructure renewals expenditure that we determined at the previous price review and overspent against the level of maintenance non-infrastructure, within the same service. For these companies, where they provided adequate justification for this in terms of the serviceability of their assets, we allowed a virement of expenditure to maintenance non-infrastructure using the logging-up mechanism. This means that companies were not penalised for reprioritising maintenance expenditure within a service.

At the 2009 price review, we introduced the capital expenditure incentive scheme (CIS). It provides strong incentives for the companies to put forward challenging and efficient business plans and to strive to beat our price limit assumptions after them.

Under the CIS, each company recovers its actual capital expenditure plus or minus an incentive allowance that depends on its forecast of capital expenditure and its actual expenditure in 2010-15. At the next price review, we will reconcile the rewards or penalties due under CIS, taking account of actual capital expenditure along with the expenditure assumptions and additional income allowed in price limits. We will also adjust each company’s regulatory capital value (RCV) to reflect actual 2010-15 capital expenditure.

The CIS allows for symmetric treatment of capital expenditure over- and under-spends against the assumptions in our determinations. So, if a company chooses to spend more than our price limit assumptions, we will reflect actual expenditure in the future RCV.

5. Roll forward of the RCV at the 2009 price review

In calculating the opening RCV at 1 April 2010 for the 2009 price review, a number of adjustments are made. These are:

• indexation;
• logging up/down and shortfalls;
• changes in the notified index;
• land sales; and
• other adjustments.

5.1 Indexation

This represents the movement in the closing RCV from the previous review period, from 2008-09 prices (the price base used in RD 06/09) and 2009-10 prices, which are used in this letter.

5.2 Logging up/down and shortfalls

This deals with changes to the sector-specific legal obligations placed on a company since price limits were last set. Where a change, either in terms of additional obligations or the removal of obligations, is material this can trigger an interim determination of price limits. If the change is not sufficient to trigger an interim determination (or the company chooses not to seek one) we ‘log up’ any reasonable net additional costs to be taken into account at the next price review. Similarly, reductions in the required outputs are ‘logged down’.

Capital expenditure which is logged up is added to the opening RCV. These amounts are scrutinised and challenged by us to ensure the addition to the RCV reflects what would be expected from an efficient company. The RCV is reduced by the amount of any logging down.

Where a company has failed to meet the outputs required and allowed for in the RCV when prices were set in 2004, the RCV is also reduced to take account of this. These are known as ‘shortfalls’. Customers should not continue to finance services that they have not received.

5.3 Notified index

The RCV, which is determined at each price review, reflects our assumptions about the movements in construction price inflation for the price setting period. The net capital expenditure which is added to the RCV reflects assumptions about the movement in COPI relative to the movement in RPI. This difference is known as the notified index. The adjustment at the price review therefore reflects the difference between the change in COPI we assumed when we set price limits in 2004 (as updated by IDoKs) and the actual change over the period.

5.4 Land sales

The RCV is also adjusted for any disposal of land by the regulated business. When a company disposes of land, the licence requires that the proceeds are split equally between shareholders and customers. The mechanism for doing this is through the RCV. The customers’ share of any net proceeds is deducted from the RCV. The adjustment therefore reflects land sales made over 2005-10.

However, when we set prices we do not know what the actual land sales are for the last year of the period, that is 2009-10. Therefore, we use an estimated figure which gets corrected at the following review. A small number of companies had overestimates made at the 2004 review, followed by low levels of land sales from 2005 onwards. These companies had a positive adjustment made at the 2009 review.

6. Basis of the RCVs included in appendix 1

The opening and closing RCVs are in March 2010 prices and use year-end RPI to index from 2008-09 prices to 2009-10 prices.

The average RCV for each year is presented using year-average RPI. The average RCV cannot therefore be calculated as the simple average of the opening and closing RCVs.

The indices which have been used to inflate the RCVs are:

7. Publication in future years

We will continue to publish RCVs in this format every year. The values presented will be updated to reflect an additional year’s inflation. Change to the RCV between price reviews only occurs if a company has an interim determination of its price limits. We will publish RCVs in April each year once the interim determination process is complete and the March RPI is known.

Yours sincerely

Keith Mason

Director of Finance and Networks