Water UK is warning that unless Ofwat changes its approach, equity investors will not provide all the capital the sector needs at AMP8, especially when more attractive investment opportunities are available elsewhere.

The warning comes in the formal response to Ofwat’s draft determinations from Water UK, the body which represents all the water companies in the UK at both national and international level.

According to Water UK, Ofwat needs to change its approach if it is to successfully conclude PR24. Given the scale of the sector’s concerns with the draft determinations and the limited time remaining before the final determination needs to be published, Ofwat needs to engage in a different way, the response says.

Commenting In an accompanying letter to Ofwat CEO David Black, David Henderson CEO of Water UK says that on behalf of the whole sector, “the industry’s strong belief (is) that without significant change” Ofwat is currently headed for an outcome of failure.

The response levels a number of swingeing criticisms at the regulator, saying that there has been “a deep and widespread loss of confidence among domestic and international investors in Ofwat’s decisions and their ability to enable the long-term investment needed by the sector.”

The response says that both Water UK and independent commentators have concluded that Ofwat’s draft decisions make some fundamental mistakes that result in failure to provide sufficient funding, achievable targets or the ability to attract a sufficient level of investment.

“For example, on attracting investment, it is now clear that without changes Ofwat’s draft determinations are likely to make it impossible for the water sector to attract the level of equity investment that it needs. This assessment is supported by credible independent commentators, such as Moody’s (who have warned that Ofwat’s decisions may directly affect company credit ratings), is aligned with the view of analysts like Barclays and is now emphasised by independent consultants Oxera – who, in a new and comprehensive report published alongside this submission, analyses the investability of the draft determinations. Indeed, some existing investors have already indicated that, unless the draft determinations change, they will not provide the substantial injections of new equity initially proposed in their business plans.”

The industry body is calling for Ofwat to urgently revise its draft determinations by making specific targeted changes, including providing enough funding to meet obligations and future challenges.

Ofwat’s record-breaking cuts to proposed improvements of £11.4bn (25%) will make hundreds of projects unviable

According to Water UK, Ofwat’s record-breaking cuts to proposed improvements of £11.4bn (25%) will make hundreds of projects unviable, even where Ofwat has in theory agreed that they should go ahead. This may force some water companies to miss statutory deadlines, scale back their investment plans, shift activity towards lower-value projects that just tick ‘regulatory boxes’ (rather than delivering real value) or deprioritise maintenance activities.

Ofwat has also reduced day-to-day expenditure based on unrealistic forecasts and assumptions, which means that companies will be unable to sufficiently maintain and upgrade their infrastructure. This completely misses an opportunity to overcome well-recognised and longstanding shortcomings in asset health maintenance. Compared with companies’ plans, this will likely delay efforts to reduce leaks, sewage discharges and service failures.

The response also notes that “it was surprising that Ofwat suspended its asset health team for a crucial year in the run-up to this price review.”

Water UK has set out a number of recommendations which Ofwat should implement, including:

• Provide sufficient funding allowances for investment
• Remove excessive and arbitrary evidence requirements and efficiency challenges
• Revert to engineering-based assessments of major projects that properly take account of regional characteristics and costs, rather than simplistic benchmarking models.
• Use realistic forecasts of future costs, based on the evidence provided by companies to refine the allowances, assumptions and adjustment mechanisms for frontier shift efficiency, energy costs and business rates.
• Revise the proposed approach to asset health maintenance - the response also notes that “it was surprising that Ofwat suspended its asset health team for a crucial year in the run-up to this price review.”
• Hold the sector to account effectively

The response says Ofwat’s draft determinations do not achieve the objectives of seeking to push the sector to innovate and deliver improved outcomes for customers and the environment and holding water companies to account whenever they fall short. they should be. Water UK says that because of miscalibrated performance targets and incentive rates, they create excessive levels of downside risk with limited scope for companies to improve their performance.

Water UK estimates companies could face significant performance penalties of between £2.5bn and £8.4bn over the next five years and warns that almost every company will automatically fall into penalty (and so be seen as failing) from day one, because Ofwat has not properly taken into account real world performance. As well as making it harder for companies to improve, this will undermine trust and confidence in the sector – including in the regulator and its framework.

Ensure the sector can attract the investment it needs

In Water Uk's view, as it stands, Ofwat’s draft determinations for PR24 represent a critical risk to the sector’s ability to raise the levels of investment needed for ensuring the security of the water supply and to stopping sewage entering rivers and seas. By providing insufficient funding and setting companies up to fail, the draft determinations will force the water sector in some places to either delay or scale back some of their plans. This comes just when the sector needs to overcome a decade of underfunding following the suppression of bills below inflation. This cut £11bn from potential investment over the last ten years - based on Water UK calculations of the amount of investment that would have been available had Ofwat simply allowed revenues to keep pace with inflation from since 2015.

However, the response says that without change then Ofwat’s draft determinations would likely make it impossible for the water sector to attract the level of equity investment that it needs - an assessment is shared by credible independent commentators. Water UK refers to the engagement with over 30 senior investors by which Oxera found that there has been a deep and widespread loss of confidence among domestic and international investors in Ofwat’s decisions and their ability to enable the long-term investment needed by the sector.

“This loss of confidence seems to have grown even from the striking findings of Ofwat’s last investor survey (conducted before draft determinations were published in late 2023) which found that every single private equity investor thought that investors were not being listened to, and 90% disagreeing or strongly disagreeing with Ofwat’s approach to regulation,” the response says.

Water UK also criticises Ofwat’s assessment of the business plans as seeming to have focused on separate elements of its methodology (e.g. outcomes, costs, finance) rather than fully considering the individual circumstances and regional characteristics of each company, saying:

“Indeed, it is not clear how Ofwat has assured itself that the determinations for each company are, overall, coherent, deliverable and financeable.”

In Water UK’s view, this approach has been exacerbated by limitations in Ofwat’s approach, including:

• the absence of an initial business plan assessment stage (as per PR19)
• a short consultation period for the draft determinations (with a consultation period of less than seven weeks to respond to 3,000 pages)
• the late inclusion of new or incomplete proposals (particularly on outcomes and price control deliverables).

Water UK is suggesting that at this stage in the process, it is therefore vital that Ofwat takes the time it needs to study carefully the individual issues raised in the response and company submissions.

The response warns:

“The level of concern among industry is now such that the sector would be willing to work with Ofwat on an unprecedented delay of final determinations to late January 2025 if that would allow more meaningful engagement and a better settlement for customers, the environment and a sustainable long-term industry. This would need to include working with Ofwat on overcoming any practical barriers to agree specific charging arrangements, as well as managing any supply chain issues.”

"Without change, new homes could be blocked and the recovery of our rivers will be slower" 

Writing to Ofwat CEO David Black in a letter accompanying Water UK’s response, David Henderson Chief Executive Officer of Water UK said:

“As you examine their plans for that investment, I know how difficult it is for any regulator to distinguish between genuine issues and special pleading, and it is natural for a degree of cynicism to enter into the judgments you must make. That must be even more the case where there has been such variable performance between companies.

“Sometimes that cynicism is justified. On other occasions – as we saw with the last offshore wind auction seeking new energy investment – such cynicism is unwarranted and the outcome is failure. On behalf of the whole sector, I wish to make clear the industry’s strong belief that without significant change, Ofwat is currently headed for the second of these possibilities.

“Unless Ofwat alters its course, there is a very real risk that much-needed economic growth will be constrained and the continued over-abstraction of water from fragile ecosystems will not improve. Without change, new homes could be blocked, the recovery of our rivers will be slower and I see us failing to show anything like the required urgency in dealing with the water shortages we know are coming.”

Click here to download Water UK’s formal response to Ofwat Draft Determinations