The water companies have expressed serious concerns about industry regulator Ofwat’s approach to setting price limits.

The water companies believe that as it stands, Ofwat’s preliminary model is the opposite of what it set out to achieve i.e. over-complication as opposed to simplification.

The comments come in the response to Ofwat's informal consultation on future price limits by Water UK, the body which represents all the UK water and wastewater companies at national and international level.

Despite the fact that Ofwat stressed that its preliminary model is not a statement of policy, either in relation to the next price review in 2014 or beyond, the water companies are clearly concerned that the regulator may continue along the path outlined in Ofwat's preliminary model. The Water UK response says that Ofwat has not yet given any alternative approaches a full examination – at least not in any industry-facing context.  

Water UK is calling for Ofwat to deliver “on the promise of an open minded, transparent process which considers evidence objectively and builds confidence in the regulatory regime.” The response says:

“Ofwat has set out clearly that its preliminary model “should serve as a basis for debate, not as a constraint on other possibilities” and we believe that this means that future consultations should have considerably more scope to examine a range of potential solutions, in contrast with the more single-minded approach adopted in the informal consultation. “

Water UK says the Ofwat process must now be seen to deliver on some of the key assurances set out in the informal consultation about its future approach and should consult in the autumn on a range of alternative options. The response says that it should be of concern to Ofwat that both companies and independent commentators have questioned the logic of Ofwat’s preliminary model.

Key areas of concern include:

• Disaggregation of price controls into separate components appears contrary to Ofwat’s drive for simpler, outcome focussed regulation. Ofwat has yet to set out a reasoned case, beyond presumption, to support proposals to disaggregate price limits.
• Water UK said it was “notable” that the preliminary model makes no mention at all of the Service Incentive Mechanism which early indications suggest is proving to be a positive and effective driver of company behaviour in delivering the outcome of better customer service. The response says the omission of any mention of the SIM suggests that it may not have a significant role in Ofwat’s preliminary model, just one price review on from its introduction – describing it as a mistaken approach.

The water companies are also concerned about the role of the Regulatory Capital Value in the Ofwat model from an investor’s point of view. The response says keeping the RCV whole and ensuring the remuneration of it is consistent with the long term expectations of investors who have committed their capital to the industry.

However, Ofwat’s assertions that the RCV will be protected are potentially hollow if there is doubt about what that means. Water UK says that Ofwat must recognise that it is the future income stream from the RCV which is of significance to investors, rather than the absolute level of the RCV itself.

The response warns:

“It would be entirely understandable for investors to worry that future developments in the regulatory regime might lead to a waning commitment to the RCV, breaking the regulatory contract that has underpinned so much investment into the sector that has yet to be remunerated. “

The water companies are also concerned that in its preliminary model “Ofwat appears to misread the intention of the Special Infrastructure Projects Regime.” The response points out that the Regime is not intended to be a general framework which seeks to put out significant capacity enhancements to competitive tender and that the introduction of such an approach would be a significant departure from current regulatory and legislative arrangements.

Finally, the response also expresses concern that Ofwat’s desire to “future proof” the price setting process in the long-term could seriously compromise the practical delivery of key priorities for the upcoming Price Review for 2015-2020. Water UK said:

“The reality is that no price review structure is likely to be totally future proof and whilst there is broad agreement on the nature of future challenges, their scale, and the extent to which they impact the appropriate price setting process, remain uncertain. “

Water UK now want Ofwat to form a working group to consider practical arrangements and project planning and to pay “careful attention to the capacity and time constraints within which both the regulator and the industry are working.”

The organisation says that Ofwat must articulate and demonstrate clearly the way in which the revised price review process simplifies the regulatory burden placed on companies, commenting:

“Industry is concerned that the preliminary model which has been outlined appears to significantly complicate – not simplify – the price review process and regulatory incentives and we consider that both the principles of better regulation and the preliminary feedback provided by the Defra Review of Ofwat and CCWater suggest that this is a key criterion for Ofwat to consider when it consults in the autumn on all aspects of its approach to PR14.”

Ofwat will launch a formal consultation on its framework for future price limits in October 2011 and finalise the framework in spring 2012, before setting out itsdraft methodology for the next round of price setting in autumn 2012.