At the 1999 Periodic Review (PR99), OFWAT employed an allowed real post tax cost of capital of 4.75% for the UK water companies, a figure somewhat lower than the rate of return allowed in the previous water price review in 1994. The lower allowed rate of return combined with other elements of OFWAT’s methodology, such as tougher assumptions regarding cost efficiencies, resulted in significant price cuts across the industry.

Following PR99, equity investors in the UK water industry have seen their returns fall significantly and it has been widely reported that companies have been trading at valuations below the levels that would apply if their share prices fully reflected their “Regulatory Capital Values” (RCVs). Against this background, Water UK commissioned NERA to undertake a series of analyses to examine financing issues in the UK water industry and in particular the extent to which OFWAT’s PR99 allowed rate of return assumption compares with the empirical evidence on market costs of capital for the sector. This paper presents a summary of the work undertaken by the NERA team, led by NERA Director Dr. Richard Hern, as well as the primary conclusions.