Ofwat has said it sees “big opportunities” in the upstream value chain, in particular for water resources and sludge, which are not being utilised right now - but is not convinced that "water companies always have the most efficient ways of doing things.”

Ofwat Chief Executive Cathryn Ross told attendees at  Moody’s UK Water Sector Conference yesterday that with new technology and changes in prices of related products, sludge is now an asset as a source of energy, saying that the water sector is now “teetering on the edge of a market for sludge.”

Cathryn Ross said that if the market were to develop it could reveal information on available capacity and costs and allow optimisation across company boundaries. It would enable companies to choose whether to invest in new sludge treatment capacity themselves or contract on a commercial basis with a third party. It would enable them to use their existing assets to take in sludge from other companies, bringing in revenue and possibly delivering economies of scale. It would also provide incentives with to maximise value from sludge, which would have environmental benefits.

 “The sludge market seems to us - and indeed to some of the companies who are at the cutting edge of sludge treatment - to have real potential for value creation.” Ross said.

Water trading other key area for value creation if better use is made of markets

Ofwat’s Chief Executive also flagged up water trading as another area where the regulator can see scope for value creation if better use is made of markets, drawing attention to the Environment Agency map showing water resource zones, with areas of scarcity right next to, or pretty close to, areas of abundance. However, while some form of interconnection was often seen between the zones within the boundary of a water company where that is the case, it was very rarely seen across companies’ boundaries.

According to Ross, while the move to totex in PR14 has helped to remove one barrier to trading created by the regulatory regime, the volume traded between companies has remained constantly low at about 4–5% of total supplies.  The companies’ PR14 business plans had also shown that only a small number of additional trades are planned over the next five years, despite:

• the identification by Ofwat  in March 2010 of about £1 billion of potential savings in England and Wales from more water trading compared with the proposals in companies’ draft WRMPs; and
• work by the Water Resources in the South East (WRSE) group published in May 2010 which identified £500 million of potential savings from sharing resources in the south-east of England alone.

Cathryn Ross said she did not however underestimate some of the challenges that would need to be dealt with to realise the opportunities through better use of markets. Ofwat would need to think carefully about what stays regulated and what can be deregulated - and the boundary between the two, together with how best to balance risk and reward and to share value that is created between investors, customers and the environment.

“ I am not convinced water companies always have the most efficient ways of doing things”

Commenting on the 2019 Price Review, Cathryn Ross told the audience:

“ I want to say now that if you thought PR14 was a challenging review, and you’re expecting an easier time of it in PR19, you need to think again.”

According to Ross, Ofwat has always seen PR14 as a transitional price review and always intended to build on it in subsequent reviews. PR14 had taken place against the backdrop of a massive reduction in the cost of capital.compared to PR09 when Ofwat set a cost of capital of 5.1pc.  PR14 saw a cost of capital of 3.74pc at the appointee level, while a 3.6pc wholesale cost of capital was the lowest ever for a regulated sector in the UK. She “wouldn't rule out a somewhat lower cost of capital in PR19” although not in the order of 2 percentage points lower again, commenting:

“Frankly, I think we could have gone slightly lower - I know some of you do too. The cost of capital accounts for roughly a third of the average bill. Ultimately, the effect of that massive drop in the cost of capital was that everyone could have more of everything. We got that more for less.”

Cathryn Ross then went on to question the level of effort delivered by the sector in PR14:

“But how hard did the companies have to work to deliver that? How hard did they have to challenge themselves to reduce the cost of actually running their businesses, to use scarce resources more efficiently, to innovate?”

“… I have to tell you that I am not convinced water companies always have the most efficient ways of doing things.”

The conference also heard that the water companies would “have a lot more to do on customer engagement” and that there was still too much emphasis on customer surveys in the context of business planning. According to Ross, there had not been enough evidence of companies really getting to know their customers and too many companies “not having the difficult conversations with customers.”

“I have heard members of company boards tell me that they will be under-investing in this control period because it was 'too difficult' to get 'customer support' for schemes for example where the effects were intergenerational. Not good enough. And not true”, she said.

Loss of legitimacy will put investability of the sector at risk

Ofwat’s Chief Executive also told the audience that the challenges the water sector faces at this moment are more complex and more dynamic that at any point since privatisation, saying it was imperative that sector is seen right now as being capable of delivering.

Ross warned that if it isn't it would lose legitimacy, commenting:

“And if vital public services like these lose legitimacy, it won't happen quietly. It will happen on the front pages of the newspapers, in the TV studios and in the Houses of Parliament. And if that happens, you don't need me to tell you, the investability of the sector will be at risk.”

Click here to read Cathryn Ross’s presentation in full