It only seems five minutes since the last five-year price review, known as PR19, but Ofwat is already looking ahead to the next one.
It has issued a paper, PR24 and beyond: Creating tomorrow, together, inviting contributions and submissions from the water sector. The paper outlines Ofwat's initial views on the framework for PR24 and future price reviews which ultimately aims to create value for customers, communities and the environment.
Ofwat expects the structure of price controls in PR24 to be generally the same as for PR19 but with improvements to how they are implemented. The aim is to enable targeted and proportionate regulation for different activities, compare different companies' costs and support alternative delivery models (for example, through markets and innovation).
Ofwat wants to embed a sharper emphasis on creating value. This means addressing four key themes in PR24 to successfully meet existing and future challenges facing the sector and to capitalise on opportunities. The four themes interlink and complement each other.
We briefly outline those themes and Ofwat's thinking behind them below.
Increased focus on the long term
With net zero being high on the agenda - and to avoid underinvestment in asset maintenance - Ofwat believes that water companies need to focus on the long term view. They should do so by centring business plans on the longer term horizon. Water assets have long lives. Decisions made now impact the services that customers experience, and the bills they pay, long into the future. Water company strategies should cover long term outcomes for customers and incorporate strategic planning frameworks, evidence customer views and address affordability constraints. Business plans should counter uncertainty by using simple scenarios to stress test how robust a particular strategy is in different conditions.
Stakeholders have already floated the idea of extending periodic review periods to help support an increased focus on the long term. Ofwat contends that this would actually stifle the ability of water companies to adapt to future needs, relying on the lessons learnt from Ofgem at RIIO-1 (where 8 year control periods led to higher company returns and higher customer bills).
Deliver greater environmental and social value
Water companies hold an almost unique position in their communities by being one of a few long term stakeholders providing essential services.
Society increasingly expects decision making by water companies to be driven by a broad range of environmental and social factors. Ofwat wants PR24 to mean companies deliver even more environmental and social value by exploring different approaches to their core activities. Ofwat is considering incentivising sustainable outcomes, nature based solutions and behaviours that deliver the most value over the long term, ranging from collaboration with local partners to working innovatively with customers and communities. So looking at opex rather than capital-based solutions – with incentives to do so – building on the direction of travel in the last price review.
The price review in isolation is unlikely to meet these aims, so the sector as a whole and other regulators are expected to play an integral role in projects which ensure that decision making consistently seeks to maximise benefits to communities and the environment.
Reflect a clearer understanding of customers and communities
Over the last decade the sector has come to realise that engaging well with customers is fundamental to delivering services that meet their needs. Continued high quality engagement is essential to ensuring customers' views are captured in the simplest, targeted and most effective way. Ofwat has invited the sector to help inform the minimum standards for high quality research to making the research process more efficient. Overall, the intention is for Ofwat and water companies to foster a collaborative approach to research to understand what matters most to customers. The findings of the collaborative research is then expected to feed into business plans and Ofwat's determinations.
Ofwat suggests that getting more for customers and communities is best achieved by:
- continuing to use business plan incentives which stretch water companies to best achieve customers' interests;
- reducing the number of stages in the price review process by potentially combining the initial business plan assessment stage with the draft determination stage;
- retaining cost sharing and thereby ensuring proper risk allocation; and
- making use of targeted challenges to hone in on weak spots where the sector needs to improve.
Drive improvements through efficiency and innovation
As environmental challenges continue to mount and the need to deliver more for less, Ofwat states that water companies must innovate to meet these challenges head-on in a sustainable and cost effective manner. One way that productivity might be improved is by the use of financial incentives where companies adopt new and innovative techniques to delivering outcomes, particularly over the longer term – exemplifying the interactive nature of the themes. Ofwat suggested that digital transformation and optimal use of open data is crucial to meeting this aim.
Ofwat has set up specific innovation tools supporting this theme, for example the 'innovation fund' which gives companies the opportunity to bid for funds specifically for innovative solutions to frequently encountered problems facing the water industry.
Markets can also drive innovation and efficiency, so Ofwat will further develop markets for developer services, bioresources, water resources and the provision of large infrastructure in PR24.
This is just the first step in the next round of water price reviews and there's more to come. It seems for now that Ofwat are broadly following the structure of the PR19 review, but potentially streamlined slightly to merge the initial assessment of plans and draft determination stages. Given that the CMA upheld appeals by a number of licensees in relation to PR19, licensees across the board will no doubt scrutinise Ofwat's model and assumptions keenly as they develop. The uplifts in WACC, cost of equity and particularly cost of debt will likely be key focus areas as licensees that did not appeal during PR19 may seek to 'catch up' to other licensees.
Data will likely be an area of attention for both Ofwat and licensees during PR24 given the intense debate both with the CMA and, indeed, by the CMA, about the use of 2019/20 data during PR19 (with Ofwat contending it should not be used as 2019/20 was not a wholly reflective year). Quite what is normal for the period ahead remains unclear.
Wider policy issues for both Ofwat and licensees will also need careful consideration:
- Ofwat's focus on net zero and environmental themes is consistent with investors and licensees' own strategic concerns and those of policymakers. The action by regulators for environmental issues (including the most recent review by the Environment Agency on water company pollution) poses a real challenge for licensees who will be pressing Ofwat on the funding available to deal with major environmental issues when set against Ofwat's general push for lower consumer costs. Many licensees will, of course, be considering whether the ambitious approach of some European regulators towards collaboration on ESG issues has a wider read-across.
- It's also interesting to see the focus on long term plans: this is similar to the Williams-Shapps Plan for Rail with its 30 year strategy and 5 year Control Periods. It's also interesting that Ofwat have taken learnings from Ofgem in energy regulation and chosen to stick with 5 year review periods, as the 8-year RIIO-1 period was shown to result in companies getting higher returns than expected.
- Ofwat are also looking to Ofgem's RIIO-2 in proposing Price Control Deliverables, linking funding to specific outputs. Ofwat also have an eye on the Ofgem CMA appeals and are exploring whether to index the allowed return on equity.
Given the successes of appellants during PR19, PR24 may see some concessions from Ofwat; equally, it may see licensees taking a more challenging stance where they disagree with Ofwat.
Ofwat invites comments from the water sector and submissions to the various questions posed in the PR24 paper by 5pm on 22 July 2021. There will then be further working papers, workshops and working groups to help develop the price review framework before Ofwat publishes its draft methodology in summer 2022. We are engaging with a number of industry participants on their next steps in the process.