Water industry regulator Ofwat has published detailed cost allocation rules setting out a standard set of cost drivers that the water companies must use for allocating their costs for the purpose of setting the household retail and non-household retail price controls from 2015-20.

Ofwat took the decision to issue the cost rules in order to ensure that the companies allocate their costs in a consistent manner across the boundaries between the retail and wholesale business units and between household and non-household customers. However, the regulator has acknowledged that "detailed regulatory requirements are at odds with the general principle of giving companies ownership of their business plans for PR14."

To deliver a robust and consistent approach to cost allocation, the regulator included a retail test on this as part of its risk-based review process for PR14. Ofwat found that in general, companies’ business plans did not contain sufficient information to allow it to test cost allocation consistently. The regulator subsequently issued a request seeking additional information from them on the approach they took to allocating costs across their business.

The responses revealed that some companies had used the cost drivers set out in Ofwat’s methodology statement  in their December business plans, but that others had used alternatives.

 Many of the regulatory tools under the price controls are comparative – in particular, the ‘average cost to serve’ (ACTS) incentive seeks to drive efficiency across companies by forcing those with above average household retail costs to reduce them down to an efficient level. Ofwat said that since these tools are comparative, it is important that it can compare similar definitions of costs – ‘apples with apples’ – otherwise the regulatory incentives may be applied unfairly across companies.

Having reviewed business plan submissions, Ofwat concluded in some cases it was clear that if companies were to use different cost drivers for specific individual cost items, it could result in material changes in the overall amounts of costs being allocated to the different retail price controls.

Commenting on the the decision to set out the cost rules, Ofwat said:

” In light of this experience, we consider that it is necessary to issue these more detailed cost allocation rules for finalising price controls in PR14 – and, in particular, to require companies to adopt a consistent set of cost drivers to allocate their costs.”

“We recognise that detailed regulatory requirements are at odds with the general principle of giving companies ownership of their business plans for PR14, but given the particular industry issues, of market opening and controls based on comparative costs, set out above, we consider that further rules are needed in this instance.”

The regulator also now intends to issue new guidance on setting default tariffs for the non-household retail controls on 4 April.  Later this year,Ofwat will also consult on the requirements for regulatory financial reporting of actual costs from 2015-16.

The regulator has included a caveat that compliance with the charging rules does not override companies’ obligations under competition law and if it were to receive a complaint under the Competition Act 1998 (CA98) in relation to the rules then it reserves the right to exercise its  discretion to investigate under Ofwat’s CA98 powers of investigation.

Click here to access the cost allocation rules in full.