Water sector regulator Ofwat says allowed return on capital was "generous to companies" in the 2014 Price Review for the AMP6 2015-2020 investment programme.

PR14 aimed to better align investor and management risk and return with customers, with operational performance having a greater impact on returns and financing performance a lesser impact. The review found evidence that Ofwat’s approach succeeded in aligning returns with operational performance.

However, Ofwat admits:

“In hindsight however, the PR14 allowed return on capital was generous to companies. Assumptions on the cost of debt and the cost of equity both contributed to this.”

The comments come in a newly –published detailed 113 page review paper presenting Ofwat’s findings on the impact the 2014 price review (PR14) had on the sector during the 2015-20 period.

Introducing the paper, Ofwat said that PR14 had marked a new approach to the process in the water sector and that the review, in particular, would help it to improve the design of future price reviews, including the 2024 price review, PR24.

The report is focused on five key areas of change at PR14:

• the introduction of the outcomes framework and Outcome Delivery Incentives (ODIs), which helped focus on delivery for customers;
• the approach to securing value for money for customers, including the introduction of ‘totex’ approach;
• the approach to the balance of risk and return;
• the approach to sustainable use of water resources; and
• the creation of separate targeted wholesale and retail controls.

Commenting on the focus on delivery for customers, the review suggests the outcomes regime did have a significant impact on the way companies were managed and significantly heightened their focus on customers. “However, it takes time to embed these changes, and the full effects may not have materialised over the 2015-20 period,” the report says.

Totex approach may take time to bed in - full impact may not be seen for several price controls

One of the key changes at PR14 was the move from an approach where capital expenditure (capex) and operating expenditure (opex) were assessed separately, to total expenditure (totex) wholesale cost allowance approach.

The review says the totex framework gave companies more flexibility to choose the best way to provide outcomes for consumers. This helped increase value for money, as it reduced incentives to opt for potentially less efficient capex-based solutions.

However, Ofwat says there was recognition among the stakeholders it engaged with that “the totex approach may take time to bed in, and the full impact may not be seen for several price controls.”

They also said that while totex was often discussed with supply chain as a key driver of change resulting from regulation, it was then not translated down to project or procurement level.

The regulator also received feedback that during the 2015-20 period, tenders were” still very much price led, with the main focus being low risk, low cost to deliver.” The review paper states:

“We were told that outcomes and ODIs were often ‘buzz words’ that were talked about during the procurement process, but companies were not always clear on what they wanted or did not actually use them in tender evaluation criteria. This reduced the incentives on the supply chain to develop innovative solutions specifically focused on ODI performance.”

PR14 allowed return on capital above the return required by companies and their investors

PR14 aimed to better align investor and management risk and return with customers, with operational performance having a greater impact on returns and financing performance a lesser impact. The review found evidence that Ofwat’s approach had succeeded in aligning returns with operational performance.

However, Ofwat admits:

“In hindsight however, the PR14 allowed return on capital was generous to companies. Assumptions on the cost of debt and the cost of equity both contributed to this…”

“In hindsight, the PR14 allowed return on capital was above the return required by companies and their investors. This is primarily due to interest rates being lower than expected at PR14 final determinations and outperformance by most companies on the allowed cost of debt. In line with regulatory practice that was commonplace at the time, we used a long trail of historical data to inform certain cost of capital inputs, resulting in allowances which did not anticipate the environment of low and falling finance costs that characterised 2015-20.”

The review also concludes that while some highly-geared companies had already improved their financial resilience by reducing gearing and others plan to do so, a number of actions Ofwat took over the period “may have encouraged them to do this.”

Targeted incentives did not deliver material short-term improvements during 2015-20

Commenting on the introduction of targeted incentives by the regulator to encourage increases in water trading, the review says that this did not deliver material short-term improvements during the 2015-20 period.

However, Ofwat explains that “it can take many years to identify viable water trades, so the full impact of this incentive, which has been maintained in PR19, may not have played out within the 2015-20 period.”

“There could have been greater focus on asset health and its role in delivering resilient services”

Ofwat’s intention with the PR14 outcomes framework and totex approach was to encourage a long-term focus on asset health, using short-term incentives as a stepping stone.

However, many water companies told Ofwat that, although they set out longer-term strategic contexts in their business plans, they tended to focus on short-term delivery – where incentives were clear – at the expense of longer-term objectives.

In particular, some companies said that they delayed spend on capital maintenance in order to focus on delivering against specific PCs by the end of the 2015-20 period. Ofwat comments in the review:

“As companies no longer had to report against set asset health metrics as they had at previous price reviews, we had less visibility of companies’ overall asset health performance..”

“…we consider that work conducted by Ofwat, including on PR19, the targeted review of asset health and the asset management maturity assessment (AMMA), has highlighted that there could have been greater focus on asset health and its role in delivering resilient services in the long-term during the 2015-20 period.”

“PR14 was a learning experience for Ofwat . ..we will continue to consider the impact in PR24”

Acccording to Ofwat, although there is already much that can be learnt about PR14, “the impact of the new framework is unlikely to have fully played out”.

The totex framework facilitated a cultural shift towards more consideration of whole life cost, and flexibility and innovation in solutions that may not have been considered under a capex / opex regime.

However, Ofwat describes this as “a journey that may take time to fully embed in companies and supply chains, and the full impact of opportunities for more balanced capex/opex solutions may not be seen for several price controls.”

The review states:

“It can take time for the industry to introduce new ways of working that reflect the new incentives we provided. … PR14 was also a learning experience for Ofwat, and we have already reflected some of this learning in PR19 and will continue to consider the impact in PR24.”

Click here to download the PR19 Review Paper in full