H3O: Determination in regulation

Next month Ofwat will release its Final Determinations on PR19, which has been widely referred to as the toughest yet. As part of Utility Week’s H3O series we reflect on the changing role of the regulator and why it’s taking such a strong stance now.

Ofwat was born as a purely economic regulator but 30 years on its role has evolved. Now it not only directs companies on pricing and sets the cost of capital, but also shakes the sector up to be socially responsible and ensure fairness for customers.

Only three companies had their business plans for the next five years fast-tracked by Ofwat with the rest required to re-evaluate and resubmit to demonstrate greater efficiencies, higher leakage reductions and lower bills. When Draft Determinations were submitted at the end of August, PR19 was called “unworkable” and “unfinanceable” by more than one company.

“Companies feel Ofwat is being really tough on them. But the problem is in the past they haven’t been. Investment has been good and there have been improvements to service, but previous reviews have been too generous for the companies,” a senior industry source tells Utility Week.

“When customers know that they think it’s not fair that the companies have been making higher returns than they should have been over a long time. Ofwat needs to get to grips with that because it’s really not sustainable.”

The generosity of the regulatory system since privatisation has been painted as contributing to high returns for investors. In a game of Monopoly, holding the utility squares is an unexciting but tactically sensible move. This combination of low risk and steady return is the reason many pension funds are invested in utilities.

A senior industry figure explains how, in their mind, this generosity has caused sector-wide problems: “The returns for investors since privatisation have not been fair to customers. If you had invested a pound in the water companies the returns you’d have made would have been much higher than if it had been in the general stock market, despite the fact that water is much lower risk. If you’d have done that at the time of privatisation and knowing water is low risk, you wouldn’t expect to make as high a return.”

They say Ofwat is trying to put this right in the current price review, but in the past there was too much leniency.

Tightening the tourniquet 

The first price review in 1994 was “relatively uneventful” according to Robert Miller-Bakewell, independent analyst on the sector, but subsequent reviews brought companies down with a bump.

“The one that started to shake things down was the 1999 price review,” Miller-Bakewell says. “Since 1999 we have seen a tightening of the tourniquet at each price review.”

Each price review has been tougher than the last, with the regulator asking for more from the companies in efficiency. There has been greater methodology in terms of detail being submitted at each review, coupled with a reduction in the allowed return and tightening of the regime for the companies.

Miller-Bakewell says: “Where we are with this price review in 2019 is probably the bottom of the cycle in terms of the tightening of the allowed returns. This is undoubtedly the toughest price review and it is being undertaken in the context of a very low interest rate environment so that allows Ofwat without changing the methodology simply to take the latest evidence of the cost of capital and to use that lower cost of capital as reflected in the debt capital markets to deliver quite a demanding result from the companies’ point of view.”

Attractive beginnings

In 1989 companies were on the whole given a clean slate. Debt was largely written off to make them an attractive investment opportunity and the privatisation settlement set out the structure of the water market. This included independent economic regulation from Ofwat, which set the first round of prices. To further appeal to investors it was agreed that prices would rise five per cent above inflation for the first five years, meaning customers would feel significant bill increases.

And they certainly were attractive – perhaps more so than they should have been.

Colin Skellett, chief executive at Wessex Water, believes the early days of regulation left holes open to exploitation by a handful of charlatan investors. “If the regulator had said the balance sheet could only be used for core regulated activities, then everyone now would probably say privatisation has been a great success. But the regulators took the opinion that capital structures were for the companies not for the regulator. But debt, gearing and asset values were left down to the companies.”

High gearing left previously healthy companies in poor state of health with investors taking more out of the company than they should have been able to. One commentator argues Ofwat is now trying to turn the clock back by taking debt levels down.

Going too far?

Has the regulator now overcompensated from a position of leniency to an unreasonably tough stance? The responses from majority of the 17 water companies in England and Wales show widespread displeasure with what is expected from the regulator.

While some praise the strength of the regime, others think it has gone too far.

Bob Taylor chief executive at Portsmouth Water says Ofwat has driven improved efficiencies, reductions in leakage and huge improvements in customer service.

“Although bills have gone up, the industry as a whole has become much more efficient. The strength of regulatory regime is the key to that.” Taylor explains. “We need strong regulators in this monopoly. We get strong leadership from regulators, but the sector also needs flexibility and room to manoeuvre. Success comes from a combination of both.”

This view is echoed by Peter Simpson chief executive at Anglian Water, who says pushing companies to exceed expectations results in real savings, which can be passed on to customers.

“We’ve been incentivised to drive efficiency since 1989 so customers get a lot more from the company,” Simpson says. “The model is very powerful and better than models I’ve experienced working with in the United States – I don’t think they drove the same efficiency to manage the assets that we’ve got here.”

However, some companies, while welcoming the need to be challenged, think the current challenges mean anything below excellence will face penalisation.

One chief executive tells Utility Week: “Ofwat is there to mimic the competition so they will always look around and see what the standards or benchmarks are. They are doing that, but it’s gone too far and it’s trying to argue that unless a company is perfect it will be penalised.”

“The industry en masse is saying: you’ve gone too far. Yes, it’s right to push us and yes, we want to do right for our customer but asking us to suddenly be instantly perfect is too much and unrealistic. Point to where it ever happened ever, and we might have an argument about it.”

They speculate that the number of mentions of CMA appeals show how extreme Ofwat’s review is.

“It’s very surprising for the whole industry to say it’s too much. Normally one or two say it’s too much but this is unprecedented. Conversations and speculation seem to suggest a number of referrals to the CMA. The process is expensive and time consuming so most people wouldn’t skip through the door for that. If a big number of companies all go to the CMA that wouldn’t be indicative of a successful process, so let’s hope it doesn’t come to that.”

Tough job, but someone’s got to do it

Miller-Bakewell says the higher number of companies mooted to appeal to the CMA shows strength in Ofwat’s process. He says: “I’ve always argued that the true demonstration that Ofwat has really pushed things to the limit in terms of what is acceptable is for there to be multiple appeals. That’s the test of this review.

“Will all those that are threatening appeals actually do so, that will demonstrate that Ofwat has actually ‘squeezed the pips’ and confirmed that we’ve got to the bottom of the cycling in terms of the tightening of the methodology.”

When Ofwat was set up its role was an economic regulator but its role has evolved to embrace a wider range of inputs for example, leakage. Leakage targets only really became an issue in the latter part of the 1990s. Setting leakage targets and funding through the price mechanism expenditure to cut the rate of leakage was only introduced post-privatisation.

The evolution of the regulator reflects the impact of lobby groups that add pressure as political expectations have changed over time – something that applies to other regulated industries too.

Miller-Bakewell explains these changes haven’t been dramatic steps. “It has been an evolutionary process with the direction of travel of raising expectations in all areas for what companies can sensibly be expected to deliver,” he says. “You can identify different approaches associated with different leaders at Ofwat. We have moved from the civil servant type approach to a business type of approach.”

Since the second review in 1999, when companies recognised the political context they were in through the changes of the past 30 years there has been a degree of adversarial debate between the companies and regulators.

As one commentator concludes: “It’s part of the regulatory process and it’s not unique to water. If it was all lovey-dovey you would be deeply suspicious.”