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PR19 – A calculated gamble by Ofwat? 

Richard Khaldi | Water Briefing | 19 July 2017

This article first appeared in Water Briefing

With the publication of its methodology Ofwat has increased markedly the level of prescription both of the outcomes it expects from water companies, and of the price review process itself. It has stated that its aims for PR19 are more innovation and resilience within water companies, a step change in customer service, and bills that remain affordable.

The question is whether Ofwat has allowed the regulatory pendulum to swing too far and whether it risks failing to achieving its aims for PR19 before the review has even begun?

The regulatory pendulum is often discussed in regulatory circles. The hypothesis is that levels of regulation, and its intrusiveness and prescription, oscillate back and forth over time. This happens as regulators react to times of concern or crisis then shift back to lower levels of regulatory activity until the next issue arises.

In this way PR14, with both its RIIO-style focus on outcomes and its incentive mechanisms for customer engagement and business plan quality, can be viewed as Ofwat’s reaction to the limited success of PR09. That review marked the zenith of an output-focused, detail-driven approach where the regulator took a much more deterministic role. However, despite PR14 marking a distinct shift in approach, it did not achieve everything that Ofwat hoped.

Ofwat has taken a calculated risk with the toughness of its proposed review

From the relative freedom of PR14, this latest methodology consultation suggests that the pendulum has swung back. As far as Ofwat is concerned, this reflects the current political and regulatory environment where renationalisation is being openly discussed and regulators are being asked to ‘correct’ competitive markets through price caps. Certainly Ofwat has taken a calculated risk with the toughness of its proposed review and only time will tell whether this proves to be an over-correction. However, concerns have already been raised by the rating agency Moody’s that the proposed reduction in water companies’ financial flexibility could lead to a downgrade in their credit ratings. Clearly there are some serious implications for water companies within the PR19 proposals as the regulatory requirements reduce their room for manoeuvre.

PR14 required companies to engage with their customers more than they ever had and focus on delivering those outcomes that truly mattered to them. However, it has become clear that PR14 did not deliver sufficiently strong incentives for all companies to deliver consistent and demonstrable operational performance. Those water companies that were already performing well operationally have continued to do so. Likewise, those at the bottom of the league have stayed there. Meanwhile, financial performance has been strong for pretty much everyone.

Some water companies seen as failing to deliver for customers - a situation Ofwat will not allow to continue

This has created a dilemma for Ofwat. Its vision for the sector is where customers and society have trust and confidence in water services and in the companies that provide them. If PR14 has not delivered consistent and demonstrably strong operational performance by all companies, but those same companies continue to perform well financially, it seems inevitable that trust and confidence will start to be eroded. That has already been reflected in the NAO’s criticism of Ofwat in 2015 for failing customers by allowing over-generous returns to companies. Since the general election there has also been renewed political scrutiny of the water sector and its regulation in the light of the Labour party’s stated policy of renationalisation. I am not here to argue for or against renationalisation, but regardless of your political persuasion it is clear that some water companies have been seen as failing to deliver for their customers and that is not a situation that Ofwat will allow to continue.

So how is it dealing with these issues in PR19? First, it is introducing 14 common performance commitments with stretching targets across a range of operational areas, particularly in those areas it sees as crucial to customers such as leakage. It is also taking the caps off its ODI incentives, increasing the RORE range for those ODIs and introducing enhanced rewards and penalties for exceptional and sub-par performance respectively.

Second, it intends to index the cost of new debt and has indicated that the cost of equity will be significantly lower. All indications are that this will lead to an overall company WACC of below 3%. Taken together, Ofwat’s intention is for companies to have limited opportunities to financially outperform the PR19 settlement without there being a direct link to operational excellence. Companies will also be required to deliver this increased level of operational performance from day one of AMP7, with the regulator insisting that none of the 14 common performance commitments can have a ‘glide path’ over the review period.

Ofwat limiting companies’ freedom & narrowing regulatory tramlines to ensure more consistency of performance.

There will be other requirements for water companies to meet in PR19. As well as being innovative, they must demonstrate that their company is resilient. This means not just the traditional focus on a company’s infrastructure assets, but on resilience across Ofwat’s new, wider definition that encompasses all of the key aspects of a company’s operations. Companies must also consider direct procurement for customers for any scheme that has a TOTEX value of more than £100m. And affordability and companies’ ability to meet the demands of customers in vulnerable circumstances are now also key business plan assessment measures. All of these initiatives suggest that Ofwat is limiting companies’ freedom and narrowing the regulatory tramlines to ensure that there is more consistency of performance across the sector.

Another of the lessons of PR14 was that incentivising companies to be innovative with their business plans without setting many rules on how those plans should be presented led to a wide variation in approaches. This inevitably increased the challenges in carrying out a comparative assessment of those plans. For PR19 water companies will again be required to produce an innovative business plan, but in doing so they must also complete specific tables and limit their plans to a maximum of 300 pages (water only companies will have to make do with only 200 pages). Again, Ofwat has narrowed the regulatory tramlines.

The regulator has already made clear that it views PR19 as being a tough review and that ‘average’ companies will struggle. This raises the question of whether Ofwat can realistically expect those same companies to deliver in innovative ways or has the regulatory pendulum swung too far? Will any company be viewed as truly innovative in the PR19 process and therefore be assessed as exceptional with the financial benefits that assessment brings? It is possible, but that opportunity will not be available to many. I believe that most companies will have a challenge just to keep up with Ofwat’s expectations on operational performance, customer service and affordability.

There is certainly a risk that companies will struggle to deliver for customers

There is certainly a risk that companies will struggle to deliver for customers. The focus on operational performance will put pressure on company management teams as they try to meet the needs of both customers and investors. With transparent performance commitments comparable across the sector, there will be few places for an underperforming company (and, by extension, its management) to hide. Further, water is a long-term, infrastructure-focused industry and there are a limited number of quick fixes available should a company need to turn around its performance fast. In the short term I expect this to lead to at least one or two companies challenging their PR19 settlement at the CMA.

With a lower cost of capital we may also see investors reassessing their portfolios and further ownership changes. Certainly Ofwat’s response to the recent sale by Macquarie has indicated that it is open to new investors entering the sector and sees benefits from that change. It is also likely that there will be further M&A activity during AMP7 should smaller companies struggle to deliver value for money and bigger companies seek further economies of scale. Again, if these changes bring new ideas and impetus into companies that are struggling then they will be welcomed by Ofwat.

So, the regulatory pendulum has definitely swung back and companies now have a bigger challenge and much less latitude than they did at PR14. PR19 is Ofwat’s response to the changing, and challenging, political and regulatory environment. It has taken a calculated risk with the toughness of its proposed review and that may, in time, turn out to be an over correction. However, in the short term it is clear that many companies will have a challenge on their hands as the regulatory tramlines narrow.

Richard Khaldi is a water sector expert at PA Consulting Group

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