Ofwat has revealed plans to enable water companies to compete for additional funding for net zero investments that go beyond its baseline target for decarbonisation.
The net zero challenge funding pot was one of a number of proposals in the regulator’s draft methodology for the PR24 price review for 2025 to 2030.
Ofwat said it has four key ambitions for PR24: focusing on the long-term; delivering greater environmental and social value; reflecting a clearer understanding of customers and communities; and driving improvements through efficiency and innovation.
Accordingly, the regulator said water companies will be required to set their five-year business plans within the context of 25-year long-term delivery strategies with adaptive pathways. Their delivery strategies and business plans should be informed by – and align with – the existing strategic planning frameworks, including water resource management plans and drainage and wastewater management plans.
Ofwat has also proposed to introduce new common performance commitments on key environmental issues, such as improving bathing and river water quality, reducing the impact of storm overflows and lowering greenhouse gas emissions, as well as a new BR-MeX performance commitment for English water companies to improve performance in relation to wholesale services provided to retailers and business customers.
The regulator said it will provide spending allowances for companies to meet the new emissions target, but it is also proposing to allow companies that wish to go further to bid for additional funding from a net zero challenge pot.
It said this extra funding would be concentrated on the most efficient companies to ensure faster emissions reductions are achieved at the lowest cost. Learnings from these investments would then be shared, allowing all companies to implement solutions that prove effective during future periods.
Despite the introduction of new common commitments, Ofwat said it expects the overall number of performance commitments to be cut in half due to fewer bespoke targets – at most two or three per company.
Ofwat is also planning to extend the enhanced outcome delivery incentives (ODIs) introduced at PR19 to all companies for a select group of well-established common performance commitments. Enhanced ODIs, which offer stronger incentives for exceptional performance, are currently applied at the request of water companies.
The regulator said enhanced ODIs would only offer rewards for outperformance and would not include penalties for underperformance, as is the case for the current asset management period. The thresholds for enhanced ODIs would be set on a “consistent and streamlined basis,” only offering rewards to companies for “frontier-stretching” performance delivered through “genuine innovation”.
Ofwat said it expects to manage ODI risk primarily at an aggregate level, only applying individual collars and caps to performance commitments on a targeted basis. It is not proposing to use dead bands for any performance commitment.
Its initial proposal is for aggregate incentives beyond plus or minus 3% of return on regulatory equity (RoRE) to be shared 50:50 with customers, with 90% of incentives beyond plus or minus 5% of RoRE going to customers.
The regulator said this sharing mechanism would not apply to payments from the measure of experience (MeX) performance commitments – C-MeX, D-MeX and BR-MeX.
Ofwat said it expects companies’ business plans to set out their proposals for dividends and performance-related executive pay, with the latter demonstrating a “substantial link to stretching performance delivery for customers, communities and the environment.”
The regulator is proposing to require water companies to hold open challenge sessions both during and after the development of their business plans to enable customers and other stakeholders to challenge them directly in an open forum. It said these could be facilitated by the Consumer Council for Water (CCW) to ensure consistency between companies.
Ofgem said it is working with both water companies and CCW to implement a collaborative approach to research that affects common areas of business plans such as customers’ priorities, their views on affordability and appropriate rates for ODIs.
To encourage the use of nature-based solutions, Ofwat said it wants to provide increased funding surety to schemes that are more reliant on operational expenditure. It said the options it is considering include capitalising the net present value of the whole-life operating expenditure of nature-based solutions and adding this to the companies’ Regulatory Capital Value, and setting ten-year operating expenditure allowances to be recovered over two price control periods.
It also wants to leverage competition to drive improvements in the delivery of large infrastructure projects and is therefore proposing to require companies to use direct procurement for customers (DPC) by default for all projects with a lifetime total expenditure value of more than £200 million. Ofwat said it will not provide funding for in-house delivery of DPC eligible schemes, instead providing funding for the procurement process.
The regulator said it expects the cost of debt to be “materially lower” than at PR19 and that there is a case for lowering the gearing for the notional company to ensure “equity buffers” are sufficient as the water sector faces a more uncertain future.
Ofwat chief executive David Black said: “Water and wastewater companies provide an essential service for customers across England and Wales. We’ve listened to people’s concerns and ambitions for the water sector. We understand the urgency of the environment and climate change challenges and the pressure on people’s finances. In PR24, companies need to step up to meet these challenges by finding new and innovative ways of delivering reliable and resilient services.”
Aileen Armstrong, senior director for company performance and price reviews at Ofwat, said: “This price review will continue to push the sector to deliver more for customers and the environment. We are proposing changes to ensure that customers’ voices are heard more clearly and are better understood in this review than ever before. We’re also proposing to focus attention on the outcomes that really matter now and for the long term, and that companies should set their plans in the context of their strategies for the next 25 years.
“Overall, our proposals are designed to challenge companies to deliver affordable water and wastewater services that meet the needs and expectations of customers and the environment.”
CCW senior director Mike Keil said: “We’re really pleased to see a much greater emphasis on involving consumers in the key decisions that will shape the future services they receive. The collaborative research we’ve been working on with Ofwat has been a very positive step forward and the proposal for open challenge sessions has a lot of potential.
“The cost of living crisis has put an intolerable strain on many households’ finances so it is good to see Ofwat recognising the importance of affordability in its methodology. The sector needs to accelerate its efforts to help those struggling to stay afloat and we’re delighted to see the regulator putting down a clear marker for water companies to pave the way for a new water affordability scheme.”
“The challenge for companies is substantial as Ofwat has raised the bar on performance, efficiency, collaboration and competition,” commented PA Consulting energy and utilities expert Wendy Kimpton.
“The lower cost of debt and lower levels of gearing for PR24 will be demanding. The proposals on the base service levels required, long-term investment needs, growing pressure on customers’ pockets and company financeability will all be tough for companies to meet.”
She continued: “Ofwat has set a clear direction of travel but the exact destination and the impact on companies remains to be seen.
“There are few surprises in the headline areas of focus around increasing environmental and social value, better understanding of customers and further improvements in efficiency and innovation. However, there are important changes in the three key building blocks – outcomes, costs and risk and return – that companies may find concerning.”