Future Water: A long-term strategy that reduces regulatory risk?
UK Water Utilities May 2008
On 2 February the UK government published its long-term priorities for water entitled
Future Water. Reducing water demand and responding to climate change are the
government’s over-arching policy objectives. The companies have also recently
published 25-year Strategic Direction Statements defining their outlook for bills,
investment priorities and carbon commitments.
We believe this clearly defined strategy and increased investment visibility will reduce
the regulatory risk that Ofwat dramatically reduces the allowed cost of capital for 2010-
15. We also examine whether competition proposals and current debt market difficulties
increase risk in UK water.
The ratings of both Pennon (target price 730p, 685p previously) and United Utilities
(target price 820p, 740p previously) are upgraded to Overweight from Neutral. SVT’s
target price is increased to 1,570p from 1,530p, while the rating remains Neutral.
Northumbrian Water Group is downgraded to Neutral from Overweight, target price to
350p from 380p.

Investment summary
A government strategy for UK water
The threat of weather unpredictability and climate change has driven the government to define a longterm
strategy for UK water this year. In addition, the water companies have produced 30-year Strategic
Direction Statements setting out their priorities for investment to cope with climate change, meet the
standards required by environmental legislation and upgrade and maintain their assets.
Increased visibility for Ofwat
We believe both of these will help Ofwat set appropriate returns to deliver the strategic priorities from
2010-2015. We believe allowed returns will fall. Our assumption is a post-tax real return of 4.65%
compared with 5.1% now. The companies will have less scope to outperform financially. However, the
current debt-market difficulties may make it more difficult for Ofwat to be very aggressive in reducing
allowed returns, given the need to invest to mitigate the effects of climate change.
Competition
Ofwat’s latest proposals on competition do present the possibility of breaking up regulated water
monopolies, first through separate accounting and price controls and then through the introduction of
competition in retail services and possibly water trading. This could increase the risk perception of the
industry by capital providers. We believe that competition and strategic climate-change investment may
neither be compatible nor deliver increased value to customers.
Creating value
We analyse the companies’ current cost of debt and cost of equity. We look at market betas and debt
issuance to assess whether the cost of capital has increased in the current climate of debt instability.
Operational and financial outperformance are reasons to increase our valuation. We assume that Pennon
and Severn Trent can continue to deliver capex out-performance of 5% and 6% to 2015. We factor in the

low interest costs achieved by the Pennon and UU treasury teams, both of which have managed to drive
down the cost of debt to around 100 basis points below their peers.
Northumbrian Water – Rating downgraded to Neutral from Overweight. We have a target price of 350p,
previously 380p. The change reflects a lower spread from 2010-2015 against Ofwat’s assumed cost of
capital. Unlike the other three companies in this report, Northumbrian’s holding company and its
regulated utility have markedly different gearing. This has implications for the cost of debt it can achieve.
By March 2007, it had the highest interest rate of the four stocks we cover, just under 6%. It is not
predicting out-performance for either capex or opex to 2010, and it has the highest observed beta of the
stocks, 0.72.
Pennon – We upgrade our rating to Overweight from Neutral and raise our a target price to 730p from
685p, based on our expectation of continued operational and financial out-performance through 2015.
Pennon’s regulated water company, South West Water, has the second-lowest cost of debt among the
utilities, 4.25% in March 2007, and has outperformed Ofwat’s capex assumptions by 5%. We also think
operational out-performance is possible and we expect the company to comment on this at its full-year
results presentation on 3 June 2008. Viridor is the most dynamic non- regulated business of any of the
companies in this report; it can deliver growth in a dynamic UK waste sector driven by legislative change.
Pennon also has the lowest observed beta of the stocks, 0.55, reflecting its low financial-risk profile.
Severn Trent – We increase our target price to 1,570p from 1,530p. Our rating remains Neutral, since
this offers an 8.7% potential total return to the current share price. The main reason for the increase is the
reduced equity beta, down from 0.82 to 0.62. This observed beta reflects a perception of lower
operational risk – Severn Trent is improving its performance and there is greater clarity about potential
fines and reduced costs from last summer’s flooding. It still has high head-office costs, although they
have been reduced aggressively. Better visibility is available now on regulatory penalties, after Ofwat
proposed a fine of GBP38m for customer-service failures. In addition, a resolution may be reached this
financial year in the litigation issues that have been under consideration by the Serious Fraud Office and
Ofwat for over two years. We think a further GBP60m fine might be levied by the courts and Ofwat for
offences under the Water Industry Act 1991.

目录

Investment summary 1
Future Water: A long-term
strategy that reduces
regulatory risk 5
Future Water 5
Strategic Direction Statements 6
Industry risk analysis 7
PR09 Ofwat’s latest thoughts 9
2010-15 working assumptions 13
Valuation methodology 14
Northumbrian Water Group 19
Valuation 22
Risks to our rating 24

Pennon Group 30
Growing efficiency 30
Recent developments 30
Future priorities 31
Positives 31
Negatives 31
Key financial issues 32
Valuation 32
Severn Trent 39
Valuation 41
United Utilities 48
Cost-of-debt advantages and dividend headroom created 48
Recent developments 49
Positives 50
Negatives 50
Key issues 50
Valuation 51
Disclosure appendix 59
Disclaimer 64
Contents