Wendy Kimpton, energy and utilities expert, PA Consulting Company strategy, Finance and investment, Policy & regulation, Regulation, Strategy & management, Water, Opinion

Wendy Kimpton, energy and utilities expert at PA Consulting, gives a run down of Ofwat’s draft methodology for PR24 released on Thursday (8 June) and the main changes when compared to the previous price review. She says whilst it is a “close cousin” of PR19, there are some key differences that will make PR24 challenging for water companies.

The PR24 draft methodology embeds the familiar ingredients of stretching improvements in service, challenges on costs, promotion of competitive tendering and markets, and continued focus on financial structures. However, there are key aspects of the approach that will present a new level of challenge to the industry around overall risk and potential returns.

Ofwat’s expectation is that everything should be comparable and largely homogeneous with almost everything already accounted for in base costs. The emphasis is on a comparable view of what customers want with less focus on local and regional conversations, implying that in the water industry “levelling up” has already been achieved.

Customers and the three regulatory building blocks around outcomes, costs and the risks/return balance, are still very much in the forefront but the regulator’s approach means that companies will need to consider them through a very different lens to that used for PR19.

Much greater comparability, far fewer regional difference

In PR19 companies were expected to create a tailored conversation with their customers to discover what mattered in their regions. Although the requirement for customer engagement remains, the role of central research in determining valuations, the greater emphasis on common performance commitments (PCs) and the near elimination of bespoke PCs will change the nature of that relationship.

This approach reduces possible concerns about a postcode lottery in service standards but there will be less opportunity to account for evident regional differences. For example, South East regions may have greater concerns about water availability while the other regions may have more concerns about flooding.

Ofwat’s approach to cost assessment is broadly consistent with PR19 but raises the question of whether that consistency allows for significant changes in future costs or delivery methods. Ofwat has signalled a cautious intention to consider future costs in cost models and to reflect nature-based solutions in future regulatory capital value. These are positive steps, but key details remain to be established, including whether the benchmarks for service and costs will be at upper quartile or beyond. It will also be fascinating to see how the models perform against the observed experiences in PR19 and if they are able to account for future tensions in costs releveled during PR24.

The regulator has stated its clear expectation that base costs are sufficient to improve service and maintain asset health. If this is the case, how much capacity is there for future costs be factored in? In addition, the requirement for investments with lifetime totex costs above £200 million to be DPC (direct procurement for customers) by default may have potential impacts on future cost models.

Risk and return

The methodology again states an expected range for return on regulatory equity (RoRE) of +/- 1 – 3%. The PR24 proposed design places most of the outperformance opportunity into service performance to incentivise companies to focus on delivering service to customers. The stronger focus on common PCs and virtual demise of the bespoke PCs means that for companies, the balance of risk and reward will be different in PR24.

There are also important changes for returns and financial structures. As new debt raised at lower rates gradually replaces embedded debt, Ofwat expects the cost of debt to be materially lower than PR19, contributing to a reduction in the allowed return. Furthermore, it is actively encouraging increased equity as a buffer against uncertainties. The notional capital structure may have a higher share of equity and reduced gearing, which, in a period where companies may be facing significant investment needs, could put pressure on some companies’ financeability without equity injections.

A further concern lies in the significant emphasis on the “wider regulatory tool kit”. Whilst this emphasis can help simplify aspects of the price review process, it risks creating a perception of greater regulatory uncertainty for investors.

PR24 methodology ‘in the round’

In many respects the PR24 methodology is a close cousin of PR19 and therefore largely predictable. However, it is important to recognise that Ofwat still can exercise its judgement around the cost of capital and financial structures, choice of service and efficiency benchmarks, and the overall balance of risk and return.

The proposed plan assessment process provides the ability to differentiate between companies by up to 60 bps on the target return on RoRE along with substantial variation in cost sharing rates. The draft methodology does in principle give companies the chance to argue for tailored costs and service metrics, but this will require meeting a very high evidential bar. Their ability to articulate the long term delivery strategy elements in their plans will be key to ensuring that the business plans reflect regional circumstances and needs and that these are factored in the Final Determinations.

Despite the much greater emphasis on comparability and common targets, the work required in preparing business plans will be every bit as great as at PR19. The potential challenges and threats are already becoming visible, and companies will need to work hard, within a narrow window of opportunity, to achieve the right balance of risk and return.