‘The million-dollar question’: Are regulators getting the cost of equity right?

Balancing risk and reward

Anthony Legg, energy and utilities partner at PA Consulting, says on the water side there appears to be some recognition that “the methodology is delivering a lower cost of equity than Ofwat is hearing from the industry and investors, so they are proposing to aim up from the methodology.”

“Broadly speaking, the investors that I’ve spoken to don’t feel that the allowed cost of equity is adequate for the risk that they’re taking on,” he adds.

For various reasons, Legg says these risks are likely to be greater than they have in previous price controls: “You’ve also got to look at the package of performance commitments: the totex allowances, the ODIs, the PCDs.

“Basically, when you wrap all of that together, the performance targets look difficult to achieve, the efficiency targets look difficult to achieve and there are strong financial penalties for not achieving those things. So overall it will look to investors like their expected rate of return is actually going to be lower than the allowed rate of return.”

AMP8 will see a large ramp up in investment to, among other things, address the headline issue of sewage discharges, which in recent years has generated huge public anger and frontpage headlines. Legg says there has “traditionally been a view that increased capex leads to increased risk and that should be remunerated through a higher cost of equity”.

Similarly to Ofgem, Legg says Ofwat may also be cognisant of the previous set of water company appeals: “During the water company appeals at PR19, the CMA decided to aim up on the cost of equity. So Ofwat may feel that by aiming up in the draft determinations, they are being consistent with the CMA approach.”

Legg says if Ofwat were to reexamine the components of its calculation of the cost of equity, the most likely to change would be the equity beta and total market returns, which involve “a bit more judgement” than the more “mechanistic” risk-free rate.

But rather than “one big fix”, Legg says the regulator is much more likely to make “a combination of adjustments” to various parts of the price controls: “So some adjustments to the performance targets, some adjustments to the totex allowances, some adjustments to the ODI and PCD penalty rates, as well as some uplift to the allowed cost of capital.”

Investment will be vital for 2030 push

As with water, Legg says the energy networks will need a big boost in investment in their next set of price controls: “Certainly, for the electricity networks, there’s a huge amount of money that needs to be spent so setting a low cost of equity when you’re trying to attract all of that equity into these businesses and the importance of building the networks at pace to facilitate net zero, that would be counterintuitive.”

He says network companies “will need to be trying to find ways of accelerating their investment in response to the new government’s drive for a net zero power sector by 2030, which could mean even more equity, even more construction, even more capex intensity and the risk that comes with that”.

Legg says one thing that stands out when comparing the two sectors is that the UK Regulators Network study, which was meant to bring greater standardisation, “doesn’t seem to have led to close alignment between Ofwat and Ofgem yet”.

“We have two regulators in the UK regulating very similar industries and somehow coming up with quite different answers.”

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