MCC Economics, on behalf of the Consumer Council for Water (CCW), has reviewed Ofwat’s PR24 final WACC determination to assess whether it fairly balances customer and investor interests. The report questions Ofwat’s decision to include costs stemming from companies with high financial gearing, arguing this may shift undue risk to customers. By applying a market-based, notional-efficient approach, MCC finds the WACC could have been set 1.08% lower — potentially saving customers £5.4 billion, or £41 per household, over five years. The review also highlights how new risk-reduction mechanisms in PR24 could justify a lower return, offering critical insight for both policymakers and the Competition and Markets Authority.
MCC Economics was commissioned by the Consumer Council for Water (CCW) to review Ofwat’s PR24 final WACC determination. The report examines whether Ofwat’s approach appropriately balances customer interests against investor requirements. It identifies potential upward bias in key components — including the cost of equity and debt — largely influenced by financial behaviours of highly geared companies. MCC proposes a market-led recalibration of the WACC that aligns with the notional efficient company and regulatory best practice. This would reduce the WACC by 1.08%, potentially saving customers £5.4 billion over five years. The report also assesses risk protection measures introduced in PR24 and offers recommendations for future regulatory frameworks and CMA deliberations.
1. MCC Economics (we or MCC) were commissioned by the Consumer Council for Water (CCW) to review Ofwat’s final determination for the weighted average cost of capital (WACC) allowance as published in December 2024 at the end of Price Review 2024 (PR24).¹
2. Ofwat has run a robust and lengthy PR24 process. Customers have contributed more than ever before. However, Ofwat introduced some late and material changes which may have unintended adverse consequences for customers, including: 1) the October 2024 consultation on incentives (the ‘outturn adjustment mechanism’); and 2) deciding to aim up when choosing a cost of equity allowance in contrast with its ‘final methodology’.
3. There appears to be an upward tendency in the ranges chosen for the major sub-components of the WACC, mostly driven by financial conditions faced by specific companies that have moved away from the notional capital structure, adopting highly geared structures and weakening their financial resilience. These conditions have arisen not from external market pressures but from choices made by their shareholders. Including those costs in the final determination risks shifting the consequences of those decisions onto customers.
4. Ofwat has previously been clear that companies are free to deviate from the notional structure, but that they do so at their own risk. However, this principle may not have been consistently followed in the final PR24 decision. The result is a WACC that may overstate the returns needed to attract finance for a well-run, notionally structured company.
5.Accordingly, we ask:
- Has Ofwat’s decision to adopt upper-bound values for some WACC components resulted in a shift of risk from shareholders to customers? If so, what was the size of this shift?
- Do the allowances reflect the lower investor risk created by the package of protections introduced in PR24?
6. Has enough been done to prevent moral hazard, so that the costs of inefficient financial strategies are not borne by customers?
7. Using MCC’s alternative values for the main components of WACC, which are based on market evidence and notional efficiency assumptions, we calculate that the allowance could have been set 1.08% lower. That difference, if applied across the sector’s Regulatory Capital Value (RCV), could save customers around £5.4 billion over the next five years - the equivalent to about £41 per household per year.
8. This is not a criticism of Ofwat’s overall framework. Our report offers a different view on how its own principles and evidence could have supported a lower WACC, and thus a more balanced outcome for customers.
9. Notably, the companies now seeking a redetermination from the Competition and Markets Authority (CMA) are amongst those with the most highly geared structures and the largest departures from the notional gearing assumption of 55%.
10. Fortunately, the CMA has an excellent opportunity to protect water customers and the water industry from any moral hazard.
11. Accordingly, we ask if the CMA could:
a) set a lower WACC allowance to reflect the available evidence;
b) allocate risks to companies rather than customers;
c) consider whether the ‘growth duty’ is consistent with aiming up;
d) consider the moral hazard risk - where highly geared companies receive a higher WACC allowance - and the related ‘resilience duty’;
e) consider whether a higher WACC allowance will lead to higher water investments or higher dividend distributions given the totex incentive mechanism is a much stronger incentive not to invest.
12. Ofwat has faced a challenging task in PR24, amidst heightened concern about the performance and conduct of the water companies, and the clear need for remedial action and additional enhancement investment on their part. The latter was a major theme in Ofwat’s decision and it has influenced Ofwat’s choices more than any other factor. We see it used as a justification for Ofwat’s choices at each major decision point in the determination. However, customers should not compensate shareholders for the consequences of their own inefficient practices and risky financial structures.
13. Ofwat is committed to this principle, but may not have given it practical effect in its decision making despite explicit warning (see 2004 for example). If Ofwat had done so, it could have chosen WACC components toward the centre of its ranges and its final values for debt and equity would be lower. Past guidance (2004 and 2024) explicitly stated Ofwat’s expectation that companies retain earnings to support large capital programmes.
14. While Ofwat introduces several mechanisms that reduce exposure to outlier outcomes, it is unclear whether these mitigations have been consistently reflected in the calibration of the WACC point estimate. Ofwat has implemented a material recalibration of the risk and return framework including enhanced true-ups and reduced performance targets. These adjustments give investors more stable (and probably higher) returns.
“...the PR24 draft determinations represent a material recalibrationof the incentive package which increases the levels of risk protection compared with our final methodology (and by extension, PR19)”.
15. If Ofwat had placed greater weight on certain market-led inputs or placed less emphasis on investment delivery incentives, a materially lower WACC could have been justified - potentially reducing bills by a significant amount. An illustration of what this reduction could look like is presented below.
16. The WACC allowance (%) is multiplied by the Regulatory Capital Value (RCV) to calculate the monetary (£) allowance, paid for by water customers each year. The RCV could be close to £100 billion by the year 2027-28 (the midpoint of the next price control). If so, each 1% on the WACC allowance will be worth £1 billion per year.
17. Replacing Ofwat’s final determination with the market-led values calculated by MCC would reduce the WACC allowance by 1.08%, as shown in Table 1. This would have reduced customer bills by £5.4 billion over 5 years2, which is worth £41 perhouse hold per year.3
18. The ‘market-led view’ is further supported by the following tables and the analysis presented in the remainder of this report
19. We now step through each component of the WACC to outline our assessment and the alternative conclusions we have reached.
20. Inflation assumptions are required in multiple parts of the WACC assessment. Wehighlight two areas: 1) the cost of debt, and 2) the TMR. In general, lower inflation assumption yield a higher WACC allowance.
21. Ofwat uses 2% for inflation expectations within the cost of debt. This 2% assumptionis lower than: 1) the Office for Budget Responsibility (OBR) who refer to 2.4%; 2) the Bank of England (BoE) gilts data which suggest approximately 3.%; and 3) the BoE survey response (see question 2c) dated February 2025 of 3.6%. The potentialdifference is shown below
Figure 1: Inflation expectation options for the cost of debt
22. Our assessment is that OBR’s estimate of 2.4%, which is arrived at by their forecast model, is the most appropriate for the calculation of the WACC components. This is due to it being theoretically and empirically sound, accounting for variables that are likely to affect long-term inflation, and not being influenced by short-term changes in market expectations.
23. Ofwat uses approximately 3.7% for outturn inflation from 1900 to 2023 within the Total Market Return. Ofwat’s assumption relies on a CPIH back cast. By contrast, other sources (the Office for National Statistics (ONS), the BoE and Dimson Marsh Staunton) do not use the CPIH back cast. The potential difference is shown below. Also, we suggest that the averaging technique for inflation estimates (arithmetic or geometric) is consistent with the averaging technique for TMR outturn values.
Figure 2: Inflation outturn options for TMR
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