Select Committee on Public Accounts Fiftieth Report


  1. The regulators' estimates of a reasonable return on capital are one of the most important elements of the price setting process. There are two complementary risks in setting the allowed return on investment. On the one hand, if regulators set too high a level of return companies could make excessive profits. The networks are capital intensive operations and returns on capital can constitute a sizeable proportion of the bill paid by consumers - up to one third in the case of water. On the other hand, if the regulators set too low a level companies could struggle to raise finance for new investment.[38]
  2. OFTEL said that they sought to produce an estimate of the return that would be needed to ensure that British Telecom renewed its network and invested in new technology. They did so by estimating a range of figures for return on capital (in percentage terms) after consultation with British Telecom and other operators on both methodology and the detailed figures. From this range, they chose mid-points.[39] OFWAT said that they took into account the perceptions of the markets at the time of setting the cost of capital to reflect a stable, robust company. OFGEM added that they set the weighted average cost of capital in a comparable way to the other regulators and by reference to capital market information.[40]
  3. There is an incentive within the price capping process for companies to seek to lower their own financing costs below the level estimated by regulators. To the extent that debt finance is cheaper than equity finance, a regulated company has an incentive to reduce its financing costs by altering its financing structure to increase the ratio of debt to equity. As OFWAT said, if the company were to beat the regulator's assumptions, then that would be a benefit that they would keep until the next price review.[41] In the water industry, several companies have moved to a financial structure dominated by debt. The most prominent example is Glas Cymru, a company limited by guarantee which purchased Welsh Water in 2001. Glas Cymru is funded entirely by debt, though it has substantial reserves because it purchased Welsh Water at a discount to its regulatory capital value. Other water companies adopting a heavily indebted structure include Mid Kent Water and Portsmouth Water.[42]
  4. There may be risks to consumers arising from these structures. A heavily indebted company may have less flexibility to respond to unexpected events, such as a sudden increase in operating or financial costs, than a company with a substantial equity reserve. If a company has insufficient equity reserves to call on, there is a risk that it may have to pass on unexpected cost increases to consumers through higher prices. OFWAT said that Glas Cymru was the only water company wholly financed by debt, and that they had only allowed this transaction to proceed after very carefully considering the dilemmas posed by the new structure. They pointed out that the Glas Cymru proposal had clear support in Wales, and had a very clearly articulated set of precautions to guard against the risks of brittleness and inflexibility that were inherent in a wholly debt-financed company.[43]
  5. Other water companies had not been proposing that equity should disappear, but were increasing the proportion of debt in their financial structure. In these circumstances, OFWAT had aimed to introduce licence amendments to ensure that customers' interests were fully met, for example by reviewing procurement plans where an increase in debt finance is accompanied by an increase in outsourcing. They expected a company largely or wholly financed by debt to respond to external events just as well and efficiently as other companies but would not bail out a company that had chosen a particularly risky structure.[44] But it was not clear to us how the regulator could avoid allowing higher charges to customers if a company was unable to call on shareholders' funds to withstand a large shock, such as increased borrowing costs.[45]
  6. OFTEL said that British Telecom had been reducing its debt to a level below 40 per cent in the face of market pressures. OFGEM said that in the electricity industry the level of debt was in the region of 50 to 60 per cent and that they would have reservations about companies having a very high level of debt.[46]
  7. One test of the appropriateness of assumptions made by regulators is the relationship between the Regulatory Capital Value (the capital base on which the company earns the percentage rate of return estimated by the regulator)[47] and the value placed on companies by financial markets, for instance through the publicly quoted share price. A significant and sustained divergence between the regulator's and market's estimate could indicate that the regulator has made inappropriate assumptions. OFWAT acknowledged that for several years, since just before the most recent price review, the valuation placed on companies in the water industry by financial markets had been lower than OFWAT's valuation, but noted that recent prices paid in acquisitions of water companies indicated that market values were not very far from the Regulatory Capital Value. They considered that differences between market and regulatory valuations were a common part of regulatory systems when new price limits are introduced. They would, however, bear the relationship between these two variables in mind as they prepared for the next price review.[48]
  8. There are clearly good reasons why the regulators should pay particular attention to the allowance for cost of capital in their next price reviews. They have established a joint working group to learn from each other in making assumptions about the returns on capital they should allow so as to avoid unnecessary differences in approach. As OFTEL told us, its purpose would be to assess whether the regulators' fundamental model was sound and to look at any differences in their approaches, so that they there would be a clearer justification for the approach adopted.[49]
  9. There are some indications that the returns on capital that investors require may be affected by their perception of regulatory uncertainty. Unexpected changes in regulatory policy and approach may deter investors from providing funds to regulated companies, hence making it harder for them to finance their functions. According to a survey by the National Audit Office, virtually all the regulated companies considered that regulators needed to give priority to reducing of uncertainty about the regulatory approaches to controlling prices in the long term.[50]
  10. OFWAT agreed that reducing unnecessary risk was very much part of their job, adding that regulatory uncertainty should be interpreted more widely to incorporate Government as well as their own actions. As part of their drive to make their regulatory stance clearer and increase transparency they have announced that they will in future share the financial model they use to calculate price controls with regulated companies. They also said that they were aiming to publish to publish their forward perspective on companies' regulatory capital values, and that this would help the financial markets to be clearer about OFWAT's approach to this issue. They did not, however, believe that they could remove all regulatory risk without affecting the interests of customers.[51]
  11. Both OFGEM and OFWAT felt that the Utilities Act 2000 had helped reduce regulatory uncertainty by creating a regulatory authority for OFGEM consisting of 11 individuals. OFWAT expect the forthcoming Water Bill to provide for a similar move to a regulatory authority for the water industry.[52]


38   C&AG's Report, para 3.15 Back

39   Q8 Back

40   Q11 Back

41   Q13 Back

42   OFWAT, Annual Report 2001-02 Back

43   Qs 12, 18 Back

44   Qs 19-20 Back

45   Q23 Back

46   Qs 22-23 Back

47   Ev 18-19, Appendix 1 Back

48   Qs 12, 90 Back

49   Q95 Back

50   C&AG's Report, para 3.29 Back

51   ibid, para 3.30; Qs 17, 91-92; Ev 18 -19, Appendix 1 Back

52   Qs 17, 97 Back

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Prepared 8 August 2002