Financeability tests and their role in price regulation - IPART - NSW ...

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5 How should IPART respond when a business fails the financeability test? Box 5.3 Case study: Ofwat In its 2004 determination, Ofwat included a financeability adjustment mechanism to fulfil its obligations to ensure that the regulated water companies could finance their activities and to retain investor confidence. As a result, water companies’ revenue increased by GBP 430 million during the regulatory period (AMP4).a This reflected the industry’s continued high levels of investment and the impact this might have on companies’ financial health if revenues were to be derived purely from the normal building block approach to price setting. The regulator’s financial test included the following: � Identifying indicators and thresholds – it used cash-based indicators and thresholds that are in line with investment grade credit ratings. � Developing a modelling framework – it applied a notional gearing ratio of 55% to all businesses and dividends that were consistent with the cost of equity (less an amount to fund future growth). � Applying the test – Ofwat retained discretion in applying the test. In its 2009 price review, Ofwat maintained the inclusion of a financeability adjustment mechanism. It based its financeability analysis on the financial ratios in the table below. Ofwat 2009 price review – financial ratios used in financeability analysis Ratio Water and sewerage Water only Cash interest cover (funds from operations/gross interest) About 3 times About 3.5 times Adjusted cash interest cover (funds from operations less capital charges/net interest) About 1.6 times About 1.8 times Funds from operations/debt About 13% About 17% Retained cash flow/debt About 8% About 10% Gearing (dent debt/regulatory capital value) Below 65% Below 60% Source: Ofwat. In its final 2009 determination, Ofwat targeted financial ratios under the notional structure that are consistent with an A- credit rating.b It also switched from making revenue adjustments to equity injections. a Upfront although much of it was back-loaded. b This is consistent with the target credit rating for the cost of debt estimate. 32 IPART Financeability tests and their role in price regulation
Box 5.4 Case study: Ofgem 5 How should IPART respond when a business fails the financeability test? Ofgem is currently undertaking fundamental review of energy network regulation, known as RPI-X@20. As part of its consultation for this review, Ofgem is reviewing how the new regulatory framework may embed Ofgem’s financing duty. In May 2010, Ofgem released a paper outlining its initial thinking on the issue of financeability. A final decision is to be expected in mid-2010. The 4 main messages from Ofgem’s May 2010 paper are that: � As long as the allowed rate of return, depreciation profile and capitalisation are set appropriately and that there is consistency in Ofgem’s respective future determinations, the notional company should be financeable. � Ofgem will continue to consider the financial ratios (and possibly other qualitative or quantitative indicators) that the credit rating agencies look at to determine a business’ credit rating. � Ofgem will not advance cash flow in light of apparent short-term deteriorations in the financial ratios or credit ratings. It will attempt to understand the reasons behind the deterioration but the onus will be on the business to resolve the situation (for example, by injecting equity or reducing dividend payments to shareholders). � On the other hand, when relative expenditure levels decrease, a business may choose to remove equity if it deems it appropriate (for example, through the payment of special dividends). Ofgem considers that by placing a greater onus on businesses to take action to ensure shortterm financeability it reduces the requirement for it to make adjustments to other areas of the price control. Financeability tests and their role in price regulation IPART 33
Page 1: Independent Pricing and Regulatory
Page 4 and 5: © Independent Pricing and Regulato
Page 7 and 8: Contents Contents Invitation for su
Page 9 and 10: 1 Introduction 1 Introduction In ma
Page 11 and 12: 1 Introduction We expect that the o
Page 13 and 14: 2 Why do IPART and other regulators
Page 19 and 20: 3 How do IPART and other regulators
Page 21 and 22: 3.1.2 Computing the financial ratio
Page 23 and 24: 3 How do IPART and other regulators
Page 25 and 26: Box 3.1 Differences in financeabili
Page 27 and 28: 4 How IPART should address finaceab
Page 33 and 34: 5 How should IPART respond when a b
Page 35 and 36: 5 How should IPART respond when a b
Page 37 and 38: IPART seeks comment 5 How should IP
Page 39: 5 How should IPART respond when a b
Page 43: � identify the reasons for the de
Page 46 and 47: 6 Summary of IPART’s preliminary
Page 48 and 49: B Financeability tests in other jur
Page 50 and 51: 42 IPART Financeability tests and t
Page 52 and 53: 44 IPART Financeability tests and t
Page 54 and 55: C CEPA note on UK legislative requi
Page 56 and 57: C CEPA note on UK legislative requi
Page 58: D Quantifying the impact of credit

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