The weighted average cost of capital is the return a regulator allows a company to earn on the money invested in its network, blending the cost of borrowing (debt) with the return shareholders need (equity). Water companies are monopolies, so instead of competition setting their profits, Ofwat sets this rate every five years in a price review; the 2024 review, PR24, covers 2025 to 2030. The rate is applied to the Regulatory Capital Value, the regulator’s measure of the investment base, which across the sector is about 100 billion pounds. That is why a difference of one percentage point is worth about a billion pounds a year to customers. The review is built around a benchmark called the notional efficient company: an imaginary well-run firm financed with 55 per cent debt. Companies are free to borrow more than that, but Ofwat’s long-standing principle is that they do so at their own risk, not their customers’.
That the allowance could have been 1.08 percentage points lower on Ofwat’s own principles. MCC rebuilt the main components of the WACC using market evidence and the notional efficiency assumptions Ofwat itself endorses, and the result is an allowed return of 2.89 per cent against the 3.97 per cent Ofwat determined. Applied across the sector’s asset base for five years, the difference is about 5.4 billion pounds, or 41 pounds per household per year across the 26 million household customers of England and Wales. The table below sets the three views side by side.
Table 1: The PR24 allowed return in three views: Ofwat’s 2022 early view, Ofwat’s December 2024 final determination, and MCC’s 2025 market-led alternative. All values in real terms at 55 per cent notional gearing.
Source: MCC Economics report for the Consumer Council for Water.
Two questions run through the review. Has Ofwat’s choice of upper-bound values shifted risk from shareholders to customers, and do the allowances reflect the much lower investor risk PR24 itself created? Behind both sits a moral hazard concern: many companies chose highly geared, fragile financial structures, and an allowance calibrated to their circumstances asks customers to pay for those choices.
Because it is priced off the actual borrowing of companies that abandoned the efficient structure, rather than off the market benchmark an efficient company would face. Two building blocks matter: the cost of the debt companies already hold (embedded debt) and the cost of the debt they will raise (new debt).
Ofwat set the embedded debt allowance at 4.82 per cent nominal, using actual and forecast company debt issuance, including instruments from companies rated below the notional benchmark. Ofwat itself acknowledges the problem, noting that some companies have issued debt at rates well above what an efficient, notionally structured company would pay, and that over time this discrepancy could significantly affect the benchmark. Sector debt costs have spiked over the past two years, and the spike is concentrated where financial distress and gearing are highest: Thames, Southern and Anglian sit far above benchmarks, and the sector as a whole has lost its historical debt cost advantage. Ofwat now rates 10 of 16 companies at elevated concern or action required for financial resilience, and those concerns track gearing above the notional level. MCC’s view is that an index-led approach should dominate: at the very least the allowance should be capped at the 4.59 per cent nominal the benchmark index implies, and MCC’s market-led value, reflecting the index and market inflation, is 4.24 per cent nominal.
Figure 1: Observed water company bond yields against benchmarks (2015-2024), showing the recent spike concentrated in the most distressed and highly geared companies.
Source: Ofwat’s allowed return appendix, Ofwat’s debt model and MCC analysis.
Figure 2: Regulatory gearing against Ofwat’s financial resilience rating, red for action required and yellow for elevated concern, showing resilience concerns cluster above the 55% notional gearing level.
Source: Ofwat monitoring financial resilience report 2023-24 and MCC analysis.
Figure 3: Ofwat’s decision on the cost of embedded debt, summarised.
Table 2: Ofwat’s and MCC’s views of the cost of embedded debt allowance, nominal, inflation and real.
Source: MCC Economics report for the Consumer Council for Water.
For new debt, Ofwat starts from the iBoxx benchmark indices, then adds a benchmark adjustment of plus 30 basis points for water-sector circumstances. MCC finds this hard to square with the evidence Ofwat itself cites: the adjustment is estimated from just four companies, of which three have gearing above 68 per cent and two are at elevated concern for resilience; Ofwat’s own measured spread was 24 basis points and falling after its data cut-off; and Ofwat itself records significant uncertainty about whether the spreads will persist. The adjustment matters disproportionately because, unlike the new debt cost itself, it is never trued up: it endures for the whole five years. MCC’s view is that minus 15 basis points, the value in Ofwat’s own final methodology, is more consistent with the long-term trend and a notionally efficient company.
Table 3: The four comparator firms behind Ofwat’s plus 30 basis point benchmark adjustment.
Source: Ofwat monitoring financial resilience reports 2022-23 and 2023-24, summarised in the MCC report.
Figure 4: Ofwat’s decision on the benchmark adjustment for the cost of new debt, summarised.
Source: MCC Economics.
Table 4: Ofwat’s and MCC’s views of the cost of new debt allowance, nominal, inflation and real.
Source: MCC Economics report for the Consumer Council for Water.
Table 5: The overall cost of debt allowance: Ofwat’s final determination against MCC’s market-led view.
Source: MCC Economics report for the Consumer Council for Water.
Debt allowances are set in nominal terms and converted to real using an inflation assumption. Ofwat assumed 2 per cent; MCC’s market-led view uses 2.4 per cent, reflecting market expectations, and argues the averaging technique used for inflation should be consistent with the technique used for market returns.
Figure 5: Inflation expectation options for the cost of debt (per cent)
Source: MCC analysis, Ofwat, Office for National Statistics, Bank of England millennium of macroeconomic data and Dimson Marsh Staunton data.
Figure 6: Inflation outturn options for the total market return.
Source: MCC analysis, Ofwat, Office for National Statistics, Bank of England millennium of macroeconomic data and Dimson Marsh Staunton data.
Because at each step of the standard model, Ofwat selected from the top of the evidence, and then aimed up again in the final choice. Ofwat estimates the return shareholders need using the capital asset pricing model, which combines a risk-free rate, the total return investors expect from the market, and beta, a measure of how risky water companies are relative to that market. MCC accepts the model and the framework; the disagreement is about the values chosen at each step.
Ofwat switched from the 15-year index-linked gilt rate it used at PR19 to a 20-year proxy, against the possibility that gilts understate the true risk-free rate. MCC notes three problems: the switch is inconsistent with Ofwat’s own 10-to-20-year model horizon; Ofwat examined the distortion evidence diligently and itself found it unconvincing; and looking beyond gilts is an idiosyncrasy of UK regulation with no wider precedent. On Ofwat’s own numbers, staying with 15-year gilts would have set the risk-free rate about 30 basis points lower.
Figure 7: Ofwat’s decision on the risk-free rate, summarised.
Source: MCC Economics.
Ofwat selected its market return range from only two families of indicator, weighted toward arithmetic and historical averages. Had it used the geometric average, the bottom of its range would have been 5.25 per cent rather than 6.87 per cent, and the investor-horizon estimators Ofwat itself says deserve continued weight sit at 6.14 to 6.83 per cent, yet were not incorporated in the range. MCC sees a strong case for a total market return of 6 per cent, reached by the geometric average plus an uplift, or by giving proper weight to those horizon estimators, regulatory precedent and non-overlapping estimates.
Figure 8: The full set of total market return indicators, showing Ofwat’s selection sits toward the top.
Source: Ofwat’s allowed return appendix and MCC analysis.
Figure 9: Ofwat’s decision on the total market return, summarised.
Source: MCC Economics.
MCC largely agrees with how Ofwat built its beta range but finds the chosen point high: Ofwat’s final unlevered beta of 0.282 sits above nearly every estimate in the evidence it cites. Given Ofwat’s own statement that PR24’s enhanced risk protections should reduce beta risk, MCC argues the choice should have been no higher than the mid-point, an unlevered beta of about 0.25, an equity beta of about 0.55. MCC also shows that a more sophisticated estimation method, a model that allows market volatility to vary over time rather than assuming it constant, of the kind Ofgem already uses, consistently produces lower betas still.
Figure 10: The beta evidence, unlevered and raw equity estimates across methods and windows, with Ofwat’s final choices marked at the top of the range.
Source: Ofwat’s allowed return appendix, FTI’s 2022 report and MCC analysis.
Table 6: Raw equity and unlevered beta estimates: GARCH against ordinary least squares, by sample period and company.
Source: MCC Economics report for the Consumer Council for Water.
Figure 11: Ofwat’s decision on the re-levered equity beta, summarised.
Source: MCC Economics.
Figure 12: Ofwat’s decision on the cost of equity point estimate, summarised.
Source: MCC Economics.
Table 7: The equity allowance, component by component: Ofwat’s range and point against MCC’s market-led point.
Source: MCC Economics report for the Consumer Council for Water.
No, and that is telling. Ofwat’s market-to-asset ratio check found listed water companies trading at a 9 per cent premium to their regulatory value in September 2024, in line with the 10 per cent long-run average, which is hard to reconcile with claims of negative investor sentiment toward efficiently financed companies. On the gap between debt and equity returns, Ofwat found the implied equity premium of 1.63 to 2.38 per cent not clearly too low, and MCC notes the premium was up to half that level for a decade between 1995 and 2005. The one cross check where MCC disagrees is asymmetry: Ofwat judged the package of returns broadly symmetrical, but in MCC’s view the full set of risk reductions means companies have a material prospect of beating the allowed return.
Figure 13: Water sector market premia to regulatory value for listed companies, January 1993 to September 2024, showing the September 2024 premium near the long-run average.
Source: Ofwat analysis of Refinitiv, Bloomberg and equity analyst data.
It is the reason Ofwat gives, but on Ofwat’s own analysis it does not hold. PR24 approves an enhancement programme of about 44.5 billion pounds against roughly 8.3 billion at PR19, an increase of more than 400 per cent, and Ofwat cites the need to finance it at each major decision point. Yet when Ofwat examined whether the programme raises the sector’s systematic risk, it concluded it does not: capital intensity over 2025 to 2030 averages 10.9 per cent of the asset base against 8.0 per cent over the past fifteen years, unremarkable by regulatory standards; the theoretical and empirical link from capital intensity to beta is weak; and the enhanced protections should reduce beta risk. MCC agrees, and draws the conclusion Ofwat did not: if the programme does not raise beta, the place where investment risk would appear, there is no coherent route from a big programme to a higher allowed return. The stronger concern runs the other way: with sector gearing near 70 per cent against the 55 per cent notional level, roughly 15 billion pounds of borrowing capacity has been used up by shareholder choices rather than kept available to fund the programme.
Figure 14: Capital expenditure relative to asset base for PR24 alongside benchmarks from other regulated sectors.
Source: Ofwat’s allowed return appendix and other regulatory decisions.
Substantially, by Ofwat’s own account. Ofwat describes its final decision as a material recalibration of the risk and return package, and quantifies it: the changes reduced the downward skew companies perceived on the expected return on equity by around 360 to 480 basis points against the draft decision, through cost allowance changes, easier outcome targets and a higher allowed return. The catalogue is long: base cost allowances raised to 60 billion pounds, 7 per cent above past spending; cost sharing rates softened; around 55 per cent of expenditure covered by true-ups for external prices; formal gated allowances for 13 large projects worth 2.3 billion pounds; and new delivery mechanisms for Thames and Southern. MCC highlights four examples.
Ofwat’s draft position was that companies should meet their existing PR19 performance levels unless there was compelling evidence otherwise. In the final decision, targets for pollution incidents, internal sewer flooding and leakage were set below the PR19 trajectory, after companies argued the sector’s poor performance made the old levels too demanding. The three charts show the pattern: targets moved toward actual performance rather than performance being pushed toward targets.
Figure 15: Pollution incidents per 10,000 kilometres of wastewater network: the PR19 target, actual performance, and the easier PR24 target.
Source: Ofwat performance data and PR24 final determination models.
Figure 16: Internal sewer flooding incidents per 10,000 connections: the PR19 target, actual performance, and the easier PR24 target.
Source: Ofwat performance data and PR24 final determination models.
Figure 17: Leakage reduction from the 2019-20 baseline: the PR19 target, actual performance, and the easier PR24 target.
Source: Ofwat performance data and PR24 final determination models.
PR24 introduces a set of new in-period adjustment mechanisms that reconcile allowances to outturn conditions during the control, with around 55 per cent of total expenditure covered by true-ups for external input prices. Ofwat also brought forward the energy price true-up, uplifting allowances now using an industrial energy price index and unwinding the uplift on a six-year glide path, even while noting the index could return to its long-run level in around three years.
Table 8: The PR24 in-period adjustment mechanisms, by implementation process.
Source: Ofwat, PR24 final determinations, in-period adjustments.
Ofwat increased the rates at which the regulated asset base is returned to shareholders, improving companies’ short-term cashflows. The adopted rates imply a remaining asset life of about 25 years, which MCC finds low for long-lived water assets, and they generally exceed historical cost depreciation by a material margin. Returning capital faster helps financeability today but exhausts the asset base sooner, storing up a problem for future customers; MCC’s view is that rates anchored to historical cost depreciation would serve the determination better.
Figure 18: Final determination asset run-off rates against historical cost depreciation, showing run-off generally exceeding depreciation.
Source: Ofwat’s final determination financial models and annual performance reports.
That who is appealing is itself evidence. Six companies have asked the Competition and Markets Authority to redetermine the decision: Anglian, Northumbrian, Thames, Southern, South East and Wessex. They are six of the eight most highly geared companies in the sector, all above 68 per cent against the 55 per cent notional level, and five of the six sit at elevated concern or worse on Ofwat’s resilience ratings, including all three rated action required. On some measures the underlying leverage is still starker: including parent company debt and derivatives, Anglian’s gearing reaches 85 per cent, Yorkshire’s 88 per cent and Southern’s 95 per cent. MCC’s message to the appeal body is to abstract from these specific circumstances and decide for the notional efficient company, and it poses five questions: whether the evidence supports a lower allowance; whether risks should sit with companies rather than customers; whether the statutory growth duty is consistent with aiming up; whether rewarding high gearing with a higher allowance creates moral hazard at odds with the resilience duty; and whether a higher allowance will fund investment at all, given the incentive framework makes not investing more rewarding, so the extra return may flow to dividends instead.
Figure 19: Gearing and resilience ratings with the six appealing companies marked, showing the appeals cluster among the most highly geared.
Source: Ofwat monitoring financial resilience report 2023-24 and MCC analysis.
They rise more than in any previous price control. Ofwat’s own estimate is that average annual water and wastewater bills increase by 157 pounds in real terms between 2025 and 2030, average real growth of 36 per cent for water and wastewater companies and 22 per cent for water-only companies, from about 445 pounds in 2024-25 to 597 pounds in 2029-30 in 2022-23 prices. Most of the increase lands immediately: MCC’s spliced series of bills since privatisation, built from Ofwat, Discover Water and the companies’ own financial models, shows real growth of 21 per cent in the first year, then 3.8, 3.3, 2.1 and 2.5 per cent. Bills reach all-time highs in cash terms and keep rising above inflation throughout the period. Against that backdrop, the 41 pounds per household per year at stake in the cost of capital is not a rounding error.
Table 9: What PR24 does to average household bills.
Source: Ofwat 2024 estimates and MCC’s spliced series from Ofwat, Discover Water and company financial models; real values in 2022-23 prices.
Figure 20: Average annual household bills since privatisation in cash terms, showing the PR24 jump.
Source: Ofwat, Discover Water, company financial models and National Infrastructure Commission data, MCC analysis.
Figure 21: Average annual household bills since privatisation in 2022-23 prices, showing PR24 producing the sharpest real increase of any regulatory period.
Source: Ofwat, Discover Water, company financial models and National Infrastructure Commission data, MCC analysis.
That customers should not pay for the consequences of shareholders’ financial choices. Ofwat ran a robust and lengthy process, and MCC’s alternative works entirely within Ofwat’s own framework. But at component after component, the values chosen sit at the top of the evidence, driven visibly by the circumstances of companies that geared up far beyond the notional structure and weakened their own resilience. With the appeal now before the Competition and Markets Authority, brought disproportionately by those same companies, the appeal body has, in MCC’s words, an excellent opportunity to protect water customers and the industry from moral hazard: by setting the allowance for the efficient company the framework was always meant to price.
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