It has been more than a month since Ofwat published its final methodology for PR19. Partners Rona Bar-Isaac and Andrew Walker look beyond the Wacc, and dig into the detail.
It has been more than a month on since Ofwat published its PR19 final methodology. The significantly lower weighted annual cost of capital (Wacc) – 2.4 per cent – hit the headlines in the weeks following, and understandably so, as the industry got to grips with a record low figure for a regulated utility.
But looking beyond the surprising Wacc, and digging deeper into Ofwat’s methodology – a blueprint setting out how it’ll regulate the English and Welsh water industry for five years following 2020 – there are three significant areas it’s important to observe.
Resilience in the round
Resilience emerged as a key theme of PR19, focusing on ‘resilience in the round’ – examining not just the ability of an organisation’s infrastructure to cope with disruption, but also its financial arrangements and corporate governance.
As set out in September 2017’s resilience in the round paper, Ofwat is taking a systems-based approach and those objectives are touched on in the PR19 methodology and performance expectations. It now includes specific commitments on resilience to drought and flooding, the environment and long-term sustainability and better engagement with customers.
It’s in line with the Water Act 2014, which introduced a new statutory duty on Ofwat to further the ‘resilience objective’: promoting long-term planning and investment, the use of a host of measures to manage water resources in sustainable ways, increase efficiency in water use, and reduce the demand for water to minimise pressure on resources.
Direct procurement for customers
PR19 introduces a new model for larger water infrastructure projects to secure competitive financing: direct procurement for customers (DPC). It mimics the OFTO model in the energy industry, where infrastructure connecting offshore wind farms to the mainland is owned and operated by a separate company following a competitive process. However, there are significant differences, which raise questions as to how the model will work.
Any project with a total expenditure of over £100 million and classed as discrete (little overlap or complex interaction with other infrastructure) can be considered for DPC. Under the model, the incumbent water company tenders the project and the winning contractor will design, build and operate it, in return for a fixed revenue stream of 15-25 years.
The incumbent water company must prepare an economic case showing that the costs and benefits of putting the project out to DPC outweigh those of building and operating it in-house, which, given the lower Wacc, might be difficult to do.
There are two models of DPC: the contracting model, where the incumbent retains the licence and contracts out its obligations to the contractor, while retaining licence responsibility; and the utility model, where the contractor obtains its own licence – the Thames Tideway Tunnel being an example of this in practice.
The contracting model of DPC is an untested approach, and in the discussions surrounding PR19, there have been concerns as to how protected the incumbent water company would be if the contractor defaulted on its contractual obligations, given that the water company remains accountable to Ofwat as the licence holder.
The Thames Tideway Tunnel is a successful example of DPC, but it was based on the utility model, which has its own licence, and was backed up by various government support mechanisms which are unlikely to be replicated in future projects.
Market opening and competition
The last price review, PR14, only separated the water and wastewater wholesale markets in its revenue control. PR19 goes further, adding water and bioresources, as increasing transparency and accountability will act as a spur to innovation and more prospect for competition, in turn, improving resilience.
By setting a separate revenue control for bioresources, Ofwat wants to encourage more trading between water and wastewater companies for the treatment, transport, recycling and disposal of sludge and also trade and collaboration with firms operating in other waste markets.
Similarly, there will be a separate revenue control for water resources, detached from ‘network plus water’, for England only. This may encourage trading of water across company boundaries now, and looking to the future, the Water Act 2014 will allow business retailers to procure water resources from third parties directly, when the relevant provisions are brought into force. Ofwat’s working assumption is that this bilateral market entry will be implemented in 2022, although the Government has not yet decided when, or indeed whether, to implement it.
Our take on the three significant areas of PR19 we have examined above, is that resilience in the round clearly has commendable objectives, but how those are translated effectively into companies’ business planning in response is yet to be seen.
DPC is in many ways a reworking of PFI ideas – with all their pros and cons. A balance must be struck between allocation of risk and more competitive financing for larger water infrastructure projects, but it’ll be a challenge. In the absence of more from the Department for Environment, Food and Rural Affairs (Defra), the measures to encourage competition between water and wastewater companies and bioresources are relatively modest, but an incremental approach is welcome as the change of the last few years is absorbed.