Outlook: Water regulator calls time on Northumbrian's debt leverage

HICP versus RPIX; Ryanair assault
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The Independent Online

Shares in Northumbrian Water have not exactly stormed ahead since they were refloated on the stock market three months ago, and to add insult to injury, they were yesterday given a real soaking after the director-general of Ofwat, Philip Fletcher, warned of heavy penalties if the company failed to take firm action to bolster its credit rating.

This was downgraded to one notch above junk just before the company was refloated on AIM. The downgrade is important because it both increases the cost to Northumbrian of servicing its debt and curtails its ability to raise new capital in the markets to fund its investment obligations.

The water watchdog has long been concerned about rising levels of debt leverage in the industry, but has found it difficult to act against a process which it to some extent brought upon itself. In setting the tariff that water companies are allowed to charge, the regulator defines a fair rate of return, which in turn assumes a going rate for cost of capital.

Since the cost of equity capital is nearly always higher than debt, this has encouraged water utilities to swap equity for debt so as to reduce their cost of capital and thereby enable themselves to exceed the regulator's assumed rate of return. Call it financial engineering if you like, but it has been extremely effective.

The process reached a crescendo during the technology bubble when investors became almost wholly uninterested in reliable old yield stocks such as water companies. Share buybacks, special dividends, and capital restructurings became the order of the day. Eventually Northumbrian too joined the fray. Northumbrian was bought out from its French owners by a consortium of City interests, who geared it up with debt and refloated it on the stock market.

Up until now, the working assumption has been that provided the sponsors can maintain investment grade while leveraging a water company, then the regulator will remain sweet. The implication of yesterday's statement from Ofwat is that this is far from the case. Even a triple B rating, the one assigned by Standard & Poor's to Northumbrian, now seems to be unacceptable.

At this stage it is hard to know quite how serious this is for Northumbrian's debt and equity holders. In order to safeguard the interests of Northumbrian's customers, the core utility is ring fenced for regulatory purposes, but the holding company still relies on the utility's cash flow to pay interest and dividend costs as well as to underpin access to the capital markets for further finance. The regulator's concern is that this access might be denied if Northumbrian's finances become too shaky. Equity costs more to raise than debt, but it is also a capital buffer zone without which companies can easily find themselves in a funding trap, unable to tap either the debt or the equity markets. In ordinary companies, insolvency is staved off by shrinking the enterprise and cutting back on investment. In a utility, where there is a public service obligation, this is not an option

Northumbrian reckons it can improve its credit position without need for a rights issue, perhaps by securitising the revenues of one of its key reservoirs, but it may be touch and go and in the meantime the regulator is threatening further to restrict the holding company's access to the utility's cash flow if the rating doesn't improve, which would mean no dividends. In any case, if the capital markets sense a rescue rights issue, they'll charge Northumbrian an arm and a leg for the privilege, which is rich when you consider that the leveraging up of Northumbrian was in part a fee-earning device in the first place.

Still, they like clouds in the water industry and the silver lining in this particular one is that it enables the water companies to go to the regulator and say, "if you want more equity in these utilities, then you are also going to have to allow for a higher cost of capital in the present pricing review, and therefore an even more lenient regime than the one we are already looking for". Hey ho.

HICP versus RPIX

The Chancellor and the Treasury have got their knickers in a terrible twist over plans to use the European measure of price inflation - the harmonised index of consumer prices (HICP) - for inflation targeting purposes. The proposal was criticised last week by the Governor of the Bank of England, Mervyn King, who said the move would only serve to confuse. Ever since then the Treasury has been all over the place in attempting to explain precisely what it is proposing.

What the Chancellor said when he published the results of the five euro tests last June seemed clear enough. "I have written to the Governor of the Bank of England today stating that subject to confirmation at the time of the pre-Budget report I intend to change the inflation target at that time. The inflation target for Britain will be set on the consumer prices definition."

Any reasonable person reading such a statement would deduce that the Chancellor expected to set a new inflation target using the European measure in the November pre-Budget report. And so he is, says the Treasury, but that doesn't mean the new target will be imposed with immediate effect. In fact, it will be some years before the Bank of England is expected to meet the new target. So there really isn't anything to argue about. Only there is.

Obliging the Bank of England to meet a new inflation target at some stage in the future while coincidentally expecting it to meet the old one in the meantime seems the worst of all possible worlds. Mr King is right. Confusion will reign, both in deciding interest rate policy and in public understanding of it.

The problem arises because as things stand there is a 1.6 percentage point difference between the British inflation rate as defined by HICP and the existing measure, RPIX. Under RPIX, the rate of inflation is 2.9 per cent while under HICP it is 1.3 per cent. Policy is already arguably too tight under RPIX but under HICP it is quite plainly far too tight. The difference between the two rates is accounted for largely by housing. RPIX takes account of house price inflation, housing insurance and council taxes, while HICP does not. House price inflation is a more important constituent of cost of living in Britain than it generally is on the Continent. It therefore seems more appropriate to set policy according to RPIX than HICP, or that at least is Mr King's argument.

Of course, even the Bank of England assumes that house price inflation will eventually abate to zero, so in theory the two inflation rates should converge of their own accord over the next few years. But there is no guarantee this will happen, and in the meantime plans to insert some measure of house price inflation into HICP could take years to come to fruition. It follows that the risks of inappropriate policy action would be quite high, even under the Treasury's "new" plan to phase in the revised inflation target over a period of years.

The Chancellor wants to use HICP to make everything look neat and tidy ready for euro entry should Britain ever decide to press the button. But like so much else to do with the single currency, it's proving a lot more complicated than it seems.

Ryanair assault

Ryanair's Michael O'Leary finds himself under fire from the Consumer Ombudsmen of Finland, Sweden, Norway and Denmark for failing to provide compensation for delayed flights and refusing to allow transfer of tickets. Regular readers will know I'm no great fan of Ryanair, but it is hard to disagree with Mr O'Leary's insinuation that this is little more than an attempt to protect the flag carriers SAS and Finnair from Ryanair's determined assault on their markets. Nobody is obliged to fly with Mr O'Leary, who wears his faults well tattooed on his forearm. But before Ryanair arrived in Scandinavia, you were obliged to fly with highly priced SAS.