Out of WACC? How greater consistency would bring down utility bills

What should investment cost? 

Although it is an arcane area of regulation, how regulators set the cost of capital affects everyone. As we invest huge sums in energy, transport, aviation, telecommunications and water, it crucial that regulators get it right.

If the regulator sets the cost of capital too high, customers will end up paying more than they should. If it’s too low, the risk is that companies fail to raise the money needed and the new reservoir, wind farm or runway doesn’t get built.  

Not many people know that customer bills only pay for about half of what water companies in England and Wales need to spend between now and 2030. That means water companies need to raise huge amounts of extra money from financial markets to pay for new reservoirs, pipes and water treatment works. Similarly, British energy companies need to raise extra money for new power stations, wind farms and transmission lines. Money also needs to be raised for the costs of maintaining and upgrading Heathrow Airport, as well as laying broadband cables by Openreach and some major transport projects. In total, £550 billion of private investment is needed over the next decade alone.  

The problem is that the system that governs how these sectors can raise this money isn’t working in the interests of either investors or customers. The rules vary across each sector, even where the elements are identical and so should be the same. When the conditions for investment unnecessarily differ across sectors, time and money is wasted as special expertise is needed to understand the approach taken in each sector. The costs of dealing with this sort of inconsistency are ultimately paid for by customers.  

Water UK strongly supports greater consistency. The good news is that these rules are being rewritten right now. The UK Regulators' Network (UKRN) sets the guidance that regulators across the water, energy and aviation sectors use to work out what investment should cost – the ‘cost of capital’. The UKRN has consulted on updating its guidance, and last week Water UK submitted its response.  

We are urging the UKRN to ensure that the rules enable water and other sectors to raise the finance needed to deliver records levels of investment, now and into the future. 

How do the water, energy and aviation, telecommunications and transport sectors raise finance? 

When a water company builds a new reservoir, when an energy company builds a new transmission line or when Heathrow upgrades one of its terminals, the owners pay for the costs upfront. Those costs are a mix of interest paid on money that has been borrowed (the debt costs) and the cost of persuading owners to put their own money in (the equity costs).  

Instead of looking at what the actual debt and equity costs are, regulators such as Ofwat, Ofgem and the Civil Aviation Authority determine what they think the costs should be. They estimate a blend of both equity and debt costs which they call the Weighted Average Cost of Capital (often shortened to the ‘WACC’).  

What needs to change? 

When regulators set the cost of capital, they make a series of assumptions which contradict reality. With billions at stake, we cannot afford to continue in this way.  

For the cost of debt, regulators assume that companies need to borrow far less than they do.  

For the cost of equity, UK regulators largely rely on something called the ‘Capital Asset Pricing Model’, which assumes a world without taxes and that all assets can be infinitely divided. As we know, we all pay taxes and things like reservoirs, power stations and airport terminals are not infinitely divisible.  

In setting their own rules for calculating the cost of capital, UK regulators also create an ideal (but imaginary) company which they call the ‘notional company’. Regulators then allow real companies to raise finance based on what they calculate it would cost the notional company.  

It would be much better to look at real companies and the real challenges they face rather than hypothetical ones. That would not mean signing blank cheques for investors, far from it. We want regulators to properly think about real-world circumstances when deciding the level of the cost of capital that is needed to attract investment, particularly as investors have choices and can go elsewhere.

Either way, if regulators are to determine how much investment in vital services is allowed based on their ideas of a ‘notional company’ and the Capital Asset Pricing Model, both of which are known to have deep limitations, then we think they should at least do so by using consistent approaches.  

For example, when determining the benchmark for measuring the risk borne by investors in energy, aviation, transport, telecommunications and water, regulators calculate what they deem to be the ‘risk-free rate’. That is generally thought to be whatever it costs the government to borrow. There are different ways of calculating it, but regulators should all pick the same way and stick to it. After all, if there is a ‘risk-free rate’ of borrowing, it is risk free whatever the sector.  

Greater consistency in the way that regulators calculate the cost of capital would make it simpler for investors when they decide whether to invest in the UK. If investment is simpler, it is quicker and cheaper. Because of the way regulators set customer bills, any savings would be passed onto consumers and bring down the cost of living for them.  

To achieve greater consistency, we are calling on the UK Regulators’ Network to set up a ‘standing committee’, with an independent chair, which has the job of reviewing and updating the guidance whenever markets move or regulators’ decisions diverge. As the Independent Water Commission proposed, a central body could be given the job instead, which would be a matter for government.

This may all seem obscure, but unless these rules change, we won’t get the investment our country needs and customer bills will be higher than they need to be. Get it right, and we will be able to attract investors from around the globe – helping to fix broken regulatory systems and be able to upgrade infrastructure across the economy.

This has been a UK Government priority since at least 2014. The UK Regulators’ Network should be applauded for trying to address these issues, which are admittedly complicated and challenging given it has no statutory power to make different regulators act more consistently.  

In our response, we set out in detail how we think the UK Regulators’ Network should go further and, in so doing, play its part in helping to boost economic growth and reduce the cost of living.  

Read Water UK’s full response to the UKRN’s cost of capital guidance here.