On your marks, get set – and go. Water regulator Ofwat has published the framework for the all-important price controls that will govern the water sector from 2015-20. The publication of the methodology last month fired the starting gun on PR14 – the lengthy and complex process that will form the basis of all water companies’ business plans until the end of the decade.
There are more than a few head-scratchers in the 156-page document. First up, Ofwat is changing the rules of the game by setting separate price controls for retail and wholesale services. There are further layers of complexity within that, with two price control frameworks for the retail customer segment. One will be for non-domestic customers, using a default tariff and minimum service level; the other will be for domestic customers and will use an average cost to serve.
Likewise, there will be two wholesale controls: one for water and one for sewerage. Ofwat will continue to use the familiar regulatory capital value (RCV) model and link returns to the retail price index (RPI). The regulator aims to address the industry’s perceived bias towards capital expenditure (capex) by moving to a total expenditure (totex) approach. The idea is to enable companies to make a return for spending wisely on operations, rather than just on assets.
These are fine aims – contained in reams of paper – but key questions remain, according to the industry.
1) How will Ofwat set baseline costs?
Under the new regime, companies will choose from a menu of options, each of which combines a different level of allowed expenditure relative to Ofwat’s baseline, which is matched to a cost incentive rate. Ofwat will set the baseline for each company based on the revenues it needs to deliver its outcomes.
For example, companies that spend less than Ofwat’s baseline and select a more demanding efficiency challenge will earn higher returns on any cost savings made. On the other hand, higher expenditure choices will lead to lower returns on cost savings.
The methodology outlines a totex regime to replace capex and opex, so costs will be assessed under one incentives scheme rather than two different ones.
Tom Livingstone, a consultant at IPA Energy and Water Economics, says: “From my direct experience working alongside developing the econometric models to be used, I can say there is a level of complexity not seen before in water.
“Some companies may have trouble understanding how these models work, which could lead to a risk-averse approach.”
Ofwat concedes that these models are “more sophisticated” than those previously used to assess costs, and Livingstone says water firms will need to work hard and quickly to understand them to ensure the incentives work effectively.
To calculate the preliminary baseline, Ofwat says it may need to exclude certain costs from the approach used in the general cost assessment. This may apply where costs are uncertain or less controllable.
Livingstone says the cost exclusion approach needs further development.
“There needs to be a suitable framework that makes clear what costs will be considered for exclusion,” he says. “This is to avoid situations in the past where there were numerous costs that companies submitted for potential exclusion.”
2) How much will it cost companies to move to totex?
The industry has embraced the totex approach, but it could cost them. Mark Turner, water sector leader at consultancy Ernst & Young, says the fact that companies’ established processes deal with capex and opex differently is a problem.
“All water companies’ systems and business processes are set up on the basis that capex is treated differently from opex,” he says. “Even their IT systems will be written in a way adjusted to this process. They’ll need to change IT systems, processes and their way of working because totex requires them to work in a different way.”
Turner says companies will also want to know how they will fund the cost of this changeover. One option is to increase bills, essentially asking customers to pay, but whether the regulator will allow this remains to be seen.
3) What is defined as retail?
The methodology splits price controls for retail and wholesale business for the first time. This means defining retail and wholesale, but this is not as easy as it sounds. There are some grey areas – for example, meters. Ofwat has moved meter installation, maintenance and repair to the wholesale side of the business, however retailers will still have a role deciding meter functionality and capability.
It is not clear how this will work in practice.
Rob Wesley, head of policy at Water UK, says more thought is needed on the separation of retail and wholesale business units but “appropriate links” should be made where necessary.
Livingstone says: “The definition of retail is extremely important in the future development of the industry and therefore getting it right is essential.”
4) How will customers feed into the price-setting process?
Ofwat aims to put greater emphasis on customers’ views and is challenging companies to use customer panels to inform their business plans. Customer challenge groups (CCGs) will be required to challenge the quality of companies’ customer engagement and test business plans. The CCG will then provide an independent report to Ofwat when companies submit their plans in January 2014.
Roger Darlington, chair of South East Water’s customer challenge group, says Ofwat has essentially “left open how the CCGs will work and how they are to structure their reports”.
Livingstone says that although the overall procedure has been outlined, how Ofwat interprets the CCG’s report will be based on its perceived effectiveness and quality, which could bring further problems.
“There is a risk that the differing structure and focus of each report may differ widely, leading to some customers’ views being represented more than others,” he says.
5) What about raising investment?
Water companies need to invest an estimated £25 billion in UK infrastructure during 2015-20. The ability to raise money remains a key concern for water companies – and the ways in which Ofwat allows them to do so are a crucial part of the methodology. Ofwat has borrowed from Ofgem’s RIIO approach, setting a framework designed to incentivise innovation.
Like Ofgem, it will be using a measure called Rore (range of return on equity) to decide an upper limit for how much return shareholders can make during the price review period. However, it has yet to set out the assumptions that it will make to define the Rore.
Paul McMahon, head of economic regulation at Water UK, says this raises questions about how water companies put together finance plans and whether Ofwat will accept or override them.
These issues are explored in a paper Regulatory Reform and Financing Networks: Lessons from Other Regulators that Water UK has published to coincide with its City Conference last Thursday (28 February) . It says: “It is less clear at this stage exactly how the results of the calculation will be used. For example, Ofwat has indicated that the results could affect the rate of return and some of the incentive rates but has not stated whether the gearing level might also be adjusted.”
This article first appeared in Utility Week’s print edition of 1st March 2013.
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