Price control periods: is bigger better?

With PR14 now completely put to bed after the Competition and Market Authority’s ruling on Bristol Water’ final determination, attention in the water sector can now turn towards PR19.

One issue that is re-awakening is on the length of the price control periods. Ofwat has stuck with the tried and tested five year cycle since privatisation, but in 2013 Ofgem switched to an eight year phase, claiming it will encourage longer term thinking.

Ofwat has indicated it is open to the possibility of longer price control periods, at least in part, for the sector, but longer Asset Management Plan (AMP) periods would bring its own benefits and challenges.

An elongated AMP would allow for greater investor certainty, but it would also lock in any financial issues, and could lead to a brain drain at the Ofwat between reviews.

Finally, alternatives are already being developed, and implemented, in the water sector, to help achieve the long term goals, without disturbing the five year status quo.

Locked in: certainty or issues?

Ofgem made the switch to eight year AMPs in 2013 for the electricity and gas transmission companies and the gas distribution companies. The electricity distribution companies saw their extended AMP period begin earlier this year.

Northern Gas Networks chief executive Mark Horsley noted the eight year AMP had enabled him to think longer term, something he added would have been “impossible” under the previous regime.

That is exactly what Ofgem wanted to achieve with the change, and it estimates the eight-year period will not only increase investor confidence, but could also deliver £1 billion of savings.

The Energy Networks Association (ENA) highlights the greater investor certainty as the “most notable” benefit of the longer price control period. It echoes the point made by Ofgem that costs will be kept down because the increased clarity lowers the cost of borrowing.

The ENA also states innovation is set to be boosted by the eight year cycle, because increasing the length of time between price control settlements means “the benefits of innovation projects are retained for a longer period of time”.

The confidence of investors is something Ofwat is targeting and the water regulator’s senior director for Water 2020 David Black admitted “it is quite easy to see a case for moving to a longer term control” because long term investments are being made.

However, Black’s comments were only about longer AMPs for “part of the wholesale value chain”, rather than for the entire regulated sector. Plus he has reservations about when these changes should be implemented because of the number of changes being introduced to the sector. “It seems unlikely this will be the last stop for those changes, so do we want to lock in those price controls for a longer period,” he says.

The issue of “locking in” issues into the AMP is something that has convinced Jefferies equity analyst Peter Atherton that Ofwat should stick with the current set up.

“I’d stay with five years as eight years is an awfully long time and requires some mid-term re-opener,” he tells Utility Week. “And there is always some controversy around that.”

He warns that locking in a bad deal in an extended AMP would be “pretty damaging to consumers and/or companies” and although there are safety valves within longer periods, he adds the best option “may just be staying with five years”.

South West Water chief executive Chris Loughlin also expresses concern that a longer AMP period “requires more changes within periods, which isn’t good for customers”. He adds: “The long established five year period has worked well so far.”

Atherton also warns that the regulator itself could suffer if it decides to introduce a longer AMP. “One of the issues you face if you move to a longer period is the effect it has on the expertise on the regulators. If there is only one every eight years, how does it retain the corporate knowledge and expertise to do the next review?”

He added that Ofgem, with three sets of price controls is more able to cope because it has staggered the price reviews and is therefore able to move people from one review to another – an option not available to Ofwat.

Other long term options

Other options are available, and Ofwat is assessing longer term incentives around crucial areas of delivery such as customer service as far out as 2040.

The consultation from regulator Ofwat, which closed at the end of August and will feed into the PR19 process, asked whether setting long term outcome delivery incentive (ODI) targets from 2020, when the next regulatory cycle begins, would lead to better service delivery and more resilient water services.

Providing these long term incentives, both financial and reputational, will encourage water companies to focus on the longer term as part of the standard five year AMP cycle.

Ofwat is thinking long term, and it is discussing how best to translate this into the business plans of the companies. Longer AMPs may be part of the solution – at least for part of the sector – while other incentives could help to stretch the thinking horizon.