The devil in the detail of PR19

Battle lines are being drawn between the regulator and water companies over the next price review. Utility Week sums up the main areas of contention.

Battle lines are being drawn in the UK water sector. Ofwat has made no secret of its intention to drive down customer bills and limit returns for investors – an intention that runs throughout its proposed framework for the next price review, PR19. But water companies say the regulator has gone too far, and their responses to the consultation on the framework, which closed last week, warn that the framework as it stands will send investors running for the hills and could ultimately end up costing tomorrow’s customers far more.

Customer representatives are weighing into the fight too, with the Consumer Council for Water (CCWater) arguing that financial rewards for outperformance should be linked solely to customer satisfaction and have the explicit backing of customers.

Ofwat has received more than 60 responses to its consultation, and will publish its answers alongside the final framework for PR19 in December. Here, Utility Week rounds up the main areas of debate in the consultation responses that have been made public to date.

1. The cost of capital

The cost of capital, which governs the return investors make from water companies, is always the most controversial element of a price review, and for PR19, more so than ever.

Ofwat is looking to set the cost of capital at a historic low in response to what is calls the “lower for longer” interest rate environment. The regulator will also be mindful of accusations that it has previously been too generous in setting the cost of capital, allowing companies to pocket the difference over the current and previous cycles.

Macquarie estimates that the plain vanilla real weighed average cost of capital (Wacc) will be 2.3 per cent for PR19, based on Ofwat’s published range, which is down 38 per cent on the current asset management plan period. Ofwat will confirm the Wacc when it publishes the final framework in December.

The cost of capital is made up of two elements: the cost of equity and the cost of debt, and it is the cost of equity, or more specifically the total market return (TMR), a key element of the cost, which is causing the most debate.

Traditionally, regulators have set the TMR based on historic data, usually within a range of 6.1 per cent to 7.3 per cent. However, Ofwat says this time round, the unique economic environment means that historic data is not the best way of forecasting returns for the price settlement period of 2020-25, and has instead employed consultant PwC to make a forecast using different data, coming up with a range of 5.1 per cent to 5.5 per cent real.

Water companies have taken serious issue with this approach, with three – Anglian, Northumbrian and Affinity – going so far as to hire a rival consultant, KPMG, to conduct an alternative analysis. KPMG’s numbers put the range at 6.25 per cent to 7.3 per cent – or, using the same approach as PwC but correcting what they call “shortcomings in its analysis”, at 6.5 per cent.

2. ODIs

Outcome delivery incentives (ODIs) are financial rewards or penalties that companies receive based on their performance against various key indicators. The idea is that if they perform well, they make more money, much as companies operating in a competitive market do. Ofwat is keen to make more use of ODIs in the next price review, to widen the gap between the financial rewards for top performing companies and the penalties for underperformers, and to raise the bar on performance – effectively meaning companies have the potential to make more money, but they will have to perform much better to do so.

This changes the risk profile of water companies for investors, who are conservative by nature and have traditionally been attracted to the low-risk, fixed returns available from water companies.

The companies are broadly supportive of the move to make greater use of ODIs, and to make them more challenging. However, they warn that Ofwat has gone too far by proposing that “an average company with average performance would expect to incur penalties on its ODI package, rather than rewards”, because this means an average company that improved its performance over the price review period could still end up being penalised. This, they say, is too tough.

Anglian Water also points out that the current framework would see companies that were top performers in certain areas – as Anglian is on leakage – effectively penalised, because they do not have the scope to improve at the same pace and to the same degree as lower performing companies. This, they say, is unfair.

Companies support ODIs in theory – and little wonder, as given the potential upside. Severn Trent, for example, made £47.6 million in 2016/17. But customers, as represented by CCWater, are not so sure – again, hardly surprising, given that they ultimately pick up the tab. CCWater argues that any ODI should have the explicit backing of customers, warning that customer backing for the measures was limited in the previous price review, and that greater use of ODIs could lead to “a negative customer reaction, particularly if ODI rewards drive bill increases and inflation also rises”. It also suggests that outperformance rewards should be limited to customer satisfaction metrics, so customers only pay more if they clearly receive better service.

3. Glidepaths

Traditionally, when regulators impose tougher targets, they allow companies a period of time to work up to them, rather than face immediate penalties for not meeting them. Controversially, this time round, Ofwat proposes not doing so – a proposal that has caused muttering in the sector, and one that some companies now take issue with in their consultation responses.

Anglian argues: “Regulatory precedent would suggest that it would be appropriate for glidepaths to be provided in such circumstances, rather than cliff-edge shifts.”

4. Direct procurement

One of the biggest reforms proposed in the framework for PR19 is the introduction of direct procurement, which would see water companies putting the delivery, financing and possibly the operation of major capital projects out to tender. Most companies are supportive of direct procurement, with many seeing it as an opportunity to compete out-of-area on other companies’ capital projects.

However, Anglian believes it is unfair that companies cannot compete for their own major projects, and suggests an alternative model whereby a third party would be appointed to run the tender, allowing incumbents to compete.

Anglian also suggests that Ofwat’s proposed limit over which projects are subject to direct procurement should be set on a capex rather than whole-life totex basis. Otherwise, it argues, long-life assets which have a relatively low capital value but reach the totex threshold over the course of their life will fall into direct procurement when it is not really appropriate for them to do so.

5. C-MeX

The service incentive mechanism (SIM), introduced in 2010, is widely acknowledged to have driven up service levels across the board, by incentivising companies to focus on customer satisfaction. However, with most companies delivering scores at or near the top of the range, it is reaching the end of its useful life, and the sector agrees it is time for an overhaul.

Ofwat’s proposed solution is C-MeX, a new measure that will survey the satisfaction both of customers who have not contacted the company and customers who have; and offer potentially higher rewards than the SIM, but only for upper-quartile performers.

The companies offer broad support for C-MeX, with just some comments on the practical detail. CCWater, however, suggests more far-reaching change to the proposed framework, calling for the measure to be split into two parts. The first, C-MeX contacts, would measure customer contacts and complaints handling; the second, C-MeX satisfaction, would measure customer satisfaction with value for money and net promoter scores, a widely used measure of customer satisfaction.

CCWater proposes that these two C-Mex measures are linked to two separate ODIs, which comprise “most or all of the value of the full package of financial ODIs”.

It is worth noting that alongside the areas of disagreement outlined above, there are numerous areas of agreement, with all the consultation responses made public so far keen to emphasise their support for the structure of PR19 and its broad aims. It is also worth noting that not all stakeholders have agreed to make their consultation responses public – although all will be published by Ofwat in December, along with its answers and final framework.

How different will the framework look to the proposals put out to consultation? Time will tell, but Anglian Water regulation director Alex Plant expects Ofwat, “as a good regulator, to take on board and consider consultation responses and weigh them in the balance”. The sector, and its customers and investors, eagerly await Ofwat’s final decisions.