Ofwat has launched an informal consultation on its proposal to modify licence fees paid by water companies which are currently capped – the regulator’s aim is to ensure that the budget agreed with HM Treasury as part of the 2021 Comprehensive Spending Review (CSR) can be funded and to future-proof the fee cap.

Ofwat is mainly funded by licence fees paid by the companies and there is a cap on the level of the fees contained in the water companies’ licences. Ofwat has now set out proposed changes to the regulation fee cap formula in Condition N of the licences, on the grounds that it has become outdated because the formula only assumes inflation adjustments to historical budgets, rather than specific adjustments for new projects or regulatory activities.

“The issue in relation to the wording of the existing licence condition fee cap is the underlying assumption that the future looks very much like the past,” the consultation paper states.

The cap includes two elements and, in summary, means that the total amount of all Annual General Fees and Special Fees payable by water companies in a five-year period cannot exceed:

• a fixed amount based on historical costs for each year that increases in line with inflation (CPIH has been used as the relevant measure since 2020); and
• a percentage of each water company's average annual regulated business turnover in the prior five-year period

Ofwat explained that in recent years it has taken on additional regulatory functions that have been subject to business case justification though the CSR process based on the outcomes and benefits it is delivering for customers, society and the environment.

Examples include:

• Ofwat’s work in the business retail market
• delivering Direct Procurement for Customers (DPC)
• establishing the regulator’s Wales office
• expanding its role in relation to the environment
• establishing the Regulators’ Alliance for Progressing Infrastructure Development (RAPID) to enable longer term infrastructure schemes to be progressed faster

While Ofwat has secured agreement for budget increases to fund this additional work, the regulator’s budget remains flat in nominal terms, which means Ofwat is required to absorb increases due to inflation through efficiency gains. “We note that this will be more challenging with increasing inflation rates”, the consultation paper says.

It states:

“Despite our core regulatory budget reducing in real terms and delivering efficiencies if we did not modify the existing cap, we would not be able to set the budget at the level agreed with Government through the CSR and deliver on the additional work the cap does not reflect – in relation to RAPID, DPC and the environment which impact residents of England and Wales.

“The cap as set out in condition N currently is forecast to be £17m less over the 2020-25 period across the industry, than that agreed with HMT. This equates to the cost of RAPID, environment and DPC work we are undertaking. We would also be constrained in our ability to fund the full costs of a price review for England and Wales in the final year of the current price control and CSR periods (2024/25).”

The regulator said it is therefore consulting on proposed changes to the regulation fee cap to ensure that the budget already agreed with HM Treasury can be funded and to future-proof the fee cap.

Ofwat is seeking comment on the following questions:

• Do you agree with the principle of changing the regulation fee cap to ensure that the budget agreed with the Treasury can be funded?
• Do you agree with the option for changing the regulation fee cap that Ofwat proposes and, if not, which alternative option would you prefer if the regulation fee cap is changed?
• Do you have any comments on the draft wording for the proposed new regulation fee cap ?

Deadline to submit responses to the consultation is 12 July 2022 – click here to access the consultation document.