The headline-grabbing recommendation, one of four that the Government has immediately accepted, is to abolish Ofwat (or the Water Services Regulation Authority, to give it its full title) and bring the water functions from the Environment Agency, Natural England and the Drinking Water Inspectorate into a new regulator (with a separate regulator for Wales).

The current system has an inherent complexity, where the Environment Agency, Natural Resources Wales and the Drinking Water Inspectorate set the requirements that determine much of water companies’ costs, while Ofwat then determines the revenues companies can receive to cover those costs. Environment Secretary Steve Reed agreed that “having four separate regulators with overlapping and conflicting remits has failed customers and the environment” and that the UK Government would bring water functions from four regulators into one “single power super-regulator responsible for the entire water sector, and with the teeth to enforce the high standards the public rightly demand”. 

Ofwat will remain in place during the transition period and continue to oversee the current price review and investment plan during that time, with an interim Strategic Policy Statement to Ofwat setting out the Government’s expectations and requirements. 

In practice, and in light of David Black’s resignation as CEO, there is likely to be some uncertainty for water companies in their interactions with Ofwat during this transition period. We expect Ofwat (and water companies) will want to minimise the disruption but with CMA appeals ongoing and the Thames Water situation unfolding, it is likely to be a challenging period for all stakeholders.

The Cunliffe Report acknowledges that economic regulation of water companies is needed and that the five-yearly price reviews should continue, but with some changes. The IWC recommends that the new regulator adopts as more ‘supervisory approach’ to regulating individual companies, engaging with them on a forward-looking basis rather than relying on a data-driven, desk-based approach.

The IWC also recommends ring-fencing capital maintenance, base operational expenditure and enhancement capital expenditure allowances. This is a shift from the ‘Totex’ approach, which risks companies being incentivised to underspend on asset renewal. This is because, by underspending against capital maintenance in their totex allowance (which is counted as ‘efficiency savings’), they can spend this unused funding on other costs elsewhere or distribute it as dividends. 

The Cunliffe Report also proposes that the Competition and Markets Authority (CMA) should set a common Weighted Average Cost of Capital (WACC) methodology across all UK regulated sectors, which would make the water sector more competitive in attracting investment. Investors said that Ofwat’s WACC is significantly lower than comparative sectors nationally and internationally so that the water sector struggles to attract capital investment, and Ofwat’s notional gearing ratio may have incentivized companies to increase their debt. 

A further recommendation which should help water companies who dispute Ofwat’s price review determinations is to change this to a standard appeal process, in line with other regulated sectors. This should make the appeal process more efficient, faster and cheaper, but mean that water companies would not be the only parties able to raise an appeal: customer and environmental groups could challenge a price review decision.

Other regulatory changes the Cunliffe Report recommends include ending the system of operator self-monitoring, where companies take water samples at wastewater treatment works and submit them to the Environment Agency or Natural Resources Wales. This system has resulted in a lack of public trust, in particular around the reporting of sewage leaks. The Government has accepted this recommendation and confirmed that it will transition to Open Monitoring (real-time monitoring of the wastewater system with data being made public online) instead.

A further recommendation that the Government has accepted is to establish a new statutory Water Ombudsman. The IWC recommended that the Consumer Council for Water be converted to a new mandatory Water Ombudsman. The Government’s initial response isn’t clear about how the new Ombudsman will be created, so we will have to wait and see how it will be constituted, and how impactful it will be.

Chapter 6 of the Cunliffe Report covers company structures, ownership, governance and management and its recommendations are designed to ensure that the interests of private water companies are aligned with the public interest. The gist of the recommendations are more control by the regulator over changes of control of water companies and the power to direct parent companies and ultimate controllers, to stop them taking action that would undermine the resilience of water companies.

One of the key recommendations here is that the ‘public benefit’ clauses that have recently been added to water companies’ Articles of Association should be reflected in their licence conditions, so that the regulator can enforce them.

There are also recommendations about how to make water companies more financially resilient, and therefore more investable, such as a financial supervision framework, a power for the regulator to set minimum capital levels for water companies, a formal turnaround regime for poorly performing companies, and a framework for ensuring companies are prepared for SAR (Special Administration Regime). The government will have learned lessons from the turnaround regime implemented in respect of Thames Water as a tool to avoid SAR.

The IWC’s recommendations reflect what is happening in other sectors such as energy and transport, where the Government seems to be “taking back control” – e.g. establishing the National Energy Systems Operator and systems planning in energy; and an overarching ‘guiding mind’ for the rail industry in Great British Railways. It is not a return to nationalisation but more central steering of the private sector.

The IWC advocates for a new, long-term 25 year, cross-sectoral, systems-focused National Water Strategy for England and for Wales. This should come from the Government, as only the Government has the system wide view of water that is required. The Strategy should be for a minimum of 25 years with milestones on a 5/10/25 year basis, reviewed every 5 years in line with the Price Review cycle.

Below this, there should be a simplified planning system for water that reflects the needs of local areas. The Report stresses that water needs to be managed as a system. Business plans cost the industry an estimated £250m each Price Review cycle and are “plainly not working”. It recommends retaining the 5 year price reviews but conducting investment planning on a 5/10/25 year basis, with greater certainty and granularity for the first 5 years, more indicative plans for the following 5 years, and higher-level indication for the longer-term. It also recommends streamlining water industry plans from 9 plans into 2 core planning frameworks: Water Environment and Water Supply.

In its initial response to the Report, the Government has committed to including a regional element within the new regulator to ensure greater local involvement in water planning, moving to a catchment-based model for water system planning.