New evidence submitted to the Competition and Markets Authority’s Price Review investigation is suggesting that Ofwat’s Gearing Outperformance Mechanism (GOM) is flawed and should be rejected, its approach to assessing financeability is inadequate, and the Final Determination appears to be imbalanced in favour of short-term bill reductions at the expense of consumer interests in the medium and long-term.

The criticisms have been made by the Energy Networks Association (ENA), which represents the ‘wires and pipes’ transmission and distribution network operators for gas and electricity in the UK and Ireland.

The 29 page submission, the third ENA has submitted to the Authority’s inquiry in PR19 appeals by four water companies, covers a range of errors ENA thinks the water sector regulator has made and is asking the CMA to consider.

“Serious flaws in Gearing Outperformance Mechanism arbitrarily misallocate risk and return across stakeholders, and create pretence that consumers are further protected”

Commenting on Ofwat’s Gearing Outperformance Mechanism (GOM), ENA says that Ofwat’s Final Determination implements the GOM in order to address high gearing that Ofwat contends has the potential to misalign interests between consumers and investors.

ENA notes in its evidence that “no such mechanism exists nor has been proposed by Ofgem for RIIO-2”, and calls for the CMA to consider very carefully any new regulatory measure that:

1. has the potential to affect revenues
2. constitutes a departure from established CMA precedent
3. is entirely formulaic leading to mechanistic outcomes, and
4. may penalise past decisions on capital structure taken in good faith.

ENA says that the extent and quality of evidence for risk dispersion across stakeholders under conditions of high and varying gearing levels is not adequately observable from market conditions or from other sources.

According to the Association, this undermines the design of quantitative tools such as Ofwat’s GOM which has “led inevitably to an arbitrarily determined level of prescribed gearing levels and allocation of supposed benefit.”

“ These are serious flaws, as they arbitrarily misallocate risk and return across stakeholders, and create a pretence that consumers are further protected, “ the evidence document says.

“Ofwat’s approach to assessing financeability is inadequate”

The ENA also contends that Ofwat’s approach to assessing financeability is inadequate- suggested corrections include:

• It is essential that errors made in Ofwat’s calculation of Weighted Average Cost of Capital (WACC) are corrected prior to financeability assessments
• Financeability assessment must consider beyond the AMP7 and 2025 to 2030 (AMP8) periods as well as the short-term
• Financeability must be assessed using current rating agency methodologies including their focus on core financial metrics

“Welfare loss from under investment or longer-term deterioration in investor confidence is large’

In ENA’s view, the allowed rate of return is the single most important incentive to invest faced by a regulated entity. Setting the headline allowed rate of return too low can be expected to give rise to a material risk of underinvestment - leading to both short and long run detriment for users of the infrastructure and the wider economy, the evidence paper says.

ENA says it agrees with NWL’s statement that

‘Given that demand for most regulated services is inelastic, because these services are essential in nature, the welfare loss from under investment or longer-term deterioration in investor confidence is large’.

ENA notes that Ofwat has been developing its financial monitoring in recent years and Ofwat has acknowledged that certain water companies have undertaken commitments to improve financial resilience. However, ENA’s view is that it is more appropriate to focus on financial resilience measures rather than introducing "a flawed new policy tool."

The Association has now raised “several significant concerns” with respect to Ofwat’s financeability assessment in the Final Determination.

Financeability adjustments needed for 12 of 17 companies “may indicate a fundamental problem”

Pointing out that Ofwat found that financeability adjustments were required for 12 of 17 companies, ENA says this “may indicate a fundamental problem with how Ofwat has determined key building blocks in the price control.”

ENA also believes that the financeability of regulated companies should be evaluated over the long term as well as the short term. The evidence paper says:

“Regulated infrastructure assets often have lives of over 40 years and the financing of such assets should be evaluated by reference to a similar time horizon. Failure to do so risks harming consumers through deferred or avoided investment.”

According to ENA, Ofwat’s credit metric assessment does not exactly follow any rating agency methodology.

Ofwat’s view is that it is not required to follow any rating agency methodology because methodologies vary between rating agencies, rating agency methodologies vary over time and rating agencies should not influence the regulatory outcome and therefore costs to consumers.

However, the submission says the regulator should have tested financeability by reference to all relevant rating agency methodologies, commenting:

“The rating agencies are independent bodies who assess the credit worthiness of companies across the world and, unlike many market participants, have unique access to forward-looking information from companies.”

ENA says the key point is that the assessment of all rating agencies is relevant to whether a company is able to maintain investment grade credit rating.

CMA should consider whether Ofwat’s Final Determination adequately serves the long-term interests of consumers

ENA says the CMA should also examine whether the Price Control strikes the required balance between short-term and long-term considerations, including whether the balance struck by Ofwat is supported by the available evidence. According to the Association, Ofwat’s Final Determination appears to be imbalanced in favour of short-term bill reductions at the expense of consumer interests in the medium and long-term.

Its submission states:

“ENA is concerned that Ofwat’s Final Determination appears to be imbalanced in favour of short-term considerations, which risks producing adverse consequences for consumers and other stakeholders in the future.”

“Price control contains a number of material deviations from regulatory precedent”

ENA is also concerned that the price control contains a number of material deviations from regulatory precedent and says the CMA should examine whether they are adequately founded on a robust evidence base. The submission paper says:

“ENA has set out elsewhere in its submissions specific areas where Ofwat has deviated from established methodologies in a manner not supported by available evidence.”

“ The application of robust and well evidenced assessment tools can lower costs (and therefore customer bills) whilst simultaneously driving service quality improvements and enhanced efficiency and innovation. However, departing from established precedent and adopting new methodologies in setting a price control without an adequate evidence base risks undermining the predictability and stability of the regulatory regime, thereby creating a chilling effect on investment contrary to Ofwat’s general duties. “

Before deciding whether to endorse Ofwat’s approach at the Final Determination, ENA says the CMA should examine closely whether the changes in methodological approach adopted by Ofwat are supported by the available evidence.

Ofwat’s price control may fail to deliver incentive regulation needed to deliver performance improvements

ENA is also warning that Ofwat’s PR19 price control may fail to deliver incentive regulation essential to delivering performance improvements in areas that consumers value and that incorrectly calibrated incentive mechanisms may not deliver the performance improvements they are intended to secure.

The Association is arguing that Ofwat’s PR19 price control is internally inconsistent in two key aspects:

in setting the cost of debt Ofwat makes assumptions with respect to credit ratings and key financial metrics informing the same (e.g. interest coverage ratios) that cannot be attained by the notional company given the significant financeability challenges in the price control package.

Ofwat has set a stretching package of performance commitments whilst also setting cost allowances to include a stringent efficiency challenge. This may produce the result that companies have inadequate funds to deliver the performance improvements that are required to protect the consumer interest and ensure resilience.

Ofwat’s Final Determination does not explicitly demonstrate how evidence of customer feedback has been weighed

According to the submission, ENA understands that the various water companies have undertaken extensive customer and stakeholder engagement on their PR19 business plans. The Association says that evidence of stakeholder (including customer) views is an important aspect of the price control process and should be weighed appropriately by the regulator when assessing business plans.

In ENA’s view, Ofwat’s Final Determination does not explicitly demonstrate how evidence of customer feedback has been weighed, commenting:

“ENA would have expected Ofwat to reflect in particular customer feedback more explicitly in its Final Determination, and submits that the CMA should examine this evidence closely in its redetermination.”

“Imbalanced approach for consumers and other stakeholders”

The submission concludes by examining the consequences of an imbalanced approach for consumers and other stakeholders, saying that ENA understands that in its Final Determination, Ofwat made a number of significant downward adjustments to the price control.

“ENA is concerned that these adjustments appear to have the effect of producing short-term (i.e. in-AMP) bill reductions, at the expense of incentivising investment and innovation. Such an approach would not best serve the medium and long-term interests of consumers. It is not clear to ENA whether the evidence base to support such decisions is sufficiently robust to justify Ofwat’s approach.”the submission says.

According to the Association, a price control which does not strike the required balance between short-term and long-term considerations is not consistent with Ofwat’s statutory general duties – duties which “are not best served by short-term bill reductions alone ..including the furtherance of the consumer objective.”

ENA’s submission says:

“Consumers require resilient and high quality water supply and wastewater systems in both the short and long-term. The ability to attract and service efficiently-raised finance is essential to delivering on long-term consumer interests, including resilience. The risk of consumer welfare loss resulting from underinvestment in essential infrastructure far outweighs the consumer benefit from short-term bill reductions.”

Click here to read ENA's latest submission in full.