Rising to the water regulatory challenge

As the water industry’s regulatory framework continues to evolve, companies need to understand how the changes affect them and how best to fulfil their obligations. Antonio Barroso reports.

The water sector in England and Wales is undergoing a period of substantial regulatory change that could ultimately alter the future structure of the industry. With the 2014 Price Review (PR14) completed, the sector is preparing for the introduction of retail competition for non-household customers in April 2017. At the same time, Ofwat is laying down the foundations for PR19 and beyond.

As the regulatory framework evolves over the next decade, water utilities could adopt a number of new structural models in response. While the extent of change will depend on individual company circumstances, the industry could see the current vertically integrated regional monopolies replaced with a more disaggregated value chain and companies specialising in specific services based on their competitive advantage.

Moving on from 2014

A number of key steps in the development of the legislative and wider regulatory framework in England and Wales were taken in 2014. The Water Act, introduced in 2014, enables all non-household water customers to choose their retailer from April 2017. The Act also paved the way for a greater use of markets for upstream reform in wholesale water and wastewater services.

The PR14 process undertaken by Ofwat represented the biggest change in regulatory approach in the past 15 years, and included a number of key developments:

• Separate price controls: wholesale water, wastewater, retail non-household and household;
• Increased customer engagement in the development of company business plans;
• A cost assessment approach that focuses on total expenditure (totex);
• A focus on the delivery of outcomes by companies, with specific incentives aligned to performance.

This marked a significant change for water companies. The use of a totex cost assessment system encourages companies to embrace new technologies. For example, a number of companies are moving from procuring large IT systems towards cloud-based software services. In other cases, IT and transformation alliances are being developed to deliver future business change needed to respond to regulatory challenge.

Ongoing sector challenges

However, companies continue to face a variety of current and future challenges within the water sector: 

• Environmental – growing pressure from customers and regulators to address water quality and water scarcity concerns, the latter arising from the uneven distribution of population and water resources;
• Customer outcomes, such as resilience;
• Affordability issues.

Water companies also need to deal with evolving demands from customers as a result of population growth, changing customer expectations, technology improvements and climate change. The regulatory framework now needs to look ahead and build on the key elements of PR14 to help companies address these ongoing challenges.

Next steps for regulatory policy 

To move forward, Ofwat has established the Water 2020 programme to facilitate the development of the future regulatory framework, including the approach to upstream markets for wholesale water and wastewater services in England.

The regulator has made it clear that Water 2020 would retain key elements of PR14, including the focus on customer and outcomes as well as the totex approach to cost assessment, as it develops the framework for PR19 and looks beyond 2020.

In May 2016, Ofwat published its new regulatory approach to the industry, outlining a number of decisions taken with respect to PR19. The proposal supports new markets in bioresources – a term that describes treated sewage – and water trading. Separate price controls and information platforms are also planned for both markets. The Retail Price Index as a measure of inflation will be replaced by the Consumer Price Index through a transitional approach. Ofwat, which describes the approach as pro-market, aims to incentivise water companies to focus on their customers over the longer term, beyond the five-year price reviews.

However, regulation will need to develop a more tailored approach, allowing it to solve specific challenges for specific companies. It will also need to support more integrated catchment management approaches to deliver low-cost solutions to meet higher quality standards.

To facilitate this type of regulation and support companies to make the right decisions, regulators will need to gather information on efficient costing and the value that customers place on specific outputs. They will also need to develop trust between various stakeholders – the customers, companies and the regulator – to help them develop collaborative solutions.

The publication of the Water 2020 discussion document (July 2015) and that of the new policy approach (May 2016) brings more clarity to the direction of future regulatory policy. Companies now need to invest time in understanding what the proposed changes mean for them, what opportunities they offer and what are the most efficient ways of meeting the regulations.

At the same time, regulators will need to strike a delicate balance in implementing future change. On the one hand, elements of regulation have delivered investment and improved quality standards that cannot be removed without affecting investor confidence. On the other hand, markets are more likely to deliver future innovation to meet challenges in the sector, but water companies will not want their existing assets to become stranded.

Companies do and will respond to a changing regulatory landscape. The policy changes may well lead to a market and customer-centric industry with a multiplicity of players along the value chain that could look very different from today’s vertically integrated regional monopolies.