The publication today by UK water industry regulator Ofwat of its Future price limits – statement of principles paper has flagged up the potential for far-reaching changes with significant implications for the way the UK water companies do business in future.

Ofwat has published its statement of principles on its proposed framework for setting price future limits which it expects to be followed – and adapted – over more than one price control period, together with From principles to price setting - next steps outlining the key areas for further work, including responding to stakeholders’ feedback.

Ofwat said its proposed changes are needed to remove what it describes as a “dependency on the regulatory framework to drive outputs” and an “unintended bias towards capital expenditure that could lead to unsustainable investment.”

The statement of principles contains a number of key proposals with significant and far-reaching changes for the sector. In Ofwat’s view the retail and wholesale parts of the water and sewerage sectors should be regulated differently. Where markets are working effectively, regulation should be reduced or removed entirely.

The statement says:

“We consider that the two types of activity are so distinct that by setting separate controls we would create the greatest incentive on the retail businesses in particular to have a greater customer focus.

Setting separate wholesale and retail price controls is a tried and tested approach to regulating utility sectors in the UK .….introducing contestability in water and sewerage services to non-household customers ..means that setting separate wholesale and retail price controls is likely to be the most effective way to regulate.“

 On the evaluation of company business plans, Ofwat said that where a company submitted a well-evidenced plan – including evidence of effective customer engagement –it would take a less detailed approach to its challenge of the plan. It would also simplify the business plan submission process by removing the need for draft business plans.

Ofwat also confirmed its intention to retain and continue to use the regulatory capital value (RCV) as a key regulatory tool in the long term. Primarily used in setting price limits, the RCV is now widely used by the investment community as a proxy for the market value of the regulated business and has, in some instances, become enshrined in bond covenants. Other tools Ofwat will continue to employ include interim determinations, whereby the companies can apply for interim price increases during the period.

Companies must adopt outcomes-based approach in business plans

The statement of principles sets out Ofwat’s framework under the following three headings.

•            Elements applying to the overall price setting process.

•            Those aspects applying primarily or only to the wholesale control.

•            Those aspects applying primarily or only to the retail control.

Under elements applying to the overall price setting process, Ofwat intends to require the companies to propose in their business plans the outcomes they will deliver which should be developed in consultation with their customers and stakeholders. The companies will also have to propose the milestones and measures the regulator will then use to monitor progress in delivery. If a company does not deliver the required outcome, it will need to carry out whatever additional expenditure or outlay was needed to rectify this at no added cost to customers.

Ofwat said it would give further consideration to whether companies will be required to propose a delivery incentive mechanism that would come into effect if a company fails to deliver an outcome. The incentives would comprise ‘pledges’ of what the companies would do if they failed to deliver a particular outcome.

There are more than 11,000 schemes comprising about 2,000 ‘outputs’ in the current price control period and delivery of these will have to be measured at the end of the period. Ofwat expects there to be a greatly reduced number of compliance measures in the next price review period under an outcomes-based approach.

Extended engagement needed with water companies on licence amendments 

The statement says that Ofwat also intends to set two types of price control – wholesale and retail, allowing it to use different approaches in each area. The water companies’ retail business would be regulated differently, depending on whether the business is serving customers that have – or are likely to have – choice of supplier (the contestable market) or not (the non-contestable market).

The regulator is currently consulting on making appropriate amendments to company licences to enable it to set separate price controls, including other changes such as varying the duration of the controls in the future. However, the water companies have already rejected a proposed amendment to their licences needed so Ofwat has now extended the period of engagement to consider how best to resolve the issue.

While the regulator will set the wholesale and retail controls for a period of five years from April 2015, the consultation will consider the case for flexibility in company licences to potentially alter this duration in future price controls from 2020 onwards. As part of Ofwat’s goal of simplifying the process of setting price limits, the regulator is also planning to allowing more time after its draft determinations for companies to make representations, including time for them to consult again with their customers.

On revenues generated by unregulated activities, the statement said Ofwat will continue to use a ‘dual till’ approach for the treatment of regulated and unregulated activities i.e. revenue from the latter will not be taken into account when setting prices for regulated activities.

"Totex" to replace opex and capex

Other measures in the statement include a proposal to treat capital expenditure (capex) and operating expenditure (opex) together – in a total costs or totex approach. Many stakeholders have told Ofwat that treating capex and opex separately has become complex and burdensome. The approach could also create perverse incentives, ranging from a bias towards capex, to “encouraging ‘gaming’ or ‘padding’ of business plans by companies that may consider it in their interest to inflate costs in their original submission.” Ofwat commented:

“We acknowledge the shortcomings to our past approach and agree that it needs to change.”

Ofwat also plans to introduce the following new incentives into the wholesale control to incentivise the companies to manage water resources more efficiently:-

• increase water trading
• abstract water from the most environmentally positive sources and to reduce unsustainable over-abstraction (the abstraction incentive mechanism – orAIM);
• and optimise company networks to facilitate the better allocation and management of water resources, including through better interconnection and water transfers.

Sub-limits for price controls to be developed in longer term 

Within the price control Ofwat also intends to develop a sub-limit that will apply to the network and treatment assets. Known as the network plus control, Ofwat expects the first implementation of the sub-limit to be non- binding and to focus primarily on revealing information that will help to develop the control over time.

The regulator said although it had also considered introducing a sub-limit on the sludge treatment and disposal business in response to its joint work with the OFT on the anaerobic digestion market, it had decided that this would not be proportionate at this stage. However, the statement says Ofwat considers it would be worthwhile to explore the proposal further as part of the longer-term framework after the next price review.

More incentives for water trading and disincentives for over-abstraction

On water trading, Ofwat is proposing to introduce a number of positive incentives which could include:

• deregulating bulk water trading;
• increased returns for water importers and exporters of water across company boundaries; and
• stronger obligations on the companies to consider imports when planning how they will manage resources through the water resource management planning
• process.

Alongside water trading incentives, Ofwat is also planning to introduce an abstraction incentive mechanism (AIM) to identify where and when abstraction could be most damaging, and to disincentivise it, making it less likely or frequent. Ofwat proposes to include AIM in its short to medium term framework to ensure water trading incentives do not unintentionally incentivise an increase in unsustainable abstractions.

Network optimization incentives further down the line

The regulator is also seeking to introduce network optimization incentives to encourage the water companies to manage their networks in a way that facilitates and enables the best choice of transfers and trades.

Athough the statement says that network optimisation incentives should form part of the regulator’s future price limits framework, most companies are opposed any sort of network optimisation incentive, arguing that as they already carried out this function adequately, it would be difficult to define the function and it would vary from company to company.

However, Ofwat plans to develop network optimisation incentives that will sit within the wholesale business as part of its long-term framework. The statement says:

“We would very much welcome input from the companies into this work as it goes forward. “

Stakeholder engagement key to both regulatory proposals and business plans

The proposals appear to have met with a mixed response to date from stakeholders involved in consultations with Ofwat. For example, while environmental stakeholders, consumer representatives and the water companies have generally welcomed an outcomes approach, all of the companies have opposed the network plus sub-limit, citing uncertainty over future developments arising from the Water White Paper and arguing that it would be disproportionate.

Ofwat is undoubtedly expecting to see a considerably increased level of customer engagement in the development of the water companies’ business plans. The companies were required to engage directly with their customers when setting their outcomes.

The regulator expects improved customer engagement to provide “enhanced legitimacy” of the final business plans and the bills customers pay. The statement says:

“At a time when many customers are finding it difficult to pay their bills, this is becoming ever more critical. The lack of understanding that customers have is clearly evidenced in their current confusion over why they face usage restrictions in times of heavy rain and flooding. And customers are strongly critical of their company’s performance on managing leakage. The companies need to be more responsive to this type of feedback. “

The regulator now plans to do more work with stakeholders over the summer to decide whether certain elements can or should be implemented in full for the next price review, or whether they should be staged over more than one price review period. ‘From principles to price setting – next steps’ sets out the work it intends to do between now and the autumn and explains how stakeholders can be involved in and influence Ofwat’s thinking during this phase of work.

The regulator will consult on the proposed methodology for setting price limits in 2015 in the autumn.