Water UK, the body which represents the UK water and wastewater companies, has flagged up a number of concerns and suggested alternative approaches to Ofwat’s initial views on the framework for PR24 and future price reviews.

In a detailed response to the regulator’s consultation on the upcoming Price Review in 2024, Water UK said that while Ofwat’s document was positioned as being about ‘PR24 and beyond’, the overwhelming focus was on the framework for PR24.

While the overall ‘building block’ approach based on outcomes, costs and risk and return should be maintained, Water UK strongly supported the underlying premise that five-year price reviews should be “staging posts within a long-term context, rather than seen in isolation.”

Greater clarity about the long-term direction of regulation and the enduring principles that will apply over successive price reviews was needed “to enable an evolution from discrete five-yearly price reviews to price reviews that are coherent staging posts towards long-term outcomes. This is particularly important because of the long-term nature of the sector and its investors.”

Water UK pointed out that substantial investment would be needed not just at PR24 but in subsequent regulatory periods, commenting:

“Given that long-term investors value stability and predictability, this will not only require the sector to continue to be seen as an investable proposition, with a reasonable prospect of an appropriate balance of risk and returns, but also one with a clear and predictable long-term regulatory framework.”

Ofwat should commit to incorporating CMA redetermination decisions in future price reviews

Water UK is also calling on Ofwat to commit to incorporating in future price reviews decisions made in redeterminations, such as “reflecting the Competition and Markets Authority (CMA) position that “financeability is as a matter of principle best addressed by setting the WACC at a reasonable level.”

“We look forward to Ofwat’s acceptance of the broader principle that the appropriate way to address financeability constraints is by setting an appropriate WACC - rather than, as Ofwat has suggested in the consultation, artificially adjusting parameters used in the calculation of WACC such as assumptions on gearing or index-linked debt,” the response says.

The trade body warned that Ofwat’s changes in the notional structure would “move it further from a sensible basis consistent with observed sector performance or indeed capital structures observed in competitive environments.” It would also be unlikely to be seen by investors as being consistent with “stable, predictable and evidence-based regulation.”

Decisive shift needed across whole sector to outcomes-based approach

Water UK said a decisive shift was needed across the whole sector to a genuinely outcomes-based approach, with a regulatory framework that supported and incentivised catchment and nature-based solutions. The shift would need to recognise the different risk and cost profile of catchment and nature-based schemes compared to traditional capital schemes, without which “the tensions between competing pressures at PR24 may be hard to reconcile.”

In the context of net zero, Water UK agreed with Ofwat that ‘seeking opportunities to reduce carbon may reveal opportunities for reducing cost and increasing environmental benefits via nature-based solutions’.

However, Water UK warned that PR24 “should not be predicated on the assumption that nature-based solutions are currently enabled ‘in practice’ by environmental frameworks across England and Wales.”

“Significant regulatory transformation (by both environmental and economic regulators) will be needed to support a step-change in the approval of nature-based schemes,” the response says.

“Rigorous, evidence-based regulatory impact assessment” needed for each of Ofwat’s specific proposals

In Water UK’s view, “converting high-level ambitions into tangible reality” will require incorporating fresh thinking and ensuring that “every detailed element of the price review, including those of the changes proposed by Ofwat that are ultimately taken forward after further consideration”, are integrated and consistent with the overarching ambitions.

This should include a rigorous, evidence-based regulatory impact assessment of whether each of the specific proposals for change put forward by Ofwat:

• materially assists in meeting long-term ambitions
• has a more marginal impact
• or risks unnecessarily increasing regulatory burdens or distracting the focus and attention of the sector away from those long-term ambitions

According to the trade body, carrying out such a regulatory impact assessment would enable a prioritised set of changes to be identified, which would also build confidence in the deliverability of changes at PR24 to a demanding timetable.

Concerns over proposals for centralised customer research for PR24

Water UK also expressed some concerns over the potential adverse impacts of Ofwat’s proposals to conduct customer research on a centralised basis, saying it would be critical that “any centralised research does not undermine or dilute the companies’ own relationships with their customers and the ownership of those relationships. “

It was important that all companies had the option to be fully involved in the development of any centralised customer research, the response says. The results of any research - whether carried out centrally or by individual companies- should also be considered on their merits, “rather than results being artificially weighted depending on which organisation has carried out the research.”

Early evidence-based pre-business plan guidance by summer 2022 from Ofwat “essential”

Noting Ofwat’s view that providing early guidance on some aspects of the price review process could streamline the process and enable greater focus on longer term issues, Water UK said:

“It will be essential that there is early clarity on the detailed scope of pre-business plan guidance from Ofwat, and that this early guidance is evidence-based and provided sufficiently far in advance of business plan submission …for companies to be able to take it into account in developing their plans.”

The response says the guidance needs to be provided no later than the summer of 2022, well in advance of business plan submissions, and the timing, scope and delivery of centralised customer research will need particular care to align with those timelines also.

“Given the importance of individual companies, and their Boards, owning their business plans, and the importance of there being a clear line of sight from customer views to those plans, it will be crucial for all companies have visibility of, and the option of directly contributing to, all aspects of the design of any centralised research.”

Water UK cautioned that if companies lacked confidence in the results of the research because they were insufficiently able to participate in assuring its appropriateness and design, then “it may be difficult for companies and their Boards to take ownership of the results and use them as the foundations of business plan proposals.”

“Centralised approach ..increases delivery risk for overall price review process by introducing a potential single point of failure”

Water UK also warned:

“We also note that this centralised approach makes the development of every company’s business plan contingent on the timely and complete provision of guidance from Ofwat, inevitably increasing delivery risk for the overall price review process by introducing a potential single point of failure.”

Commenting on Ofwat’s proposal to establish a ‘PR24 Challenge Panel’, Water UK said it was “somewhat unclear what purpose this would serve”. It also appeared to be inconsistent with Ofwat’s statement that ‘it is the role of the water companies to seek challenge to their plans from other regulators and stakeholders in advance of submission’.

The trade body is asking for early clarity on Ofwat’s thinking both in terms of any panel’s substantive contribution to the price review and on how the regulator would see it fitting into the process and timeline.

Financeability - sector must seen as “investable proposition with reasonable prospect of an appropriate balance of risk and returns”

On financeability, Water UK said the sector needed to be seen as “an investable proposition, with a reasonable prospect of an appropriate balance of risk and returns.”

This was particularly important in light of the “substantial investment” that would be needed in subsequent regulatory periods to meet the challenges of climate change and growth.

Financeability provided an important cross-check on the choice of the cost of capital and the overall balance of risk and return in the price control. The response says:

“As the CMA reflected in their redetermination, as a matter of principle, if the WACC is set at a reasonable level, both debt and equity investors should earn sufficient returns to cover the costs of financing.”

“In this context, we welcome Ofwat’s recognition of the CMA’s rejection of the specific alternative approach Ofwat took to financeability at PR19 (advancing future cashflows), and look forward to Ofwat’s acceptance of the broader point made by the CMA that the appropriate way to address financeability constraints is by setting an appropriate WACC - rather than, as Ofwat has suggested in the consultation, artificially adjusting parameters used in the calculation of WACC such as assumptions on gearing or index-linked debt.”

Water UK also draws attention to the PR14 and PR19 approach of setting base total expenditure (botex) allowances with reference to expenditures incurred historically by lower-spending companies. According to the trade body, this has had the effect of locking in a slightly declining trend in capital maintenance activity over multiple AMPs – “as seen in the significantly lower volumes of maintenance that companies do now in comparison to 20 years ago”.

The response says:

“We recognise that this is not a conscious decision on the part of Ofwat, based on its assessment of underlying engineering needs. Rather, it is a consequence a wholly backward-looking, benchmarking-led approach to setting base expenditure allowances having been adopted, where the expenditure of lower spending companies effectively drives the sector budget.”

Case for rebasing of activity levels

The response says that while on the face of it, the current approach may not be disadvantaging current customers in terms of measured outcomes, asset health and bills, Water UK goes on to argue the case for a rebasing of activity levels.

“There is not currently a crisis of under-performance (or over-spending). There is nevertheless a strongly held view across companies that the prevailing levels of and the trend in capital maintenance activity within the sector are sub-optimal.”

The trade body warns that:

• current low replacement rates mean that the average age of the industry’s asset base is increasing and, therefore, the average remaining life is decreasing, with implications for asset condition
• this is happening at a time when the demands that companies are having to meet in relation to service, environmental outcomes, climate change and resilience are increasing

“Even if companies are able to manage for the time being with low capital maintenance levels, the view is that this is at the expense of increasing levels of risk… The concern is that this will eventually come to a head and future generations of consumers will suffer service failures and/or have to pay the bill for higher maintenance expenditure.”

“In essence, everyone, including Ofwat, will unavoidably need to make a choice at PR24.”

Funding capital maintenance and maintaining asset health is key area needing “fresh thinking and fresh approach”

Water UK suggest that to avoid the risks, PR24 should be a review in which there is a consensus amongst companies, customers and the regulator that there should be “latitude in the approach” to setting the portion of botex allowances that relates to capital maintenance.

The response highlights funding capital maintenance and maintaining asset health as one of the key areas where, in the interests of current and future customers, there is a need for fresh thinking and a fresh approach.

Welcoming “Ofwat’s keenness to build at PR24 on the PR19 approach by taking into account a forward-looking element”, Water UK said this should recognise that forward-looking maintenance requirements might be different from historical levels of activity. In particular, there should be a degree of flexibility within the business plan framework for companies to increase the amount of funded maintenance activity that they do starting from 2025/26.

“Companies consider… that capital maintenance ought to be marked out clearly as a special case within the PR24 methodology”, Water UK said.

Ofwat will need to signal in advance acceptance that “direction of travel ought to be towards higher capital maintenance activity”

Image Source Ofwat: Draft PR24 Timetable: 

Ofwat would also need to signal in advance that it accepted that “the direction of travel ought to be towards higher capital maintenance activity.” The process for approving capital maintenance plans would therefore “be separate and materially different from the standard cost adjustment framework, consistent with a mutual understanding that there is – at industry level and in general terms – a need for higher maintenance spend.”

However, the response says that the water companies understand that regulatory recognition that the future is likely to be different from the past and acceptance of a need for forward-looking approaches to capital maintenance was bound to mean that any additional funding they receive “cannot be a blank cheque.”

Water UK acknowledged that it would be “untenable, in particular, for incremental allowances for additional maintenance activity, if not spent in full, to translate into shareholder profits.”

However, the over-arching regulatory philosophy at the moment is primarily focused on outcomes, the response says i.e. a company that is able to deliver performance commitments at lower-than-anticipated expenditure gets to keep up to half of its underspend.

In contrast, the appropriate risk allocation for capital maintenance would ideally see companies:

• do the work they said they would undertake or otherwise return to customers any monies associated with lower-than-anticipated volumes of work;
• still face incentives to deliver maintenance work efficiently.

Ofwat is planning to publish the PR24 draft methodology in summer 2022, with a proposed business plan submission date of 2 October 2023. Final determinations for all the water companies will be made in December 2024.

Click here to download Water UK's response to OFwat's PR24 Consultation in full