Blueprint becomes reality

Ofwat’s draft determinations have been broadly welcomed as the first two water firms get the go-ahead for their business plans. The rest of the market could face a rougher ride, says Conor McGlone.

Last week, the blueprint that Ofwat chair Jonson Cox laid out for water companies became reality. The only two companies to win enhanced status, South West Water and Affinity Water, received the green light for their business plans – subject to final approval. The headlines of those plans reads like a checklist of Cox’s agenda for the sector, first set out in a speech at the Royal Academy of Engineering in March 2013.

Lower bills for customers? Check, with South West Water cutting bills by an average 7 per cent and Affinity by 11 per cent. Sharing gains with customers? Check, with
South West Water’s innovative Watershare scheme formalising a mechanism by which unearned gains go back to customer pockets – including 50 per cent of its £11 million reward for achieving enhanced status. Lower returns for investors? Check, with South West and Affinity accepting Ofwat’s proposed weighted average cost of capital (Wacc) of 3.85 per cent.

Subject to final approval from Ofwat in December, South West Water’s average annual household bill for water and sewerage – currently the highest in the country – will fall before inflation from £516 in 2014/15 to £479 by 2020 and Affinity Water’s average annual household bill for water-only charges will fall from £174 in 2014/15 to £155 by 2020.

These are higher reductions than those in their original business plans, for a 4.5 per cent and 3.5 per cent drop respectively, back in December. They represent the lower Wacc demanded by Ofwat in January.

It might sound counter-intuitive for a water company to agree to a lower rate of return, but Ofwat is adamant investors will not lose out, claiming changes in reward structure during the next price review can ensure investors are compensated for a lower Wacc with the possibility of higher rewards for outperformance. This has parallels with energy regulator Ofgem, which has traditionally had a lower guaranteed return with higher rewards for doing better. In PR14, Ofwat has adopted this approach – a canny move given the public pressure on affordability.

In his speech, Cox also handed the initiative to water companies when he said he expected them to make suggestions on how to share pain and gain with customers.

South West has taken this on board, with its Watershare pledge to share the benefits of unearned success fairly between customers and investors. The framework involves it publishing an annual scorecard that summarises its performance and would allow for the sharing of net benefits with customers.

Affinity’s community focus also won praise, having split its region into eight subdivisions. This ensures it remains accountable to the communities it serves, says Ofwat.

The water company also demonstrated a sense of initiative with its new asset health measure, water available for use (Wafu). This directly relates to the serviceability of the infrastructure assets, demonstrating the capacity of the treatment assets to meet customer demand, minus any outage due to planned or unplanned maintenance.

For the water companies, the enhanced status brings reputational benefits as well as a cash injection and the pride of a job well done. But what of their customers?

Consumer body CCWater has broadly welcomed the draft determinations. It says South West has “responded well” and its plans mark further progress towards addressing the high bills “customers have faced over many years”.

As for Affinity, Sir Tony Redmond, London and South East chair for CCWater, says: “The company has listened to its customers and our challenge now is to ensure it delivers on its promises, including supporting those households struggling to afford their bill.”

It is worth remembering, however, that those headline price cuts exclude inflation; CCWater is worried that customers could actually face an increase in water and sewerage bills by 2020, depending on inflation levels over the next few years.

It has also voiced concerns that customers may have to pick up the tab from a package of financial outcome delivery incentives.

Steve Hobbs, senior policy manager at CCWater, says: “Customers do not support the principle of companies being rewarded for ‘doing the day job’, which then results in them paying more in the future. Water companies need to reflect their customers’ views on rewards and penalties and Ofwat should do the same.”

However, Ofwat argues that incentives should drive greater efficiency and better service. A spokesperson says: “This is definitely not a one-way bet – if companies fall down on service, they will be hit in the pocket.
We want companies to listen to their customers and respond to what they want. No ­company will get a reward for simply doing their job. This is about stretching companies to do more and engage with customers to deliver the outcomes that their customers value.”

Early indicators suggest that the draft determinations have been a success story for Ofwat. Liberal Democrat MP for Torbay, Adrian Sanders, described South West Water’s bill reductions as “good news”. And it’s no easy task to placate customers in this region, who have faced the highest bills, even with a £50 annual reduction from government until 2020.

Ofwat has managed to get two companies to slash their bills through innovative processes, without the need to intervene – exactly the kind of hands-off approach the regulator has been trumpeting.

What can the remaining 16 companies learn from these early indicators? Not a lot, according to Ofwat, which says the draft determinations were largely based on the two companies’ “high-level” business plans.

“This will not necessarily be the case for standard companies receiving their draft determinations… because it may be appropriate for us to intervene in these companies’ plans if this is necessary to protect customers,” it says.

For South West Water and Affinity, it’s on to the business of AMP6 and the broader horizons of competition introduction and upstream reform. The rest of the market cannot afford to rest on its laurels – Ofwat’s note of caution might suggest some will be in for a rougher ride when they receive their draft determinations in June and August.