A fair return for taking risks? – A framework for modelling and managing investor risk exposure in the water sector
HOW DO WE MODEL THE LEVEL OF INVESTOR RISK EXPOSURE, WHAT IS A REASONBALE RISK RANGE AND HOW DO WE STAY IN THAT RANGE?
The water sector needs to attract and retain a significant amount of capital investment from the private sector. Investors will only provide capital if the regulatory package is a ‘fair bet’ i.e. where they can expect to make a return on their investment that is commensurate with the market cost of capital, given the risks they are facing. Additionally, different levels of risk exposure attract different pools of investors.
The challenge is not whether or not the package should be a fair bet. All stakeholders in the sector agree with this principle. Indeed Ofwat models the risk ranges for each charge control to determine if, under its own assumptions, the package is a fair bet. Instead, it is the following:
- How can we accurately model how much risk is really in the package? This requires modelling expected performance across costs, performance incentives and debt financing across the sector, under various scenarios.
- What is the optimal risk profile? – both the range and distribution, given the risk appetite of the investors in the sector and the welfare implications of having asymmetric distributions
- What levers are there to pull to bring the risk profile within the optimal range?
- How is this communicated effectively with all stakeholders
The challenge for this Sprint is to Develop a framework for analysing risk, which addresses the above challenges.
By the end of the sprint, we aim to deliver:
- Clear terminology for discussing and communicating ‘risk’
- A methodology for analysing risk in the regulatory package
- A methodology for assessing what optimal risk profiles are and a recommendation for PR29
- A set of levers that may be pulled to change risk profiles
- A proposal for how the above may be implemented
Together, we will do the following:
- Articulate the problem, using the lessons learned from PR24
- Develop a common set of concepts and terms for talking about risk in the package
- Identify the objectives that need to be met when calibrating the risk in the package and where the trade offs might be
- Propose an optimal risk distribution, given the objectives and trade offs identified
- Identify the main approaches for modelling the level of risk and which approaches may have the most merit
- Identify the main levers that can be pulled in order to move from modelled outcomes to the optimal risk distribution
- Design a conceptual framework for analysing risk that can be taken to the new regulator/investors/gov
Participants will collaborate through a series of structured and interactive sessions to:
- Day 1: Start with Why – Explore the problem we are trying to solve with an improved risk analysis framework and workshop the correct terminology and a common language
- Day 2: What does good look like? – Explore what risk profile should be targeted. What are the objectives that we’re trying to meet and how different distributions of risk perform against these objectives, before agreeing on a preferred distribution or ‘lead contender’ that requires further testing
- Day 3: How risk should be modelled and levers for managing risk – how can the modelling of the degree of risk be done as accurately as possible e.g. based on past performance or benchmarking to other industries and what options are available for managing risk e.g caps and collars, aiming-up etc.
- Day 4: Making it real – we will explore how we might go about developing the framework and getting buy-in from the new regulator, investors and government
- Water company employees and investors working on risk analysis, cost of capital and capital raising
- Regulators, and Government, who are seeking to understand how to attract investment
Any questions: contact Geoff Randall: Geoffrey.Randall@nwl.co.uk