Concrete decisions in AMP6

Stuart Crisp examines the new funding environment for the water industry under AMP6 and looks at how it is likely to affect product choices for the water industry.

In the 25 years since the water industry in England and Wales was privatised there have been dramatic improvements in many areas. The key driver has been the need to meet European standards on water quality, and the result has been an investment of around £100 billion in upgrading water and sewerage networks.

The model under which water companies have operated has been to set a performance standard and then put in place a series of actions designed to achieve agreed outputs over a five-year period. The result has been a tendency to focus on projects whose performance can be accurately predicted over a particular timescale with a heavy emphasis on capital investment (capex). Capex has been debt-funded through the regulatory capital value (RCV) mechanism.

Under this mechanism, water companies can fund debt based on their value – a value that rises in line with their level of investment. This can be viewed as encouraging a disproportionate emphasis on capital expenditure.

Operational expenditure (opex), on the other hand, is funded through company revenue and has an immediate impact on costs for the customer or earnings for the company. Opex, in the case of the water industry, includes the cost of renewing the infrastructure, mainly comprising underground assets such as water and sewerage pipelines.

Employing different funding mechanisms exacerbates an already fragmented organisational structure with planning, delivery and operational departments operating independently of each other within the water companies.

Ofwat has recognised some of the “unintended consequences” of the funding structure and for the next asset management plan (AMP) period – AMP6 – it is introducing radical changes in the way cost and value are measured.

Under the new rules, Ofwat will no longer view capex and opex as distinct cost arenas, but will instead ask water companies to look at the combined expenditure required, called totex. A decision will be made at the start of the period as to how this cost is funded between company revenue and debt. It is up to the water company to decide what the percentage split is but, because the funding is not decided on a distinction between capex and opex, the company will have more freedom to try different solutions within the baseline costs agreed.

The idea is to focus attention on whole-life costs and to support collaborative working practices where everyone in the organisation works together to achieve the desired outcome. This is positioned as an advance on current working practices, which can see a series of specific outputs planned at the start of the asset management period, each of which can be separately evaluated, without necessarily considering the impact of the entire working practice on the optimum result.

This move therefore also allows for long-term decision making. Outcomes are extended beyond the traditional five-year regulatory cycle, giving companies far more flexibility and creating an environment in which they are rewarded for delivering the long-term outcomes required by the customer.

So far, so good. However, given the fact that this shift represents a significant change to the operating principles of this industry, there is a lack of clarity on how totex will be calculated or evaluated.

Ofwat has not been particularly helpful in this regard. While consistently emphasising the importance of using totex as a baseline for expenditure, it is not attempting to prescribe how totex is calculated by the water companies. It is also not yet clear what methodology Ofwat is proposing to use to evaluate expenditure plans put together for AMP6, despite the fact that business plans for this period had to be submitted in December 2013.

On the plus side, this lack of precise prescription does allow water companies the flexibility required to be innovative in their approach. On the downside, it could introduce a significant degree of variation in the requirements of individual water companies, making it difficult for suppliers to know how to present their case. Unless the definition of totex is at least transparent, if not necessarily consistent, it will also be difficult to ensure that a fair and accurate comparison is possible between different materials, products and systems.

Here at the Concrete Pipeline Systems Association we are looking at the new regulatory environment from the perspective of manufacturers providing a substantial percentage of the assets of any water distribution system. We have viewed with alarm the slow rate of replacing and renovating the existing pipework infrastructure. If this rate does not increase, any sewer pipeline products installed today would need to last on average for over 800 years. At the same time, specification decisions are commonly being made on the basis of a design life of just 50-125 years.

If lifecycle costs become an intrinsic element of the design-procure-construct-­operate-maintain process, with more sway than initial capital costs, then products with the greatest proven life expectancy, typically well in excess of 100 years, will look even more attractive.

In our view there has always been a moral case for choosing products with an extended life-span. However, the historic capex bias has made it difficult to defend a product designed to deliver an extended life-span when a cheaper option is available, albeit with a lower or unproven life expectancy. In an environment where asset life is often calculated at a maximum 50-year term there is less incentive to opt for the more durable product.

As a sector producing high quality, durable products with proven longevity, we would like to see a fundamental and genuine shift in the water industry to move from lowest capital cost solutions to those that deliver better whole-life value. The new totex calculations required for AMP6 should deliver this environment.