At the Periodic Review 1999, Ofwat concluded that a gearing level of 45–55% would represent an appropriate capital structure for a water company over AMP3. However, there exists a perception amongst a proportion of the UK financial community that financial restructuring with the replacement of equity by debt, or “gearing up,” can significantly reduce the cost of capital for UK water companies. It is important to understand clearly whether the cost of capital can be reduced by gearing up above this level and whether prices at future Periodic Reviews should be based on a more highly leveraged capital structure.

In this paper, sponsored by Water UK, NERA examines theoretical and empirical evidence of the relationship between gearing up and the costs of equity and debt for UK water companies, taking into account factors such as the ability of UK water companies to benefit from corporate tax shields, the importance of personal taxes, non-tax costs such as capital allowances, and market evidence on liquidity premiums in debt markets.

The author’s prime conclusion is a simple one: even if typical gearing levels in the industry rise from around 50% to 75% by the time of the next Periodic Review, the effect of higher gearing on the variability of equity returns and on the cost of debt would imply that any reduction in the pre tax cost of capital caused by higher levels of gearing would be, at most, marginal.