Water industry regulator Ofwat has launched what it describes as an informal consultation on Thames Water’s price limits for 2014-15 –which could potentially result in a decrease, rather than an increase, for customers’ bills.

The consultation sets out Ofwat’s initial thinking on whether it should make a further determination of what Thames Water’s can charge its customers during 2014-15. It is also separate from Thames Water’s recent request for an interim increase in prices due to cost pressures (including bad debt and private sewer transfer costs) which Ofwat has already challenged and which appears to have opened up a hornet's nest at Ofwat for the utility.

The regulatory framework provides the regulator with a mechanism to examine whether there has been a favourable effect for Thames Water because of factors that rest largely outside of its management’s control i.e. Ofwat can assess whether customer bills should be reduced rather than increased.

Ofwat is now inviting interested stakeholders to comment on the consultation as soon as possible – deadline is 7th November 2013.

Ofwat said that when it made its original decision in the 2009 Price Review with regard to the prices Thames Water could charge its customers during AMP5 its projections were made during a “particularly uncertain” macroeconomic environment.

Where particular identified expenditures are difficult to predict and manage efficiently, the existing regulatory framework in the water sector in England and Wales includes provisions for price limits potentially to be re-opened if the combined net effects of actual changes are assessed to be material enough. Crucially, it also allows Ofwat to claim back for customers certain, defined, costs that will no longer be incurred, according to the same criteria.

Thames Water's licence provides for two re-opening mechanisms for this purpose.

The standard interim determination mechanism (IDoK)

The regulator can trigger a review of price limits for specific items that have a total net material impact on the company of at least 10% of relevant turnover. Thames Water’s application to re-open its 2014-15 price limits through the IDoK was based on its view that relevant changes of circumstance (RCCs) had increased its costs (in net terms) by more than this 10% threshold.

A price review based on “substantial effects”

The materiality threshold for the trigger of a price review based on substantial effects is higher than for the standard interim determination mechanism, as the value of effects must be at least 20% of a company’s turnover.

The IDoK mechanism allows companies to request price limits to be re-opened to the extent that certain, defined, costs materialise that were uncertain or unknown at the time price limits were set (notified items), or so that costs associated with relevant changes of circumstance (RCCs) can be remunerated. Separately, Ofwat can also seek to re-open price limits unless intervening changes (beyond management control) have had ‘material’ financial effects; materiality thresholds which apply to both increases and reductions in costs and prices - which provides the basis of the new consultation. 

Thames Water’s IDoK application, which Ofwat has already challenged and is currently still assessing, said the company said has experienced changes to certain specific costs of which Ofwat did not take account when price limits were set in 2009. Its draft determination on the request also said it was now looking at whether Thames Water had benefited from economic circumstances beyond its control.

The consultation paper states:

“We are considering a substantial favourable effect determination as a targeted approach for Thames Water for its 2014-15 bills as it is the only company that has asked us to review its price limits in the current control period, because of intervening changes in its costs since current price limits were set."

"In the current price control period, we are aware of other companies that have taken a different approach and have not sought to change their price limits. These companies have clearly stated that there have been cost pressures – for example, as a result of changes to legislation, most notably the transfer of private sewers – and have also acknowledged that other aspects of the price limits, such as the cost of debt, have been far more beneficial than was envisaged."

"Other companies have publicly explained how they are sharing ‘gains’ with customers in the form of incremental investment programmes.”

In Ofwat’s view there are two areas where Thames Water may have benefited from circumstances that are beyond prudent management - additional revenues arising from the Retail Price Index and the favourable impact of monetary interventions by the Bank of England on market costs of capital. Ofwat is now considering whether the two factors combined have resulted in a significant financial benefit to Thames Water.

Ofwat said it will now continue to carry out its analysis in conjunction with the advice of its consultants had not reached a view on this issue at this stage. The regulator will reach a decision on whether the effects were likely to have been substantial after considering the responses to the consultation and the advice from PwC.

Under Thames Water’s licence, Ofwat normally has three months in which to reach a final decision, once the IDoK or substantial effect mechanism is triggered. However, Ofwat’s intention would be to make a decision on the substantial avourable effect by early 2014 in order for any adjustments to be included in bills for 2014-15. 

Thames Water confirmed on Wednesday that it is planning to challenge Ofwat's preliminary decision to reject the request for an interim 8% price increase next year - the utility has submitted further evidence in support of its application ahead of Ofwat's final decision in November.