Advice on Alternative Approaches to Setting the Cost of Debt at PR19

This work will be used by both Ofwat and the CAA

The primary purpose of this work will be to undertake a fundamental review of the potential approaches to setting the cost of debt and advise on the principles we should consider when determining the most appropriate approach. The work should provide supporting evidence to assist our decision on the most appropriate approach to setting the cost of debt at PR19 and H7, while reflecting the need to ensure that at its heart the selected approach delivers the best outcome for customers.

The work will draw on market evidence and include an assessment of the relative merits for customers and investors of adopting alternative approaches to setting the cost of debt, including a fixed cost of debt, indexation methodologies and alternative risk sharing approaches.

The work will consider:

• Who bears the risk associated with different approaches to setting the cost of debt • How and when financial outperformance could and should be shared • The principles we should apply in reaching our view on the appropriate approach to the cost of debt.

It will be important to draw out whether these principles differ if there is a move to a longer price control or to fixing elements of the price control over several periods, or there is a step change in the size of the regulated asset (eg For the CAA new runway capacity).

In carrying out the work, the contractor will have regard to recommendations set down by the NAO and the subsequent report by the PAC. In particular, we expect the contractor will:

• Articulate the issues to be investigated, including the link to systematic risk and possible linkages to market to asset ratios • Set out the approaches to assessing the cost of debt that have been used in regulated sectors and the drivers for considering alternative approaches, including the extent to which interest rate risk is predictable • Consider the scope for financial out- and under-performance on the cost of debt against other areas of the price setting package • Using available evidence (including market evidence about the future cost of debt), consider the relative merits of alternative approaches to setting the cost of debt.

This should consider, but not be limited to:

o Fixed cost of debt approach (which may include a fixed cost for all or some debt) o Indexation methodologies (such as adopted by Ofgem) o Risk mitigating approaches (such as the Thames Tideway) o Benchmarking approaches (such as upper quartile or average, by reference to benchmarks both within and outside the sector and any other approaches) o Pain/gain sharing approaches (taking account of the delta between actual and allowed debt costs akin to totex).