Centre for International Public Health Centre for International Public Health PolicyPolicy

Seminar 4: Overcharging for Water: Fundamental Flaws in Utility Pricing in the UK.

Jim and Margaret Cuthbert

30th April 2007

This affects all of us.What we are talking about today is not a trivial issue. If

we are right, (and we are confident that we are), then there is a fundamental flaw in the basic price setting method for utilities, as used almost universally in the UK, and widely elsewhere. The implications are

– Overcharging of UK consumers, on a massive scale.– Distortion of capital investment priorities.– Since the method is being aggressively pushed for

implementation in third world countries, there are major adverse consequences there for affordability of basic commodities like water, and sustainability.

The Ground to be Covered Today

• How utility price setting works.• What is RCV, and how calculated.• How current cost RCV leads to overcharging.• What the consequences are.• Why there are fallacies in conventional defences

of RCV• What should be done.• What OFWAT’s response is: and why it makes no

sense.

References• “How the RCV method involves excessive returns

on capital expenditure”: response to OFWAT/OFGEM discussion document on "Financing Networks", published on OFWAT and OFGEM websites : (August 2006).

• "Fundamental Flaws in the Current Cost Regulatory Capital Value Method of Utility Pricing": Fraser of Allander Institute Quarterly Economic Commentary, Vol 31, No.3: (2007).

• “Accounting for Economic Costs and Changing Prices”: report of a working group chaired by Ian Byatt, (the “Byatt report”): H.M.Treasury, (1986) .

Why Regulate: and How to Set Charges

• Many utilities are dependent on networks which are natural monopolies: there is no natural market which can set a market price.

• The solution: oversight by a regulatory body in setting revenue or price caps for the utility.

• Many of price setting techniques used by regulatory bodies involve an assessment of the total value of the capital assets employed by the utility: this is known as the Regulatory Capital Value, (RCV)

The RCV Method

RCV is an estimate of the total value of the capital assets employed by the utility in performing its functions.

RCV pricing involves setting prices to cover:-      operating expenses.      capital used up: (depreciation)      cost of capital: (return on capital assets used). Both of the latter depend on RCV.

Historic Cost or Current Cost RCV• The fundamental divide : RCV calculated at historic cost,

or RCV calculated at current cost: (CCRCV). • Under CCRCV, estimated RCV is rolled on from year to

year byuprating for inflationadding in investmentsubtracting depreciation, (calculated at current cost).

• CCRCV is used by OFWAT, OFGEM, Network Rail, CAA, Scottish Water Industry Commission: by several overseas countries: and is aggressively advocated by several international consultants.

Sources of Funding

• Debt.• Equity.• Retained Profits.Retained profits often overlooked in much

conventional discussion.A lot of what we shall be talking about concerns the

issue of how different sources of funding should be rewarded. But there are also wider issues, like what return should be due on ownership of the basic commodity.

Confusion About Equity

The term “equity” is often used in a sloppy fashion, which does not distinguish adequately between the following three quite different concepts.

• Equity in the sense of the market valuation of a company’s shares.

• Equity as (CCRCV – debt).• Equity as the amount of capital which has actually

been raised through the issue of shares.

Base Case : Entirely Debt Funded Utility

• If the utility charges an amount equal to historic cost straight line depreciation of the capital assets, plus interest on outstanding debt, then this will generate sufficient revenue to repay the capital which has been borrowed, and give lenders a return on the loans equal to the opportunity cost of their capital. (Schmalensee.)

• This approach is the so-called Brandeis formula, which is simply denoted here as the “historic cost” approach.

Base Case Model• The utility starts out with no accumulated historic

debt or financial surplus. • Every year it carries out a fixed amount of real

investment: (for simplicity the annual amount of real investment is assumed to be 1).

• Capital assets have a fixed life, of n years. • The inflation rate each year is r, (expressed as a

fraction). • The utility finances its investment by borrowing at

a fixed interest rate, i, (again, expressed as a fraction).

Base Case Model: Financial Surplus Generated by CCRCV Pricing

• For the base case model, we can work out how much more customers would be charged under CCRCV, compared with the utility’s actual cash requirement.

• The answer is, in real terms, once the industry has settled down to steady state,

[1 + i(n+1)2

r)-1](1 - [1-(1+r)]

nr

-n

- i[1 - 1nr(1-(1+r))]/r-n

What this means: 1 Table 1a. First scenario: The Surplus Generated by RCV, in Excess of

the Historic Cost Requirement, as a Percentage of Capital Investment, for Interest = 5%, and for Varying Lengths of Asset Life and Inflation Rates.

Asset life (years)10 20 30 40

0 0.0 0.0 0.0 0.00.5 2.6 6.2 10.4 15.41.0 5.1 11.9 19.8 28.81.5 7.5 17.2 28.3 40.72.0 9.7 22.1 36.0 51.1

Inflation (as percentage) 2.5 11.9 26.7 42.9 60.33.0 14.0 31.0 49.2 68.53.5 16.0 34.9 54.9 75.74.0 17.9 38.6 60.1 82.14.5 19.7 42.0 64.8 87.85.0 21.4 45.2 69.0 92.9

What this means: 2 Table 1b. Second Scenario: as above, but for Interest = 7.5%

Asset life (years)10 20 30 40

0 0.0 0.0 0.0 0.00.5 2.8 7.0 12.2 18.51.0 5.5 13.5 23.3 34.81.5 8.0 19.5 33.3 49.22.0 10.5 25.1 42.3 61.82.5 12.8 30.3 50.5 73.13.0 15.1 35.1 58.0 83.0

Inflation (as percentage) 3.5 17.2 39.6 64.7 91.94.0 19.3 43.8 70.9 99.84.5 21.3 47.7 76.5 106.85.0 23.1 51.4 81.6 113.15.5 24.9 54.8 86.2 118.76.0 26.7 58.0 90.5 123.86.5 28.3 60.9 94.4 128.37.0 29.9 63.7 97.9 132.47.5 31.4 66.3 101.2 136.0

Or in wordsThe CCRCV method turns the act of capital investment into a profitable activity in itself, yielding a large financial surplus. For example

• for an asset life of 30 years, an interest rate of 5%, and an inflation rate of 2.5%, the financial surplus is 42.9% of capital investment.

• for an asset life of 30 years, an interest rate of 7.5% and an inflation rate of 3.5%, the financial surplus is 64.7% of capital investment. The tables show that the surplus increases rapidly with each of n, r and i.

Gearing

• Gearing is the ratio of debt to CCRV.• For our base case model, (and under the

assumption that the financial surplus is not retained in the company), then gearing depends only on asset life and inflation:-

Gearing: values from model

Table 2: Gearing, (that is, ratio of debt to RCV), for a Utility Operating under Historic Cost Model.

PercentAsset life (years)

10 20 30 400 100 100 100 100

0.5 99 97 95 941.0 97 94 91 881.5 96 91 87 832.0 94 89 83 792.5 93 86 80 743.0 92 84 77 71

Inflation (as percentage) 3.5 91 81 74 674.0 89 79 71 644.5 88 77 68 615.0 87 75 66 585.5 86 74 64 566.0 85 72 62 546.5 84 70 60 527.0 83 68 58 507.5 82 67 56 48

What this means

• Remember, for the case we are considering, the only source of finance for capital is debt.

• For asset life of 30 years, and inflation of 2.5%, the table shows that debt represents 80% of CCRCV: so 20% of CCRCV has been funded from thin air: (actually, from the effect of inflation).

• Suppose that some lucky venture capitalist had put an initial token equity stake into this company: then, under CCRCV pricing, the capital charge on this 20% of CCRCV, (plus the difference between current and historic cost depreciation), would be available to be taken as a dividend return on the initial token investment.

Or putting this another way

• For an asset life of 30 years, then our base case utility will be operating with a capital stock which is, on average, several years old: so the interest and depreciation charges it has to pay reflect the lower prices then current

• But CCRCV pricing sets prices as if interest and depreciation were worked out at today’s prices: and the difference is available to be taken as a dividend reward by equity holders.

What Are the Likely Effects?

• Overcharging.• Excess dividend returns.• Distortion of gearing ratios.• Distortion of capital programmes: incentive

for companies to indulge in “big capital” solutions, even if they are not fully justified by their real operational returns: (“build dams rather than repair leaks”).

Is this credible?

Yes.• “Irrational” takeover frenzy for English Water and

Sewerage Companies.• Excess dividend returns in English WASCs: (see next

slide).• High UK utility prices: (e.g., water, rail.)• The unregulated parts of the private sector have

largely abandoned current cost accounting.• Use of water pricing threat as political lever in

Northern Ireland.

Dividend return in WASCs.

Table 3. Water and Sewerage Companies in England and Wales: Dividends as percentage of

called up share capital plus share premium.

1996/97 22.2% 1997/98 34.5% 1998/99 32.4%

1999/2000 18.6% 2000/01 19.3% 2001/02 13.9% 2002/03 23.5% 2003/04 18.4% 2004/05 18.6%

The Conventional Defences of CCRCV: 1

• Capital Maintenance .But, as base case model shows, the current cost RCV method overestimates the cash requirement for running a utility company on a sustainable basis.

• Opportunity Cost of Capital .Fundamental fallacy: requiring a market rate of return on CCRCV does not ensure efficient allocation of capital resources where the industry is a price maker.

The Conventional Defences of CCRCV: 2

• Securing the Benefits of Competition .But free entry of competitors is largely a myth for network utilities:and encouraging a bidding war for companies does not benefit consumers.

• Enabling the Industry to Attract Sufficient Funds for New Investment. CCRCV sets charges at a level well above what is required to satisfy the Net Present Value criterion for investment, which is the base level that would be required to attract new investment funds.

Why Have the Problems With CCRCV Not Been Spotted.

• They have: there are many references in the literature to the high prices associated with applications of current cost pricing to utilities.

• The very act of giving responsibility to a regulator tends to inhibit debate and thought.

• Vested interests.• Intellectual sloppiness over the different uses of

the word “equity”.

What should be done: the basic parameters of an improved pricing system

A good pricing system should secure• Operational efficiency.• Adequate and appropriate capital investment.• Fair prices, with social justice issues addressed.• Appropriate incentives towards economic

development: and avoidance of perverse economic incentives.

• Environmental and sustainability issues addressed.

What Should Be Done: 1

• We are not simply advocating using historic cost RCV: there are acknowledged problems with this. But what results should be much closer to historic cost RCV than current cost RCV.

• Revisit the principles of current cost accounting, and achieve general agreement on how CCRCV should be split down into its funding sources of debt, equity, retained profits and inflation.

What Should Be Done: 2

• Work out a pricing method which adequately rewards the different funding sources: and adequately rewards customers for their stakes in the operation: (e.g., customer risk, and the economic rent attaching to the right to supply.)

• Democratise decision making, so opportunity cost decisions rest where they belong- the customer.

What Should Be Done: 3

• Rethink the whole concept of the ownership of a utility, and what utility privatisation actually means. There would be many advantages for a model in which a potential private sector entrant bid, not for the whole CCRCV of a company at inflated prices, but only fori) that part of RCV funded from equityii) the right to manage the utility for an agreed period

OFWAT’s Response: 1

“Our current approach to pricing means that almost all companies are cash flow negative. … This is entirely at odds with the situation described by your analysis.”

Why this is wrong.OFWAT’s definition of cash flow is:-

Net cash flow from operating activities, less interest, less dividends, less taxation, less investment.

So on OFWAT’s logic, a company with excessive dividend payments would have negative cash flow, and OFWAT would use this as evidence that profits were not excessive!

In any event, companies with heavy investment programmes would normally be borrowing, and hence have negative cash flow: so negative cash flow is a meaningless test.

OFWAT’s Response: 2

“... the paper does not recognise that deducting Historic cost depreciation (HCD) rather than Current cost depreciation (CCD) from the regulatory capital value (RCV) would mean that the RCV is higher and therefore the absolute level of return would be higher to recognise the increased allowance for a return on capital that would occur.”

Why this is wrong

This is nonsense: we are arguing that there needs to be a fundamental rethink on how the funding sources for CCRCV are remunerated: it makes no sense, and we are not arguing for, altering one part of the CCRCV system without a thorough reform.

OFWAT’s Response: 3

“The dividend yield calculations are flawed because they are based on called up share capital rather than looking at dividend yields based on share prices, which reflect actual market valuations.”

Why this is wrong

But the market valuation is in itself meaningless, being largely a function of the decision to allow the company to charge customers the cost of a market rate of interest on the whole of CCRCV. The way we have looked at return is the appropriate way, reflecting the return earned on the equity resources actually put into the business.