Water UK, the water sector’s trade body, is warning Ofwat over the risk of potential mass appeals by the water companies to the Competition and Markets Authority in 2025 unless significant changes are made to the 2024 Price Review process.

The warning comes in a letter dated 4 November from David Henderson CEO of Water UK to Ofwat Chief David Black in response to Ofwat’s consultation on a potential outturn adjustment mechanism that could be introduced in the regulator’s PR24 final determinations.

In a series of swingeing criticisms, the letter begins by reiterating Water UK’s initial response to Ofwat’s draft determinations expressing its concern that unless the draft determinations change, water companies will not be able to attract the levels of investment that they need.

“We are concerned that without those levels of investment, the water sector will fail to meet the expectations of customers, deliver the largest environmental programme in the sector’s history, and provide the right conditions for economic growth and water security over the long term,“ the letter says.

David Henderson describes Ofwat’s consultation at such a late stage between draft and final determinations as unprecedented – the consultation launched on 15^th October and closed on 4^th November. The Water UK chief warns that in the industry’s view, the regulator’s proposal leaves fundamental problems unresolved and that the need for the late-stage mechanism appeared to be “an attempt to fix the symptoms of a much deeper problem - Ofwat’s general approach to setting performance targets.”

Ofwat should "fully fund water companies’ expenditure requests and set performance targets that are achievable and deliverable"

A separate Annex accompanying the letter says that if Ofwat is “minded to proceed” with the outturn adjustment mechanism, Water UK suggests that Ofwat “ fully funds water companies’ expenditure requests and sets performance targets that are achievable and deliverable."

The Annex flags up a number of underlying issues with the current performance framework that the proposed mechanism does not address which Ofwat should address first, including:

Unfunded and undeliverable targets

Ofwat’s significant cuts to expenditure allowances and approach to performance targets in its wider determinations, make it highly unlikely that companies will meet the performance targets Ofwat proposes to set.

Even less trust in the water sector

Ofwat’s proposal has the additional disadvantage of generating a further weakening of trust and confidence in the water sector. Even if the financial impact from failing to meet undeliverable performance targets is partially offset by a financial adjustment at the end of the period, the water sector would still incur the significant reputational damage of failing to deliver those unachievable performance targets. Money cannot compensate for such damage. Without changing the targets themselves to levels that are achievable, further confidence will likewise be lost in Ofwat and government more generally.

Weaker incentives to collaborate and innovate

Because of the relative nature of the proposed mechanism, water companies’ returns would be reduced if every single company outperforms. Water UK is concerned that this would have the unintended consequence of deterring companies from working together on joint initiatives or innovations. For example, an individual company would still have higher returns for improving its own performance, but would have an incentive to not share the information that led to its achievements as it would necessarily affect the performance of the median company and, therefore, reduce its returns.

The letter explains that in the current AMP7 period, 15 out of 17 companies are in net penalty for their performance, stating:

“This means that 15 independent boards, all of them faced with expenditure allowances decided by Ofwat, and strong financial and reputational incentives to meet the targets set by Ofwat, have been unable to achieve them.

“It seems unreasonable to suggest that the failure of nearly 90% of companies to reach the targets set by Ofwat is entirely their fault. The targets themselves are simply not in the right place.”

In Water UK’s view, Ofwat’s approach to requiring companies to deliver “inadequately funded and unrealistic ambitions” is set to continue, or for some cases worsen, in PR24. Southern Water’s performance this year, which is expected to result in a £20 million penalty, is cited as an example - the same performance next year would see a £200 million penalty under Ofwat’s draft determinations.

Henderson comments:

“Hitting companies with ever greater penalties for failing to reach ever harder targets has not produced the result Ofwat expects.

“Yet, in its draft determinations for PR24, Ofwat does not sufficiently change its approach. It should now be clear that, unless Ofwat changes its approach, companies will not meet their targets, which will lead, year after year, to severe and increasing criticism of Ofwat and government as the guardians of a failing system.

“The only sustainable answer to this problem is to start with stretching but achievable targets, matched by adequate levels of funding.”

The letter goes on to suggest that water companies, regulators and government now face a degree of complexity that makes it very difficult to predict with certainty how Ofwat’s various mechanisms will interact. According to Water UK, the late addition adds “yet another layer of complication” onto an “already convoluted framework.”

This now consists of “many layers of different mechanism designed to reduce the financial risk ultimately created by Ofwat’s approach to setting targets and allowances, all of which interact in complex and unpredictable ways.”

“We very much hope that the Independent Water Commission will enable us to break out of this needlessly complex regulatory framework,” Henderson comments.

Water UK is calling for Ofwat to change the mechanism to apply annually rather than at the end of the period. In the trade body’s view, this would sharpen incentives, reduce uncertainty and help to overcome financeability concerns with the proposal as it currently stands.

Water UK is also proposing that the mechanism excludes enhanced payments, which are earned when a water company pushes forward the frontier of performance.

“This would remove disincentives for companies to collaborate and share knowledge, ensuring that the customers of all companies are able to benefit from new innovations and discoveries.”

Water UK is also urging Ofwat to reconsider wider aspects of the price review, saying it considers significant changes are required and that without deliverable performance targets and a reasonable balance of risk and returns, the water sector will fail to deliver the expectations of customers, environmental improvements and economic growth.

The letter concludes by saying:

“Addressing these issues and ensuring the final determinations for PR24 are deliverable, financeable and investable will avoid years of delay and the lost progress that will be inevitable from potential mass appeals to the Competition and Markets Authority in 2025.”