Inflation and the Cost of Debt

Overview

Awarded using Crown Commercial Service (CCS) Management Consultancy Framework Four (MCF4) (RM6309), Lot 4 Finance. Key parts of a price control include setting the cost of debt allowance and determining how the capital/asset value is indexed over time. There have been significant gains and losses by water companies from the inflation assumption used in our determinations being different to what occurs in practice. Citizens Advice estimate that the windfall to the water sector for the first 4 years of the PR19 period was in the order of £2bn. In the 2020-25 period these gains helped companies offset cost pressures and reduce gearing. After 2025 there are significantly more mechanisms in place to protect companies from cost shocks including indexing costs where independent indices exist and customers sharing a higher proportion of cost under and outperformance. Therefore, higher than expected inflation is now more likely to lead to higher profits for companies. In its provisional determinations Ofgem has proposed to set a nominal allowance for fixed-rate debt to reduce the exposure of consumers to inflation and adopting a different approach to indexing the Regulatory Asset Value (RAV). Public responses from the electricity and gas companies and Citizens Advice agree with the change in principle. We want to consider the approach Ofgem has taken, as if it is adopted it appears that it could reduce the likelihood of windfall gains and losses for customers and investors and provide greater stability. This aligns with the direction of travel set out in the Independent Water Commission (IWC) final report that suggested reducing volatility of returns at risk and greater consideration of indexing observable and time-varying components of the Weighted Average Cost of Capital (WACC). We anticipate that a report resulting from this work will form the basis for discussions between stakeholders in the water industry on this issue. We require advice on the matters required to be considered before any decision could be made about whether similar changes to those proposed by Ofgem should also be implemented in the water sector. We require a supplier branded report that we expect to share publicly with stakeholders. The report is to consider the advantages and disadvantages of a change to set a nominal allowance for fixed and floating rate debt in the water industry at PR29 and to index only the Regulatory Capital Value (RCV) of water companies for the proportion of it assumed to be financed by equity and indexed linked debt components thereafter. We are not looking for definitive recommendations at this stage. Instead, we require a report that can be used to help us engage with stakeholders and decide how to progress.