BUSINESS PLAN Chapter B7. Financial Projections. unitedutilities.com

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1 BUSINESS PLAN Chapter B7 Financial Projections unitedutilities.com

2 United Utilities Water Business Plan EXECUTIVE SUMMARY KEY MESSAGES A.. Introduction The key elements of our financing plan are: We face a more risky, uncertain and less favourable economic climate than ever before, which presents a material downside risk inherent to the delivery of this plan Current and prospective trends in inflation have a large effect on the company s financial ratios The cost of capital appropriate for setting price limits has been assessed as 4.85% fully post tax Allowed returns need to be sufficient to enable new equity to be raised No financeability adjustments have been applied after testing ratios against a stable A3/Acredit rating A balanced approach to risk has been applied across our FBP No adjustment to current cost depreciation (CCD) results from the comparison with maintenance expenditure Higher pension contributions are needed as a consequence of the economic downturn Increase to taxation results from reduced capital allowances including the abolition of industrial buildings allowances (IBA) This Chapter sets out the implications of United Utilities Water s (UUW s) business plan in terms of price limits and sources of finance. We face a more risky, uncertain and less favourable economic climate than ever before. The UK economy is in recession for the first time since privatisation and experiencing price deflation for the first time since the 960s. We have taken account of the recession and the prospective impact on inflation in the short term, assuming that this will recover relatively quickly over the AMP5 period. However, if inflation and economic activity take a longer time to recover than assumed in this plan then this will result in a material downside risk to the maintenance of adequate financial ratios (principally gearing). The cost of capital appropriate for setting price limits has been assessed as 4.85% fully post tax, at the centre of the range resulting from the work carried out by NERA on behalf of Water UK. No financeability adjustments have been applied after testing ratios against a stable A3/A- credit rating (necessary for efficient financing over AMP5), with no split rating assumed. The outcome of this assessment is that we only just meet the criteria for a strong investment grade credit rating. This assessment may change depending on future economic conditions and subject to interpretation of the ratio constraints applied by Standard & Poor s. We present some alternative inflation scenarios that demonstrate how sensitive our financeability assessment is to changes in economic assumptions. After re-profiling, our proposed K factors for the period are shown in table ES- below. Page i

3 United Utilities Water Business Plan Table ES - : Required AMP5 price limits Required AMP5 price limits 200/ 20/2 202/3 203/4 204/5 Water 8.9% 3.9% 2.0% -.6% -.8% Wastewater -.4% 2.% 3.6%.8%.7% TOTAL 2.9% 2.9% 2.9% 0.3% 0.2% This results in an average price increase of.8% and an increase to the average household bill of.4% per annum (both geometric averages). This is consistent with our Strategic Direction Statement (SDS) commitment that prices would not rise faster than household incomes over the long term, and recognises the impact on customers of the recession by avoiding large price increases in the short term. A.2. Ofwat's financeability duty One of Ofwat s three primary statutory duties is to ensure that efficiently run water and sewerage companies can finance their functions. Companies finance their functions using real-world debt and equity markets. In assessing company plans and setting price limits, Ofwat should therefore take account of evidence from the financial markets. UUW s understanding of these markets and the implications for price limits are set out in the following sections. The regulatory regime has, to date, been effective in providing reassurance to equity and credit investors. It is essential that this continues through AMP5 and beyond. This reassurance is not simply about basing price limits on an adequate cost of capital but also relates to the basis on which interest rate assumptions are made, the package of financial indicators used to assess financeability, and the threshold value attached to those indicators sufficient to maintain strong investment grade ratings. Page ii

4 United Utilities Water Business Plan A.3. Financing requirements in AMP5 and beyond A.4. Impact of the capital markets The capital markets are inherently volatile. Although they may appear relatively benign at times, there will be periods when higher returns are required to secure finance. The impact of the recession has occurred earlier and more immediately in the financial sector. Whilst the impact in other sectors is likely to be observed over a longer timescale, financing costs have increased dramatically, and concerns around deleveraging have arisen in both the corporate and household sectors. Water companies with ongoing capital expenditure programmes clearly need to continue raising finance in both benign and more difficult economic environments. Short term cheap finance cannot be assumed to continue when fixing prices for a five year period. New finance must be raised to refinance existing debt, finance enhancement programme Capex and also to cover pre-financing needs to secure cash flows for the business and ensure credit ratings are maintained. For UUW this means an aggregate financing requirement in AMP5 of An assessment of the cost of capital must be made in the context of real-world financial markets. We have assumed a cost of capital at 4.85% real, post tax. This assessment has been made on the basis of information collated by NERA in their report for Water UK. Given the ongoing market volatility, the cost of capital needs to be kept under review over the course of the year and NERA will be reassessing their estimate of the Weighted Average Cost of Capital (WACC) in the summer. Page iii

5 United Utilities Water Business Plan A.5. Credit ratings A.6. Assessing financeability Page iv

6 United Utilities Water Business Plan A.7. Risk Page v

7 United Utilities Water Business Plan A.8. Depreciation and IRC The plan includes infrastructure renewals charges (IRC) of 648m, and current cost depreciation of,949m over the period A comparison between current cost depreciation and maintenance non-infrastructure expenditure has been assessed and shows that no broad equivalence adjustment is required for the AMP5 period. A reconciliation of modern equivalent asset values (MEAVs) from the June Return to PR09 tables has been undertaken, highlighting significant increases in MEAV replacement costs. A.9. Regulatory Capital Value As described in Chapter B2, our analysis of capital expenditure in AMP4 is supported by the logging up and down, shortfalling and timing adjustments that best reflect the company s performance against the PR04 final determination. Our analysis, leading to no RCV capping over the AMP4 period, represents the most appropriate treatment of the company s capital expenditure performance over AMP4. A.0. Pensions Page vi

8 United Utilities Water Business Plan A.. Taxation Changes to the UK tax regime will have a significant effect on the tax payments that are passed into price limits over AMP5. The abolition of industrial buildings allowances, together with the continuing impact of the treatment of deferred revenue expenditure increases the tax payments forecast for UUW. We forecast the effective cash tax rate over AMP5 to be around compared with a comparable figure for AMP4 of However due to the current inherent uncertainties in relation to the future capital allowance regime and the disproportionate impact any changes will have on the water industry, a specific Notified Item for material changes to the capital allowance regime has been included in Chapter B. A.2. Changes from DBP to FBP The key changes from our DBP are as follows: Increase in WACC from 4.66% to 4.85% to reflect the latest NERA report Account taken of the worsening economic conditions, and in particular forecast reductions in RPI and COPI inflation Increase in our assessed pension deficit consistent with our latest pension scheme valuation Assessment of risk in the business plan included in this chapter. Page vii

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10 United Utilities Water Business Plan Table of Contents SECTION. Weighted average cost of capital (WACC)..... Investors required returns known as WACC Using NERA s analysis of WACC Assuming post tax real WACC of 4.85% WACC needs to be high enough for equity issues to succeed... 2 SECTION 2. Capital structure Targeting an A3/A- credit rating Plan model consistent with A3/A- profile Ofwat used A3/A- for PR04 financeability Pension deficit risk to financial ratios Impact of deflation or low inflation... 4 SECTION 3. Cost of debt Consistent & transparent approach to setting the cost of debt More to the cost of debt than first meets the eye Long real UK government bond yields distort observations of risk-free rate Credit spreads at unprecedented levels that could persist for 0 years Material issuance costs sometimes overlooked Hedging costs incurred to swap available funding to regulatory framework Pre funding costs significant with persistent negative free cash flow... 9 SECTION 4. Other cost of capital assumptions Cost of capital Dividend assumption Inflation assumptions Quantitative easing Risk to future embedded debt costs... 4 SECTION 5. Practical difficulties raising finance Monoline meltdown could create systemic financing risk Uncertainty regarding capital structure could close the credit market to UK water Total return credit investors hold the key Long term credit investors: endangered species?... 8 SECTION 6. Embedded debt Ofwat should not make embedded debt adjustments for conventional fixed rate debt Any embedded debt adjustments should be non-discriminatory... 9 Page i

11 United Utilities Water Business Plan SECTION 7. Capital structure: why A3/A- credit ratings are important Ofwat used A3/A- in PR04 and has given investors confidence A3/A- capital structure cheaper for customers Limited market capacity below A3/A UK Water must avoid split credit ratings SECTION 8. Financial indicators and covenants Markets will use credit rating agencies assessments Moody s financial indicators Standard & Poor's financial indicators less clear Standard & Poor s FFO ratios more onerous than at PR S&P not allowing financeability benefit of index-linked Risk to maintenance of S&P credit rating UUW financing restrained by covenants SECTION 9. Views of the equity market Investor survey results Gearing Credit rating Key ratios WACC Key risks facing the sector Financing future investment Appetite for rights issues Market to asset ratios... 3 SECTION 0. Financeability Ofwat rightly recognises the importance of stable credit quality Only one option for financeability with NPV> The market is unlikely to accept compromise on financial ratios There is no public market for index-linked debt Index linked swaps do not offer an effective alternative Lack of liquidity prevents the development of index-linked market Limited prospect of further index linked funding Additional equity not a solution Revenue uplift a feasible solution with NPV> SECTION. Need for long term consistent approach to cost of debt Careful liability management required in regulated UK water companies Partial vacuum since rejection of indexation of cost of debt Page ii

12 United Utilities Water Business Plan Uncertainty over treatment of embedded debt Uncertainty over mix of current versus historical market evidence Interest rates represent a diversifiable risk SECTION 2. Risk in the FBP Notified items Special Opex adjustments Efficiencies Approach to costing the capital programme Regulatory mechanics Competition Recession and wider economic impacts SECTION 3. Taxation Abolition of industrial buildings allowances Deferred revenue expenditure Specific tax notified item / material changes to capital allowance regime Detailed requested tax commentaries to Ofwat Regulatory tax Table B New HMRC features rules SECTION 4. RCV Regulatory capital value Opening value and adjustments RCV capping... 5 SECTION 5. Pensions Revisions to pension regulation Economic conditions Deficits could undermine the financial stability of water companies Reconciling actual contributions with allowances over AMP Pension cost allowances in our AMP5 business plan Trustee valuation as at 30 September Pension contribution requirements in AMP Solving the deficit problem in the longer term SECTION 6. Accounting standards Application of accounting standards Key areas of difference: UK GAAP and IFRS Impact on the company of adopting IFRS/UK GAAP convergence ASB discussion paper on pensions SECTION 7. Depreciation Page iii

13 United Utilities Water Business Plan Calculating AMP5 depreciation charges Current cost depreciation (Ofwat Regulatory Tables B7.3 to B7.6, and B7.9) Historic cost depreciation (Ofwat Regulatory Table B7.7) CCD and MNI comparison Infrastructure renewals accounting Modern Equivalent Asset Revaluation Reconciliation (Ofwat Regulatory Tables B7.3 and B7.4) SECTION 8. Financial modelling Solving for K Financeability Reservoir Inflation scenarios SECTION 9. Appendix Tax commentary Detailed taxation commentary (tax category analysis of capital expenditure) Detailed taxation commentary (opening position/stand alone basis) Detailed taxation commentary (other matters) SECTION 20. Supporting appendices Page iv

14 United Utilities Water Business Plan Table of Tables Table B7 - : Components of the cost of capital... Table B7-2: AMP5 inflation assumptions... 2 Table B7-3: Moody s Credit Rating Criteria for the UK Water Sector (Moody s Frankfurt Conference 4 September 2006) Table B7-4: UUW s agreed financial covenants for some existing long-term funding Table B7-5: Opening Regulatory Capital Value at April Table B7-6: Opening Regulatory Capital Value for Regulatory Table B Table B7-7: Comparison of PR04 allowances and actual contributions over AMP Table B7-8: UUW s AMP5 pension contributions (outturn prices) Table B7-9: Summary of impact on CCD from PR09 Asset Inventory adjustment Table B7-0: Summary of Draft Business Plan depreciation and capital expenditure data (net and post efficiency) Table B7 - : Non-infrastructure investment (net) by asset category 200/ to 204/ Table B7-2: Asset lives for depreciation Table B7-3: Current cost depreciation 200/ to 204/ Table B7-4: Expenditure commissioning profiles Table B7-5: Impact of the commissioning adjustment and Use of System recharges Table B7-6: Comparison of CCD to MNI Table B7-7: CCD on assets not replaced before Table B7-8: Calculation of Infrastructure Renewals Charge 200/-2024/ Table B7-9: Average implied lives of infrastructure assets Table B7-20: MEAV reconciling items Water Table B7-2: MEAV reconciling items Wastewater Table B7-22: Revenue requirement and K Water... 8 Table B7-23: Revenue requirement and K Wastewater Table B7-24: Revenue requirement and K Total Table B7-25: Key financial ratios Table B7-26: Revenue expenditure not allowable... 9 Table B7-27: Spreading of pension payments for tax allowances... 9 Page v

15 United Utilities Water Business Plan Table B7-28: Capitalised revenue expenditure deducted in year of spend Table B7-29: Percentage of IRE deducted in year of spend Table of Figures Figure B7 - : Current Cost Depreciation methodology flow chart Table of Charts Chart B7 - : Sterling A rated corporate credit spreads over UK government bond yields... 7 Chart B7-2: UUW trading tighter than AWG in the euro bond market... 6 Chart B7-3: Current cost depreciation 2007/08 to 204/ Chart B7-4: HCD vs. CCD Base Charges Total Chart B7-5: Inflation scenarios Page vi

16 United Utilities Water Business Plan SECTION. Weighted average cost of capital (WACC).. Investors required returns known as WACC In order to attract essential capital to finance the company's investment programme, both credit and equity investors need to be offered the opportunity to earn their required rates of return. If investors are offered inadequate returns, the company will not be able to attract capital and will be unable to finance its functions. These investor required rates of return represent the company's cost of capital. The weighted average cost of (debt and equity) capital is generally referred to as WACC..2. Using NERA s analysis of WACC Water UK commissioned an independent cost of capital study from NERA Economic Consulting. The authors of the report are Dr Richard Hern, Tomas Haug, Anthony Legg, Professor Paul Grout (University of Bristol) and Professor Ania Zalewska (University of Bath). A copy of its January 2009 updated report (the NERA report ) is annexed to our plan. For the purposes of this plan, we are using a WACC at the middle of the range produced by NERA. However, it must be noted that the economic environment has changed significantly since much of NERA s analysis was undertaken. We would urge Ofwat to be mindful of this continually evolving situation when setting allowed returns for AMP5. We expect NERA to publish a revised version of their report later in the year..3. Assuming post tax real WACC of 4.85% Reflecting NERA s research, we are using a post tax real weighted average cost of capital of 4.85%. This is lower than the 5.% which Ofwat determined to be investors weighted average required rate of return for PR04. Page

17 United Utilities Water Business Plan WACC needs to be high enough for equity issues to succeed Although in this business plan UUW is not assuming that it will raise new equity, it is important that Ofwat sets a cost of capital for the industry that is high enough to enable equity issuance to succeed. This is of particular importance given the increasing incidence of companies seeking equity capital from investors. Therefore there is competing demand for a limited amount of funds. Equity investors will need to view the allowed return as attractive and have confidence in the long term stability of the regulatory regime if they are expected to provide new funding. Page 2

18 United Utilities Water Business Plan SECTION 2. Capital structure Future Water and Sewerage Charges Final Determination, Ofwat December Page 3

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20 United Utilities Water Business Plan SECTION 3. Cost of debt 3.. Consistent & transparent approach to setting the cost of debt The market has rightly commended Ofwat for its approach to better regulation. This has manifested in Ofwat generally taking a transparent and consistent approach to major issues. However, in recent years Ofwat has appeared to signal significant potential changes in the principles it applies to determining the cost of debt for the industry. Given that the cost of debt is one of the largest components of companies cost structures this lack of consistency and transparency can undermine a company's ability to finance its functions. We understand that Ofwat may need to preserve its prerogative to modify its approach when circumstances change. However, we believe that Ofwat s approach to determining the cost of debt needs to be based on transparent analytical principles that are consistently applied over the long-term, reflecting the long-term nature of the industry's financing needs. In particular, consistency and transparency are essential in Ofwat s approach to: Interest rates Embedded debt. The importance of these points is discussed later in this chapter More to the cost of debt than first meets the eye Section 8.6 of NERA s report on the cost of capital contains a discussion of other costs associated with raising debt finance. Since some other costs are often overlooked in observing the cost of debt, we comment below on the various components that make up the cost of our debt financing. The cost of debt comprises: The risk free rate A credit spread Issuance costs Hedging costs Pre-funding costs. These are each discussed in turn below. Page 5

21 United Utilities Water Business Plan Long real UK government bond yields distort observations of riskfree rate We agree with NERA s conclusion that observable real yields on ultra longterm UK government bonds are presently distorted. In June 2008, the UK government's index-linked.25% of 2055 bond at times traded with a real yield below 0.30%. This is clearly no reflection of the risk-free rate. It is more likely that this distortion is caused by a scarcity of such long real bonds and excess pension fund demand as managers increasingly seek out liability matching investments. This effect is likely to be compounded by the Bank of England s adoption of quantitative easing. On page 3 of its report, NERA observes that the average real risk-free rate used by European price regulators over the period 2000 to 2008 was around 2.5%. NERA s analytical based estimate for the risk-free rate at 2.6% is in line with these recent regulatory precedents Credit spreads at unprecedented levels that could persist for 0 years Credit spreads have deteriorated significantly since UUW submitted its draft business plan. We do not believe it is possible to predict whether this is a temporary or more permanent change in how the market prices credit and liquidity risks. Although it uses a basket of bonds of maturities shorter than should generally be used by a water company, Chart B7 - below illustrates the recent deterioration. Page 6

22 United Utilities Water Business Plan Chart B7 - : Sterling A rated corporate credit spreads over UK government bond yields Source: Barclays Capital Prior to this recent substantial deterioration, credit spreads followed somewhat of a roller coaster journey. After a benign period, they ballooned out following the Russian default and the collapse of the Long Term Capital Management hedge fund in 998. From early 2000 and in the run-up to PR04, credit spreads for water companies were adversely affected by uncertainty over potential industry restructuring. This commenced with Kelda Group PLCs announcement 2 that it would carry out a strategic review of its group structure. It subsequently announced 3 the formation of a Registered Community Asset Mutual (RCAM) to take over ownership of its regulated company. The Kelda announcements created significant uncertainty making it extremely difficult for water companies to raise long-term debt. 2 London Stock Exchange Regulatory News Service, April London Stock Exchange Regulatory News Service, 4 June Page 7

23 United Utilities Water Business Plan In 2000, to address investor concerns UUW engaged in a substantial amount of pre-marketing in order to communicate directly to credit investors the defensive features of water company bonds. The maximum tenor the company could obtain in the euro currency market at reasonable cost at this time was seven years. Despite this relatively short maturity, and this market offering best relative pricing, the company was obliged to pay a credit spread equivalent to almost 00 basis points over the London Inter Bank Offered Rate (LIBOR). The credit spreads remained high through the Technology Media Telecoms credit bubble. The immediate period following PR04 saw a fairly benign credit market with credit spreads tightening. However, credit spreads have ballooned dramatically following the so-called credit crunch in On 20 February 2009, it was widely reported in the media that Sir John Gieve, the Bank of England deputy governor, has warned that Britain is at risk of slipping into a ten year recession, similar to that experienced by Japan in the 990s. There is a tendency in bond markets for credit spreads to widen when government yields fall. This reflects investors need to maintain total yield. This phenomenon could apply with lower inflation as investors will be seeking to maintain nominal returns. Lower inflation could therefore result in increased WACC. NERA will provide an update on their assessment of WACC around the time of the draft determination and we would expect this update to include consideration of the impact of low inflation or deflation on required returns. We expect that both NERA and Ofwat will take account of observable market conditions at that time Page 8

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26 United Utilities Water Business Plan SECTION 4. Other cost of capital assumptions 4.. Cost of capital As consistent with the ranges set out in the NERA report for Water UK, we consider that the analysis below sets out a reasonable estimate for the cost of capital for a water company. NERA will provide an update of their report to be published around the time of the draft determination which will reflect the risks identified within this chapter e.g. inflation and definition of credit rating ratios. Table B7 - : Components of the cost of capital PR04 FD UUW FBP Low NERA Range High Cost of debt (pre tax) 4.3% 4.% 3.8% 4.3% Cost of equity 7.7% 7.7% 7.4% 8.2% Gearing 55% 60% 60% Cost of capital (vanilla) 5.8% 5.54% 5.3% 5.8% Cost of capital (post tax) 5.% 4.85% 4.6% 5.% 4.2. Dividend assumption Page

27 United Utilities Water Business Plan Inflation assumptions The current economic climate appears set to result in a substantial level of uncertainty in the level of future inflation. The RPI inflation level has changed materially within a very short time period, from a high of 5.0% in September 2008 down to zero in February It is widely forecast that the UK will experience RPI deflation for the first time since the 960 s. We have taken account of the recession and the prospective impact on inflation in the short term using forecasts published by HM Treasury. We have, however, assumed the economy will recover relatively quickly over the AMP5 period with inflation reverting to a steady state RPI level of 2.75%. This is consistent at a broad level, over the medium term, with the consumer price index (CPI) inflation level of 2.00%, as targeted by the Monetary Policy Committee (MPC) of the Bank of England (BoE). The forecast assumptions for RPI and COPI used within this plan are set out in Table B7-2 below. Table B7-2: AMP5 inflation assumptions 2008/9 2009/0 200/ 20/2 202/3 203/4 204/5 Year end RPI 0.03% -.00% 2.75% 2.75% 2.75% 2.75% 2.75% Year average 3.4% -2.08%.7% 2.75% 2.75% 2.75% 2.75% RPI Tariff basket 4.28% 3.00% -2.70%.76% 2.75% 2.75% 2.75% RPI Year average -2.00% -2.08%.7% 2.75% 2.75% 2.75% 2.75% COPI 4.4. Quantitative easing On 5 March 2009, the BoE continued its remarkable and aggressive monetary easing campaign, lowering its bank rate a further 50bps to a mere 0.5%, a new historic all time low. The bank rate has now been reduced by an unprecedented 4.5% in just six months, from the 5% level seen in September Page 2

28 United Utilities Water Business Plan This extreme course of action appears, however, to be insufficient to counter the current deflationary trend. With monetary easing increasingly ineffective and the scope for further cuts constrained by a floor to the bank rate of 0%, the BoE have now turned to non-conventional monetary policy measures. The BoE had been signalling since the February inflation report that nonconventional monetary policy measures would probably be needed. The Government had already given the BoE authority in late January to engage in credit easing, the purchase of longer dated financial assets financed by the sale of shorter dated treasury bills. However, the BoE confirmed on the 5 March 2009 that it now intends to move much further than this and introduce quantitative easing where it directly boosts money supply growth by no longer stabilising its purchases of longer dated assets with the sale of shorter dated treasury bills. Quantitative easing commenced on March The BoE hope that by increasing the money supply they can begin to stimulate the ailing economy. The success of this stimulus however is wholly dependent on the new money being used for spending rather than saving. The outcome of this remains far from certain. The implications of significantly increasing the money supply are likely to be realised only over the longer term. Quantitative easing is necessarily a delicate balance: too little may risk longer term deflation (Japan s lost decade), whereas too much raises the risk of hyperinflation. Future BoE MPC meetings will now focus on the sole material remaining monetary policy tool of quantitative easing, adjusting its scale and timing as appropriate. The BoE has been very clear on the point that the money supply is being increased in a controlled manner for a finite period. This in itself poses uncertainties, as reversal of today s quantitative easing has the potential to suppress inflation or even result in future deflation. The uncertainty is all the greater when one considers that fundamentally these policy actions are intended to increase spending and therefore increase economic activity. By resolving the immediate recessionary concerns, but without offering any solution to the core underlying problem of excess leverage at all levels of society (individuals, corporations and even the sovereign nation) today s solution may well simply result in further problems in the future. Page 3

29 United Utilities Water Business Plan Risk to future embedded debt costs Page 4

30 United Utilities Water Business Plan SECTION 5. Practical difficulties raising finance 5.. Monoline meltdown could create systemic financing risk Downgrades and turmoil amongst the specialist monoline insurance companies that issue creditor default protection could lead to systemic difficulties in the UK water sector. A very substantial volume of UK water company bonds have been monoline wrapped. This increased the credit rating on the underlying bonds to triple A. In so doing, it reduced the amount of regulatory capital that financial institutions needed to set aside to hold such paper. Following the recent downgrades, financial institutions will need to set aside greater amounts of capital against these assets. If they are unable to raise the capital (and we are seeing a number of financial institutions having difficulty raising capital at present), they may become distressed sellers of water company bonds. This competing supply of water company paper coming into the market at the same time as companies seek to raise essential new capital could create a major financing problem for the sector Uncertainty regarding capital structure could close the credit market to UK water In 2000 Kelda's announcement regarding a potential new capital structure, and the subsequent formation by Welsh Water of a mutual created great uncertainty amongst credit investors. It had the effect of closing the market to long-term issuance and caused companies to have to pay substantially higher credit spreads to raise even relatively short-term bond finance. Credit investor concerns about leveraged capital structures appear to be beginning to re-emerge. This is evidenced by credit spreads on secondary market bonds. Anglian Water s (rated A3/A-) 6.25% Euro denominated bonds, maturing in 206 are currently trading at a credit spread that is 00 basis points wider (higher) than the spread on UUW's (also rated A3/A-) 4.25% Euro denominated bonds, maturing in Page 5

31 United Utilities Water Business Plan Source: Iboxx/HSBC Standard & Poor s credit rating downgrade of Yorkshire Water in March 2009 may exacerbate these concerns. The present focus on introducing competition into the UK water sector and the debate about splitting the asset-base is equally likely to have an adverse consequence on credit investors committing long-term capital to the sector. We note that Ofwat commissioned its own study in January 2009 Competition proposals and financing issues which included work to explore whether the uncertainty over the eventual path of competition reform (direction and timing) is affecting the conditions for and pricing of new finance. This includes a consideration of how this might inform Ofwat' s approach to the cost of capital at PR09. Page 6

32 United Utilities Water Business Plan Total return credit investors hold the key The phrase credit investor can describe a wide variety of institutions. However, a relatively small number of life (insurance) companies and pension funds hold the key to providing appropriate debt finance to the regulated UK infrastructure utility sector. It is largely this small category of credit investor that is willing to take and hold to maturity illiquid long-term utility bonds with a tenor in the order of 30 years. Such investors do not follow a mark-to-market approach and are sometimes referred to as total return investors. These investors are of paramount importance to providing essential long-term financing for the industry. The water industry's assets have very long lives. Consequently, financing should also be long-term in nature. Even if a company issued only 30 year bonds, the average period to maturity would be around 5 years which is significantly shorter than the lives of the assets being financed. It is important to note that 30 year corporate bonds are very illiquid. An investor purchasing such an instrument needs to do so in the knowledge that it may be very difficult to trade out of its investment. Many fund managers trade credit and are measured against a published benchmark, often with a relatively short time horizon. Such investors may synthesise a credit position by being long of cash and assuming credit risk by entering into a Credit Default Swap (CDS). Such an approach does not provide useful financing to the company. While such investors play an important role in the credit market, their views may not be as important as long-term total return investors. Many credit fund managers are monitored against a benchmark. Their objective is to beat the benchmark. Consequently, they may express a view that they do not object to uncertainty or instability in the industry's profile. Such a position should not be confused with the requirement of total return investors for stability in paper they expect to hold to maturity. Credit rating agencies, commercial bankers, investment bankers and fund managers will often gladly express opinions on the credit market for UK water companies. However, these views may not necessarily represent those of the key total return investors. In determining credit investor attitudes to water utility financing it is very important that Ofwat consults closely with total return investors. In consulting with credit investors on their appetite for water utility bonds, it is important to obtain clarification not only of their willingness to buy but also how far in terms of maturity and what quantity. We note that it was largely total return investors who responded to Ofwat's PR09 consultation paper last year. Page 7

33 United Utilities Water Business Plan Long term credit investors: endangered species? Spectacular growth in the CDS market is adding substantial liquidity to the credit market generally. Our bankers estimate that in a typical week, 0 times the volume in CDS now trades as in our underlying debt securities. We welcome the development of this instrument in creating a more efficient market for credit. However, there are significant risks that it could lead to the demise, as we know it, of a long-term credit market. In the world's major currencies, it has largely been in United States dollars and sterling in which there has uniquely been a reasonably active market for corporate bonds with a maturity date longer than 20 years. The market for credit beyond 0 years in the Euro currency was beginning to develop, but we have seen recently an almost complete retrenchment back to its familiar territory of seven years or less. As explained earlier in this Chapter, this long-term credit market is dominated by a very small number of total return investors. Such investors seek the duration available from long-term government bonds but add a yield pick-up by taking some credit risk. One major downside to the investors of this approach is a loss of liquidity. The growth in the CDS market means that such investors could benefit substantially. Provided stakeholders are willing to sanction derivative positions (which is increasingly becoming the case as conventional managers learn from hedge funds), total return investors can obtain the same yield for the same risk profile but have the advantage of liquidity. All they need do is purchase (more liquid) long-term government bonds and further take credit risk through CDS. UUW is concerned that such developments would see the end of what is a relatively small existing market for long-term credit. These developments could be accelerated if investors lose confidence in the hitherto stable approach Ofwat has taken to regulation. Page 8

34 United Utilities Water Business Plan SECTION 6. Embedded debt 6.. Ofwat should not make embedded debt adjustments for conventional fixed rate debt Since PR99, when the issue first arose, UUW has consistently argued against the need for Ofwat to make embedded debt adjustments to allowed returns for conventional fixed rate debt. The 989 privatisation prospectus for the industry stated The appointed companies must be left with incentives to act efficiently. Subject to meeting the requirements of the regulatory regime, the Companies will be free to follow their commercial objectives. They must be able to make decisions without undue interference, including those concerned with the financing of investment. We understand that some companies have suggested that they have had to issue fixed-rate debt to satisfy market requirements. Such long term fixed- derivatives to swap their fixed-rate issues to rates proved to be onerous. However, companies were free to use floating. With the exception of ultra long-term index-linked debt companies should largely be able to separate financing from interest rate management by using derivatives. It should be noted that acceptable terms via the swap market to convert long-term fixed real rates on index-linked-debt to shorter term rests in line with regulatory periods, are not currently available. Consequently, companies fixing real rates spanning several regulatory periods may face embedded debt issues in the future. In an industry that is persistently free cash flow negative, water companies need to be able to raise new long-term debt at times when company management believe it is attractive Any embedded debt adjustments should be non-discriminatory If Ofwat is to make any adjustment for embedded debt, such adjustments should be non-discriminatory in order to encourage innovation, reward outperformance, and avoid perverse incentives in treasury management. In recent years UUW has seized what it believes to be attractive opportunities to issue long dated index-linked borrowing. In doing so, the company has taken a considerable risk. This is especially relevant given the recent uncertainty and therefore risks regarding Ofwat s approach to the treatment of debt financing costs. Page 9

35 United Utilities Water Business Plan The long-term index-linked financing raised was significantly in advance of the timing of expenditure under the company's capital investment programme. The recent availability of ultra long-term index-linked financing has relied largely upon two foreign bank investors. These were not conventional investors but so-called asset swappers. They took index-linked sterling bonds and swapped them into synthetic floating rate assets denominated in euros. We understand that the index-linked sterling cash flows were ultimately swapped with UK pension funds seeking to match better assets and liabilities, following liability driven investment (LDI) principles. The two asset swappers covered off the long-term credit risk by purchasing credit insurance from specialist insurance companies (the monolines). The support of monoline credit insurers was essential to these LDI derivative structures. In the past, monoline insurers largely only assumed risks on United States municipal credits or where they were able to take security over assets. We believe it is partly through proactive credit investor relations work undertaken by UUW with the major monoline insurers that this opportunity in index-linked funding developed. If Ofwat were to be discriminatory in its treatment of embedded debt, it would remove incentives for companies like UUW to assume risk and to be innovative in the development of new financing structures. In addition, it could create perverse incentives. For example, companies could become incentivised to move their treasury operations to the parent company, outside of the regulated business. Page 20

36 United Utilities Water Business Plan SECTION 7. Capital structure: why A3/A- credit ratings are important 7.. Ofwat used A3/A- in PR04 and has given investors confidence By following the principles of better regulation, Ofwat has rightly encouraged investors not to be overly concerned with regulatory risk. Otherwise, investors required returns would be needlessly higher. As explained earlier, there is only a small number of total return investors willing to purchase the long-term bonds necessary to fund the UK's essential privatised infrastructure. We believe that Ofwat is right to encourage expectations of stability. The financial indicators used by Ofwat for PR04, as set out on in Table 47 on page 233 of the PR04 Final Determination, are widely regarded in the capital market as being in line with an A3/A- long-term credit rating. In its March 2008 methodology paper, Ofwat said It is important for consumers that investors and markets see water companies as good quality credits...we do not have a prescriptive view of the credit ratings that a company should maintain, as this is for markets and management to determine. But we will want to be sure that credit ratings lie comfortably within the investment grade. In doing so, we will have regard to the market capacity for different types of issuer, the spread between different tranches of investment grade debt, and recent innovations in the debt markets (such as the ability of the sector to issue index-linked debt). We believe that Ofwat's actions and statements have given investors confidence that PR09 should not deliver any surprises and that Ofwat is continuing to focus on delivering stable credit for the sector. Given credit investors expectations, it is important that Ofwat delivers stability in credit quality through the PR09 determination. Sentiment is extremely important in being able to sell bonds to credit investors whose continuing support for the sector is crucial to financing future investment A3/A- capital structure cheaper for customers In Table. on page 00 of their report, NERA estimates that investors required returns for a BBB+ (equivalent to Baa) rated water company with RCV gearing of 68% are some 40 basis points higher than an A- (equivalent to A3) rated company with RCV gearing of 60%. Adopting an A3/A- capital structure, which we believe is optimal for the industry, and not gearing up to a higher level, should enable UK water companies customers to benefit from lower prices. Page 2

37 United Utilities Water Business Plan Limited market capacity below A3/A- UUW s parent company is rated just one notch lower at Baa/BBB+. However, it has recently experienced difficulty in obtaining essential swap dealing lines from its bankers. We have noticed a marked hardening of bankers approach to taking credit risk to counterparties in the triple-b credit area. Ofwat has stated in connection with the Northumbrian Water restructuring that BBB is an unacceptable credit rating for the UK water sector (August 2003). We understand from our bankers (utilising data from Bondware) that the total value of sterling bonds with an original maturity date longer than 20 years of benchmark size ( 200 million or larger) issued during the 2 month period ending 30 June 2008 was approximately 2 billion for corporates rated A3. By contrast, at 0.2 billion, the value of issues rated just one notch lower at Baa represented /0th of this A3/A- volume. This illustrates the significant reduction in available liquidity moving from the bottom of the single A band to the top of the Baa band. It is likely that this reflects the way clients of fund managers draw up their investment rules and a more prudent approach to credits rated in the Baa band. Similarly, it is our experience that the capacity from bankers for swap dealing facilities is adversely affected by this one notch differential. We have observed this in our dealings with banks for UUW s parent. The availability of swap dealing facilities is important to UUW and other water utilities in order to diversify sources of finance into foreign currency markets and also to manage the interest rate exposure that would otherwise arise on long dated fixed-rate issues (avoiding embedded debt difficulties). In order to finance the investment needed by the UK water sector, it is important that issuers can diversify their sources of funds away from the UK market, the size of which is extremely small for long dated issuers carrying a relatively weak credit rating. It is therefore essential for some UK utilities to have continuing access to overseas markets. While it may be possible to obtain credit investor support for some long dated BBB rated issues in markets such as the United States, utilities will also need to have access to currency swap facilities with banks in order to hedge their currency risk on such longer dated issues. The appetite of banks in the current economic climate is significantly reduced and makes obtaining such swap lines even more challenging. Further reductions in counterparty credit ratings would compound this further. Page 22

38 United Utilities Water Business Plan UK Water must avoid split credit ratings The most influential principal providers of long-term credit ratings are Moody's and Standard & Poor's. Fitch also provides ratings on some water companies. However, its ratings are in some cases unsolicited (as in the case of UUW) and are less influential. In these very difficult market conditions, we consider it essential that the market has an unequivocal, clear view of the credit quality of UK water companies. Consequently, Ofwat needs to ensure that companies are able to maintain consistent ratings from the two principal agencies. Split ratings, where the principal agencies differ on their ratings opinions, should be avoided. Page 23

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40 United Utilities Water Business Plan SECTION 8. Financial indicators and covenants 8.. Markets will use credit rating agencies assessments UUW needs to raise capital in the markets, and the markets will use credit rating agencies assessments when making investment decisions. We believe it is important for Ofwat to base its approach to assessing financeability on the same credit rating agency assessments. In order to maintain a stable A3/A- credit rating, we believe Ofwat should use the relevant ratios specified by the credit rating agencies. We do not believe there is any scope for flexibility in Ofwat s interpretation of the financial indicators used by the credit rating agencies Moody s financial indicators At a conference in Frankfurt on 4 September 2006 (Europe Middle East and Africa Utilities rating methodology and credit outlook), Moody's Investors Service set out on a slide the following credit metrics for the UK water sector. Table B7-3: Moody s Credit Rating Criteria for the UK Water Sector (Moody s Frankfurt Conference 4 September 2006) Credit Rating Adjusted net adjusted debt / RCV FFO IRC & CCD / Net Interest RCF / Adjusted net debt A 40% < < 50% 2.5 < < 3.5 4% < < 8% A2 50% < < 60%.8 < < 2.5 0% < < 4% A3 60% < < 68%.6 < <.8 8% < < 0% Baa 68% < < 75%.4 < <.6 6% < < 8% Baa2 75% < < 85%.2 < <.4 4% < < 6% The slide pack for the conference is available to Moody's subscribers via its web site. We are not aware of these ratios being put into the wider public domain by Moody s. UUW has contracted with Moody's for the supply of long-term on its debt. credit ratings Page 25