RCV Indexation: real term price effects

The objective of this work is to provide supporting evidence to assist our decision on whether to move away from RPI to an alternative form of indexation for the RCV and revenue controls for future price control periods. There are a number of potential arguments supporting a shift from RPI to CPI:

• CPI is gaining legitimacy as an alternative indexation measure to RPI. In fact, while the 2015 Johnson review suggested that ‘no taxes, benefits or regulated prices should be linked to the RPI’ and that the ONS shall request regulators to justify why they continue to use RPI in price controls, a number of other regulators and public bodies have already moved to CPI indexation for at least part of their controls (CAA, Ofcom, DECC and WICS);

• A move to CPI could lower the overall long-term risk placed on customers since CPI is less volatile;

• CPI could be more closely correlated with movements in water companies underlying costs (excluding financing costs);

• The (financeability) mismatch between a real cash inflow and mostly nominal outflows may be reduced if we were to move to CPI; and

• There may also be additional drawbacks associated with a shift to CPI. One of the most important of these is likely to be the potential increase on customer bills from the increase in the real cost of capital, although we consider that this can be mitigated through the use of PAYG levers. However we consider that there are a number of other potential costs from moving to CPI indexation that should also be taken into account:

o The lower availability and potentially higher costs associated with obtaining CPI rather than RPI linked debt; o Costs associated with a mismatch between existing RPI instruments and CPI indexation of RCV and revenues; o Potential increased scope for error in estimating the real risk-free rate.

We consider that the work will need to address the following overarching questions:

1. What are the quantitative benefits and costs of moving from RPI to CPI indexation? 2. How might these benefits and cost change in the future? 3. What transition mechanisms could we use to maximise the benefits and minimise the costs of moving from RPI to CPI indexation? 4. How best should we transition the impact of a move to CPI in order to protect customer bills?