PR09 Final Business Plan Part B: Key Components

Transcription

1 PR09 Final Business Plan Part B: Key Components PR09 Final Business Plan: Part B anglianwater.co.uk

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3 7 Final Business Plan: Part B Part B7 Financial Projections 7.1 Summary 7.2 Introduction 7.3 Financing plan Financial strategy Cost of Capital Financeability Opening Regulatory Capital Value 7.4 Capital Charges Infrastructure Renewals Charge Current Cost Depreciation 7.5 Taxation Gearing assumption for the tax calculation Taxation allowance 7.6 Risk sharing mechanisms 7.7 Appendices 7.8 B7 Tables Glossary Glossary i

4 PR09 Final Business Plan: Part B anglianwater.co.uk Contents

5 Final Business Plan: Part B Part B7 Financial Projections

6 2 Final Business Plan: Part B Part B7 Financial Projections 7 Part B7 Financial Projections Key points We require a cost of capital of 4.9% to finance our Final Business Plan (FBP). Given the assumptions upon which the plan is based, no adjustment is required to make the plan financeable. This requirement is based on the assumption of a return towards more stable conditions in the financial markets by the start of AMP5. However, in certain downside scenarios for the general economy and the financial markets, including a continuation of recent difficult conditions, this cost of capital would not be sufficient to enable an efficient company to finance its functions. In such circumstances we would look to established risk mitigation mechanisms, including the Substantial Effects clause, as a means to reconsider price limits. We ask that Ofwat provide greater clarity on how it might implement such a provision. Our financial assumptions reflect our financing strategy and are consistent with a range of market evidence as set out in NERA s report on the cost of capital for Water UK, and observation of subsequent market activity. Tax allowances are calculated assuming gearing of 83%. Our Infrastructure Renewals Charge of 81m per annum is based on planned IRE from 2011 to We calculate a total CCD charge for AMP5 of 1,338m before allowing for the impact of Relative Price Effect, based on a revaluation of our asset base. We seek Notified Items to cover bad debt, changes to tax rules, the costs of implementing the Traffic Management Act and the cost of accounting separation. We seek further risk correction mechanisms in the event that rates costs are not included in price limits or that we cannot hedge energy price risk. PR09 Final Business Plan: Part B anglianwater.co.uk We base our FBP on assumptions consistent with a notional financial structure and expect that Ofwat will make its determinations on this basis. We have used Ofwat's financial model to generate our submission. However, the model does not appear to allow a notional level of indexlinked debt, independent of our actual debt instruments, to be assumed. We believe this to be inappropriate and we have therefore calculated notional financial ratios using our own financial models.

7 3 Key changes since the Draft Business Plan There has been an unprecedented deterioration in the world's financial markets which appear to have caused a general repricing of risk. Access to finance has become more difficult and costly. Interest rates have fallen leading, whilst the overall cost of borrowing has not, leading to a large rise in the carrying cost of debt which must be raised in advance of requirement to spend on capital investment. There has been substantial deterioration in the UK economy. NERA has increased its estimated range for cost of capital by 0.2%. We reflect half this increase in our FBP on the basis of a return to more stable conditions in the financial markets by the start of AMP5. We have therefore raised the cost of capital required by 0.1% to 4.9%. We have strengthened our view that Ofwat should target an A3/A credit rating to ensure an efficient company can finance its functions in these difficult market conditions and explicitly base our cost of capital requirement on this assumption. We have completed our asset inventory and valuation. Current cost depreciation is around 100m higher over AMP5 than at DBP. We have reviewed our approach to risk and modified some of our DBP proposals. 7.1 Summary We believe that we have put in place a sound financial strategy which will enable us to provide a robust and effective service to our customers over the long term Conditions in the financial markets over recent months have been unprecedented. Raising finance is more difficult than it has been at any time since privatisation. Since we submitted our Draft Business Plan, global financial markets have experienced a severe shock with a dramatic impact on available liquidity and substantially higher costs of debt. Bank lending has become significantly tighter and more costly and equity holders are seeking higher returns in these risky markets. We do not expect conditions to improve substantially in the near future Our approach to financing is proving effective in these conditions but at a significantly higher cost. Low deposit rates have dramatically increased costs of prefunding investment. We expect costs to remain high and availability of finance to be constrained compared to the early part of AMP4. However, we will continue to need substantial new investment to finance our capital enhancements and it is essential that investor confidence in the water industry is maintained.

8 4 Final Business Plan: Part B Part B7 Financial Projections To finance this plan for the next five years requires a cost of capital of 4.9%. At this level our plan is financeable on a notional and actual basis and no adjustment for financeability is required. Our actual gearing structure is inherently more risky than the notional structure assumed in preparing the Final Business Plan and it requires is to maintain higher headroom against key financial ratios However, this cost of capital assumes a return towards more stable conditions in the financial markets over the medium term. Under some downside scenarios, including a continuation of current conditions, a 4.9% cost of capital would not be sufficient to enable us to finance our functions. We look to Ofwat to provide greater clarity on risk mitigation mechanisms in such circumstances The cost of capital has fallen marginally since PR04 mainly because of a lower cost of debt and higher notional gearing. Cost of capital is 0.1% higher than assumed in our Draft Business Plan because debt costs have increased due to conditions in financial markets. Our predicted cost of debt over AMP5 reflects cost of existing debt and the higher costs we face to raise debt in the future. Assumed gearing is around the industry average. Our cost of equity remains unchanged since DBP primarily because of the weight afforded to very long run time series data in estimating the Equity Risk Premium (ERP). We note, however, that a number of commentators have stated the view that the cost of equity has increased by 2 to 3% since the global financial crisis reflecting a general repricing of risk. Our cost of capital assumption is supported by comprehensive economic research updated for recent market data as well as our own bottomup forecasts of debt costs. Table 7.1 Cost of capital assumptions Component PR09 PR04 Gearing (Net debt/rcv) Cost of equity (real, posttax) Cost of debt (real, pretax) Cost of capital (real, posttax) 60% 7.9% 4.0% 4.9% 55% 7.7% 4.3% 5.1% PR09 Final Business Plan: Part B anglianwater.co.uk Observed acquisition premia and markettoasset ratios do not provide good evidence of the appropriate cost of capital for PR09. Acquisition prices have been driven higher by global demand for regulated infrastructure assets. In acquiring Anglian Water our investors took account of future growth of the business as well as its current value. On this basis, they calculated a markettoasset ratio of 1.1 by the end of AMP5, a more relevant figure than that derived from comparing acquisition price with current RCV. Reasonable outperformance and growth expectations also increase market valuation relative to RCV We calculate a total Current Cost Depreciation (CCD) charge for AMP5 of 1,338m before allowing for the impact of the Relative Price Effect. This is broadly consistent with expectations given the level of additional investment in maintenance and enhancement planned over AMP5. Since our Draft Business Plan we have fully factored in the results of a revaluation of our assets as at 31st March 2008 in accordance with Ofwat's guidance. Our overall charge is around 100m greater than estimated in our Draft Business Plan, reflecting the application of more robust inventory and valuation approaches.

9 Our Infrastructure Renewals Charge will be 81m per annum over AMP5. We base our charge on projected Infrastructure Renewals Expenditure for 2011 to We believe this is consistent with the longterm view we take in relation to planning for maintenance of our assets. It has increased since AMP4, reflecting higher capital maintenance needs We calculated an allowance for taxation on the basis of UK GAAP, reflecting key changes introduced by the Finance Act We propose that potential changes to UK GAAP to make them consistent with International Accounting Standards qualify as a Notified Item We propose a number of items which should qualify for specific risksharing either as a Relevant Change of Circumstance or a Notified Item. We have updated our proposals in relation to the cost pass through mechanism to mitigate energy price risk proposed at Draft Business Plan. We would only propose such a mechanism if it proves impossible or uneconomic to manage this risk commercially. 7.2 Introduction In this part of the Final Business Plan we set out the rationale for a number of assumptions which support our financial projections. In particular we explain the: financing plan, in particular the cost of capital on which we have prepared the Final Business Plan and its implications for financeabilty opening Regulatory Capital Value projected charge for Current Cost Depreciation Infrastructure Renewals Charge tax allowances proposals for risk sharing Our commentary should be read in conjunction with Ofwat tables B7.1 to B7.14. Structure We have structured Part B7 as follows Section B7.3 sets out our financing plan: in B7.3.1 we explain our financial strategy and structure. We also set out our current financing arrangements and how we expect to finance the investment we require in AMP5. We also look at the past and present conditions in the financial markets and prospects for financing over AMP5 in B7.3.2 we explain our assumed cost of capital, examining notional gearing, cost of equity, and cost of debt in B7.3.3 we consider the financeabilty of the plan assuming a notional and actual capital structure in B7.3.4 we set out our opening Regulatory Capital Value, and discuss logging adjustments Section B7.4 sets out our calculation of depreciation allowances:

10 6 Final Business Plan: Part B Part B7 Financial Projections in B7.4.1 we explain the Infrastructure Renewal Charge on underground assets, relating it to longterm trends in expenditure on maintaining these assets in B7.4.2 we explain our charge for Current Cost Depreciation on above ground assets relating it to the revaluation of assets explained in detail in Part C3 of the Final Business Plan and to longterm trends in expenditure on maintaining these assets Section B7.5 deals with taxation: in B7.5.1 we set out the gearing assumption on which we base tax calculations in B7.5.2 we explain how we calculate our tax allowances In B7.6 we set out in detail the risk sharing mechanisms proposed. Modelling basis for this submission In the absence of any guidance to the contrary we assume that Ofwat intends to set prices on the basis of a company with a notional financial structure. To do otherwise would be a major departure from past practice and would be counter to the longestablished principle that it should be for company to manage its own finances. We strongly support this principle In consequence, the financial assumptions on which this plan is based are set assuming a notional capital structure, in particular: cost of capital and its components assumed level of gearing assumed levels of test ratios for financeability testing assumed level of indexlinked debt The exception to this is the allowance for taxation, which in line with previous practice, has been calculated assuming our actual capital structure and hence higher deductible interest payments. It should be noted that whilst we have followed past regulatory practice in respect of calculating the allowanced for taxation, we do not believe that it is an appropriate basis on which to determine price limits. We have in the past made representations to Ofwat in relation to this and our view has not changed. PR09 Final Business Plan: Part B anglianwater.co.uk In brief discussions of a technical nature between ourselves and Ofwat's modelling team shortly before finalisation of this plan, it became apparent that Ofwat's team is expecting companies to submit FBP data on an 'actual' financing basis, by which we understand we should set the relevant flag within the financial model to 'actual' rather than 'notional'. We have been told that Ofwat then proposes to adjust to the notional basis using the model's own functionality in order to make its determinations and, in particular to test for financeability. We have provided all data about our actual financing structure as required by the guidance. However, we have not been able to find any guidance relating to the need to submit on an actual basis We have submitted our plan with the flag set to 'actual' as required by the Ofwat modelling team but observe that the cashflows and the resulting financial ratios set out in Ofwat table B7.1 are no longer appropriate for assessing whether the FBP is financeable on a notional basis. We would not therefore expect Ofwat to have any regard to these figures.

11 We also have reservations about the method by which Ofwat will adjust gearing from actual to notional. Without further adjustments to the model our relatively high level of actual indexlinked debt influences the assumed level of notional indexlinked debt applicable. In other words, the notional financial structure appears, in part, to depend on our actual financing structure. It is not possible within Ofwat's financial model for us to make an assumption regarding a notional level of indexlinked debt. We believe that this treatment, if it is correctly described, is entirely inappropriate given the key principle set out above We have similar concerns over whether our existing debt instruments are also factored into the notional financial structure in the modelling, but it has not proved possible to fully trace through the relevant calculations in the financial model. Anglian Water Services Financing Group The Anglian Water Services (AWS) Financing Group structure consists of Anglian Water Service Ltd (AWSL), which is the licensed appointee, AWS Financing plc, a subsidiary of AWSL, through which all new debt is raised and two pure holding companies above AWSL. The AWS Financing Group created a contractual financial ring fence around the cash flows and obligations of Anglian Water. This is in addition to the ringfencing provisions provided by the terms of the licence We have presented this Business Plan on the basis of the AWS Financing Group rather than AWSL in isolation. This is to reflect the substance of the financial ringfence rather than the artificial picture which would result from focusing solely on AWSL. All references to Anglian Water in the Final Business Plan therefore refer to the AWS Financing Group This approach is consistent with that adopted at PR04 and at Draft Business Plan. An adjustment to cash balances reported at JR08 has been made to reflect this approach. Lines in JR08 table 19 have been amended as follows: Line 6 Debtors Cr m Line 7 Cash Dr m Line 13 Creditors Cr m These changes net to zero so will not cause an imbalance in the HCA and CCA balance sheet. Other issues relating to Ofwat's financial model We had significant difficulty in using Ofwat's financial model for the purposes of the Draft Business Plan submission. We have set out our concerns regarding Ofwat's financial model in a letter accompanying the Draft Business Plan submission. Since that time a large number of amendments have been made and the model is now useable and appears to be substantially more robust. However, there remain a number of difficulties, which we describe below Ofwat informed us on 3 March 2009 that the functionality which calculates the impact of including the rolling opex incentive allowance and the revenue adjustment for Overall Performance Assessment was not working correctly. It offered a workaround solution and stated its intention to correct its financial model for the Draft Determination. Having analysed the workaround, we are not confident that it results in appropriate adjustments to

12 8 Final Business Plan: Part B Part B7 Financial Projections Kfactors or the financial projections. We have therefore excluded any allowance for opex outperformance or OPA from the figures presented in the FBP. We do not judge these to have a material effect but we trust that Ofwat will adjust the model in its Draft Determination Furthermore, we are still unable to precisely replicate Ofwat's calculations of Current Cost Depreciation, although they result in figures close to our own. We calculate CCD at 1,313m ( 1,338m less an adjustment for Relative Price Effect of 25m) over the 5 years. Ofwat's financial model calculates 1,339m. Of the 26m difference, 12m is due to a known difference in method relating to the application of asset lives, leaving 14m unexplained In addition, we observe that the model is extremely complex and its calculations are not transparent. Overall, this has severely and unnecessarily hampered the preparation of Draft and Final Business Plans. The most recent version runs very slowly making the generation of scenarios, which is essential for finalising the business plan, extremely timeconsuming and cumbersome. Despite these difficulties we have used Ofwat's model as required by guidance. 7.3 Financing plan Financial strategy We plan 2.26bn of investment over the course of AMP5 to maintain and enhance services to customers, provide for growth and meet new obligations. The size of this investment programme means that revenues will not cover required cash outgoings. Net cash flows will continue to be negative through AMP5, as they have been since privatisation We have adopted a robust debtbased financing strategy which has enabled us to raise finance efficiently to build and maintain the longlived capital assets on which our services to customers depend We have no current plans to change our financing strategy, although we review it regularly. In order to finance our AMP5 investment programme, and refinance existing debt reaching maturity, we will need to raise new financing of 1.8bn Our financing strategy depends critically on the continuing stability of the regulatory regime in which we operate as well as the banking and capital markets. Investors have gained confidence about the regulatory framework over recent years resulting in lower costs of capital and consequently lower bills to customers. It is essential that confidence in the regulatory framework is maintained Below we set out more details of our financing strategy: PR09 Final Business Plan: Part B anglianwater.co.uk financial structure, including financial covenant debt financing current debt portfolio cost of debt dividend policy.

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14 10 Final Business Plan: Part B Part B7 Financial Projections PR09 Final Business Plan: Part B anglianwater.co.uk 1 Not all group companies are shown

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18 14 Final Business Plan: Part B Part B7 Financial Projections PR09 Final Business Plan: Part B anglianwater.co.uk

19 Cost of Capital The Final Business Plan requires a cost of capital of 4.9% on a real posttax basis. At this level the plan is just financeable on a notional basis, given other current assumptions. The increased cost of capital partially reflects the substantially worse capital market conditions compared to our Draft Business Plan, in which we assumed a cost of capital of 4.8% Significant uncertainty affects the capital markets at the time we submit our Final Business Plan. Our required cost of capital is premised on a return to a more stable financing and economic outlook over the period up until 2015, supported by very recent positive trends for financing in the bond markets. For this reason we have not reflected the full 20bps increase in the cost of capital since autumn 2008 suggested by recent work by NERA Economic Consulting However, current difficult conditions could continue or become worse over the short or medium term. In the face of the unprecedented difficulty affecting financing over recent months and the great uncertainty for the foreseeable future, we would expect Ofwat to update its assumptions for the most recent evidence when setting the cost of capital in its Draft and Final Determinations We also believe that greater clarity should be given to the role of risk mitigation mechanisms, including the substantial effects provisions, in dealing with downside scenarios which may emerge over the course of AMP5. Components of the cost of capital Ofwat sets a cost of capital at industry level to ensure that an efficient company with the notional financial structure assumed by Ofwat is able to finance its functions. Ofwat considers that companies ought to be able to secure credit ratings comfortably within investment grade Cost of capital required in the Final Business Plan is 4.9%, marginally lower than set at PR04, but higher than at the Draft Business Plan. Table 7.4 Cost of capital assumptions PR09 FBP PR09 DBP PR04 Gearing (Net Debt/RCV) 60% 60% 55% Cost of equity (real, post tax) 7.9% 7.9% 7.7% Cost of debt (real, pretax) 4.0% 3.8% 4.3% Cost of capital (real, posttax) 4.9% 4.8% 5.1%

20 16 Final Business Plan: Part B Part B7 Financial Projections Our cost of capital: is within the 4.6 to 5.1% range for the cost of capital suggested by NERA s report is consistent with an A/A3 credit rating being "comfortably within investment grade" will not require an additional financeability adjustment does not require an additional adjustment for the cost of embedded debt would not be sufficient in the event of foreseeable downside scenarios for the general economy and the capital markets, including a continuation of recent difficult conditions In considering the appropriate cost of capital we have considered the following specific factors and evidence: our financial structure, our financing strategy and our current financing arrangements our past and recent experience of raising finance a report by NERA Economic Consulting, 'Cost of Capital for PR09' (2). Water UK commissioned this report, which provides a comprehensive review of evidence relevant to determining the appropriate cost of capital. The report has been shared with Ofwat evidence from the capital markets since the cutoff date for NERA's report and expert views of future market conditions Water UK's latest Investor Survey, conducted in January and February 2009 work conducted on behalf of Anglian Water by First Economics to examine drivers behind observed ratios between the market value and regulatory capital value of water companies. This was also presented in the Draft Business Plan We set out a detailed justification for our views on the appropriate cost of capital in the following paragraphs as follows: capital structure of the notional company the cost of equity the cost of debt other market evidence for the cost of capital future uncertainty. Capital structure of a notional company We assume gearing (Debt/RCV) of 60% for the notional balance sheet, close to the average level of gearing in the water sector (c62.5%). Assumed gearing is higher than at PR04, reflecting the gradual increase in industry average gearing over that time. Our assumption is in line with NERA s recommendations. PR09 Final Business Plan: Part B anglianwater.co.uk Ofwat expects that companies should be able to maintain a credit rating comfortably within investment grade to ensure continued access to capital at a reasonable cost to customers. In the past, under the more benign credit market conditions prevailing at previous reviews and during the period before the onset of the credit crunch, "comfortably within investment grade" in the water industry has generally been taken to mean a credit rating of at least Baa1 (3). NERA analyses Moodys regulated business credit ratings, which show that an A3 credit rating is consistent with 6068% gearing while a Baa1 rating is 2 NERA updated its previous work for the Draft Business Plan in a report issued in February 2009 based on evidence up to December The report is available at Water UK's website. We do not reflect all NERA's detailed arguments in the commentary but we have drawn out key points where appropriate. 3 Moodys Investor Services ratings. The equivalent S&P ratings is BBB+

21 17 consistent with a 6875% gearing. These ratings are for a standalone business on a corporate basis, which can be equated with the notional financial structure assumed by Ofwat. The range covered by both ratings has not changed since PR The financial crisis has severely affected viability and cost of credit. There has been a flight to quality, and with concerns over default levels and corporate failures, credit is going to remain very important for the foreseeable future. Companies with lower credit ratings (below A level) are finding it significantly harder to raise debt with longer maturities, and in a reasonable size, and the cost differential is extremely high. Consequently a higher credit rating is appropriate. In its report, NERA estimates the cost of capital associated with gearing at 68% is around 0.2% higher than at 60%, suggesting that an optimal gearing is one consistent with an A rating. Recent experience in the credit markets support this. Debt has been much less readily available and more costly at B ratings. This remains the case even with the relatively high levels of issuance since January Most has been Arated and investor appetite has been for good quality credits Ofwat should therefore assume a target credit rating of A in setting its cost of capital assumptions for PR An A target would offer a sensible level of protection from downside shocks. A substantial downside shock, which resulted in a rating downgrade, would be much less harmful at a rating at A/A3 (shock causing a downgrade to BBB+/Baa1) than at BBB+/Baa1 (shock causing a downgrade to BBB/Baa2). The latter scenario would involve a substantially greater impact on the cost of debt. Assumed cost of equity Table 7.5 Cost of Equity Risk free rate (real, pretax) Equity Risk Premium (post tax) Beta (equity) Cost of equity (real, post tax) FBP 2.5% 5.4% % NERA 2.5% 5.4% 0.88 to 1.13 CAPM: 7.2% 8.6% DGM: 7.4% 8.2% Conclusion: 7.4% 8.2% Our assumed cost of equity is in line with NERA s range. It is 20bps higher than that assumed at PR04 but this is consistent with a 5% assumed increase in regulatory gearing. Our cost of equity remains unchanged since DBP primarily because of the weight afforded to very long run time series data in estimating the Equity Risk Premium (ERP). We note, however, that a number of commentators have stated the view that the cost of equity has increased by 2 to 3% since the global financial crisis reflecting a general repricing of risk.

22 18 Final Business Plan: Part B Part B7 Financial Projections In line with recent regulatory practice, NERA relied primarily upon the Capital Asset Pricing Model (CAPM) in estimating the cost of equity but with regard to market evidence using the Dividend Growth Model. Values for these parameters are derived as follows: risk free rate is based on a 10 year trailing average of UK swap rates adjusted for credit default risk. Use of swap rates is preferred to gilt rates because rates for longdated government instruments are artificially low due to the introduction of pension fund regulations such as the Minimum Funding Requirement and FRS17. NERA shows that nominal and indexlinked gilt yields show substantial volatility over time and variation across geographic markets, suggesting that gilt yields are a poor proxy for the underlying risk free rate. Swap rates, whilst also volatile are consistent across geographic markets Equity Risk Premium (ERP) is based on very longrun time series of historical equity returns. NERA uses arithmetic averaging to obtain its estimate of the ERP, an approach which is supported by the majority of academic research. NERA does not assume any uplift in the ERP as a result of very recent data, even though it concludes that cost of equity might have risen by around 2 to 3% since September 2008, a view shared by our own investors. Overweighting such recent data would represent a departure from the reasonably wellestablished use of longrun time series data to set ERP and is therefore not considered justified. However, should the higher cost of equity continue, a reappraisal of the appropriate assumption would be needed equity beta is set at 1, in the middle of NERA's range. This is consistent with recent regulatory practice and empirical evidence on longrun asset betas NERA used a Dividend Growth Model (DGM) to challenge the results derived from the CAPM. DGM estimates are based on share price data and dividend and earnings forecasts for listed WaSCs over 2006 to Longrun growth forecasts are based on analyst consensus. The DGM appears to broadly support the CAPM derived estimates, narrowing the range for the estimated cost of equity The cost of equity is higher, if adjusted for relative industry risk, than assumed by the Competition Commission (CC) in its advice to the Civil Aviation Authority in relation to its determinations for Heathrow and Gatwick airports in October 2007 and for Stansted airport in October NERA s estimate for the ERP is 5.4%, based on robust analysis of very longrun time series data on stock market returns, using arithmetic averaging. In contrast, the Competition Commission also considers geometric averaging of time series data to inform the bottom of its range. However, its range for the market return (risk free rate plus equity risk premium) for Stansted (5.07.0%) seems to be implausibly low in current market conditions. NERA examines the CC's advice in detail in its report, concluding that the overall market return is higher. PR09 Final Business Plan: Part B anglianwater.co.uk Assumed cost of debt Table 7.6 Cost of debt Risk free rate Debt Premium Cost of debt (real, pretax) FBP 2.5% 1.5% 4.0% NERA 2.5% 1.3% 1.8% 3.8% 4.3%

23 For the first three three years of AMP4 costs of raising debt fell compared to the 4.3% real cost of debt assumed at PR04. However at the onset of the credit crunch in autumn 2007, debt spreads widened substantially. Spreads increased exponentially again with the global financial crisis in September Current spreads are in the order of 250 to 300 basis points for Arated debt compared to spreads as little as 100 to 120 basis points early in AMP4. There has also been a substantial increase in the difference between spreads for A and B rated debt Whilst 2009 has seen much higher levels of bond issuance (and slightly reduced costs) than in the immediate aftermath of the financial crisis, this needs to be seen against a significant tightening in the loan market with reduced liquidity and higher premia, driven by banks' need to strengthen balance sheets. It is highly uncertain how bond markets will develop in the short and medium term: some forecasters see a reversal of the most recent trends in the second half of 2009 as deteriorating conditions in the UK economy continue to impact. Government actions to tackle the economy could see very large gilt issuance putting upward pressure on yields, whilst spreads remain wide, increasing the allin cost of debt Water companies' cost of debt is also affected by the requirement to prefund capital programmes around 12 to 18 months ahead. At previous reviews (and at DBP) the costs of prefunding were relatively small, reflecting the small spread between issuance rates and interest received for cash deposits (cost of carry). At the current time, cost of carry is substantial: around basis points, reflecting the very low rates achieved on cash deposits which is partly driven by low short term interest rates but worsened by the banking crisis where there is currently a disconnect between base rates, LIBOR, and deposit rates. This has a material effect on overall costs of debt. It is not clear how long this situation might persist but it is reasonable to suppose it may reverse over the medium term as markets respond to arbitrage opportunities Our assumption on the cost of debt is in line with the range suggested by NERA s report which considered a range of evidence on past and current costs of debt. We support NERA's approach to determining the appropriate cost of debt which reflects a weighted average of: the costs of debt which will not need to be refinanced over AMP5, or embedded debt, which reflects market conditions at the time that the debt was raised the likely future costs of debt required to finance new enhancement capital expenditure and refinance debt reaching maturity during AMP NERA's approach is based on industry average levels of embedded debt, debt raising and future capital expenditure and assumes a notional financial structure: conventional (nonstructured) finance at 60% gearing. As noted above, an A rating for future debt issues is assumed. This leads to NERA's range of 3.8% to 4.3% We have calculated our own blended cost of debt for AMP5 in a similar manner but considering the characteristics of our actual debt portfolio, our proposed capital expenditure programme, our capital structure and financing strategy. On this basis we calculate a required cost of debt of 4.0%, supporting our Final Business Plan cost of debt figure Whilst we recognise that it is not precisely logical to use a cost of debt calculated on the basis of our actual capital structure to support a regulatory assumption that is based on a notional capital structure, we nonetheless consider that being able to justify our required cost of debt lends our position greater weight. In theory, higher gearing in our actual capital

24 20 Final Business Plan: Part B Part B7 Financial Projections structure should increase the cost of debt but against this creditors benefit from substantial covenant protections. Market evidence shows that we are able to issue debt at rates comparable to conventionally financed companies Below we consider in turn: historic trends in debt costs, current and future costs and the balance between them, and the underlying inflation assumption. In each case we consider both NERA's assumptions and our own calculations. Historic trends in debt costs NERA calculates that industry average real debt costs over the period from 1998 to 2008 were in the range of 2.6% to 3.8% based on time series data depending on type of debt instrument. Bonds were at the upper end of that range. It assumes that c54% of embedded debt is from nominal bonds, 25% from indexlinked bonds (directly or via inflation swaps), and 21% is from other sources including banks and finance leases The average cost of our current debt portfolio is 5.9% nominal, assumed equivalent to 3.4% real. This reflects the cost of debt raised in favourable market conditions during 2005 and 2006, but also reflects the cost of older debt raised at much higher rates. The oldest debt in our current portfolio was issued in 1991 at c12%. Anglian Water s actual embedded cost of debt is therefore within NERA's range. Current and future debt costs NERA estimates a range for future costs of debt by looking at costs over the three months from September to November It also considers December 2008 data, concluding that its estimates remain appropriate. It estimates costs of 2.5% to 5.4% for debt issued at an A credit rating. The upper end of this range represents the real cost of bonds and the lower end is the assumed cost of debt sourced from the European Investment Bank (EIB) NERA weights various types of future debt finance as follows: bonds 79%, EIB 5% and other sources 16%. It assumes no indexlinked debt. It also adds an additional 59 basis points for the costs of prefunding and transaction costs It is notable that two features of precredit crisis debt finance landscape are no longer expected to play a significant role. The scope for future issuance of indexlinked bonds is assumed to be negligible. Nor is it expected that the creditwrapping arrangements provided by monoline insurers will play any significant role in the future. Anglian Water, along with others, made significant use of such instruments during AMP4 and the loss of this opportunity will lead to the cost of debt being relatively higher in the future. PR09 Final Business Plan: Part B anglianwater.co.uk Recent industry experience supports the view that water companies, along with other utilities, are finding debt is substantially more costly and difficult to raise than in the past. Conditions in the debt market are likely to remain significantly more difficult than in the past even if current 'very difficult' conditions do not persist. Our assumptions for the future cost of new debt reflects these pressures: LIBOR increases up from 1.5% to 4.5% over the period spreads over LIBOR average 2.5% for A rated debt, and 4% for BBB rated debt fixed rate debt at 7.5% average over AMP5.

25 21 Balancing historic and forward looking data NERA uses estimates of 10 year average debt costs and 3 month average debt costs (January to March 2008) to proxy 'historic' and 'current' average debt costs, and weights these factors 70:30 towards historic costs. This weighting results from assumptions at an industry level about the proportion of debt to be refinanced and the scale of capital expenditure We have modelled our own forward debt financing requirements. This takes into account debt that will need to be raised during AMP5 for refinancing or to fund enhancement and debt that will not require refinancing On this basis we have derived our overall estimate of AMP5 real debt costs: 4.0%. We have used this assumption in our Final Business Plan. Inflation In our Final Business Plan we have assumed average inflation (RPI) of 2.5% in each year of AMP5. The justification for our inflation forecasts can be found in Part B2. We use this figure in converting between real and nominal financing costs In its report, NERA derives an estimate of 'expected' RPI inflation in the UK over the period from April 1998 to March 2008 of 2.5%. It uses Oxford Economic Forecast data which looks up to four years ahead to calculate this figure. It uses this figure to adjust debt costs to a real basis for UK debt issues up to March For international debt issues it uses different, somewhat lower, inflation assumptions based on relevant international data. Other market evidence for the cost of capital As well as current and historic equity prices and bond yields from UK and international sources, other potential sources of market evidence, which might influence decisions about the cost of capital include: markettoasset ratios and acquisition premia the views of investors. Markettoasset ratios and acquisition premia A markettoasset ratio (MAR) is the ratio of a company s adjusted market value to its Regulatory Capital Value. The RCV was estimated at privatisation to reflect the economic value of each business created and has been updated by the RPIX regulatory mechanism to reflect changes to companies capital bases. Capital markets have increasingly used RCV (and hence MARs) as reference points against which to assess the economic value of regulated businesses. Practically, determining MARs is only possible for listed companies whose market value can be readily calculated from the share price, but even for these there needs to be an adjustment to remove the impact of the nonregulated element of this value. This requires assumptions to be made which can affect the resulting valuation significantly An acquisition premium is the ratio of the price paid for a regulated business on acquisition to its RCV. This is observable at the point of acquisition both for listed and (if details are made public) for nonlisted businesses. Adjustments to the acquisition price are required for the nonregulated element of the business acquired.

26 22 Final Business Plan: Part B Part B7 Financial Projections MARs and transaction premia have been used to draw conclusions about the assumed cost of capital in the regulatory framework. The basic logic applied is that a positive MAR or an acquisition premium may indicate the current assumed cost of capital (set at the last price determination) is higher than the actual cost of capital (at the time the MAR or premium is calculated). Some suggest that this in turn provides evidence for the assumed cost of capital that should be set at the next price review We believe it is very difficult to draw firm conclusions from acquisition premia and markettoasset ratios. They may reflect other factors including the global demand for regulated infrastructure assets from investment funds seeking stable, indexlinked returns. NERA considered the evidence in its report, summarised below There is good reason to expect MARs greater than one in an industry which has successfully managed a large amount of construction risk since privatisation. Below we summarise briefly the results of work commissioned by Anglian Water on this topic. NERA s findings on MARs Chapter 13 of NERA s report deals with its findings in relation to the conclusions that may be drawn from evidence of MARs and with transaction premia Listed WASCs have traded at average premia to RCV of around 8% since PR04 but in a range of 1% to 20%. Data from the last 10 years suggests that during the early part of AMP4 MARs have been significantly above levels during AMP3 (when MARs were generally <1), but are not as high as the later years of AMP2. Over the last nine months MARs have fallen substantially, reflecting falling stock prices generallly. These figures are subject to an important caveat with regard to adjustments for the value of nonregulated businesses NERA uses a financial model to examine the impact of a range of other factors which might impact observed MARs including: outperformance of capital and operating cost assumptions, tax and financeability adjustments. Together it estimates that these factors might account for changes in market value of between 6% to 14%. Or in other words, based on these factors a MAR of between 1.06 and 1.14 might be expected. Adjusting the observed MARs for this effect, NERA conclude that the range for unexplained MAR might be 0.85 to 1.14, which could be due to a difference between the regulated allowed rate of return and the actual cost of capital This range is wide, reflecting the inherent uncertainty in this type of analysis, but it is also symmetrical around one, suggesting that the assumed cost of capital at PR04 is not out of line with actual cost of capital. PR09 Final Business Plan: Part B anglianwater.co.uk However, as we note above, it would be wrong to attach great weight to these findings because: the observed range of MARs is not precise due to the large confidence interval about the value of nonregulated businesses the portion of the MAR explained by other factors is also quite imprecise because little objective data is available about what investors assume beyond AMP To derive what a particular MAR might reveal about the market cost of capital, an assumption must be made about what investors assume about the allowed rate of return at future price reviews. A plausible assumption is that most investors will assume that any

27 23 difference (which would affect value) will tend to be reversed in future regulatory decisions. On this basis NERA estimates a real posttax cost of capital of 2.1% to 8.6%. A similar analysis based on current MAR data resulted in an estimate of 5.6% to 7.1%. These ranges are too wide a range to be used with any confidence to conclude on the implied cost of capital required by investors. MARs and the management of construction risk In 2006 we commissioned work from First Economics which examined possible reasons why MARs greater than one might be observed The principal insight from this work related to the issue of construction risk. The water industry has in the main successfully and consistently managed a very large programme of capital expenditure since privatisation to time and budget. The ex ante risks associated with this activity (i.e. those facing the investor at the time of investment) have effectively been managed away. Rational investors will only invest if they expect a return on investment which appropriately rewards them for assuming ex ante risks, including construction risk. Once the risk has been managed away, it would be reasonable to expect that the investor ought to reap the benefits of this, earning an overall return above the required cost of capital Our work drew a parallel with evidence from the numerous Private Finance Initiative (PFI) investments that have been undertaken in recent years. Substantial premia are observed in the secondary market for PFI projects, in which successfully constructed projects are sold at the point they enter the operational phase. The water industry might be compared to a continuing series of large successful construction projects. It is therefore reasonable to expect that returns to investors are higher than at original investment. It is therefore both consistent and correct for MARs in the water industry to be at a level greater than We have previously discussed the findings of our work with Ofwat. A note of a meeting in October 2007 between Anglian Water, First Economics and Ofwat has been attached (Market to Asset Ratios letter). It provides a succinct summary of our approach and conclusions. This work explores new ideas and there is room for debate about its findings. However, we believe that it provides new insight and should be considered by Ofwat in drawing conclusions about the appropriate cost of capital. Acquisition premia in recent transactions High acquisition premia do not appear to be driven primarily by rates of return set by regulators. There is substantial evidence for strong worldwide demand over recent years on the part of infrastructure investors and pension funds seeking infrastructure type assets driven by low risk profiles and attractive yields compared to government securities. This demand is not present for companies with similar risk profiles but without infrastructure assets NERA presents data on recent acquisition premia for transactions involving UK and international utilities. It shows that there has been a pronounced upward shift in transaction premia over the period since the mid1990s. It also identifies a pronounced levelshift between the early part of the current decade when acquisition prices corresponded quite closely to regulatory valuations and the past few years when buyers have been willing to pay substantial premia. The average reported premium for UK WaSCs since 2005 has been around 28%, compared with a marginal discount on average in earlier periods.

28 24 Final Business Plan: Part B Part B7 Financial Projections Similar trends are observed in other industries and other countries. Average premia for other UK utilities, primarily electricity and gas companies, have been 26% since For transactions involving nonuk utilities, even higher premia are observed, close to 50% The phenomenon driving these trends has been referred to as an infrastructure bubble. It is generally accepted that it is linked to the changes to statutorily mandated investment strategies for pension funds in the UK and elsewhere. Funds are attracted to owning infrastructure assets which have risk characteristics, especially the link to inflation provided by regulatory mechanisms, which are a close match for pension funds longdated liabilities. Demand for such assets has outstripped supply, driving up asset prices Anglian Water itself was taken over by investors of this nature in late 2006 at a significant premium to RCV. Our investors' outlook is longterm and they have confirmed the importance of the demandside factors described above in their decision to acquire In calculating the appropriate price, our investors took account of future growth of the business as well as its current value. This is entirely rational and consistent with investment criteria used in many investment decisions. On this basis, they calculated a markettoasset ratio of 1.1 by the end of AMP5, reflecting a reasonable assumption about the growth in the asset base required to meet the needs of the business. This is a more relevant figure than that derived from comparing acquisition price with current RCV We conclude that these factors substantially limit the significance of observed acquisition premia in drawing conclusions about the appropriate cost of capital for PR09. The views of investors Water UK published the latest in its series of Investor Surveys in February 2009, updating its previous March 2008 survey. These surveys have become well established and reliable barometers of investor sentiment towards the water sector. The surveys aim to develop a better understanding of the views of the investment community and therefore to inform policysetting and regulation. Ofwat fully supported the survey and was represented on its steering group. Interviews for the most recent survey were conducted in January and February 2009 and, as would be expected, reflected some markedly different general attitudes in relation to prospects for financing the water sector. PR09 Final Business Plan: Part B anglianwater.co.uk Optimism about a quick end to the credit crisis has evaporated and there is a substantial and growing uncertainty about the future. Investors appear to be generally more cautious and sensitive to news flow. There is greater pessimism about the prospects for raising finance in future and a greater emphasis on the need to understand potential regulatory responses to uncertainty. All of this appears to have heightened concerns about the regulatory process, compared to PR Despite this, many of the messages from the most recent are consistent with previous surveys. Investors: generally view Ofwat and the regulatory regime positively but continue to emphasise the need to maintain transparency and consistency in regulatory decisions, especially given turbulent capital market conditions. Some were concerned about Ofwat s proposed changes to the regulatory regime and the transparency of decisionmaking, whilst recognising the difficulties Ofwat faces in reaching its decisions in highly uncertain times