Use of Inflation Indices in Water Sector

03 February 2016
Dr. Richard Hern, James Grayburn, Zuzana Janeckova et. al.

Water UK, which represents all major statutory water and wastewater service supply organisations in England, Wales, Scotland and Northern Ireland,  commissioned NERA Economic Consulting (NERA) to undertake an independent study of the implications of a change to the index used in setting price controls. 

Ofwat, the economic regulator, has recently set out a number of options for changes to the indices used to inflate prices and regulated capital values (RCV), with its preferred option the adoption of the consumer price index (CPI) in place of the retail price index (RPI).  The change to CPI has potential implications for companies’ revenue profiles over time, and therefore customer bills.  The change also has implications for companies’ financial position, given the high-levels of RPI index-linked debt (ILD) used to finance the sector, and therefore the potential mis-match between the change in companies’ RPI ILD debt liabilities and the growth in the RCV over time.   

NERA evaluated the different options drawing on structured interviews with around twenty investors in the sector, and financial modelling of companies’ financial position.   We found that there was concern about the impact on companies’ financing position and costs given the high levels of RPI ILD, the difficulties of hedging RPI exposure under a CPI regime, and the absence of any CPI indexed-linked sovereign or corporate debt market for future debt funding. 

NERA's financial modelling shows that companies’ financial ratios may deteriorate sharply if the adoption of a new index is not implemented in a value-neutral way, and that transitional paths that reflect the long-dated nature of companies’ RPI ILD help minimise risk.