Ofwat’s price cap regime does not balance risks appropriately between companies and consumers and is “not yet achieving the value for money that it should”, with customers failing to benefit from at least £800 million in net windfall gains between 2010 and 2015, according to a new report from the National Audit Office (NAO).

The Economic Regulation of the Water Sector report published this morning assesses outcomes in the water sector up to 2015 and comments on Ofwat’s approach in its price control for the period 2015 to 2020.

The report says the regulatory framework for the water industry has contributed to major improvements in water quality. Customers, however, have not always benefited enough from gains due to factors outside the industry’s control.

According to the NAO, the water companies in England and Wales have benefitted to the tune of at least £800 million from net windfall gains between 2010 and 2015. The report says that while the companies absorbed costs and provided water bill discounts worth up to £435 million over the period, they gained around £410 million from lower than expected corporation tax rates and £840 million from lower than expected interest rates. However, they could have made a loss if interest and tax rates were higher than expected.

Under Ofgem price control approach customer bills would have been £840m lower in AMP5

The public spending watchdog says that when setting price limits for 2010 to 2015, if Ofwat had used the indexation approach taken by energy regulator Ofgem in 2013-14 for its 8-year price controls, total customer bills would have been £840 million lower between 2010 and 2015. Conversely, under Ofgem’s approach customers could have faced higher bills if interest rates had risen above their long-term average.

Meg Hillier MP, Chair of the Committee of Public Accounts said:

“Most taxpayers rely on the regulator, Ofwat, to ensure they get a good deal from the monopolies which supply them. …Yet Ofwat’s approach to setting prices has meant that customers largely lost out on sharing in £1.2 billion of windfall gains the sector made over the last five years.”

“….more work is clearly needed to ensure customers share in savings made by water companies and there may be lessons which can be learnt from regulators in other highly regulated industries.”

Ofwat should increase the pass-through to customers of costs or benefits which are outside companies’ control

For the 2019 price review, the NAO wants Ofwat to increase the pass-through to customers of costs or benefits which are outside companies’ control and carry out a full assessment of likely impacts, including:

• potential gains to customers through lower prices and to companies through reduced risk  
• potential costs of inefficient financial structures.

The report says Ofwat should also use evidence from energy distribution and transmission companies to analyse results under Ofgem’s different approach.

The report says that cuts in corporation tax rates after the price limits were set meant that regulated companies paid up to £410 million less in tax than Ofwat had assumed:

“ This combined with other factors, such as regulated companies offsetting taxable profits with unpaid-for losses from holding companies, to lead to an overall gap of at least £710 million between actual tax payments and Ofwat’s assumptions. Ofwat only shares the benefits of lower than expected tax payments with customers if the change is due to a financial restructuring of the regulated water company.”

Since privatisation in 1989 most measures of service quality have improved markedly

Overall, the NAO found that since privatisation in 1989, most measures of service quality have improved markedly, including the quality of the UK’s drinking and bathing water. Unlike other member states, the UK has to date not had to pay fines for failing to comply with EU water directives.

However, customer bills have increased to pay for the improvements - the average household bill for water and sewerage was £396 in 2014-15 – a 40% increase in real terms since privatisation, with most of the rise happening between 1990 and 1995.

And while bills have stabilised, they still represent an important component of household spending -  around 2.3% in 2013, rising to over 5% for the poorest households.

Reduced scope places pressure on Ofwat’s approach to costing

The NAO acknowledges that Ofwat’s approach has encouraged greater company efficiency, resulting in lower customer bills, but points out that the rate of saving is now smaller than in earlier years. Ofwat expected £39 of new efficiency savings from the average household’s annual bill between 1995 and 2000, but this fell to £11 annually for the period 2010 to 2015. The report says that the reduced scope for efficiency gains from comparative regulation places pressure on Ofwat’s approach to costing, commenting:

“Ofwat does not currently analyse in detail how much the different elements that make up water and wastewater services should cost if delivered efficiently. This means that its approach to cost benchmarking does not provide full confidence that leading companies are as efficient as possible.”

The report also says that while Ofwat has sought to improve company governance since 2013, it could do more to understand the corporate and financial resilience of the sector to external shocks.

Amyas Morse, head of the National Audit Office, said today:

“Since privatisation, Ofwat and Defra have overseen major improvements in water quality and service quality. Ofwat’s 2014 price review committed companies to improving services further over the next five years while cutting customer bills, increasing value for money for consumers.”

 “Customers, however, have not seen enough of the benefits of companies’ unexpected financial gains from factors such as falls in corporation tax rates. Ofwat made significant improvements in 2014, but its price cap regime is not yet achieving the value for money that it should.”

Financial resilience - regulatory framework has helped to establish a favourable climate 

On Ofwat’s role in promoting financial resilience in the sector, the regulatory framework has helped to establish a favourable climate for financing, benefiting both companies and consumers, the report says. The water sector regulator has also established strong regulatory protections which reduce the likelihood of company financial failure and its impact on services if it does occur.

However, while Ofwat has taken important steps to help improve the resilience of water companies, much of its systematic information-gathering takes place only at price reviews. The NAO says that Ofwat’s assumption that each company has the same financial structure means it may not reflect a company’s true financial resilience.

“Price cap regime does not balance risks appropriately between companies and consumers”

In its conclusion on value for money, the NAO says that Ofwat still needs to tackle important issues as it prepares for future price reviews, commenting:

“We consider that the price cap regime does not balance risks appropriately between companies and consumers, and so does not yet achieve the value for money that it should.”

Ofwat chief “surprised” at suggestion that price control regime does not yet achieve value for money

While welcoming the NAO report,  Cathryn Ross, Ofwat Chief Executive said she was surprised by the suggestion that price control regime does not yet achieve value for money, particularly given the evidence of strong delivery throughout the report and that she stood by Ofwat’s approach:

"The report is right to say that companies made significant unexpected gains during the 2010 - 2015 period. This is not new information:  Ofwat Chairman Jonson Cox challenged companies on this when he took the Chair in 2013. The gains were largely as a result of unexpectedly low borrowing costs following the severe global financial crash, high inflation and changes in tax rates during the 2010 to 2012 period.”

 "In looking at this the NAO also however acknowledge that the way Ofwat balanced risk between companies and customers shielded customers from increased financial risk which could have led to significant bill increases had rates increased. I stand by this approach, because it protected customers from a risk that we did not think they should bear and provided certainty about the cost of their water bills."

Cathryn Ross welcomed the NAO's clear recognition of the benefits already achieved, saying:

"It highlights that Ofwat has been constantly refining its approach to respond to a fast moving world of uncertainty, and its new regulatory framework will make the sector more resilient and accountable in future. “

Water UK: “unplanned or unexpected gains or losses will be taken into account at the next regulatory review”

Commenting on the report, Water UK, the body which represents all the UK water companies, said the price review had set a package of measures at a time of financial crisis and uncertain economic climate, making accurate forward projections extremely difficult and challenging, both for OFWAT and water companies.

The water companies had enjoyed lower than predicted costs of borrowing to finance the multi-billion pounds of investment projects during the period 2010-2015, enabling them to increase investment on customer priorities, not put up prices as much as they were allowed, while also increasing assistance to customers who were facing financial hardship.

Water UK commented:

“As part of accepting the regulatory package, water companies take the risk of costs rising, as well as falling, in the knowledge that unplanned or unexpected gains or losses will be taken into account at the next regulatory review.”

Click here to download the NAO Report in full