Towards Water 2020: a glimpse of the future

The discussion papers published by Ofwat last week have given the industry a glimpse into what could be a significantly different sector in the next decade, as well as inviting them to help shape it.

With topics from customer engagement through to the length of the price control period laid on the table, the regulator has opened the door for a potential overhaul of the sector.

Ofwat hopes igniting the debate around how the sector runs and is regulated will address the pressing issues of water scarcity and environmental quality – things exacerbated by population growth and climate change. Finding solutions – and ones that are affordable to the companies and their customers – is the ultimate aim of these papers.

The hot topics:
• Encouraging a longer term approach
• Separating price controls further
• Making more use of markets
• Customer engagement
• Risk and reward

Encouraging a longer term approach

Climate change and population growth – and their impact on water scarcity and the environment, are long term issues that require long term planning. So Ofwat is asking whether there should be long term incentives to encourage water companies to plan and act accordingly to deal with this challenge.

The regulator highlights that extending the price control period – as has happened in the energy distribution sector – is an option, as is creating longer term outcome delivery incentives, something the regulator first mentioned earlier last month.

Another solution to prevent short-termism and the boom-and-bust nature of the five year investment cycle could be a staggered approach to price controls for different elements of the water sector – such as water and wastewater areas.

Separating price controls further

PR14 saw Ofwat set separate binding controls for wholesale activities and retail activities for the first time. Now the regulator is considering going further still.

In the paper, Ofwat says that a greater degree of price control separation in wholesale activities could reveal the relative efficiency of companies in different areas – and therefore where further efficiency savings can be made.

These new separate price controls could range from fully binding, separate controls through to non-binding or indicative separation. With this greater clarity, Ofwat suggests it could then in turn enable better price signals and potentially support new entry in various new markets.

Making more use of markets

A market-based approach to upstream services could encourage innovation and improve allocative efficiency, by revealing important information on the cost of providing services and the value that consumers place upon them.

The two key areas highlighted as being ripe for competition are water resource and sludge treatment and disposal.

Water trading and allowing new entrants to offer sludge services to incumbents could “drive innovations and deliver savings”, according to Ofwat chief executive Cathryn Ross. This could also see the vertical integration of the market begin to break up as new entrants take on roles traditionally take on by the incumbents.

Competitive tendering – similar to the regime used for the Thames Tideway Tunnel and Ofgem in offshore transmission – is another avenue Ofwat is keen to explore. Not only could this produce a new way of delivering much needed assets, but it will test the market to ensure these assets are being delivered as cost effectively as possible.

Customer engagement

This was “at the heart” of the PR14 process, but the regulator wants to build on this success for PR19.

Developing a longer term approach is something Ofwat is eager to encourage the companies to focus on when they engage with their customers. Again, should outcomes longer than the five year AMP cycle be considered and the regulator also questions whether five year rewards for projects that last decades are appropriate.

The role of customer challenge groups (CCG) is another area up for debate. Do they continue to lead the customer engagement for their respective companies, or do they take a step back and function in an assurance role, monitoring the progress made on the PR14 promises?

Ofwat looks keen to push for cross CCG collaboration to ensure that the companies are held to account fairly, with their performance and business plan promises held up against those elsewhere from the sector.

Risk and reward

This is central to Ofwat’s aim of aligning the interests of customers, investors and company management.

One suggestion is that the reward for outperformance is increased, while the baseline return is scaled back – adding to the incentive for the companies to deliver as promised.

Changing how the regulatory capital value is index linked is also mooted – potentially shifting it away from the retail price index (RPI) to the consumer price index (CPI). CPI is usually slightly lower than the RPI rate, and Ofwat states a move to CPI is likely to reduce earnings via RCV growth, but increase the returns through the real cost of capital. The net result would be an increase in bills in the next price control period, but lower bills in the longer term as the RCG growth would be lower.