Ofwat plans for a total expenditure approach to risk and reward are still short on detail and poorly justified, says Karma Ockenden
Despite limited support and even outright opposition from water companies, Ofwat has stuck with its intention to move away from treating operating and capital expenditure separately.
In its Consultation on Wholesale Incentives for the 2014 Price Review, Ofwat argues that this total expenditure (totex) approach will address the industry’s perceived preference for capex even when operating solutions might be cheaper and better. It plans to use a “menu” approach under which companies can choose their preferred level of risk, which determines how much they will be rewarded for outperformance (see box). The more challenging the risk target, the better the reward if it is delivered.
Menu methods
The watchdog has put three totex menu options on the table for PR14, dubbed B2, B3 and B4. They differ according to the number and nature of menus in play; how baseline costs are assessed; and how companies would recover revenue. Revenue recovery will comprise a proportion received in the year costs are incurred – “pay as you go” (PAYG) – and a proportion recovered over a longer term as regulatory capital value (RCV).
Two key concerns have emerged. First, a lot will ride on how robust Ofwat’s baseline cost assessments are. Thames Water, for instance, previously cautioned that Ofwat’s cost assessment options were “data intensive, complex and prone to errors”. Phil Wickens, head of economic regulation at Wessex Water, questions whether robust baseline costs will be out in good time for PR14. He says: “We are concerned that a baseline will not be available for the menu to be created in time for a choice to be made. Without a baseline, a menu approach is not workable.”
The second big concern surrounds what proportion of revenue will be treated as RCV. According to one observer: “Investors will be asking, will you get a return or not? You just don’t know.”
Revenue recovery
Two main revenue recovery options are being considered. Under B4, Ofwat would set the RCV/PAYG split. Under B2 and B3, firms would be allowed to propose the split themselves – effectively to suggest how much of the totex will be operating cost (PAYG) and how much will be capital investment (RCV). Ofwat would likely set a “cap” and “collar” – upper and lower limits on firms’ choices.
Sam Williams, a director at Economic Insight, thinks Ofwat is likely to opt for B2 or (most likely) B3. That would appeal to many companies, given the greater cost recovery freedom these options carry. Wickens, however, says Wessex prefers B4: “It is an evolutionary approach to totex ensuring implementation risk is low.”
Should Ofwat opt for B2 or B3 with a wide cap and collar, it may leave the industry free to continue to favour capex. One source suggests this may even be intentional. “Ofwat seems to be shying away from setting the RCV/PAYG split. Even if it believes there is a capex bias, it seems to find it unattractive that it has to fix it. It knows there’s a downside and it doesn’t want to be responsible for undermining future investability or even for short-term financeability problems.”
Consultation concerns
Certainly there is a feeling in the sector that the move to totex has not been fully justified by the regulator and that the approach is advancing without criticisms being answered or alternatives explored. Williams says it is unlikely that the consultation will convince those who feel capex bias is unproven.
Furthermore, there is industry concern that Ofwat’s consultation is short on specifics, which is making it hard to respond to. Tellingly, some companies approached by Utility Week declined to comment, saying they could not answer questions with any certainty. There is little detail, for example, on how caps and collars would be set in practice; how cost recovery would be handled for companies that fell outside of the cap and collar range; or how Ofwat would split RCV/PAYG should it opt to make that call itself.
The equalisation of capex/opex incentives received wide support from the energy industry when introduced there. Ofwat seems to be playing at the riskier end of the menu.
How the menu system would work
The menu system offers higher rewards for more challenging targets. How would this work? A company would propose an outcome – say, less discolouration by a given date. Ofwat would set a “baseline” cost for that outcome – what it calculates it would cost an efficient company to deliver it. The company would then submit its cost forecast and choose its menu position and associated “cost performance rate” – the percentage amount of any eventual outperformance it will keep. Ofwat would then set an allowance for delivering the outcome, a figure likely to sit somewhere between Ofwat’s baseline and the firm’s forecast. Once the company incurs its actual costs the regulator would reward or penalise it. The reward or penalty would be the product of the cost performance rate and the difference between allowed and actual expenditure.
This article first appeared in Utility Week’s print edition of 28th September 2012.
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