There is profound uncertainty in today's water market. Ofwat is set to introduce the most radical changes to regulated price controls since privatisation, and at the same time the government is planning a Water Bill designed to facilitate retail competition while liberalising upstream activities.
Consequently, the challenge facing water companies is how to understand and quantify the affect implementing the government's plans (due in 2017) at the same time as developing business plans for the next price review (PR14) for the five year period 2015-20.
While work to develop a framework for business retail competition and the reform of upstream activities has begun, much of it has yet to be defined and will not be confirmed until the supporting legislation and legal framework is in place. Many of the key design features are still under development. Major questions still need to be answered. Will there be a single market operator, as in Scotland, and if so, what will be its scope? What shape will the arrangements take to facilitate trading between wholesalers and retailers? And how will the market design affect the technical and commercial operation of the networks? Different answers to these questions may drive different levels of customer and industry appetite for competition and place a different set of risks on the businesses.
The programme of work to develop the above arrangements is just beginning to gain momentum, but the PR14 process is already well advanced. Companies need to prepare and submit business plans to Ofwat by the end of this year. These plans require companies to detail their proposed performance commitments for the five-year control period; to set out the criteria against which such performance will be measured; and to propose incentive mechanisms around delivery against their commitments that provide an appropriate balance of risk and reward between company and customer.
Business plans need to be based on robust foundations, including appropriate levels of customer engagement and sound financial and cost data. To assist the companies, Ofwat will shortly publish its final methodology for PR14. However, as illustrated in the diagram, many other decisions necessary to inform those business plans, in particular those required to define the market framework, will not be made until 2014 or later.
This uncertain landscape could put future investment in the sector at risk, at a time when investment in infrastructure projects is needed to drive economic recovery. So effective planning by water companies to address these uncertainties is essential both for their future success and in meeting the government's vision.
The use of scenarios is vital if companies are to present the robust and well justified plans the regulator is demanding. Most management tools are geared to a world that faces predictable and quantifiable risk - for example, budget forecasts and five-year plans. However, in times of turmoil these tools are not effective. There is clear evidence that good scenario planning leads to significant changes in the decision-making mindset and makes leaders better at responding to and anticipating forthcoming opportunities and threats.
There are precedents that can inform water companies' scenario planning activities. Electricity, gas and telecoms have all undergone extensive reforms in the past two decades, with each sector adopting different strategies to deliver the requirements of market reform. Closer to home, the introduction of retail competition in the Scottish water sector can also provide insights into the issues water companies south of border will need to consider in developing potential future scenarios.
The recent RIIO experience in the energy sector offers further valuable lessons. The new regulatory framework was developed recognising the uncertainties electricity distribution and transmission companies face around the evolution of renewable and local generation, electric vehicles and demand-side response. Their use of scenario planning to support traditional modelling and planning techniques has helped to provide insights on the range of potential future outcomes and on how the businesses can prepare their investment cases to anticipate future developments.
These scenarios were then discussed and modified as a result of customer feedback, which allowed both the companies and the regulators to take a view on probable outcomes. Perhaps most importantly, it has allowed network company management teams to understand how to assess the indicators of change and adapt flexibly to future developments.
Water companies should also bear in mind a further lesson from the financial crisis. PA's Managing Uncertainty survey, which assessed how 200 senior business leaders responded to the recent financial crisis, showed two-thirds of businesses saw uncertainty as a threat and planned defensively, while the other third saw it as an opportunity for them to beat their rivals. This latter group delivered far higher total shareholder return and customer satisfaction.
In a competitive environment, those water companies that recognise the opportunities of the coming reforms will reap the benefits, while those who do not may find themselves swallowed by bigger fish who are ready to embrace change.
Liz Parminter and John Parsonage are utilities and regulation experts at PA Consulting Group
This article first appeared in Utility Week's print edition of 5 July 2013