PR19: the squeeze is on

Ofwat has published its draft methodology for PR19, which promises to be tougher for the average company. Utility Week takes a look at the key points from the document.

It’s going to be tough: that’s been the message from Ofwat about the upcoming PR19 price review for several months now, and the eagerly awaited draft methodology published this week didn’t disappoint. The regulator confirmed that water companies should expect a “significant reduction” in the weighted average cost of capital (WACC) in the next regulatory period (2020-25), with senior director for Water2020 David Black highlighting research from PwC last month, which suggested that the cost of equity, on an RPI-linked basis, would be 3.8-4.5 per cent at PR19, down from 5.65 per cent at PR14. The regulator has declined to give an estimated WACC figure ahead of the publication of the final methodology in December, but industry sources point to the Thames Tideway WACC of 2.497 per cent as the direction Ofwat may look to head in.

It’s not all bad news for companies. Those that impress the regulator by ‘really engaging’ with their customers and delivering a high quality, ambitious and innovative business plan will be rewarded with earlier draft determinations and enhanced financial incentives.

These rewards depend on the delivery of plans, as well as the quality. “It’s not enough to just come up with a good business plan,” says Black. “You have to be able to follow through with that during the price review period.”

Ofwat warns that, for companies that don’t deliver, PR19 will be “very tough”. “We’re signalling a tough cost efficiency challenge and much lower cost of capital,” says Black. “For companies that don’t really identify what the customers want and find cost-efficient ways of delivering that, they’re going to find it a very tough price review indeed.”

Here are five key take-homes from the document.

Tougher leakage targets

The PR19 draft methodology document clearly signals a “tougher line” on leakage. Senior director of Water2020, David Black, tells Utility Week Ofwat expects water companies to “look much harder” at how they can reduce leakage.

Just weeks after the furore surrounding Thames’ failure to hit its 2016-17 leakage targets, the regulator has proposed companies set “more stretching” performance commitment levels than at PR14. It expects companies to justify their proposals against options including a 15 per cent reduction by 2025 or upper quartile performance on leakage per property per day.

This is a change of direction from the controversial sustainable economic level of leakage (SELL) – the measure of whether it is cheaper to allow the leak than to fix it – that has traditionally driven leakage targets. The regulator is concerned that the mechanism is failing to “drive companies to become more efficient in how they tackle leakage”. In 2015-16, all companies achieved or outperformed their leakage performance commitments, which Ofwat says “might suggest they were not sufficiently stretching”.

A stronger role for CCGs

Customer engagement was the buzz phrase for PR14, with the introduction of Customer Challenge Groups (CCGs) to scrutinise companies’ business plans. In the next review, engagement will be stepped up another gear, with the regulator calling on companies to use a wider range of techniques to engage customers, as well as repeating the CCG process. Indeed, CCGs will have a stronger role, assessing the quality of companies’ customer engagement and how that engagement is reflected in their proposals for outcomes, performance commitments and ODIs.

Classification of business plans

The introduction of fast track status at PR14 created a newly competitive mindset among companies, with just two – South West Water and Affinity Water – taking the prize. This time round, Ofwat has been clear it expects “enhanced-quality” business plans from all companies. There’s even more to play for, with business plans set to be separated into four categories: exceptional, fast-track, slow-track, and significant scrutiny.

Companies with exceptional business plans will enjoy financial benefits throughout the AMP cycle as well as an earlier draft determination.

The regulator will be looking for plans which are ‘ambitious, innovative and high quality’: “We will look at their service outperformance – so if there are companies which are really shifting the frontier and outperforming all other companies, that might make them exceptional,” says Black.

It may be that no company achieves the most coveted accolade, and Black suggests it will be awarded to “one or two companies at the most”.

Fast tracked status will be easier to achieve, offering companies a smoother process and earlier determination, without any of the financial benefits associated with exceptional status. Black says there is no reason why a “high proportion” of companies couldn’t be fast-tracked.

The regulator’s expectation is that no company should be in the significant scrutiny category. “We’re clear that we expect all companies to be in those top three classes,” says Black.

Service Incentive Mechanism (SIM) replaced

While not a perfect measure, the SIM is generally recognised to have fostered a new culture of customer service among water companies.

However, a decade after its introduction in 2010, Ofwat plans to ditch the measure under the next AMP cycle, replacing it with a new, wider-ranging measure.

WaterworCX will comprise two new mechanisms – C-MeX and D-MeX – which Ofwat hopes will incentivise a better experience for residential customers and developer services customers respectively.

The C-MeX will include higher potential financial rewards than SIM, making the maximum rewards the same as the maximum penalties. Ofwat plans to pilot C-MeX in 2019-20.

The D-MeX is a new incentive with financial and reputational components for developer services customers. Ofwat hopes this will stretch companies to deliver a better overall service to a wider range of customers.

Competition

PR19’s introduction of further competitive forces to the water market has been heavily trailed. The methodology confirms the introduction of a separate price control for bioresources (more commonly known as sludge), as well as the advent of direct procurement.

Following the successful trial of the direct procurement model for the Thames Tideway project, companies, under PR19, can competitively tender the delivery, financing and potentially the operation of major projects of £100-million-plus.

This, Ofwat says, can reduce costs and customer bills by increasing competition for areas – such as design, build, financing and operation – that would previously have been automatically delivered by incumbent water companies.

The regulator wants companies to assess the suitability of direct procurement as part of their business plans.

Ofwat has previously estimated that the net benefits of a direct procurement approach could be between £400 million and £850 million.