PR19 – Was Ofwat tough enough?

The regulator’s final determinations have received a mixed reaction from the water industry, with some claiming Ofwat has compromised its tough stance while others believe it has made some clever moves in heading off potential CMA referrals. James Wallin gauges reaction from across the sector.

After much debate and public posturing on the stance Ofwat should adopt on water company business plans for the next five years, the final determinations (FD) landed this week.

It may be a measure of the interest or simply the sheer volume of information in this sprawling process that the regulator’s website crashed almost as soon as the 200+ documents were uploaded at 7am on Monday.

When the details were accessible a stunned silence descended, as the industry and observers grappled to get a handle on how much ground Ofwat was willing to concede on its challenging draft determinations (DD).

For its part, the regulator summed up the process for Utility Week as: “We have set out fair, challenging determinations for each water company reflecting their plans, evidence provided and benchmarking across the sector. It is now time for all companies to step up and deliver their plans.”

But, what did the industry think? Three key issues quickly rose to the surface. The first was around the allowed return on capital – the lowest since privatisation at 2.96 per cent for the whole business and 2.92 per cent for wholesale controls. The verdict seemed to be that this was challenging but perhaps not as stretching as it could have been.

Livelier debate was immediate on the interrelated subjects of the approach taken to Thames and how this coloured the perception of the allowances for the rest of the industry.

Reaction was mixed to say the least, ranging from one expert, who proclaimed: “Ofwat have blinked. What message does (the Thames decision) send to companies who have really worked to get their house in order?”

However, another source said: “It looks like Ofwat have done something really clever here. They have forced Thames to climb down a long way – to do all the compromising for them. Then they have largely agreed to that proposal but put in quite a few caveats. That has made it very difficult for Thames to appeal because they would essentially be arguing against their own business plan. If that’s true then that’s a big headache removed for Ofwat.

“The next question is whether other companies will be bold enough to appeal without Thames leading the charge.”

For another industry insider the imminent appointment of a new chief executive, with UK Power Networks boss Basil Scarsella thought be the leading candidate, may have been key in the negotiations.

“Thames are in a hole and they need someone good – really good – to get them out of it as well as tackling all the significant challenges they’ve got to come. The threat of a Labour government – and nationalisation – is one possible red line cleared for a new chief executive but it’s also difficult to see anyone credible agreeing to take the job faced with what the DD would have imposed on Thames.

“It seems like Ofwat has taken a very pragmatic approach here to recognise that this is the biggest and most high-profile water company and it was going nowhere under what was suggested at DD.”

Minding the gap

Regardless of the stance taken, it is clear that Thames has seen the biggest shift since DD, although as pointed out, this was largely led by their willingness to revise down their expectations in response. Ofwat agreed to a substantial increase in the totex allowance (up £796 million), leaving the two sides just £8 million apart. See below for the contrasting gaps still remaining for some of Thames’ peers. The company has also won an important reduction on its leakage targets.

The gaps on bills and allowed revenue still remain significant, however, and it should be noted that Thames has been set a challenging cost-sharing rate for underperformance.

It was the additional “conditional” allowance which caught many a commentator’s eye. This sets out a £180 million pot specifically for tackling issues in north east London as well as £300 million to bolster the water network in the capital. For the latter there is an expectation of a “significant” contribution from Thames shareholders. There seems to be no further definition on what constitutes “significant” although one expert told Utility Week it was likely to be in the region of £200 million.

The source said: “This looks like an 11^th hour deal, possibly done since the election result, in which Ofwat has agreed to an extra sweetener and Thames has gauged that there will be enough support from its shareholders to swallow it.”

However, another observer argued: “What happens if the shareholders reject the offer? Or if there is disagreement among different factions? If nothing else it seems like it will take a while for them to secure agreement – and the clock is ticking.”

Ofwat said: “Thames has failed to come up with a reasoned, evidenced proposition to address water network performance issues in London, and we are concerned about consequences for customers. Given this, we have stepped in to further protect them.

“It is for Thames to develop and submit their proposals and to do so in short order. We will then assess those plans and the commitment of a substantial contribution from shareholders before deciding whether the plans meet the mark.”

The spokesperson added: “If Thames can demonstrate a concrete and deliverable proposition we will let them bid to keep up to £480 million to improve resilience and the performance of the London water network.”

According to analyst Nigel Hawkins, of Hardman & Co, this bespoke deal could set a difficult precedent which Ofwat may come to regret.

He said: “If companies do go down the route of appealing to the Competition & Markets Authority (CMA), I wouldn’t be surprised if a few of them used the Thames situation as an example of where the final determination could have gone. Why has only one company received a conditional allowance?”

Peer pressure

Hawkins said the compromises reached with Thames will have made interesting reading for the likes of Anglian and Northumbrian, whose position after FD is largely unchanged to DD. Looking solely at totex, the former still faces a £744 million gap between its business plan and FD while the latter has a £126 million difference. Northumbrian also faces an eye-watering 26 per cent reduction in its bills over the next five years.

Other companies facing a sizeable totex gap after FD include Yorkshire (£370 million), Southern (£235 million) and Wessex (£141 million).

Hawkins believes all of the above are potential candidates to appeal to the CMA.

He told Utility Week: “These companies have seen very little movement. Northumbrian and Wessex have also made their views clear on cost of capital and will not have been pleased with the figure Ofwat came out with. There’s a sense for some of them that they haven’t got the credit for what they have achieved so far.”

Another observer agreed, adding: “Anglian are leading the industry in so many ways. They were the first to enshrine the social commitments, they topped a poll this year for the best company to work for and they have really tried to work with Ofwat. Northumbrian similarly have been doing some great work with their communities and in innovation. These companies are setting themselves tough targets and they probably feel that it’s not being recognised.”

While Thames has been the biggest talking point, it is important to note that Ofwat has compromised with others. Welsh Water, for example, has seen positive movement on bills and totex since DD and is now pretty much aligned with the regulator on overall revenue.

There was also some surprise at the changes at FD for the fast track companies, all of whom saw their bill reduction targets steepen while Severn Trent and South West also took a hit on their totex allowance.

One source observed: “What exactly is the point in being fast track, other than getting to see the DD early? They’ve still been landed with these last-minute challenges and there doesn’t seem to be much in the way of special treatment.”

For Barclays analyst Dominic Nash, the impact of the FD has to be seen in the wider context of a suddenly more stable market for utilities following last week’s election. Overall, he believes Ofwat has retreated somewhat from its no-holds-barred position on companies.

He said: “Returns are down in line with market expectations. It could have been worse on returns and lower figures were being suggested.

“Broadly the review doesn’t appear as difficult for the water companies as Ofwat were threatening earlier in the year. There has been a material compromise on the totex gap and ODIs. It appears Ofwat have compromised their tough stance.

“All in all, the water sector is worth a lot more than it was a week ago, with the threat of nationalisation lifted, at least for the next five years and with price certainty from the price review.

“The listed sector is trading at a 20 per cent premium to RAB. That’s towards the higher end of historical averages. However, that’s with the caveat that the three listed companies aren’t necessarily representative of the industry as a whole.”

Healthy tension

Not all industry voices took the line that the regulator should aim for an intractable stance at all cost.

One told Utility Week: “It was always going to be the case that Ofwat would be toughest at DD – to act as a stimulus to companies to really focus on what fat there was to trim. Thames is a perfect example of that. Getting an agreement with Thames – and we can’t guarantee that will happen but it looks likely – should be seen as a success not a failure.

“Ultimately the mechanism is sound – there is a healthy tension. Ofwat’s position now is likely to be that if companies go to the CMA then so be it because the process was rigorous and they have faith in that.”

The big question now, putting CMA referrals to one side, is how deliverable the plans are. Ofwat has made much of the environmental and societal commitments the water industry will be expected to deliver over the next five years.

However, Nicci Russell, managing director of water efficiency champions, Waterwise, warned that given the scale of the challenges presented to companies, it was important that these key pledges were not sidelined.

She said: “It’s good to see Ofwat making a commitment for the industry on environmental issues and water efficiency but my concern is whether the companies will be able to deliver. The strategic narrative on water efficiency and the environment is strong but cost models can complicate that. My worry is that companies have so many stretching commitments that this may be an area where they compromise.”

Water company bosses now face some serious reflection over the festive break as to how deliverable their targets are within the parameters Ofwat has set. If they stick to the views of DD that these plans are “unfinanceable” then it seems 2020 will be yet another year dominated by arguments over PR19.