Direct procurement (DPC) drives innovation, cost reduction and long-term resilience – three things reiterated by Ofwat’s draft PR19 methodology. Ofwat’s guidance is broadly as expected. It gives companies the freedom to choose the right projects and best procurement model to help companies get the most value from their DPC schemes. And it makes DPC revenue a direct ‘pass-through’ from customers, which will be pleasing to investors. All positive messages.
But there are three areas that could discourage companies from pursuing DPC schemes – and hamper DPC’s success in PR19 and beyond.
If a DPC procurement event fails because the water company is at fault, it may be forced to bear any additional retendering costs. In the worst case scenario, it may also have its ‘allowed revenues adjusted to reflect efficiency gains from the DPC model’. This means the company will have to provide the outcome at the same cost of the failed DPC procurement.
These penalties put companies at risk of significant financial loss when a DPC procurement fails. And what’s more, Ofwat is quite prescriptive around the contract type and revenue model DPC schemes should use – see Appendix 10 of the PR19 guidance . In my view, if an event fails, it’ll be hard to say whether it’s due to inherent weaknesses in the Ofwat model or poor performance by the company. Obviously, customers need protection from companies’ avoidable mistakes. But DPC is a new delivery model, without a fully established market, and companies will have to build much of their specialist DPC procurement capability from scratch. Asking them to bear the full risk of any procurement failure doesn’t seem to balance risk and reward appropriately, and will discourage companies from being the ‘first-movers’ with DPC.
Experience in other industries, such as central government (see sections 18 and 19), shows us DPC-style arrangements need careful ongoing management to be successful. Ofwat recognises this and makes it clear ongoing management is the water company’s responsibility – but it’s not clear if companies can claim revenue to cover these costs. Water companies – some more than others – will need to build specialist management capability to manage DPC schemes, and this is likely to lead to ongoing costs from recruiting skilled staff or third-party contract management procurement. If companies can’t claim revenue for these costs, they’ll be discouraged from putting the right capabilities in place – increasing the risk of DPC schemes failing to deliver the expected benefits.
We know of a number of companies that were considering sludge-to-energy schemes as particularly good DPC candidates. These have high innovation and commercial potential, and are attractive to investors. Also, with sludge-to-energy processes lying outside a water company’s core capabilities, it makes them good candidates to outsource ‘to the experts’. Ofwat notes there are separate proposals to develop bioresources markets, but it’s not clear why DPC would be incompatible with them. On the other hand, DPC arrangements could be set up to accommodate a bioresources market, and would provide valuable cost information that could inform Ofwat’s bioresources market development.
The DPC guidance in PR19 shows positive intentions to make DPC a success. But it’s a new model that will take companies out of their comfort zone. They will therefore want to see an appropriate balance of risk and reward. This means protecting them from some of the risk of early procurement failures, and reassuring them they’ll be compensated for the extra contract and commercial management DPC schemes require. And there’s also real value in applying DPC in ‘non-core’ areas such as bioresources. If Ofwat can provide all of this, companies are more likely to pursue DPC vigorously in PR19.