A new Briefing Note on Waterbriefing by Anthony Legg at FTI Consulting raises some interesting pointers on the PR14 methodology and business planning statement issued by Ofwat last week setting out how it intends to set price limits for the 2015-20 period.

According to FTI, while the key features of Ofwat’s proposals are consistent with its earlier consultations, there are some important changes to the details of the regulator’s methodology. Crucially, it is not yet clear exactly how Ofwat will decide whether a business plan is ‘enhanced’ or not, nor when Draft and Final Determinations will be handed down.

Wholesale price control – totex, but how?

FTI points out that Ofwat has confirmed the introduction of totex and that it will use totex menus, which it will publish in 2014, as part of its incentive package. However, FTI says that the regulator appears “to have backed away” from the emphasis it had placed on totex econometric modelling to determine wholesale efficiency challenges, appearing instead to advocate applying a range of different models and combining the results in a yet-to-be-determined fashion.

The Briefing Note says that while some companies may welcome the decision to reduce the importance attached to totex modelling, they may not be satisfied with Ofwat’s continued refusal to share its totex econometric models with the industry. FTI says:

“It is unclear what comfort can be drawn from Ofwat’s indication that it will be making the dataset it intends to use available before the end of 2013 and that it will be “fully transparent” in setting cost baselines in 2014.”

Household retail price control – cost inflation can’t be passed via prices?

Commenting on the regulator’s confirmation that the household retail price control will not be indexed to inflation, FTI says that in the absence of compelling evidence, it seems increasingly likely that companies will, effectively, face the additional efficiency challenge of offsetting cost inflation that can’t be passed through to prices.

On Ofwat’s decision to calculate the denominator in the industry average cost to serve (ACTS ) based on the number of unique customers, FTI says that Ofwat’s preliminary analysis suggests that the cost to serve a water and sewerage customer is around 1.3 times the cost of serving a single-service customer, although “exactly how Ofwat generated this estimate is not explained.”

With regard to Ofwat’s definition of the retail business (which includes customer-side leaks, demand-side water efficiency services and some aspects of developer services as retail activities), FTI says the definition has wider implications because it is also likely to be the definition used for the purposes of market opening and competition from 2017.

Financial issues – a work-in-progress?

The Briefing note describes Ofwat’s thinking on financeability as appearing to be “a work-in-progress”, commenting that while on one hand, there is some helpful guidance about the ratios that it intends to look at and a confirmation it will test financeability at a whole-business level, Ofwat then “muddies the waters” by indicating an intention to examine financeability (but not financial ratios) at a price control level, and by mentioning an intention to examine equity ratios (not just debt ratios as in the past), but failing to make it clear if any weight will be attached to them. FTI says that Ofwat also provides “little clarity about how to solve financeability problems,” other than that companies need to consider a range of options including index-linked debt and equity issuance.

FTI goes on to say that Ofwat’s statement confirms that it expects companies to consider and model a range of scenarios in order to inform a view on appropriate sharing of risk and reward between investors and customers – a key input to the assessment of the allowed cost of capital and of financeability.

Calibrating the overall incentive package

Withn regard to how the regulator expects the water companies to calibrate the overall incentive package, the Briefing Note says Ofwat has confirmed that companies will need to make proposals about their outcome delivery incentives (ODIs) and both highlight the outcomes they are striving to achieve and propose the penalties and rewards that they think should be linked to those outcomes.

FTI says a key area for that water companies need to consider will be the strength and internal consistency of the various incentives, in particular the interaction between outcome delivery incentives, cost performance (totex) incentives and other incentives such as SIM and leakage – which it describes as “arguably one of the most complex features of the new regime.”

Timetable for the price control – a major gap

The Briefing Note describes clarity over the timetable for the review as “one of the major gaps in Ofwat’s methodology statement”, commenting that while companies will need to submit their plans by 2 December 2013 and Ofwat has indicated that they should plan on the basis that they may not receive their Final Determinations until January 2015, beyond that little guidance has been publically given.

The Briefing Note makes some key points about some of the current gaps in the Ofwat PR14 methodology – in FTI’s analysis it is likely that the water companies “now have as much visibility of the methodology and process as they are going to get. “

So it will be interesting to see whether these have been further clarified by the regulator in time for submission of the water companies’ Business Plans in December.

Click here to download the full Briefing Note.