Sector calls PR19 determinations ‘unworkable, unfinanceable and unachievable’

Ofwat’s PR19 draft determinations (DDs) were called the toughest yet when they were published in July but the water companies affected have now branded them “unachievable” and “unfinanceable” in their first official responses.

With the final determinations due in December, time is running out to reach a compromise that bridges sizeable discrepancies between business plans for 2020-2025 and Ofwat’s expectations of what each company should spend.

Fears and doubts related to finance were voiced by all the companies in the “slow-track” and “significant scrutiny” categories, with Thames summing up the DDs as “undeliverable and therefore unfinanceable”. It also accused the regulator of setting targets which contradicted its own resilience tests.

Ofwat’s benchmark of an efficient company was widely criticised as unrealistic and unachievable, as were its expectations of cost efficiencies.

Yorkshire said it was “surprised and disappointed at the difference between (our) own and Ofwat’s view of efficient costs” and called Ofwat’s benchmark “unattainable” as a measure of efficiency.

Speculation about the involvement of the Competition Markets Authority (CMA) has been rife since the DDs were published in July and the responses from the companies suggest that resorting to the appeals process has not been ruled out by many.

Both Wessex and South Staffs Water raised questions of legality in the restrictions the determinations would impose, with South Staffs calling the plan “unfinanceable” and in need of work to not involve the CMA.

Its board said it “does not consider that Ofwat has fulfilled its legal duties to allow us, as an efficient company, to finance our functions” and called for “constructive engagement” to avoid the necessity of an appeal.

The targets set by the regulator to achieve by 2025 include reductions in sewer flooding, supply interruptions, leakage, and additional help for almost two million vulnerable customers. This is coupled with a targeted pre-inflation drop in bills of 12 per cent

Ofwat placed Affinity, Hafren Dyfrdwy, Southern and Thames in the “significant scrutiny” category to substantially rework and resubmit plans alongside increased regulatory scrutiny.

Thames was also one of four companies the regulator gave advance notice to – with Anglian, Yorkshire and SES – regarding the persistent gap between their business plans and Ofwat’s view of what expenditure was necessary.

Utility Week rounds up the responses companies made to the regulator’s comments:

Thames Water said the draft determination was “undeliverable and therefore unfinanceable” and, if made final, “would have serious adverse consequences for (our) customers and the environment”.

The company was ordered to cut its total expenditure by £800 million between 2020-25, which it is rejecting because it would result in overspending and penalties. It argued that Ofwat’s plans did not recognise the costs associated with population growth, and targets to reduce service interruptions by 72 per cent in five years are not achievable with the expenditure cut.

Despite strongly opposing the terms of the DD, interim executive chairman Ian Marchant said the company wanted to avoid the time and cost associated with a CMA referral.

He said he was “willing to engage fully with Ofwat and sincerely hope that we can identify a way forward” to avoid that measure.

Thames submitted further evidence to Ofwat to explain the gap between its plan and the DD, which included:

• Its belief the DD is not financeable under any reasonable set of resilience tests as required by Ofwat
• Thames’ re-evaluation of its totex gap, which it said identified key areas where the gap could be explained with further evidence, and requested Ofwat increase the totex allowance
• A query of Ofwat’s expectations of delivering upper quartile performance for costs and service, and argument that no comparable company has delivered this

“Our bills have remained flat in real terms for a decade, but we recognise that Ofwat would like further reductions. In the spirit of constructive engagement, we have developed a lower-cost plan which would reduce bills and enable Thames Water to meet its statutory obligations,” Marchant said in his letter to Ofwat.

“However, it would be a missed opportunity to invest further and renew the infrastructure used to serve our water and wastewater customers in London and the South East. We believe the express preference of government, environmental stakeholders and, most importantly, our customers, is to prioritise increased investment to improve long-term resilience and operational performance.

“We remain willing to engage fully with Ofwat and sincerely hope that we can identify a way forward that avoids the time and cost associated with a CMA referral, and which allows us to get on with delivering what our customers both want and deserve.”

Anglian Water has a £251 million gap in the base cost for water, equivalent to 16 per cent of the full costs, while the difference in wastewater is £406 million, also 16 per cent of the costs.

In its submissions the company suggested the needs of its region would not be met by following the approach in Ofwat’s DD and insisted the level of expenditure it previously submitted was appropriate. It invited Ofwat to fully consider its previous application to allow it to face the challenges of climate change.

In its resubmission Anglian:

• Highlighted areas where Ofwat had not fully considered previously submitted information which would close the gap between Ofwat’s view of the necessary level of totex and Anglian’s
• Pointed out where Ofwat’s assessment of efficient costs ignores important drivers, particularly in relation to growth
• Proposed changes to the balance of outcomes, outcome delivery incentives (ODIs) and performance commitments (PCs) in the context of the “clear views” expressed by its customers.

SES Water reduced its total expenditure to £287 million – a drop of £8.8 million from its April submission – and argued its total requested spend was necessary to deliver on its stretching performance commitments. The company said it would make savings to reach wholesale expenditure of £251.6 million.

The company accepted many of the interventions in Ofwat’s DD, but said it was unable to accept aspects that “fail to take into account or to recognise” specific aspects of the company. SES said the DD “does not reflect the priorities of our customers within the overall objectives publicised and pursued by Ofwat”.

The total expenditure allowance in the DD is 18.3 per cent lower than SES requested, a gap of £54 million. The company said the allowance would not let it deliver its planned outcomes for customers and the board at SES was “unable to accept the feasibility” of the plan.

It requested:

• £17.4 million more for leakage
• Another £8.9 million for network resilience as part of its 15-year resilience plan, which is 80 per cent complete
• £10.5 million base expenditure for wholesale electricity usage because of its reliance on deep abstraction.

Yorkshire Water said it was “surprised and disappointed at the difference between (our) own and Ofwat’s view of efficient costs” and called Ofwat’s benchmark “unattainable” as a measure of efficiency.

It brought in an independent economist firm to support its view on the benchmark, which concluded “… the efficiency step change is not supported by theory or evidence – meaning that the notionally efficient firm is likely not financeable”.

Yorkshire Water said it wanted to find a “workable compromise to avoid an impasse which would not benefit customers” and focused on achievable targets.

It removed £300 million from its expenditure while continuing to commit to improving:

• Leakage by 15 per cent
• Pollution events by 41 per cent
• Service interruptions by 25 per cent
• Internal sewer floods by 49 per cent and external floods by 25 per cent.

The company called its representations the “best compromise possible in the current circumstance”.

Affinity Water, which was under Ofwat’s “significant scrutiny” band, has re-examined its funding allowances for improvement and enhancements and made savings to deliver its targets on leakage of 20 per cent reduction.

The company has restricted shareholder dividends for AMP7 and will reinvest all returns to reduce gearing levels during the AMP, meaning no dividend will have been paid for seven years (2018/19 to 2024/25) and equity will be reinvested for the six years from 2019/20 to 2024/25.

Also included in its representation:

• It queried what it called Ofwat’s “skewed” calculation for retail and suggested the cost model should be re-examined
• The company said it had embraced the challenges set by the regulator and was “committed to delivering significant improvements to our cost performance”.

Hafren Dyfrdwy said it was pleased with its response from the regulator and noted there were “no significant material issues remaining”. Its arguments it said were key to the financial resilience of the company; needed to ensure fairness and retain a fair balance of risk across a package of stretching service improvements.

The points it raised were:

• It queried Ofwat’s weighted average cost of capital (WACC) calculations as well as the base point reduction (bps) of 37, which it said would bring it to one notch above Moody’s sub-investment grade and for wholesale it would be graded as sub-investment
• It argued that targets for reducing supply interruptions were more challenging than for other companies and called for the reintroduction of the penalty collar
• It said it was the only company to have a penalty-only measure for leakage targets, which in the DD was increased by 4000 per cent with no option to earn rewards from outperformance
• It said affordability interventions – including doubling the numbers of customers helped on social tariffs – were disproportionate and dis-incentivised companies from innovating in future price reviews

Southern Water said it had made changes to meet the targets laid out in the DD and “shifted substantially” its level of cost efficiency as well as accepting a further stretch in target performance but has squeezed as far as it can.

The company said: “Taking all of this into account, we believe that a further shift in our cost allowances would put undue pressure on our ability to effectively execute our plan.”

Having accepted a c£42 million cost reduction it is challenging the remaining £262 million in the total £304 million cost gap and submitted strengthened evidence in support.

Chief executive Ian McAulay spoke to Utility Week about the remaining “reasonable gap” in its DD and the company’s hope to avoid appealing through the CMA.

Wessex Water has said the DD was “not acceptable” should it be enforced without significant change. It said some changes it proposed were required to ensure the company could finance itself and others were about ensuring it had “stretching but realistic” targets.

“The board of Wessex Water is profoundly concerned that the draft determination puts in jeopardy the financeability of the business and will not allow it to meet its legal obligations nor its broader responsibilities to the region’s economy, the environment and the customers and communities it serves.”

It proposed:

• Additional cost allowances that would close the gap of £238million in the assessment of costs
• A return to calculating revenue allowances through Pay as You Go (PAYG) rates based on the natural rate derived from cost assessment. Against the draft determination this would increase outturn revenues by c£15m a year

Northumbrian Water’s board was unable to provide assurance that the DD was financeable and indicated the package was “not acceptable”.

Its revision incorporated a £92 million reduction to its totex, which reduced the gap between its own view of efficient costs and Ofwat’s to £204 million. It said this gap related to areas of spending it believes are essential “beyond the scope of further reductions”.

Northumbrian was not the only company to query Ofwat’s upper quartile benchmarking approach to cost reductions. It questioned the viability that any company could achieve upper quartile pricing combined with upper quartile levels of efficiency with quality and service.

Like Yorkshire Water, the company brought in an independent expert to review the pricing, which found the overall package to be not financeable.

It appealed to Ofwat, ahead of the final determinations, to “take a broader in-the round assessment of these determinations” specifically whether they represent a “robust but fair level of challenge whilst still ensuring that the notional company is financeable.”

The company said “there remain significant specific issues to resolve” including:

• The risk return balance including costs, service and the allowed return
• The gap in efficient costs, which it has narrowed from £296 million to £204 million, but has investments which it remains “strongly committed to” that prevent it from further cost reductions
• It said its plan – as submitted 30 August – without further tightening would be financeable

Welsh Water (Dwr Cymru) – said despite making changes there remained an “unsustainably large gap” between its business plan and the DD. It has cut some proposed spending to bridge the £400 million gap between its business plan and the wholesale totex allowed in the DD and brought it to £250 million but it said the remaining spend was necessary to meet its statutory obligations. These include drinking water network improvements; and water treatment maintenance.

It reported serious concerns that it would have to commit to performance targets that it does not consider to be deliverable.

It highlighted the limited timeframe to resolve the remaining “substantial areas of disagreement” and therefore asked Ofwat to accept its updated business plan, which includes:

• Adjusting the pay as you go (PAYG) and run-off rates further to avoid a negative credit rating from Moody’s
• Cautioning Ofwat against using current market estimate of rate of return to justify setting ever lower targets because of volatile market conditions
• Making changes to its resilience programme and increasing the efficiency of its programmes such as National Environment Programme

The company reported a 92 per cent acceptability level from its customers and stakeholders for its business plan and said its implementation would represent “a very good outcome for customers”.

Bristol Water, which is the only company to have previously resorted to appealing to the CMA over its PR14 business plan (in which it was not successful), said Ofwat’s DD was not balanced. It accused the DD of not reflecting customer priorities and not being financeable for itself or any similarly sized water company. It called for an holistic approach to the DD, which it said was missing from Ofwat’s approach – calling it “a series of technical judgements and interventions”.

The company said it had made further progress on leakage in its plan, which Ofwat had acknowledged as “ambitious”, as well as adding a further £15 million in efficiency drives, meaning a total of £80 million efficiency savings.

The company also:

• Queried Ofwat’s acknowledgement of evidence relating to cost price pressures and the quality of evidence Ofwat relies on for its totex/outcomes frontier shift
• Provided detailed evidence to dispute Traffic Management Act costs, resilience enhancement, and strategic water resource development

Portsmouth Water said its business plan remained financeable but recognises the “not immaterial challenges” Ofwat had presented it. The company, which has a totex proposal lower than Ofwat’s own assessment, was unable to confirm the financeabilty however because of uncertainty related to project costs – namely a reservoir.

Its reply to Ofwat also pointed out:

• Delivery of the Havant Thicket Winter Storage Reservoir (HTWSR) is central to much of Portsmouth’s plans both in terms of financeability and water resource management and remains a contentious issue in the DD
• The company rejected Ofwat’s 6.5 per cent proposed per capita consumption (PCC) reduction target and maintained its 5 per cent target
• Argued against metering because of weak economic incentives for customers and reported it had limited customer support unless widespread metering was compulsory
• Questioned what it called an “abnormally large penalty” of £1.9 million for its PR14 and AMP6 water quality performance. It suggested the penalty was an unintended consequence of changes made by Ofwat after its PR14 plans were submitted and requested a reduction to £483k.

South East Water called Ofwat’s targets something “no company can achieve” and predicts negative press coverage and a fall in public trust would ensue as companies failed to hit unachievable targets, notably those related to leakage, supply interruptions and water quality compliance.

It found the cost assessment to be a “major area of concern” which it said would prevent the company from investing in bolstering water resilience, reducing leakage to sector-leading levels and providing customer service.

It has therefore provided further evidence and documentation to justify its decisions. The company said it had improved some PCs but had largely retained its previous position on ODIs.

It also:

• Argued that Ofwat had removed the value of SE’s customer views and feedback in response to performance commitments
• Maintained that with its planned level of investment the ODIs it had set would be achievable
• Said it was not “appropriate or possible” to provide assurance on whether its plan would be financeable if Ofwat made further changes

South Staffs Water, incorporating Cambridge Water, expressed fears about the financeability of Ofwat’s DD, without an appeal to the CMA. It said its credit quality would be so badly affected that it would lose access to capital markets and questioned the legality of Ofwat’s approach.

“As the draft determination stands, the board does not consider that Ofwat has fulfilled its legal duties to allow us, as an efficient company, to finance our functions. It follows that the board is unwilling to certify that it considers the business to be financeable. But we hope for constructive engagement with Ofwat over the autumn so as to avoid the necessity of an appeal to the CMA.”

Its major concerns were four-fold:

• A £15 million WRFIM adjustment which fails to account for the company’s legacy developer service charges – amounting to 14 per cent of its actual revenue allowance
• Totex allowances under which it accepted several of Ofwat’s suggestions but stated the leakage investment reduction of 23 per cent was unworkable
• Requested Ofwat reconsidered its ODI approach and reversed some of its interventions
• It is also seeking an adjustment to the WACC of 24bps.

Just three companies – Severn Trent, South West and United Utilities – had their plans approved for fast-track status.

Ofwat commented: “We set out our view of water companies’ services, investment and bills for 2020-25 in our draft determinations. We will consider the representations we have received, including where companies provide new evidence that better enables them to deliver for customers and the environment, before making our final determinations on 11 December 2019.”