Cost of capital

In coming to our judgement on the cost of capital, we have considered the price setting package as a whole. This includes:

• an assessment of the return needed by investors and lenders to compensate for their exposure to systematic risk;

• company-specific risks, which are included in our cost and revenue assumptions; and

Water and sewerage companies’ estimates of the cost of capital in their final business plans fell within a narrow range of 4.7% to 5.0% on a real, post-tax basis, with one company (Thames) above the range at 5.25%. The range for the water only companies was wider at 5.45% to 6.3%, largely because of the different views on the size of the small company premium they consider is required.

Most companies determined their proposed cost of capital from a study by National Economic Research Associates (NERA), that Water UK commissioned. In some cases, the companies supplemented this with their own analysis. NERA’s estimate of the post- tax cost of capital in its January 2009 report was in the range 4.6% to 5.1%, based on gearing of 60%. NERA did not update its cost of capital estimate in its August 2009 report despite the significant easing of the financial markets since January 2009. However, it did calculate a revised range for the current cost of equity since the start of the credit crunch and recommend an overall cost of debt at the low end of its previously proposed range at 3.8%.

We settled on a cost of capital of 4.5% for our draft determinations. We considered this to be appropriate assuming a central view of costs and a balanced view of risk. We have considered carefully the representations we received on our draft determinations that focused on the balance of risk. We comment on this further in section 5.6. We have also considered carefully the balance of risk within our final determinations. In light of this, the weighted average post-tax cost of capital for the final determinations remains at 4.5%. This is below the level set at the 2004 price review (5.1%), but is towards the high end of the range supported by our advisers (Europe Economics).

We have set out range estimates from Europe Economics’ report and the components of our point estimate in tables 45 and 46 respectively. Although we have stated the

component parts of the cost of equity in the tables, we consider it is most relevant to focus on the overall cost of debt and cost of equity.

In reaching our cost of capital assumption, we considered, among other evidence: • the updated advice of Europe Economics;

• NERA’s work (on which most companies appeared to base their proposals); • market evidence since draft determinations;

• company representations on our draft determinations; and

• we have reviewed an updated consultancy report on the cost of capital that CCWater commissioned.

Table 45 shows a range estimate for the cost of debt of 2.5% to 4.7% compared with NERA’s range estimate for the cost of debt of 3.8% to 4.3% (based on a 30:70 split of current and historic debt costs). NERA’s proposed cost of equity ranged from 7.4% to 8.2%. The cost of equity was driven by a dividend growth model assessment as this overlapped with the high end of NERA’s CAPM assessment.

In its advice, Europe Economics provided a ‘marked up’ range to take account of asymmetric consequences associated with the risk to customers of setting the cost of capital too low.This mark-up was applied to the overall cost of capital, not individual components. We show Europe Economics’ marked-up range (2.9% to 5.4% on a post- tax basis) for the cost of capital in table 45. The width of the range reflects the

uncertainty around estimating the cost of capital, particularly in the context of the current markets.

Europe Economics produced its point estimate within its range after further analysis based on a weighted assessment of two separate cost of capital point estimates. It provided a point estimate of 4.3% for a cost of capital based on current market data and a cost of capital representing its best view on where the market may settle as the current constraints in credit markets ease. Europe Economics’ report on the cost of capital for our final determinations and accompanying briefing notes are available on our website.

Table 45 Europe Economics’ range for the cost of capital for the water industry

Low High

Gearing (debt: RCV) 55% 65%

Cost of equity

Risk-free rate 1.5% 2.2%

Equity beta 0.5 0.9

Equity risk premium 4.1% 5.4%

Cost of equity (post-tax) 3.5% 7.2%

Cost of debt

Cost of debt (gross of tax shield) 2.5% 4.7%

WACC – gross of tax shield (Vanilla) 2.9% 5.6%

WACC – post-tax 2.5% 4.7%

Marked-up WACC to account for the asymmetry of consequences

WACC – gross of tax shield (Vanilla) 3.4% 6.4%

WACC – post-tax 2.9% 5.4%

While we have not chosen to distinguish between different market conditions or apply an explicit mark-up, we believe our cost of capital set out in table 46 is supported by the range of evidence and analysis set out in the Europe Economics report. It will enable efficient companies to maintain access to the capital markets throughout 2010-15 and beyond. But as stated above, we consider it most relevant to consider the overall cost of debt and the overall cost of equity rather than to focus on individual components.

Table 46 The weighted average cost of capital for the water industry

Gearing (debt: RCV) 57.5%

Cost of equity

Risk-free rate 2.0%

Equity beta 0.9

Equity risk premium 5.4%

Cost of equity (post-tax) 7.1%

Cost of debt

Cost of debt (gross of tax shield) 3.6%

WACC – gross of tax shield (Vanilla) 5.1%

WACC – post-tax 4.5%