Water UK raises concerns over proposed incentives for PR24

Water UK has raised concerns over the regulatory incentives proposed by Ofwat in its draft methodology for the 2024 price review.

In its response to the consultation, the trade body said the changes put forward by the regulator, which include the removal of caps, collars and deadbands from individual outcome delivery incentives, suggest water companies will face “increasingly asymmetric downside risks” as part of PR24.

Water UK said the changes will have the greatest impact on measures which are sensitive to outlier events such as supply interruptions.

The industry association said it is particularly concerned that Ofwat’s proposed approach to incentives would result in “almost all companies being penalised in every single year” on the Compliance Risk Index (CRI) measure of water quality. It said this approach is not supported by the regulator for drinking water quality, the Drinking Water Inspectorate, and urged the retention of a deadband for CRI set at a similar level to PR19.

If Ofwat does not change its approach, Water UK said the regulator will either need to significantly increase total expenditure (totex) allowances to enable water companies to reduce the risk of outlier events or raise the cost of capital to reflect their larger impact on incentives.

It said there is also the potential for unintended consequences from companies diverting expenditure to performance commitments presenting the greatest financial risks, which could lead to spending being inefficiently focused on short-term solutions and misaligned with customers’ priorities.

Water UK said these asymmetric risks are similarly apparent in Ofwat’s approach to setting performance targets, costs allowances and price control deliverables for investments with long-term benefits.

“We recognise the role of the regulator in scrutinising companies’ plans and seeking to ensure value for money for customers,” it added.

“However, the apparent expectation that endless service and environmental improvements can be delivered without incremental costs for customers cannot be sustainable and is not consistent with the recent water sector redeterminations, where for example incremental costs of further reducing leakage were recognised.

“The assertion that the cost of achieving levels of performance can be met from allowed base costs and further assumed efficiency gains creates a significant downward skew to the risks facing all companies.”

It urged Ofwat to work with the sector to improve its understanding of what companies can buy from base costs before assuming further efficiency gains, saying it is “crucial this includes a bottom-up, engineering-based assessment, rather than relying solely on top-down econometric models.”

The response raised concerns over companies exposure to rapidly rising prices for commodities such as energy and steel, noting that there is only an uncertainty mechanism to share the risks of real price effects for labour.

Overall, Water UK said the approach set out in the draft methodology “risks the effective erosion of resilience in the sector to shocks such as those it is seeking to cope with now through the prolonged period of dry weather, and, in some parts of the country, drought.”

The trade body additionally accused Ofwat of having “little regard” for the decisions on financing by the Competition and Markets Authority (CMA) in its recent redeterminations, especially in relation to the cost of equity. It said the regulator has “chosen to reject almost all of the CMA’s 2021 decisions, reached after intensive deliberation in what was the longest and most considered set of water price review redeterminations ever undertaken.

“In particular, Ofwat has chosen to ignore or attach little weight to the evidence which underpinned these redetermination decisions where they deviated from Ofwat’s original position in its final determinations. By contrast, where the CMA found in favour of Ofwat’s position, this is considered by Ofwat to validate its approach.”

It also pushed back against Ofwat’s proposals to lower the notional gearing level to provide a greater equity buffer for sources of uncertainty such as climate change, warning: “The combination of lower notional gearing and expectations of a greater role for equity – but a downside skewed risk-profile as noted above – risks compromising the sector’s attractiveness at a point when sustained investment is needed”.