New proposals by Ofwat look set to usher even more competition into the UK water sector, including plans to open up the market for increased water trading, energy generation from sewage sludge and more direct procurement of large-scale infrastructure investments like the Thames Tideway Tunnel.

The water industry regulator has published a major new consultation paper setting out its preferred approach to the design of the future regulatory framework for wholesale markets and its proposals for the upcoming price review in 2019.

Introducing the detailed 174 page paper, Ofwat said a further strengthening of its approach to outcomes and customer engagement had played a key part in its proposals. The regulator wants to see the water companies coming forward at the PR19 price review with solutions developed in conjunction with their customers. This would require them to go “significantly further” now in readiness for PR19, beyond the step change achieved at the 2014 price review. The paper says:

“Therefore, while the refinements to our regulatory approach as part of PR14 provided clear benefits, there is a compelling and clear case for further regulatory reform to address the challenges facing the sector and deliver a new frontier of efficiencies.”

Scope for greater use of markets in water reseources and energy from sewage sludge

The regulator says there is scope to make a greater use of markets in relation to sludge and water resources. 

In relation to sludge, Ofwat said evidence suggests that there is scope for increased optimisation of activities across the companies – and, looking further ahead, greater participation from firms operating in wider waste markets.

In relation to water resources, Ofwat says trading is below its optimal level, and taking steps to mitigate barriers to this could result in benefits of up to £1 billion for customers. Looking further ahead, there is also scope for third party participation, whereby wholesale providers of resource negotiate directly with water retailers as the retail non-household market develops in line with the Water Act 2014.

The regulator also see scope to make greater use of market forces more widely in relation to the procurement of large-scale investment on behalf of customers.  The key elements of Ofwat’s  proposals include the following:

• Separate binding price controls for both sludge and water resources for PR19. This will help better facilitate an effective market by revealing improved information that will help set more targeted incentives; supporting company decision-making; mitigating cross-subsidy concerns and helping to foster a more commercial culture and focus within companies in relation to these activities.
• The introduction of an information platform for sludge Information to be made available that will enable others to offer services if they can do them cheaper or better than the existing companies. This could contain, for example, data on things like capacity, treatment costs, transport costs and site locations at an individual site level.
• The introduction of an information database for water resources.  A framework that would allow for the ‘bidding in’ of resource options by third parties on an ongoing and fair basis that provides a level playing field between participants and the implementation of access pricing for third party providers of water resources to pay an access price to incumbents’ networks.
• Price control regulation will continue to apply to the wholesale parts of the value chain. For both sludge and water resources where Ofwat cannot be certain about how far or how quickly markets could develop, over the near term at least price regulation will remain an essential part of its approach.

Additional RCV protection to be put in place

Commenting on the RCV, the paper says Ofwat recognises the important role that the RCV has played and continues to play. The RCV, which  is not linked to any specific assets, is a device used to allow companies to raise finance and smooth the cost recovery of capital investments over time, including allowing for a reasonable rate of return to investors, as determined by Ofwat when setting price limits. This return makes up around a quarter of the total bill paid by customers.

Ofwat has previously set out a policy of providing protection to historical (efficiently incurred) investment up to 31 March 2015 as part of its wholesale controls. This protection will be extended so that water companies will always be able to recover the value of efficiently incurred investments included in the 31 March 2020 RCV, regardless of the impact of reforms by Ofwat. This will ensure that no investments made prior to any reforms will be subject to any change in risk profile.

Investments made post- 2020: For sludge, these will be subject to market risk. For water resources, Ofwat’s approach would mean that a market will apply for the incremental investment itself, at the point of procurement, with no volume risk in the price control.

By limiting the impact of a greater use of markets to new investment, the paper says Ofwat expects to "mitigate materially any potentially adverse impacts on financing costs in the sector."

“In principle, reforms that allow for greater use of markets could drive substantial efficiency gains”

The key features and issues Ofwat considers most relevant are:

• the fact that the characteristics of the supply of water and wastewater vary considerably within and across the value chain;
• the need to drive a longer-term approach, to ensure that companies optimise over the longer term and reduce their focus on the five yearly price control cycle as they look more to their customers than the regulator.
• the scope for increased efficiencies and innovation to be unlocked - closely linked to the potential for a greater use of markets to deliver gains;
• the lack of a price for water resources and therefore an absence of signals to facilitate optimisation across company boundaries or to reflect relative scarcity;
• the role of the RCV in water regulation;

The paper says it is clear that the characteristics of water and wastewater vary significantly across the value chain yet historically, the industry has been regulated as an integrated whole. According to Ofwat:

“Consequently, it seems likely that this historical approach to regulation, which does not fully reflect these differences, is unlikely to be optimal – creating a strong case for reform.”

“Following from the above, these differing characteristics also means that there is a need to prioritise the development of markets on parts of the value chain where the potential benefits are most likely to exceed the costs.”

“It is clear to see that, in principle, reforms that allow for a greater use of markets could drive substantial efficiency gains.”

“Better co-ordination could help reveal information that signposts opportunities for market entrants”

According to Ofwat, better co-ordination through engagement, partnerships, collaboration and markets could help to:

• develop a coherent conversation with customers, the wider public and other stakeholders about the provision of water and wastewater services across the suite of water and environmental planning processes such as water resource management plans (WRMPs), river basin management plans (RBMPs), drainage strategies and flood strategies;
• reveal information that signposts opportunities for market entrants or help Ofwat shape incentives and penalties for persistent monopolies;
• protect consumer interests by ensuring decisions made outside of Ofwat / company ownership do not undermine deliverability or affordability of water and wastewater services;
• identify opportunities for cost-sharing and optimisation across a range of services provided for in a catchment; and
• improve the water sector’s resilience by enabling water companies and others to take better-informed long-term decisions.

 Making greater use of direct procurement for customers

The consultation paper says Ofwat “continues to see merit” in exploring ways of making a greater use of tools that enable direct procurement of services on behalf of customers.

The paper cites the £4.2 billion Thames Tideway scheme as demonstrating the potential benefits of procuring independent providers, as does the application of similar models across a range of other regulators, including Ofgem.

Ofwat said a recent report by Anglian Water makes a valuable contribution by identifying the potential scope for third party provision of water supply assets and illustrates the need for a regulatory approach which provides sufficient flexibility to enable such possibilities.

The report suggests that options involving corporate financing by statutory water companies – single water company and water company joint ventures, benefit from risk transfer to customers and therefore may provide the lowest costs of funding, but do not necessarily maximise benefits to customers. The report also highlights that other financing options, which bring in wider groups of stakeholders, including other third parties, could give rise to additional benefits compared to water company only options.

Ofwat intends to continue to examine how direct procurement on behalf of customers could be more widely applied across the water and wastewater sector – in particular, to identify where the gains from this might be greatest.

The paper is also seeking comment on the proposal to set the expectation, for PR19 , that all companies should consider direct procurement for all discrete large scale enhancement projects. This would exclude sludge, where Ofwat's approach is primarily based on development of a market for third party provision.

Ofweat is also proposing to set an expectation that direct procurement from independent providers should occur in relation to any discrete project with a value of over £100 million - at PR14, six enhancement schemes were above this threshold.

For PR19 the regulator is planning to take account of companies’ approach to procurement when considering the extent to which they are demonstrating efficiency and as part of its risk-based review process.

Ofwat: we need to make changes to avoid raw deal for customers

Commenting on the proposals, Cathryn Ross, Ofwat Chief Executive said:

“In 2014 our approach to setting price limits helped drive service up and bills down. We need to build on that, but with big challenges ahead we need to make changes to avoid customers getting a raw deal.”

“Our job is to keep companies on their toes so that customers are protected. Companies have told us that they have already made all the easier efficiencies. That’s why we want to open up new a frontier for efficiencies.”

“Supplies are already stretched in areas where the population is rising. We want to kick start water trading where this will help keep bills down and stop us taking too much water from our rivers. We also want to deregulate to free up scope for companies to make better use of sewage sludge to help meet their own, and the country’s energy needs.

Deadline for responses to Ofwat’s consultation is 10 February 2016. By the end of 2017 the water sector regulator will have confirmed its final approach to how it will set price limits between 2020 and 2025. It will then set final price limits by December 2019.

Click here to download the consultation paper in full (174pp) Water 2020: Regulatory framework for wholesale markets and the 2019 price review

Click here to download the consultation paper in summary (42pp) Water 2020: Regulatory framework for wholesale markets and the 2019 price review – summary

Click here to download Anglian Water’s paper Financing Multi-Sector Water Supply Assets 2015