Centre for International Public Health
Policy
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 by
uprating for inflation
adding in investment
subtracting 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,
i(n + 1)
[1- (1 + r) -n ]
1
-1
- i[1 [1 +
](1 r) (1- (1 + r) -n )] / r
2
nr
nr
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.
Inflation (as percentage)
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
10
0.0
2.6
5.1
7.5
9.7
11.9
14.0
16.0
17.9
19.7
21.4
Asset life (years)
20
30
0.0
0.0
6.2
10.4
11.9
19.8
17.2
28.3
22.1
36.0
26.7
42.9
31.0
49.2
34.9
54.9
38.6
60.1
42.0
64.8
45.2
69.0
40
0.0
15.4
28.8
40.7
51.1
60.3
68.5
75.7
82.1
87.8
92.9
What this means: 2
Table 1b. Second Scenario: as above, but for Interest = 7.5%
Inflation (as percentage)
0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
10
0.0
2.8
5.5
8.0
10.5
12.8
15.1
17.2
19.3
21.3
23.1
24.9
26.7
28.3
29.9
31.4
Asset life (years)
20
30
0.0
0.0
7.0
12.2
13.5
23.3
19.5
33.3
25.1
42.3
30.3
50.5
35.1
58.0
39.6
64.7
43.8
70.9
47.7
76.5
51.4
81.6
54.8
86.2
58.0
90.5
60.9
94.4
63.7
97.9
66.3
101.2
40
0.0
18.5
34.8
49.2
61.8
73.1
83.0
91.9
99.8
106.8
113.1
118.7
123.8
128.3
132.4
136.0
Or in words
The 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.
Percent
Asset life (years)
10
20
30
40
0
100
100
100
100
0.5
99
97
95
94
1.0
97
94
91
88
1.5
96
91
87
83
2.0
94
89
83
79
2.5
93
86
80
74
3.0
92
84
77
71
Inflation (as percentage)
3.5
91
81
74
67
4.0
89
79
71
64
4.5
88
77
68
61
5.0
87
75
66
58
5.5
86
74
64
56
6.0
85
72
62
54
6.5
84
70
60
52
7.0
83
68
58
50
7.5
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
1997/98
1998/99
1999/2000
2000/01
2001/02
2002/03
2003/04
2004/05
22.2%
34.5%
32.4%
18.6%
19.3%
13.9%
23.5%
18.4%
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 for
i) that part of RCV funded from equity
ii) 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.