Fool's Eye View

[ September 18, 2000 ]

Run Ragged by Regulators

By Rob Davies (TMFEssex)

Colchester, Essex -- You might think analysing high technology companies would the hardest job for an investor. All that software and hardware, its own lingo and everything changing so fast. But I don't think so. In my experience few things are as hard to get your head round as utilities, or more specifically, the regulators.

Fools of long standing, i.e. more than six months, may recall that at the beginning of the year we wrote an Industry Focus. I drew the short straw and looked at the utility sector. In fact it wasn't as bad as I feared because the water regulator, Sir Ian Byatt, had just handed down his five-year review of the sector. Piece of cake I thought, we know exactly what is going to happen to the water companies for the next five years. And it wasn't going to be very nice, massive price cuts initially then virtually no price increases for five years. All the companies squealed and said it was unfair. Hyder (LSE: HYR), the Welsh utility, realised it could not survive and was recently bought by a US company. Kelda (LSE: KEL) came up with an innovative scheme to mutualise itself, but that wasn't allowed.

However, one company, Mid Kent Water and East Surrey Water, came up with a novel trick and asked for a reference to the Competition Commission. In particular it asked it to review the adjustment factor, K, and the standard amount for the water infrastructure charge. (K is the amount that water bills can be raised or reduced relative to the inflation rate.) Last week the Commission announced its findings and surprisingly found in favour of the water company. The arguments are pretty complex and revolve around things like the cost of capital, bad debts, pension costs and efficiency improvements, among others. Unfortunately, few numbers are detailed in the press release so we can't pass comment on them. Of course it is up to the Director of Ofwat, now Philip Fletcher, to decide if he will accept this ruling.

That remains to be seen, but the very fact of the review has already dramatically changed the outlook for the whole utility sector, which most people have written off. If the Commission's decision is accepted then presumably all the other companies are going to seek the same thing. If they all succeed then maybe the next five years for this sector won't be quite so bad after all.

In the meantime the next utility to have a price review is National Grid (LSE: NGG), but whether last week's statement will have any impact remains to be seen. Nevertheless, the intervention of the Competition Commission has muddied the waters patrolled by Ofwat and for investors it is probably good news. Though doubtless there will be some lively debate between the regulators about the arcane subject of cost of capital, so don't expect any resolution in a hurry.

Where Next?

Hopefully ledswinger will post his informed comments on the water sector discussion board so that we will all understand this complex situation a little better very shortly.