February 5, 2013 5:34 pm

Water sector urged to share pain and gain

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Thames Water

Stand-offs between companies and regulator Ofwat over tweaks to licence conditions, the threat to monopoly returns posed by a draft water bill and uncertainty on how inflation might be linked to future price increases have all unsettled the UK water sector.

It is an industry renowned for being uncomfortable with change. The muddying of regulatory waters has prompted some analysts to speculate that too much change could compromise its ability to attract investment.

However, the announcement of an agreed sale of junior water operator Sutton and East Surrey Water to Sumitomo of Japan on Monday suggests differently.

Paul Malan, senior partner of Icon Partners – which led the Canadian-dominated consortium that has held SESW since its purchase from Terra Firma in 2006 – says the sale of the company for an enterprise value of £305m marks a “vote of confidence” by a new foreign owner in the future returns on offer in the sector.

The deal came a day ahead of confirmation by Ofwat that water bills would rise this year by an average of 3.5 per cent – 0.5 per cent above inflation – leaving householders paying an average £388 in 2013-2014.

However, water companies can expect more pressure to improve performance while driving down costs under the next five-year pricing settlement expected from Ofwat next year.

Regina Finn, chief executive of Ofwat, told a City audience last Thursday that the switch from extreme drought to wet weather over the past year had demonstrated the need to maintain capital investment in the water and sewerage systems of England and Wales, which is currently running at £4bn a year.

But she argues that water companies and investors will need to temper any expectations of generous financial returns because of the pressures facing cash-strapped consumers.

“There’s been a 5 per cent reduction in household income since 2010 and average bills have gone up by 10 per cent,” she says. “With customer incomes going down and bills going up, it’s [an issue] that’s not going away any time soon.”

The regulator would not be seeking to claw back gains made by companies in the current pricing period through unexpectedly low interest rates, reductions in corporation tax and a spike in the inflation index to which bills are tied, says Ms Finn. “Are we going to tear up the past? No.”

But speaking alongside her, Ofwat’s chairman Jonson Cox says the regulator will expect water companies to come up with suggestions on how to “share pain and gain” in the next pricing round that is set to run between 2015 and 2020.

Mr Cox warns that water companies are not shielded from “the brutal forces of the commercial world” as competition is partially introduced to the sector under proposals contained in the draft water bill published last summer.

“It’s very important to maintain legitimacy among customers,” he says.

Ofwat’s last price determination in 2009 called for water companies to make £22bn of investment under a five-year price deal that, ahead of inflation, was aimed at delivering an average bill reduction of £3 to £340 a year ahead of inflation.

But this year’s increase follows a spike in the retail prices index to 5.2 per cent in November 2011 that led to the average water bill rising by an inflation-busting 5.7 per cent by £20 to £376 last year.

Last week a report by a committee of MPs overseeing the Department of Environment, Food and Rural Affairs criticised proposals under the bill that could extend the discretion of Ofwat in setting the price levels and investment plans of water companies across England and Wales.

But both Ms Finn and Mr Cox reject suggestions that added regulatory uncertainty will lead to higher bills by driving potential investors away.

Ms Finn says: “We want financing costs to be as efficient as possible”, adding that water companies continue to attract debt finance on attractive terms in spite of the debate about increased regulatory risk.

The water sector remains a “pretty attractive investment” and companies “can raise money at good rates,” she adds.

Analysts at Deutsche Bank described the City briefing as positive.

“We retain a neutral view on the water sector, as we see upside risks from M&A balanced by increased regulatory risk as we approach the next regulatory review.”

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