In an extraordinary development, Ofwat’s plans for the  new retail market in 2017 are about to undergo fundamental changes which could have significant implications for the introduction of competition – only six months after it announced the creation of Open Water Market Ltd to deliver the new arrangements.

Together with the High Level Group established by the UK Government to prepare for the new retail market, Ofwat has “come to the conclusion that Open Water Market Ltd will not provide the right model to deliver the necessary work needed to open a retail market in April 2017.”

The regulator is now planning to set up a new advisory panel of elected company representatives to advise on the design of the new market arrangements, including the draft market codes. The intention is to set up a programme of work to be taken forward within Ofwat and for the work to formally move across from OWML by the end of the year. From the beginning of 2015, the panel would make recommendations to the Ofwat Board on key issues associated with the market design, although final decisions would be taken by Ofwat’s Board.

Voluntary funding and membership of OWML is not sustainable 

In a new consultation launched today on proposed changes to water companies’ licences needed to fund the work, Ofwat said:

“Although funding and membership of OWML has been on a voluntary basis up to now, that approach is not sustainable in the longer term. Those arrangements were set up to enable prudent preparation ahead of legislation. Now the Water Act has been enacted, we need to establish a proper funding arrangement, so that the detailed development of the new market arrangements can take place – including the:

• detailed market design;
• development of draft market rules (which will form the basis of the market codes); and
• procurement of the central systems.

And this work will need to be carried out by both Ofwat and OWML.”

A key reason proffered by Ofwat for the change appears to be confusion about the fundamental nature of OWML and whether it is operating as a ‘public’ or ‘private’ body according to Government rules. The former group are subject to the same financial, governance and other controls that other public bodies are required to follow, while the latter operate as private companies under company law and the general legal framework, which is much more flexible.

 Ofwat said it had expected OWML to be designated as a ‘private’ entity, an  assumption it made because, “for example, OWML appears very ‘private’ in nature in that it:

• receives no public funding;
• has no public function (as set out in legislation); and
• is owned by a majority of private members.”

The regulator said that as a ‘private’ company, it had expected OWML to provide an effective vehicle that would allow the market arrangements to be designed and developed quickly and efficiently and also a “collaborative, inclusive and balanced model” that would allow all market participants and stakeholders to be involved in the design of the new market arrangements. The new proposals suggest that this no longer appears to be the case.

The consultation document says it now appears likely that OWML will be designated as a ‘public’ body and would be subject to similar rules and controls that other public bodies face – for example, in terms of appointments, procurement and financial management. However, at the same time, OWML would remain a private company under company law and would be subject to the tax arrangements for a private company.

The document states:

“While there are clear merits to OWML having effective financial controls, the combination of these new ‘public’ controls and the additional constraints that they will impose on OWML to operate quickly and efficiently, and maintain momentum as we move into this next phase of work, we consider will cause unnecessary risk to the delivery of the market arrangements in time for the market to open in April 2017.”

“So Ofwat, the HLG and OWML Board members have decided that in the medium term a new programme with a ring-fenced budget should be created within Ofwat to take this work forward instead. We expect that this new approach will be more efficient and effective, with clearer and more streamlined governance for the work.”

£10.5m annual funding ring-fenced to ensure it "would not be used to deliver any other Ofwat activity"

The proposed temporary licence condition would require companies to fund the development of the new market arrangements in the period from August 2014 to approximately the end of 2016. Ofwat is also proposing that it can continue to have effect until 31 March 2018 to allow for any budget requirements in the 2017-18 financial year should the transition to the enduring market operator be “delayed unexpectedly.”

The consultation document states:

“To build a degree of flexibility into the funding arrangements for this next phase, we propose to require companies to provide funding to OWML, or if companies are notified by Ofwat, to Ofwat. This is an important change to our original proposed approach.”

Ofwat is proposing to require companies to fund the development of the new market arrangements by providing funding to OWML, or if notified by Ofwat, directly to Ofwat which would “create flexibility in the arrangements”. If companies were asked to provide the funding directly to Ofwat, a ring-fenced budget would be set up for the work, which “would ensure that any funding provided under the new proposed licence condition would not be used to deliver any other Ofwat activity.”

Ofwat has proposed a  total annual contribution capped at £10.5 million in each financial year from 2014-15 to 2019-20, which includes a 10% contingency saying that “clearly, the expected annual budget is likely to be lower than this limit.”

The funding will be apportioned on a pro-rate basis based on June return data between 2008-11, with the smallest amount of 0.6% paid by Portsmouth Water and Sutton & East Surrey Water, while at the top end Severn Trent Water and Thames Water would pay 15.9% and 20.0% respectively.

OWML to become non-active shell company at end of 2014

Ofwat said that as a consequence of the change and “in response to recent comments from companies”, it is no longer proposing to require companies to become members of OWML, adding:

“However, we do consider that there continues to be a benefit from companies voluntarily becoming members of OWML, if they are not already members, and would encourage companies to consider this.”

Ofwat said it had removed the proposed requirement for companies to become members of OWML, as there is “uncertainty about the future of OWML beyond December 2014”, although it proposes to retain OWML as a dormant company. From the end of 2014, OWML would exist only as a non-active shell company until the market operator is set up, anticipated to be by the end of 2016 when OWML would either evolve into the market operator, or be wound up.

Ofwat in the firing line for more criticism?

Coming only months since OWM Ltd was set up, the new proposals are a somewhat unexpected development in the regulator’s plans for establishing the retail market in 2017. 

While it is difficult to read between the lines on this, one would have to conclude that the issue of funding has played a key role. The proposals for such significant change are likely to put Ofwat further in the line of fire at a time when it has already been on the receiving end of some serious criticism, including:

• from the investment community for its handling of the Price Review 2014
• making staff redundant at a time when a heavy workload has compelled the regulator to seek external help from consultants PriceWaterhouseCoopers to  deliver PR14 at a projected cost of up to £6.45 million.

Questions could also be raised about the fact that the regulator is proposing to bring back in-house a significant additional workload requiring good financial control and management. Just over two weeks ago Ofwat reported on its own publicly acknowledged internal organisational and financial management failures during 2013-14 - described by the National Audit Office as a “significant failure in Ofwat’s financial planning”. 

Click here to access the consultation document.