Investors in utility stocks are often drawn to the reliable business models that underpin their performance. The water sector is no different. Enormous asset bases and regulated returns allow companies to carry more leverage than would be tolerated in other sectors, while dividend payments are pretty generous. True, it's a sector susceptible to regular regulatory upheaval, but proposals are often deliberated over for a long time, and well in advance of any real, concrete change.
The danger is that this steadiness can tip into stagnation. And in recent years, water groups have come up against a number of high-profile poltical attacks. Environment secretary Michael Gove has criticised water companies' use of offshore tax structures, and there have been record fines for sewage dumping and service failures following extreme weather.
The leader of the opposition, Jeremy Corbyn, believes the current state of the industry is best solved by nationalisation, and has pledged to bring the current system back under public ownership, to be replaced with a network of municipally owned water providers.
Others believe that stronger rules are what's needed. Every five years, water services regulation authority Ofwat re-establishes the regulatory framework with which water companies must comply. These are typically known as 'cycles'. Preparations are under way ahead of the next cycle starting in 2020, so we're looking at the potential changes already under advisement, and what they could mean for investors.
The regulator is shaking up its approach to make the performance of the companies more dependent on a series of ambitious targets, not all of which are financial in nature. Essentially, Ofwat is hoping to create a regulatory environment in which companies have a more vested interest, which could have interesting – not to mention broader – implications.
As such, many water groups are currently formulating individual business plans to be submitted to the regulator in September this year. Initial assessments of these plans will be published in January 2019, before final determinations are published by Ofwat the following December.
Returns could well be lower
The first change investors will notice is a lowering in companies' allowed returns over the next cycle. Typically, regulators are keen to keep a close eye on profits generated on regulated assets – in this case the water network – and this should hardly come as a surprise given the negative perception of the water sector by government. Ofwat’s plan is to switch from the retail prices index (RPI) to a variation of the consumer price index known as CPIH, for indexing customer bills and the value of the companies’ capital bases. So far, analysts at RBC Capital Markets have calculated the aggregate effect of the switch could lower company returns by 100-140 basis points over the next cycle compared with the current one.
But this isn't the whole story. Ofwat has also introduced four possible classifications for submitted business plans. The top two – 'exceptional' and 'fast-track' – offer benefits including a 20-35 and 10 basis point uplift in company’s allowed returns, an increase from the initial 20 basis points offered to exceptional plans in the draft methodology.
Exceptional and fast-track companies will also be offered 'early certainty', which means Ofwat won't be able to reverse decisions made on parts of a business plan during the draft determination which will take place during March and April next year. This essentially allows the group to 'lock in' more favourable decisions early on.
Business plans deemed to be 'slow track' will receive no benefits or penalties, while those that fall within the lowest classification – 'significant scrutiny' – will face reduced cost sharing rates and a potential capping of their incentive payments to as low as zero.
Are dividends at risk?
The move away from RPI as a measure of inflation is understandable from the regulator’s perspective. CPI is widely viewed as more credible and is a less volatile measure of inflation. It does, however, raise questions for income investors. All three of the UK’s listed water companies tie their dividend policies to RPI, with Pennon (PNN) and Severn Trent (SVT) offering a return of RPI plus 4 per cent. While regulated returns are likely to be tighter for all three of the water majors, analysts at both JP Morgan Cazenove and RBC Capital Markets conclude none of them would need to rebase their dividends. In fact, JPMorgan described fears of deep cuts to dividends as "overdone", and expects a "flat to mild reduction in dividends".
Incentives: more to play for
Of course, regulated returns only make up part of companies' profits. Since the start of the current cycle in 2015, water companies have also been generating additional returns – or penalties – through their outcome delivery incentives (ODIs). They effectively act as a series of targets which, depending on how the company does, yields a reward, a penalty or even nothing at all. These are likely to become more rigorous in the next cycle, and could prove integral to a company’s overall return.
The incentive element of ODIs is typically either reputational or financial, or a combination of the two. Reputational ODIs require the company to report its performance to customers and customer challenge groups. Financial ODIs link a reward or penalty to a company’s performance against its target. In the upcoming cycle, Ofwat is planning to increase the strength of financial ODIs, as well as introducing a range of 14 "common commitments" allowing companies' performance to be benchmarked on an industry-wide basis. They will also be subject to bespoke commitments, which are specific to the company in question. For example, United Utilities' coverage area means it serves more customers on low incomes than many of the others, so it may have bespoke commitments that place a greater focus on affordability.
In the current cycle, ODIs are subject to a "cap and collar", meaning aggregated rewards or penalties over the period can't exceed 2 per cent of a company’s regulated equity. These will be removed in the next period, allowing companies to propose higher rewards (or penalties) based on their performance against common commitments. Ofwat has set an indicative range of 1 to 3 per cent, but a spokesperson described the new approach to incentives as "much more extreme" than the current arrangement. "You’ll see much more divergence of company positioning," they added.
Increased innovation
Where companies propose larger allowed returns, they will be required to justify it. Companies are already under pressure to innovate, but this pressure will increase in the coming cycle. In a speech earlier this year, Ofwat senior director David Black said innovation was "a necessity, not a nice-to-have". It will be one of the four key pillars in the 2019 price review, described by Mr Black as "the critical enabler" of the other three, customer service, resilience and affordability.
Attempts to innovate can already be seen: United Utilities (UU.) has adopted the "systems thinking" approach, using data and technology to improve efficiency. It has harnessed NASA-developed satellite technology to detect leaks in the network, with the intention of being able to spot potential problems before customers are affected. Severn Trent recently partnered with a team from the Massachusetts Institute of Technology (MIT) to develop robotic tools for detecting leaks in the network. In the upcoming cycle, any progress which these innovations yield will need to be shared.
