Ofwat is warning that the delivery of multi-sector reservoir (MSR) systems cannot be subsidised by water customers, saying that “as a principle, public water supply customers should not subsidise other reservoir users and we expect costs to be fairly shared between users.”

The warning from the water sector regulator follows the publication of a jointly commissioned report from CEPA and Agilia by the Regulators’ Alliance for Progressing Infrastructure Development (RAPID ), Anglian Water, Northumbrian Water and Yorkshire Water to consider the legal and commercial models that could facilitate the delivery of multi-sector reservoir systems.

The report presents a number of models setting out the range of potentially feasible options to deliver MSR projects. CEPA and Agilia have ruled out many of the models as they consider them to be “unfinanceable, not to promote value for money, or to be insufficiently flexible to accommodate multi-sector participation.”

The report concludes that best value to water customers and other beneficiaries will be secured by using a competitive procurement delivery model such as:

DPC - Direct Procurement for Customers

DPC involves a water company competitively tendering for a third party Competitively Appointed Provider ( CAP) to design, build, finance, and operate certain large infrastructure projects

SIPR – under the Water Industry (Specified Infrastructure Projects) (English Undertakers) Regulations 2013

SIPR is an alternative approach to enabling direct procurement of new infrastructure in the regulated water sector. SIPR allows the Secretary of State or Ofwat to specify a particular project for delivery by an infrastructure provider if that project satisfies certain criteria related to size, complexity, and value for money.

CEPA and Agilia have assumed that one of these procurement processes will underpin the MSR models. The report considers a number of different models for incorporating the following users into an MSR system:

• Public water supply;
• Flood management;
• Irrigation (e.g. the agriculture sector);
• Industrial and power sector;
• Leisure/Tourism;
• Navigation;
• Environment

MSR systems likely to be large (£1bn+) and privately financed over a long period

Commenting on financeability , the report says MSR systems with a public water supply component are likely to be large (likely over £1bn) and privately financed over a long (e.g. 25+ years) period.

“Funders of the reservoir systems must have sufficient credit standing, longevity and liquidity, and be willing and able to commit to a long-term contract. Water companies, energy companies, and public bodies typically have these characteristics, other private entities less so,” the report states.

Financing cost of private investor’s risk likely to be greater than that borne by water customers or by a public authority

Pointing out that delivering additional benefits may drive additional capital costs, according to the report. Where beneficiaries do not have an appropriate credit standing and/or are unwilling/unable to commit to long term contracts another entity would need to take on their revenue risk.

“This raises questions around the extent to which certain investors/funders would be willing to take such risks, and under what risk structure….

“Assuming a project is bankable … any risk around uncertain revenue will represent an equity risk…

“A higher level of uncertainty will demand a greater financing cost and affect the project’s value for money, but the extent of this will depend on the risk-absorbing entity. For example, the financing cost of a private investor’s risk will likely be greater than if that risk were borne by water customers or by a public authority.”

Revenue risk may need to be held by water company (by extension, the water customer) or a public body (by extension, the taxpayer), to make the model commercially viable

The report suggests that regardless of size, other off-takers in MSR will import additional revenue risk into the project structure as they are not supported by customer revenues or taxpayers - which must either be absorbed by the project’s financing or held by the more creditworthy off-takers, such as the water company or the public authority.

“Depending on the degree of revenue risk the financing is expected to absorb (in addition to other risks such as construction and performance), the impact on the cost of financing may be very large, or it may make the project unfinanceable”, the report warns.

In the authors’ view while the revenue risk being absorbed by the project’s financing is attractive, the feasibility of this would need to be market tested for each MSR proposal.

However, for the first MSR projects, their expectation is that this approach will either “be unfeasible or very costly, due to the lack of experience in estimating and pricing such risks.”

“This means that in some limited instances, the revenue risk may need to be held by the water company as the primary off-taker (and by extension, the water customer) or by a public body (and by extension, the taxpayer), to make the model commercially viable.”

Key question - should MSR system be procured by water company or by a key stakeholders JV?

The report highlights the key question of whether the MSR system ought to be procured by the water company or by a joint venture between the key stakeholders.

The effective allocation of risk will be essential to ensuring an MSR project is financeable and provides value for money, while protecting the interests of water customers.

“On that basis, we consider that construction risk and performance risk should primarily be held by and managed by the special purpose vehicle competitively procured to build, finance and operate the MSR, though as with the Thames Tideway Tunnel project and other previous projects, there may be a case for limiting this exposure,” the authors conclude.

They also consider the risks associated with undertaking initial development activities prior to obtaining planning consent is best managed by a water company, “given the scale of investment required at the initial stages and the relatively high termination risk.”

Finally,the report warns that revenue risk presents a major challenge in the context of MSRs, given that many of the other contract offtakers are “unlikely to share the same revenue characteristics as regulated water companies, energy companies, or public authorities.”

“ We consider that, for more complex multi-sector solutions involving less credit worthy off-takers, a risk sharing approach is likely to be required to ensure the project remains financeable, with some of the risk potentially held by water customers and/or taxpayers.”

Via the RAPID gated process, the water companies have identified the opportunity to deliver strategic reservoirs that could deliver benefits wider than just providing water services to water customers e.g. flood management, irrigation, leisure facilities, industrial users etc.

Anglian Water is currently actively considering multi sector reservoirs (MSR) options for its proposed South Lincolnshire Reservoir and the Fens Reservoir.

Ofwat has commented:

“In general, we do not expect public water supply customers to carry risk for other sectors unless they are fully compensated for this….

“As a principle, public water supply customers should not subsidise other reservoir users and we expect costs to be fairly shared between users. This may prevent MSR schemes from developing where third parties are unable to commit their involvement early in the design and development of the reservoir. Their early involvement and commitment to funding will be important to ensuring all the MSR benefits can be designed and built into the reservoir from the outset.”

Next steps include critical review by Ofwat of barriers and risks identified in the report

However, Ofwat goes on to explain that given the potential benefits that an MSR system could deliver for customers, the environment and society, it is “important for companies to continue to investigate the delivery of MSR systems and develop working models, and how the challenges ..can be addressed. “

The regulator is proposing the following key areas of work over the next year:

1. Establishing the case for a MSR system:

2. Identify potential participants and funding streams:

Ofwat is also proposing to carry out a critical review of the models identified in the report, the barriers and risks, and where it may be able to unlock any barriers or make recommendations for others to do so.

Click here to download the report in full.