Ofwat has written to the water companies warning them not overstate their anticipated energy costs in their business plans for the upcoming 2024 Price Review for the AMP8 2025-30 investment period.

Tim Griffiths Director, of PR24 cost assessment at Ofwat, has responded to the water companies following suggestions by several of the firms that Ofwat's PR24 base cost models will not adequately capture recent increases in energy costs. The companies have asked for Ofwat to make an industry wide adjustment to base cost models to reflect historical and forecast movements in wholesale energy prices to allow for this.

Any adjustment based on wholesale energy prices could "significantly overstate energy costs" over 2025-30 period

Writing to the Regulatory Directors, Tim Griffiths said:

“This approach does not appear to reflect that water companies tend to manage energy costs through hedging arrangements, long-term offtake contracts and investing in self-generation. This means that over recent years water companies have on average paid far less than the wholesale price of energy.

“Consequently, any adjustment based on wholesale energy prices could significantly overstate energy costs to be incurred by water companies over the 2025-30 period.”

Energy costs make up around 10% of water company costs - wholesale energy prices have seen significant increases in recent years above the rate of general inflation. Over the two years to March 2023, electricity prices increased by 27% on average per year above the rate of CPIH.

Ofwat has asked the water companies to provide real price effect forecasts from 2023-24 onwards in their PR24 business plan data tables which allows historical costs to be adjusted if the regulator concludes that costs (including energy costs) will increase by greater (or less) than the rate of growth in general CPIH measured inflation.

“Initial analysis indicates adjusting historical base costs for forecast real adjustments in energy from 2023-24 onwards may not appropriately reflect future energy costs"

However, Tim Griffiths goes on to point out:

“Our initial analysis indicates that simply adjusting historical base costs for forecast real adjustments in energy from 2023-24 onwards may not appropriately reflect future energy costs incurred by companies.”

To support further analysis, Ofwat is now asking the water companies to provide the following information as part of their PR24 business plan submission on 2 October:

• Energy prices – actual and forecasts: actual and forecast nominal input and export energy prices between 2018-19 and 2029-30, together with an explanation of how the energy price forecasts have been derived in an accompanying commentary. Any difference between wholesale and retail energy price forecasts should also be explained.
• Percentage of forecast energy consumption - hedged for each year up to 2029-30, as at the end of 2022-23. In an accompanying commentary, Ofwat expects companies to explain:

             i. How much of its energy consumption it hedges in advance, and if/how it operates a ‘hedging ladder’?

             ii. How much (if any) of its consumption is effectively purchased at spot market prices?

             iii. How much (if any) of its consumption is set under long-term offtake contracts?

Tim Griffiths told the Regulatory Directors that the additional information would help Ofwat “better understand the energy prices actually paid by companies, the hedging strategies companies have in place at the current time, and future energy prices companies are expected to pay.”

“We consider that requesting this information now will allow companies to better account for energy prices in their business plans. This information is in addition to the PR24 business plan data tables. Consistent with the data table guidance, we expect companies to reflect existing hedging arrangements in their business plan real price effect forecasts.”

Ofwat has recently consulted on a set of historical cost models based on data from 2011-22 – following the consultation, the models will shortly be updated to include data from 2022- 23. The regulator has said it will consider including data from 2023-24 in base cost models for final determinations when the data becomes available.