Ofwat to CMA: Funding is adequate, efficiency is lacking

Ofwat has dismissed claims that its PR19 final determinations were focused on short-term savings over long-term investment as a “false dichotomy” and told the Competition and Markets Authority that companies must be in better shape.

Despite the arguments from appellant companies Ofwat said there was sufficient funding allowed in the price review, but that businesses needed to be in a fit state to manage within their means.

“It is a false dichotomy to suggest that the choices available to Ofwat (and now, therefore, to the CMA) are between achieving short-term savings and delivering long-term investment,” Ofwat told the CMA.

In its submissions as part of the redetermination process, Ofwat answered the statements of case from Anglian, Bristol, Northumbrian and Yorkshire, which each rejected the regulator’s final determinations for the price review 2020-25.

The process with the CMA sees responses submitted by each party for consideration by an independent panel to make a redetermination of the entire business plan. Financial allowances, customer support for original plans and the need to boost resilience for future generations were cited by the appellant firms as reasons to reject their final determinations.

This price review was never about maintaining the status quo, Ofwat told the CMA, as it threw down the gauntlet by describing performance by water companies as having “flatlined” and insisting it must be turned around. It insisted the stretching targets were appropriate to restore public trust and give billpayers a competitive level of customer service.

The regulator said the determinations “provided adequate funding for an efficient company with the notional capital structure”, which was in line with its regulatory duty, but acknowledged that companies that have chosen different capital structures or have penalties to pay must make changes to operate within the permitted funding.

Ofwat said there were “profound challenges” for each of the water and water and wastewater providers to face climate change, population growth and shifting customer expectations.

The price review challenged companies to improve the reputation of the whole industry, strengthen operational performance and provide affordable services as well as stepping up corporate behaviour and strengthen financial resilience, Ofwat said.

While the majority of companies accepted the terms of their final determination, the four that did not have faced scrutiny from Ofwat on why they cannot meet the efficiency expectations and perform within budget.

“These companies continue to believe that customers should pay more and receive less than our final determinations settled for them, and less than other companies are now undertaking to deliver.”

Balancing cost efficiency with service quality has been another recurring theme of the price review and featured in the statements of case of the appellant businesses.

“Contrary to what some disputing companies claim, we have not observed an inverse relationship between historical cost efficiency and good outcome performance,” Ofwat said as it argued that some companies have managed to achieve high quality of service while being cost efficient so the impact on costs should not be used an excuse for poor service.

It said historical performance had been informative on how companies responded to the challenges of the price review. Reflecting on earlier price controls Anglian, Northumbrian and Yorkshire all outperformed on their base returns during PR14 with Anglian and Northumbrian returning dividends in that period that were “significantly in excess” of the allowed return.

On cost allowance, which was also an issue mentioned by companies that accepted their determination, Ofwat noted that in the past firms had tended to underspend on the amount set by Ofwat to improve service quality. Indeed, it said Anglian, Bristol and Northumbrian were among the companies with highest outperformance on their PR14 wholesale cost allowances.

Ofwat said the payment of high dividends to investors was at odds with the level of performance witnessed during the PR14 period, which, argued the regulator, has caused the legitimacy of the sector to be called into question.

The final determinations were accused of being too focused upon lowering bills at the expense of longer-term objectives such as resilience infrastructure. Anglian accused Ofwat of “kicking the can down the road” by denying it the funding to invest in resilience, while Yorkshire said failure to invest now represented an “inter-generational unfairness”. Each of the four disputing companies referred to the extensive input to the business plans by customers and the high approval ratings they got from their billpayers.

Anglian, Bristol, Northumbrian and Yorkshire all accused Ofwat of placing more importance on short term bill cuts instead of longer-term investment, however the regulator dismissed these assertions as ill-founded.

It said companies did not have supporting evidence of Ofwat prioritising short term bill cuts, however emphasised the importance of affordability as a “basic objective of any price control”.

However, it said the “bottom-up building blocks” approach scrutinised all elements of the business plans with customers’ needs. Ofwat said that along with reducing bills the price control was concerned with giving all customers great service, ensuring long-term resilience in the round and bringing more innovation to the industry.

The regulator argued that disagreeing with its decisions did not change the validity of its ruling or represent a failure of duty.

“We do not consider that it is helpful or accurate to characterise each such disagreement as a ‘hard-edged’ question about whether we have failed to meet our statutory duties. The reality is that these are simply disagreements as to the merits of decisions that we made in our final determinations.”

The regulator acknowledged the fast-moving crisis threatening both the nation’s health and economy but while the impacts are yet to be fully seen, Ofwat pointed out that the regulatory framework includes protective mechanisms including interim determinations. These would allow Ofwat to change the levels of price controls if certain thresholds are met, however it said no adjustments would be considered until there is “reasonable certainty” around the effects of the virus.