To mutuality and beyond

This article first appeared in The Water Report

These were the words of Jim Callaghan as he ushered in a sea change in politics in the 1970s, but are we now seeing momentum behind such a change in our water, energy and infrastructure companies and is this leading us to a mutual approach? There are key drivers behind such a path – economic, political and customer but are they really strong enough to presage a significant re-alignment?

Returns constrained

The move to mutualisation has its roots in the financial crisis of 2008. This led to an era of low interest rates that provided regulated utilities with the opportunities to make much higher than expected returns. This became visible to the media and informed the Labour Party’s call for re-nationalisation. There is clear evidence that in the current round of price controls, regulators have found new energy to tackle the cost-of-capital and constrain the potential for exceptional returns.

Ofgem has proposed that the allowed cost of equity returns will be set at a baseline of 4 per cent which is nearly 50 per cent lower than the previous price control of 7 per cent for transmission networks, at a time when interest rates have very slowly begun to rise. This follows Ofwat’s lead in lowering water companies' baseline cost of capital by over 100 base points, with a similar cost of equity, and potentially index linking it. This is in parallel to adding mechanisms that seek to capture value for customers, for example, by banking expectations in advance that companies will outperform and using capping mechanisms to increasingly share the benefits of unexpectedly high-returns.

These steps to lower baseline returns, raise the bar and limit rewards, mean a shift in the companies’ risk-reward profile. To provide greater reassurance to investors Ofgem is also putting in place protection for bondholders who fund upwards of 60% of investments in infrastructure. The management of gearing and risk is also a key focus for Ofwat.

In the energy retail market, there are similar pressures to constrain returns. Ofgem has already regulated that companies need to advise their customers of cheaper deals that could be available and last year introduced a price cap limiting retailers' ability to make returns. This is placing further pressure on an already fragile market with ten small suppliers failing last year. In the water retail market we have seen the first casualty, with Aquaflow Utilities Limited notifying Ofwat that it is likely to enter administration in early April.

A further driver is the role of the customer. In a digital age, customers have higher and higher expectations, in terms of service, price and involvement. Customer challenge groups are now fundamental to the regulatory process in water, electricity and gas industries and failure to engage and demonstrate that customer’s feedback has been taken on board will be detrimental to their outcomes. This strengthened role of customer engagement, and growing power of each company’s engagement groups, are one-step away from the type of governance boards found in mutuals, such as Dwr Cymru and pave the way for a more entwined relationship.

South West Water’s PR19 plan provides an excellent example of the progression of this idea, where they have declared: ‘We know from customer feedback that they want to see the benefits of success of the business fairly shared, which is why we have already pioneered the innovative WaterShare framework’ and ‘We will commit to holding a customer Annual General Meeting where customers can vote and have their say.’

Demand reduction

The final driver is societal and environmental. Both energy and water industries face significant challenges and there are questions as to whether the current structures are best placed to deliver these. Can the requirements of financial return be balanced against the long term, often uncertain, nature of these investments and can this model generate the requisite consumer consent and commitment to embrace and be part of the change?

The energy industry provides an example of the challenge where nuclear power was meant to be a key plank of our future energy security, delivering low carbon sustainable energy and we were due to have six power stations under construction by 2019. In practice major companies such as Toshiba have pulled out and only Hinkley Point C is being built. This is being delivered by EDF – effectively a ‘mutual, 83% owned by the French Government and the French people and China General Nuclear Power Group (CGN) a state-owned utility. The Government has faced significant criticism over Hinkley, for setting a future strike price of energy at £92.50 per MW hour compared to a current projected price of £56.00. Professor Dieter Helm of Oxford University estimates this could cost UK consumers £50bn.

At the other end of the energy value chain, suppliers are trying to roll out smart meters to all households and small businesses by 2020, to provide consumers with the means to monitor and reduce their energy usage, saving money and reducing carbon emissions. The programme is running an estimated 3 years late with only 14m out of a required 53m meters installed to date. One of the most significant issues has been consumer acceptance. Consumers just do not see their ‘skin in the game’ and it is proving extremely difficult to persuade them to be at home for half a day for the inconvenience of having a smart meter fitted.

The synergies with the current position of the water industry are very strong. In March, Sir James Bevan, Chief Executive of the Environment Agency gave a provocatively titled keynote speech ‘Escaping the jaws of death: ensuring enough water in 2050’. This set out the extent of the challenge facing the industry, emphasising that on the present projections, many parts of our country will face significant water deficits by 2050, and potentially a lot earlier dependent on population growth, particularly in the south east where much of the UK population live. This is a view fully supported by the National Infrastructure Commission (NIC) in their report: National Infrastructure Assessment – July 2018.

Sir James sets out key required actions. He endorsed the NIC’s twin track approach of increasing supply and reducing demand. He notes a need for water transfers, desalination and ‘most controversially of all, we will need to build new reservoirs.’ On the demand side, he notes the need for reduced leakage, water efficiency labelling and increased metering and ‘sustainable placemaking - working with planning authorities, businesses and local communities to design towns, cities and other places which put the sustainable use of water at the heart of their design and functioning.’

This is fully aligned with Ofwat’s direction. Resilience has been a key focus, a significant number of companies have said in their plans that they will meet Ofwat’s leakage reduction target of 15% by 2020, and over 20 water transfers are proposed and two major reservoirs are planned. The question is how the current model will deliver these. Could raising finance for a reservoir experience the same issues as financing a nuclear power plant, or will the greater certainty create a sound investment proposition? How will water companies persuade their customers to have a meter installed and receive metered bills and to embrace water efficiency as an objective.

Metering and the management of customer-side leakage are key both to reducing leakage and understanding where leakage actually is, in order to drive more effective targetting of leakage activities. But both require a high degree of customer buy-in, or incentives for the customer to participate, a more mutual model where, for example, a company could agree to price reductions based on customer participation in addressing this as a shared challenge, would be an interesting and innovative option

Edging towards mutuals?

Given this environment, should companies be considering a mutual approach? There have been some, but limited, moves to full mutuality. Dwr Cymru Welsh Water remains the most obvious and successful example. In Northern Ireland, Mutual Energy is a company limited by guarantee (often called a mutual company), which has been formed to acquire and hold important energy infrastructure assets for the benefit of the energy consumers of Northern Ireland. This includes key transmission assets such as Moyle Interconnector Limitied, Premier Transmission Limited and Belfast Gas Transmission Limited, funded by long-term bond finance.

In the English water sector, South West Water has outlined an innovative approach balancing customer and investor needs. South West Water has set out an aim to ‘transform our relationship with customers by sharing more of our success, offering them a stake and a greater say in the business’, including offering £20m of accrued benefits from their PR14 WaterShare mechanism in the option of ‘shares’. This share ownership scheme is a first of its kind and continued sharing is envisaged based on outperformance against embedded debt from 2020. Customers will receive a share of company profits just as shareholders do, receive annual reports and financial statements and have additional powers through, for example, voting on the appointment of panel members.

The regulators in energy and water have arguably been prudently preparing the options for new capital structures. They have made changes to isolate disturbances to stable cash flows such as big enhancement projects, through mechanisms such as Direct Procurement in water and removing the volatility of ESO revenues from National Grid as the transmission owner in energy.  They are building up the tools and mitigations that move us closer to a tipping point where equity investors may decide that the reward no longer matches the risk and there is insufficient scope for winning i.e. the ‘fair bet’ suggests there is insufficient upside. At this point, the transition to a mutual model may be seen as a way to secure value from the investment – selling lower yield, long-term returns to funds.

The key challenge for investors is to build an understanding of likely ‘fair bet’ that will be allowed by regulators in future settlements, predict the precise moment when the tipping point is reached, successfully capture the value and achieve regulatory agreement to a new risk sharing arrangement. The role of customers in the shape of any new structure and the delivery of efficiency across that structure will be absolutely fundamental to the delivery of successful outcomes for all stakeholders. It will be fascinating to see whether we are at a sea-change, or whether tailoring current structures allows companies to navigate a successful path through the storm.