Risk |
Mitigation |
Unfavourable price determination
The regulated business operates in an industry which is substantially influenced by the service levels, regulatory targets and price determinations set by its primary regulator, Ofwat, as well as Ofwat’s assessment of its delivery against these.
An adverse outcome to the price determination process (which limits the income the regulated business can receive from its customers) could occur for a number of reasons. These include an inadequate allowed cost of capital, turnover forecasts proving not to be sufficiently accurate, or unforeseen or unforeseeable costs which arise after the determination that cannot be recovered from customers. After a price determination, there is a right of appeal to the Competition Commission, but otherwise the scope to review the outcome within the relevant five-year period is limited. Review mechanisms can also be invoked by Ofwat to reduce the prices for customers. Furthermore, implicit within the price determination are assumptions by Ofwat concerning the group’s future operating expenditure and the achievement of operating cost savings. If these efficiencies are not achieved this may be reflected in less favourable outcomes in Ofwat’s future price determinations.
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In April this year, the group submitted its final business plan to Ofwat for the 2009 price review for the regulated business, which will set prices for the five-year period from April 2010. This plan endeavours to ensure that the assumptions and projections underlying Ofwat’s price determination are accurate and achievable. The group has committed substantive and qualified resource to ensuring the quality of its submissions throughout
the price determination process to give it the best prospect of receiving a satisfactory determination. The submission process includes an assessment of the risks associated with each component of the business to assist Ofwat’s understanding of these. Ofwat’s draft determination will be published in July 2009 and its final determination of allowable prices is expected to be published in November 2009. |
Capital investment programmes
The regulated business requires significant capital expenditure, particularly in relation to new and replacement plant and equipment for water and wastewater networks and treatment facilities. Historically, the group has financed this capital expenditure from operating cashflow and from external debt and equity financing. There can be no assurance that operating cashflows will not decline or that external debt financing and other sources of capital will be available, at similar cost to that assumed by Ofwat, in order to meet these capital expenditure requirements. Delivery of capital investment programmes could also be affected by a number of factors including adverse legacy effects of earlier capital investments or amounts budgeted in prior capital investment programmes proving insufficient to meet the actual amount required. This may affect the group’s ability to meet regulatory and other environmental performance standards, which may result in fines imposed by Ofwat of an amount of up to 10 per cent of regulated business turnover or other sanctions.
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In order to minimise the likelihood of funding shortfalls, capital investment programmes are regularly monitored to identify the risk of time, cost and quality variances from plans and budgets and to identify, where possible, any appropriate opportunities for out-performance. Development of the programme for 2010-15 is progressing in line with expectations, as is delivery of the current capital investment programme. |
Current capital market conditions
The global banking crisis continues to impact the debt and equity capital markets. It has resulted in the cost of capital increasing significantly and has made the issuance of new equity and debt capital more expensive and more difficult to secure. A compounding challenge arises from the relationship between the Regulatory Capital Value (RCV) of the regulated business and the Retail Price Index (RPI). The RCV is adjusted annually for inflation so, if RPI decreases, the RCV would be adjusted downward to reflect this. This may lead to pressure on the gearing ratios and credit ratings of the regulated business and the group as a whole and increase the cost or limit the availability of credit in an already difficult market. In the extreme, the group may be required to increase its equity base by either reducing its dividend payments or raising new equity capital. The global economic crisis has also created difficult trading and financing conditions for customers, contractors and suppliers of materials and/or services to the group.
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The group closely monitors its liquidity headroom within the parameters approved by the board, the impact of trends in inflation or deflation on its capital position as well as the potential impact of wider changes in the credit markets. Where possible, the group has sought to issue debt linked to RPI to minimise the extent of its exposure to deflationary (or low inflationary) conditions. The group also monitors the financial position of its key contractors and suppliers and seeks to use its procurement processes to ensure that alternative suppliers can be sourced quickly and, where possible, on similar terms. |
Pension scheme obligations
The group participates in a number of pension arrangements, predominantly in the UK. The principal schemes are defined benefit schemes, although these have been closed to new employees since October 2006. The assets of these schemes are held in trust funds independent of group finances, with the funds being well diversified and professionally managed. Reflecting the global economic environment, the group’s current schemes had a combined IAS 19 deficit of £213 million as at 31 March 2009, compared with a deficit of £101 million as at 31 March 2008 and a deficit of £253 million as at 30 September 2008.
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Increases to pension deficits may result in an increased liability for the group, the size of which depends upon the extent to which additional deficits are recoverable through the regulatory price determination process. The regulated business is in ongoing dialogue with Ofwat concerning the allowances for increased pension scheme deficits within the price determination process for the 2010-2015 period. The group monitors the scheme’s investment strategy implementation and assesses changes in the group’s exposure to liability. |
Failure to comply with applicable law or regulations
The group is subject to various laws and regulations in the UK and internationally. Regulatory authorities may from time to time make enquiries of companies within their jurisdiction regarding compliance with regulations governing their operations. In addition to regulatory compliance proceedings, the group could become involved in a range of third party proceedings relating to land use, environmental protection and water quality. Amongst others, these may include civil actions by third parties for infringement of rights or nuisance claims relating to odour or other matters. Furthermore, the impact of future changes in laws or regulations or the introduction of new laws or regulations that affect the business cannot always be predicted and, from time to time, interpretation of existing laws or regulations may also change or the approach to their enforcement may become more rigorous. If the group fails to comply with applicable law or regulations, in particular in relation to its water and wastewater licences, or has not successfully undertaken corrective action, regulatory action could be taken that could include the imposition of a financial penalty (of up to 10 per cent of relevant regulated turnover) or the imposition of an enforcement order requiring the group to incur additional capital or operating expenditure to remedy its non-compliance. In the most extreme cases, non-compliance may lead to revocation of a licence or the appointment of a special administrator.
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The group endeavours to comply with all legal requirements in accordance with its business principles and robust processes are in place to seek to mitigate against non-compliance. The regulated business is certified to both ISO 9001 and 14001 standards and the group continually monitors legislative and regulatory developments and, where appropriate, participates in consultations to seek to influence their outcome, either directly or through industry trade associations for wider issues. The group seeks appropriate funding for any additional compliance costs in the regulated business as part of the price determination process.
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Increased competition in the water and wastewater industry
The Cave review of competition and innovation in water markets was published in April 2009. If its recommendations are implemented, this would eventually expand the competitive market allowing retail competition to all non-household customers. Ofwat has also taken steps to introduce competition into the water supply market through inset appointments and the water licensing supply regime. Prior to 2007 (with one exception), inset appointees had all been granted to existing regulated companies. Since 2007, Ofwat has granted more inset appointments, two of which are within UUW’s region. Further inset appointments may be made in the future, resulting in increased competition.
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The group has been fully engaged in the Ofwat consultations on the Cave review, although a relatively small proportion of the group’s profits derives directly from non-household retail activities. If competition is expanded, there would be opportunities for the group to participate in a wider market in England and Wales. As far as inset appointments are concerned, these generally relate to new developments or large industrial customers. Furthermore, the regulated business has not received any applications from holders of water supply licences to supply any premises within its region.
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Events, service interruptions, systems failures, water shortages or contamination of water supplies
The group controls and operates utility networks and maintains the associated assets with the objective of providing a continuous service. In exceptional circumstances, electricity, gas or water shortages or the failure of an asset, an element of a network or supporting plant and equipment could result in the interruption of service provision or catastrophic damage resulting in significant loss of life and/or environmental damage and/or economic and social disruption. The group could be fined for breaches of statutory obligations or held liable to third parties, or be required to provide an alternative water supply of equivalent quality, which could increase costs. The group is also dependent on the ability to access, utilise and communicate remotely via electronic software applications mounted upon corporate information technology hardware and communicating through internal and external networks. The ownership, maintenance and recovery of such applications, hardware and networks are not wholly under its control.
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The group operates long-standing, well tested and appropriately resourced incident response and escalation procedures. The processes continue to be refined, together with risk management and business continuity procedures, recognising that possible events have varying impacts and likelihoods. While the group seeks to ensure that it has appropriate processes in place, there can be no certainty that such measures will be effective in preventing or, when necessary, managing large-scale incidents to the satisfaction of customers, regulators, government and the wider stakeholder community. The group also maintains insurance cover in relation to losses and liabilities likely to be associated with such significant risks, although potential liabilities arising from a catastrophic event could exceed the maximum level of insurance cover that can be obtained cost effectively. The regulated business’s licence also contains a ‘shipwreck’ clause that, if applicable, may offer a degree of recourse to Ofwat in the event of a major incident.
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Risks in the group’s non-regulated business
Outside the regulated business, the group provides services relating to the operation and management of assets for other utility clients in the UK and overseas. These services include the maintenance and operation of electricity, gas and water networks, the design and construction of new assets, the design and construction of new connections to the relevant network and the provision of ancillary services. The delivery of contracts, both existing and future, will be achieved by exploiting the group’s core infrastructure management skills and may also require capital expenditure. The overstretching of such skills could lead to a loss of customers or the inability to meet contractual commitments, or to the incurrence of penalties.
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The costs and risks associated with these new projects are subject to internal reviews before approval is given to commit to them. The group aims to comply with its contractual commitments or operating performance targets and any requirements to maintain service continuity or achieve specified operating efficiencies in relation to those clients. Within the non-regulated business, the focus is on deploying the group’s core skills on an asset-light basis, whilst continually monitoring contract performance, together with programme and project management. |
Material litigation
NOSS Consortium (NOSS), of which North West Water International Limited, a wholly owned subsidiary of United Utilities Group PLC, is a member and the sole remaining active participant, is party to arbitration proceedings in Thailand in relation to a design and construction contract dated 1 November 1993 between NOSS and the Bangkok Metropolitan Administration (BMA) to build a wastewater treatment plant and network in central Bangkok. Following disagreements with the engineer (Dorsch Consult) and disputes with the BMA, NOSS terminated the contract with the BMA and served a notice of arbitration. NOSS has total claims against the BMA of approximately six billion baht. The BMA has counter claimed for approximately three billion baht; however, based upon the facts and matters currently known, the counterclaim appears to lack substance. Although there have been some delays in the arbitral process, the arbitration now appears set to proceed.
In February 2009 the group was served with notice of a multi-party ‘class action’ in Argentina into which United Utilities International Limited (UUIL) was enjoined in 2007. The class action is related to the issuance and payment default of a US$230 million bond by Inversora Eléctrica de Buenos Aires S.A. (IEBA), an Argentine project company set up to purchase one of the Argentine electricity distribution networks, which was privatised in 1997. UUIL had a 45 per cent shareholding in IEBA which it sold in 2005. The class action is being pursued against various parties, including the original direct and indirect shareholders of IEBA, the banks which advised IEBA and the rating agencies of the bonds. The bonds, which were issued in 1997, were defaulted in March 2002 and IEBA entered an insolvency process in 2003. The claim is for a non-quantified amount of unspecified damages, and purports to be pursued on behalf of unidentified consumer bondholders in IEBA who allegedly lost money. UUIL has filed a defence to the action and will vigorously resist the proceedings, given the robust defences that UUIL has been advised that it has on procedural and substantive grounds.
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The group faces the general risk of litigation in connection with its businesses. In most cases, liability for litigation is difficult to assess or quantify; recovery may be sought for very large and/or indeterminate amounts and the existence and magnitude of liability may remain unknown for substantial periods of time. The group robustly defends litigation where appropriate and seeks to minimise its exposure to such claims by early identification of risks and compliance with its legal and other obligations. Based upon the facts and matters currently known and the provisions carried in the group’s balance sheet, the directors are of the opinion that the possibility of the disputes referred to in this risk section having a material adverse effect on the group’s financial position is remote. |