The steep decline in construction prices across the UK could have serious and unexpected knock-on effects on water industry capital investment. The problem has been triggered by Ofwat’s use of the Construction Output Price Index (COPI) as its core measure of capital cost inflation. COPI tracks construction-wide inflation and deflation and inevitably has been affected by the wider industry downturn. With the growing likelihood of a double-dip affecting construction in 2012, the size of the inflation deficit could increase to £1.8 billion, according to EC Harris estimates.
The Ofwat regulatory settlement aims to balance the duty of a water company to provide high quality, value for money water services, with the need to attract significant volumes of capital investment. Water companies assume all delivery risks associated with the capital investment programme, including scope, site condition and supply chain performance. In common with all regulated utilities, the price control mechanism provides water companies with a limited protection against construction inflation. The sharing of inflation risk has been an important feature in previous control periods when inflation has been high.
Most regulatory mechanisms are based on the Retail Price Index (RPI) or the Consumer Price Index (CPI) – measures of general inflation across the economy. Historically, RPI inflation is lower than construction price escalation, typically 3 per cent a year. An RPI cap protects consumers from the risk of above-inflation price increases. Similarly, the use of a non-construction-specific index series protects suppliers from boom and bust-driven fluctuations in construction prices.
However, Ofwat uses a construction-specific inflation index – COPI. COPI measures price movement on projects as they are delivered rather than when they are tendered. Its main use is as the deflator for national gross domestic product calculations. Over the long run, COPI has risen by 5 per cent a year, but during recessions it falls by a much greater extent than RPI or CPI.
Ofwat took account of the likely weakness of construction inflation in its final determination for the water industry’s 2010-15 capital programme (AMP5), assuming that prices would be static in 2009/10 and would not return to a long-term inflation trend until 2013/14. As a result, the value of inflation allowances included in the £22 billion AMP5 capital projects budget is approximately £1.1 billion – roughly 5 per cent of the budget.
However, as a direct result of the downturn, the value of the COPI index fell by 4.6 per cent in the 2009/10 financial year alone. COPI has recovered a little during 2010/11, but as public spending cuts bite in 2012, prices could potentially be far weaker than those forecast by Ofwat. Calculations prepared by EC Harris suggest that even assuming flat construction prices during 2011/12, the value of the inflation allowance could reverse into a deficit of £1.8 billion over the AMP5 period – 8 per cent of the total budget.
This situation is unprecedented. COPI fell slightly during the AMP1 period (1990-95) but, due to the extended economic cycle, had been increasing steadily until the crash in 2008. Should an inflation underspend occur, it can be recovered via a claw-back mechanism, triggered through an interim price determination – or alternatively “logged-up” to AMP6 – creating further headaches for water companies as they strive to beat future efficiency targets relative to cost base.
Indeed, the COPI deflation challenge has occurred at the same time as water companies have been set very high efficiency targets for capital projects relative to cost base. Typical target reductions range from 20 to 25 per cent. Water companies such as Welsh Water have implemented extensive change programmes to meet their efficiency challenges, but have also had to take some inflation savings to meet their efficiency targets. For water companies that have not progressed with their transformations as quickly as the frontier companies, meeting tough efficiency targets and making provision for a future deflationary price reduction will be a major priority until the end of the 2010-15 period.
Up until AMP5, water companies have benefitted from the inflation protection provided by the COPI inflator.
Ofwat reviewed the suitability of COPI for water regulation as part of the AMP5 final determination. An alternative sub-index, the Infrastructure Output Price Index (IOPI), was considered, but it was found to be more representative of other infrastructure sectors such as roads.
Looking forward, as the AMP5 spend period progresses, the extent to which COPI reflects water industry price trends, and the impact of any revisions to index values, will become increasingly important for water companies. COPI reflects general building prices, and in particular the price of work won in competition. With construction output forecast by the Construction Products Association to fall by 3.6 per cent in 2012 and flatline in 2013, competitive forces will be strong and upward price pressure will be low. As a result, actual inflation measured by COPI is likely to be below that forecast by Ofwat – particularly in 2011/12 where the Ofwat inflation forecast was 1.5 per cent above RPI (5-6 per cent).
Implications of continuing low levels of inflation include short-term procurement within AMP5, strategic procurement for AMP6 and the continuing debate over inflation protection.
In the short term, water companies facing inflation shortfalls will need to review their tactical procurement. Given that much of water industry procurement is based on framework rates and a shared savings model, the ability of water companies to drive further cost out of their programmes will be driven by process efficiencies and possibly by tendering work outside of existing frameworks to crystallise additional savings from a depressed market. Clearly, such moves will have implications for the business planning of contractors on frameworks and their supply chains.
Looking forward to AMP6, it is conceivable that water companies will face cost pressures from three sources: Ofwat will continue to expect efficiency gains against cost base; input price rises may pass through the supply chain; and the inflation shortfall related to COPI could be logged-up.
With the PR14 process starting in late 2012, and draft business plans being submitted in summer 2013, these issues will need to be addressed by water companies, given that the construction market that will still not have recovered to a business-as-usual state. Early engagement with the supply chain during PR14 and strategic procurement initiatives to eliminate waste and deliver value and certainty, such as programme-led capital delivery, could make a major contribution to meeting AMP6 cost challenges.
Finally, given the experiences of the water industry of the effects of COPI during a construction recession, there is sure to be further pressure for a review of alternative means of capital project inflation protection. With contrasting approaches to inflation hedging being developed by other regulators such as Ofgem under the RIIO methodology, there is certain to be a lively debate on COPI in the run up to PR14.
Terry Povall is head of water and Simon Rawlinson head of strategic research and insight at built asset consultancy EC Harris.