Demystifying DPC

Direct procurement for customers (DPC) was introduced as a model to enable large scale infrastructure projects in the water sector with an opportunity to bring third-party investment, operations and construction into the industry. Ofwat's framework for the next price review underlined the regulator's ambition for DPC to be utilised to help meet the challenges water companies are facing. Legal firm Addleshaw Goddard's water and utilities team cuts through the jargon to explain how DPC can change the face of water infrastructure

Ofwat doubles down on DPC

With the scrutiny Ofwat’s been under recently, it would have been all too easy to pause its drive for greater competition in major water and waste-water infrastructure projects. Instead, Ofwat has reiterated its commitment to one of the policy jewels in its crown: Direct Procurement for Customers (DPC). It will be the default delivery model for projects with more than £200 million of whole life expenditure – a relatively low hurdle given the need for material investment in water infrastructure over coming years.

So what’s DPC all about?

Water companies are generally funded via five yearly regulatory price controls. While they incentivise companies to drive down their costs, they’re underpinned by Ofwat’s assessment of market costs – including overheads, construction and services costs, and the cost of capital.

Ofwat believes that greater value can be achieved by increasing competition outside those price controls. It wants water companies to tender the design, construction, financing, operation and maintenance of significant infrastructure.

By doing so, Ofwat argues, customers will benefit from lower costs of capital, reduced works and maintenance costs, greater innovation in delivering clean water and processing waste.

Who’s it of interest to?

Customers are the ultimate beneficiaries, although in practice new models of procurement won’t capture public attention like hosepipe bans, leaks and pollution discharge.

Water companies are keenly following developments. Many will see it as a way of getting essential infrastructure delivered, although not all will be enthused by it.

Bundling the financing, construction and services together into a fixed concession means DPC is attracting interest from the wider market. From sovereign wealth funds, banks and pension funds, through to global construction contractors and operation and management providers seeing access to projects being unlocked, DPC will prompt new entrants looking to invest in the England and Wales water market.

Stakeholders in the energy market will also be watching closely, where parallel models for onshore transmission infrastructure are being developed.

Not more acronyms! What do they all mean?

The successful bidder for a DPC is known as a Competitively Appointed Provider (or CAP).

The water company will pay the CAP on a monthly basis from the point the infrastructure becomes operational. Where the life of the asset exceeds the contract term, there may also be a balloon payment at the end of the term. These payments are known as the unitary charge – so called because they cover all the constituent costs of the project.

The unitary charge will generally be recoverable from customers via a new regulatory settlement between the water company and Ofwat called the Allowed Revenue Direction (or ARD, for acronym fans).

Conversely, any balloon or early termination payments will be recoverable through price controls. That allows Ofwat to apply the prevailing regulatory mechanics and consider, for example, whether the entirety of that payment should be added to the water company’s regulatory capital value (RCV) on which it generates a return.

There are currently five water companies whose licences have been changed to accommodate DPC. Ofwat has indicated in its latest DPC guidance (published on 23 March) that further changes will be made to the licences of those five companies and the others delivering DPC projects in AMP8.

Are water companies being given a completely free hand?

No.

Ofwat set various contracting principles for DPC in its PR19 methodology. They cover topics like refinancing, force majeure, water company step in and early termination.

Those principles will continue to apply to any designated projects. But for others, Ofwat’s latest guidance expands on those principles.

So is everything set in stone?

Again, the answer is no.

Ofwat wrote its contracting principles at a very high level, leaving companies free to develop the detail with a view to driving best value.

That is still the case with the principles in the latest guidance, which offers more detail but falls a long way short of the level of specificity and direction provided by government models such as the Welsh mutual investment model (MIM) or the PF2 guidance, which included hundreds of pages of precedent contract terms. What’s more, the contracting principles cover only a fraction of the issues companies will need to consider.

At this stage in the development of DPC it’s perhaps unfair to draw those sorts of comparisons. However, it does give a sense of the latitude water companies have (for now) to develop the right commercial and contractual model to suit their needs.

Are there any Achilles’ heels to resolve?

DPC can be traced back to the traditional project financing models of the 1990s. But the world has moved on since then. Those models were typically based on fixed price construction contracts. Now, contractors tend to work to more collaborative, risk sharing arrangements. One of the best known is the NEC’s Engineering & Construction Contract Option C under which overspends and savings are shared, which is thought to drive better value for everyone.

Chances are that at least some water companies will look to introduce sharing concepts into their DPC agreements. But this will take some crafting. After all, the idea that the financial model and the unitary charge are fixed at the outset runs throughout traditional project financing agreements.

Another key issue will be how water companies are incentivised. Ofwat is keen to ensure they have skin in the game. But without a return for shareholders and with limited control over the CAP, some companies may be reluctant to take too much risk.

Finally, whilst the influx of new players (and accompanying capital and innovations) that DPC will bring should be welcomed, it will precipitate a big shake-up of the market. Many will come from other industries and countries, and bring their own expectations about how things should work. Those expectations could differ markedly from current norms, forcing water companies outside of their comfort zones.

Which projects are currently live?

United Utilities’ Haweswater Aqueduct Resilience Programme, delivering the infrastructure needed to transport drinking water to over two million people, was the first to market when it issued the contract notice in June this year – with support from the authors of this article.

Anglian Water’s Elsham Treatment Project has also been formally designated as a DPC project by Ofwat. The Cwm Taf Water Supply Project being procured by Welsh Water should follow suit in the coming months. The likes of Thames Water and Southern Water are also expected to develop their own DPC projects for strategic resource options.

What’s next?

Water companies are busy finalising their plans for PR24. There’s real anticipation in the market about the number of projects that are likely to come forward in the next AMP as DPCs through PR24 and the RAPID gated process.

The final tally is likely to be significantly more than in AMP7. If that proves correct, we will be interested to see how Ofwat and the industry take into account capacity bottlenecks in the relevant markets (construction, capital and advisers in particular) when multiple projects are being procured at the same time. For a market in real need of investment and innovation, that could be a good problem to have.