Water industry regulator Ofwat has sought to reassure the financial community in its latest briefing to City analysts and investors in the water sector about its proposals for regulatory reform for the upcoming Price Review and beyond.

Credit ratings agency Moody’s has recently expressed concern about the potential impact of changes to the regulatory regime and the need to maintain the stability, predictability and transparency which has made the UK water sector an attractive long-term investment since privatisation.

Speaking in London last week, Ofwat Chairman Sir Philip Fletcher reiterated that its approach to regulating the sector is on the basis that the incumbent water companies will remain vertically integrated, and that there will be no extension to domestic consumers of retail competition. 

However, change is undoubtedly on the way, despite the cautious language which reflects the Government’s own intention that nothing should be done in the upcoming Water Bill that will “spook the investors.” The Government’s recent Water White Paper said “it is crucial that the sector remains attractive to investors, so that it can maintain and develop the infrastructure we need for the future.”

"Further change needed beyond 2020"

The key change on the horizon which is likely to do this is what will happen after the end of the upcoming AMP6 investment period 2015 to 2020.

Commenting on Ofwat’s plans, Sir Philip said:

“The work we have undertaken makes clear that changes to company licences are needed. Both specifically for the next price review, which will set limits for a five year period 2015-20, and beyond. We are not at this point trying to resolve all the issues that will need to be taken into account for the period beyond 2020, but rather to provide a platform to enable a steady and orderly move forward in line with the direction set for England in the White Paper. We would expect further change in the process of setting price limits to be needed for the period beyond 2020; changes which cannot be foreseen in any detail at this point.”

Many of the price limit tools Ofwat already use will continue to “remain valid and effective”, including the regulator’s intention to retain the RCV approach for wholesale within a move to two price limits for retail and wholesale and a  committment to remunerating the RCV that is in place from 2015 and beyond to ensure that there is no loss in value to investors for the investment that has been delivered since privatisation. Regulatory tools that address risk, including price limit reopeners (IDOKs) will also be retained.

"Need for legitimacy in the eyes of customers and policy-makers"

 Ofwat comments now increasingly refer to the need for "customer legitimacy”. Ofwat Chief Executive Regina Finn told the investors that the future price limits principles and framework are designed to:

• deliver greater opportunity for innovation, creativity, and as a result, for really good management teams to outperform – sharing that with their investors;
• give the sectors the credibility and legitimacy in the eyes of their customers and policy makers
• enable a more transparent and focussed allocation of risk and ownership and accountability for delivery.

Ms. Finn said that over time there had been a narrowing in the performance of the companies, with the scope for companies to outperform squeezed as the scope for delivering efficiency savings has reduced. In future, the regulator wants investors in efficient companies with good management teams to benefit from outperformance and good performing management teams to also benefit from less regulatory intrusion.

Customers currently “strongly critical of their water companies”

 Ms. Finn said that customers are currently “strongly critical of their water companies during a time of drought and hosepipe restrictions. Customers are criticising companies on leakage performance, on profits, on bonuses, and on not taking the challenges to our water supply serious enough.”

Any changes made to the regulatory regime would be based on clear evidence and subject to consultation with all stakeholders.  Stakeholders would also continue to have “many opportunities to influence …decisions, including on the pace of change and the practicalities of how and when (Ofwat) will develop and apply the principles.”

Water companies raise ongoing concerns about proposals

Despite Ofwat’s efforts to allay concern on the part of water companies and investors about possible changes, there is clearly an ongoing debate about its proposals – the water companies have already rejected a proposed amendment to their licences causing the regulator to extend the period of engagement to consider how best to resolve the issue. Philip Fletcher commented:

“Broadly, all the water companies have said that they consider the proposed changes too broad-brush in altering what Ofwat, companies and many investors see as an important reinforcement to the stability of the regulatory regime. Any licence changes proposed by Ofwat which were not agreed by the regulated company concerned would need to be referred for resolution to the Competition Commission.”

Concern about change from capex to totex and network optimization incentive

Ms. Finn said that although the proposed outcomes approach combined with a totex had been generally welcomed for the opportunities it would provide to innovate and perform, a number of companies had raised concerns around the potential impacts of a change to totex approach. While other stakeholders have agreed that there are potential benefits from incentivising network optimization, the companies are generally opposed to any sort of network optimisation incentive.

The water companies have expressed concern about the proposed networks plus sub cap as part of Ofwat’s package of measures to incentivise the efficient management of water resources and to encourage the trading of water. However, it seems safe to assume that the measure will be brought in. Ms. Finn said:

“The first implementation of the networks plus sub-cap will be non-binding and will focus primarily on revealing information to enable its development as a regulatory tool over time.”

The utilities have also queried how Ofwat will calculate the new average cost to serve measure it plans to use to regulate in instances where customers will not have choice – primarily household customers. Questions include how the average cost would be calculated, whether it would be adjusted to reflect circumstances outside of management control, whether retail cost information was sufficiently robust for this approach to be effective and the potential impact on metering and water efficiency.

Further activities now planned by Ofwat include a consultation on the definition of retail activities in the summer and a series of workshops with stakeholders through the summer to consider the questions investors and the companies “have rightly raised. “

Commenting on other issues, Ms.Finn said that although the clause in the recent Water Industry Financial Assistance Bill which gives Government the right to allow payments directly to a water company to reduce water and sewerage bills for households “seems wide ranging”, the Secretary of State had been clear that they will only use this to help household customers of South West Water who experience the highest bills in the country.

On the second clause, which effectively allows Government to support designated large infrastructure projects in the water and sewerage sectors and, in certain circumstances, to take on some of the risk associated with their construction, she said the  Government had been clear that the Thames Tunnel is the only project to which is it currently envisaged the clause will apply. Describing the Tunnel as the largest water and sewerage infrastructure project to be undertaken since privatisation by a factor of ten, Ms. Finn commented:

“We continue to work closely with Defra, Infrastructure UK and Thames Water on the delivery of this complex capital project.”