Ofwat: It’s difficult to persuade people to pay for stuff they can’t see

Ofwat will deliver its initial verdict on water company business plans on 12 June, amid the most turbulent backdrop it has ever faced. Senior director for PR24 Chris Walters gives Utility Week some early indications of where the regulator is likely to land and whether he views the plans on the table as affordable, financeable and deliverable.

The scale of the challenge facing the water sector and the significant trade-offs its regulator must tackle would phase many people.

However, as one of those who helped to steer the NHS through a once-in-a-century pandemic, Ofwat senior director for PR24 Chris Walters is perhaps uniquely placed to bear the pressure. And while there may be a gulf between public appreciation of nurses and wastewater engineers, Walters insists that his newly adopted sector feels like a place he can really make a difference.

“Emotionally, I found working for NHS England too difficult, I no longer believed I was part of a cohort of people who could fix things, but I really do believe that about water.”

Having joined Ofwat as senior director for the price control last June, after eight years as director of pricing and costing at NHS England, Walters now faces the daunting task of evaluating water company proposals to spend £96 billion between 2025 and 2030.

He is keen to stress that he carries no emotional baggage from previous tussles between regulator and regulated and has insisted he wants to promote a different approach to price controls.

But what exactly does he mean by that? And what should companies expect come 12 June?

Affordability

While understandably cagey about opining on individual companies, Walters says he was broadly impressed by the level of ambition on show across the business plans for the second half of this decade. He views them as generally well costed and the companies as open to engagement.

However, he is aware of the significance heaped onto PR24, as a result of increased scrutiny from the media, politicians and customers. The upcoming price control is widely seen as a crucial step in the quest to futureproof supplies, protect rivers and waterways from discharges and replace ailing assets.

Ofwat will be expected to give a haircut to the £96 billion water companies have put on the table but Walters insists they should expect “a trim rather than a lop”, with investment levels anticipated to remain very much their highest yet.

This means customers will need to brace for a double-digit percentage rise to bills across the board, however Walters will not be drawn into the specifics at this point in proceedings.

“Customers need to be reassured they are not paying too much, or paying twice for the improvements they expect to see,” he caveats before accepting: “But bills will have to go up.”

This is because enhancement spending is several multiples of previous periods – around £41 billion compared to £11 billion in PR19, and could creep even higher depending on the work that is required.

This, Walters points out, highlights the need for better communication with customers to explain the need for investment in areas that have traditionally been out of sight, out of mind for the public.

“It’s difficult to persuade people they should be paying for stuff they can’t see, it’s a tricky trade-off.”

Financeability

Alongside pressure from the public, media and politicians, Ofwat will also be aware of the scrutiny bearing down from investors. Calls for the sector to remain attractive to investors are not new but they are getting louder by the day. The Ofwat board has signed off on base cost allowances and the cost of capital and although Walters will not be drawn on specific numbers, he confirms it will be “more generous to investors than PR19”.

He goes on to insist that the regulator will “err on the side of investibility” when assessing plans, and that the concerns of private equity investors have come through loud and clear.

Ofwat set its early view of the cost of equity and debt in December 2022 at a rate of 4.14% and 2.6% respectively. This was based on a notional gearing level of 55%, which is lower than the current level of 60%. These would translate to a weighted average cost of capital (WACC) of 3.29%.

Some PR24 plans proposed an alternative WACC. This included Thames Water, which finds itself back in the eye of the storm as shareholders chose not to plough further money into the business after Ofwat’s initial indications of how it would determine the business plan.

This interview took place just before Thames’ shareholders made their announcement but Walters addresses the wider point, saying: “We are not blind and deaf to the fact that the financial world has moved since we first offered an early view on what the rate of return might look like.

“It’s moved in a way that’s going to make returns more generous,” he adds.

Through ongoing engagement with investor communities, Walters says the private equity voices have been the most critical.

Among the polarity of views, Walters underlines that not all investors’ perceptions of the sector are negative.

“The message is that the sector must remain investable,” he stresses. “I’ve done a lot of engagement with investor communities and it’s true there are a variety of views out there, perhaps the most critical voices are private equity voices. Other investors have been less critical.”

The rate of return was a defining factor in the decision by four companies to appeal Ofwat’s PR19 final determinations to the Competition and Markets Authority (CMA) in February 2020.

Walters reflects that the appellants at PR19 “lost on everything, apart from what really, really mattered” which was the WACC.

With that in mind, Walters says he is “emotionally prepared for appeals”, and does not see the process as any sort of failure by Ofwat.

It’s an area he is familiar with, having previously worked at the CMA, including as chief economist. He is sanguine about the principle of companies appealing but less so about a mass rejection of Ofwat’s calculations.

“I can see the benefit of a fresh pair of eyes and am humble enough to admit I might be wrong,” he explains. “The issue for me isn’t whether there are appeals, but the number of appeals. I know how the CMA process works and in an ideal world the panel would give equal weight to the voice of Ofwat and any companies that are appealing together. But it doesn’t work like that.”

He suggests it could be a “fair fight” if there were perhaps five companies against Ofwat, “But if there’s 11 water and sewerage companies against Ofwat, then I fear our voice would get lost in that.”

But this is a bridge that does not yet need crossing, with the focus currently on the determinations. Walters warns that a lot will shift even between the draft and final iteration at the end of the year. This, he explains, is because some environmental rules are yet to be set in stone.

“The situation with WINEP is not yet resolved, so more so than in previous price reviews we will see changes between draft and final determinations as that situation resolves itself.”

The water industry national environment programme (WINEP) was jointly developed by the Environment Agency, Department for environment, food and rural affairs (Defra), and Ofwat. It was published in May 2022, but talks remain ongoing about what it should actually deliver and when.

“We’re going to have to put in some contingencies at draft determinations, and that might need trimming up, or trimming down of what money is needed, depending on what the exact requirements are”, Walters says.

Environmental spending dominates all company plans, with phosphorous and nutrient removal targets in particular adding eye-watering sums to costs, and ultimately to customer bills.

A positive outcome from this, Walters says, is that it will stimulate the nature-based solution space, something Ofwat is vocally supportive of. However, as a fledgling area of investment, it has necessitated a lot more engagement.

At PR19, Ofwat issued around 700 queries on business plan submissions, this time around there have been more than 2,700 to compile the cost analyses.

“A lot of that is grey-ish solutions, we have a strong track record of scrutinising and benchmarking those claims,” Walters says, “But a big chunk is pretty new green and blue-ish solutions. The board has been really on top of scrutinising those, so a lot of the queries have been related to those. We’re all simply less experienced there.”

All these moving parts mean the regulator is “actively talking about allowing uncertainty mechanisms, or “shipwreck clauses”, as Walters dubs them. These would offer agility for Ofwat to intervene in an active way, Walters explains, and reflect the fact that for PR24 much remains up in the air – particularly on environmental needs.

Uncertainty mechanisms are already commonly used by Ofgem, which included re-openers in RIIO2 based on, for example, the rate of adoption of low-carbon technologies.

Deliverability

Deliverability is the third piece in the balance, and that, Walters says, is the area he does have concerns.

Many companies have begun lining up the tier one and two contractors and engaged early on plans to hit the ground running.

“There’s a real head of steam there,” Walters says, “But that doesn’t mean it’s without risk.”

As a sector, water will be competing for labour, skills and resources with other major infrastructure providers expecting a similar uptick in the pace of development, not least energy and transport. As a result, Ofwat is stressing that the sector really needs to work with its supply chain.

“It’s not just about throwing more money at it, it’s about getting this stuff delivered,” Walters says and admits the plans mean little without shovels in the ground.

“It’s not in my control, it’s driven by Environment Agency goals and long-term water supply and demand position. It makes me nervous because I feel accountable here at board level for something I’m not responsible for, which is a nerve-wracking place for an executive director to be.”

Early signs suggest frameworks are being put in place for AMP8. Walters says ensuring capacity is built into the supply chain and the sector will be key to deliverability, alongside developing new skills and expertise, especially around nature-based solutions.

Overall, Walters sees a clear understanding from the submission that water companies understand expectations around both customers and the environment.

“I’ve been impressed not just with the ambition companies have shown around costs and the long-term strategies, but also that they really seem to get the level of public ire with water company performance.”

He says this has been reflected in “pretty decent” performance targets. But, they will need to deliver.

He comes back again to the scale of the task presented in AMP8, where requested spend is equal to 50% of the amount that has been invested since privatisation in 1989.

“That is a step change of investment paradigm by any definition. It’s not only the most of any period in Britain, but more than any in Europe, so the idea that it comes without deliverability challenges is, frankly, for the birds.”