Ofwat raises the bar with its draft methodology
12 July 2017
Ofwat has published its draft methodology for the next water industry price review (PR19), providing the clearest indication yet of what it expects from the industry, and laying the foundation for the development of company business plans.
In doing so, the regulator is clearly raising the bar for the quality of the business plans it expects companies to produce.
Ofwat is now expecting to categorise business plans in one of four ways: exceptional, fast track, slow track and “requiring significant scrutiny”. Fast track companies will benefit from a quicker and more streamlined review process, and will gain the reputational advantage of delivering a quality business plan. Companies with exceptional plans will also be rewarded financially.
To become exceptional or fast-tracked, the industry will need to meet Ofwat’s aspiration: “We want companies to produce high-quality, ambitious and innovative business plans, pushing forward the performance of the sector as a whole and stretching the boundaries for delivery and efficiency.”
We think water companies will find this challenging to deliver, because:
- They will need to provide evidence that they are aiming for the levels of performance delivered by leading companies outside of the water industry - it will not be enough to demonstrate that a company is outperforming its competitors.
- Companies will need to look at resilience in the round, assessing risks and identifying interventions that represent the best value for money. And their boards will need to provide assurance that plans have been informed by a robust and systematic assessment of the resilience of the company’s systems and services. This will require companies to “stress test” their plans in new and complex ways.
Ofwat has acknowledged how hard it will be for companies to meet its high standards - it has even suggested the possibility that no company will achieve the new “exceptional” status.
This is against a backdrop of a more complex price control process. PR14 saw the introduction of new processes and price controls. While this complexity will remain, Ofwat has also indicated that it:
- expects the companies to raise their game on customer engagement;
- has extended the number of price controls;
- is promoting the extension of competition in the new water resources and bioresources markets;
- expects that companies will look for appropriate opportunities to procure services directly from third parties; and
- will use more complex techniques to benchmark the costs of the wholesale and retail businesses.
In contrast, there are some welcome areas of standardisation and simplification. For example there are more common Outcome Delivery Incentives (ODIs) and a simplified approach to scenario analysis. The early publication of business planning tables, financial model and a commitment to publication of an initial allowed returns figure, later this year, also means lessons learnt during PR14 have been put into practice.
There are strong indications that the final determinations will leave companies exposed to more performance risk, whilst facing a lower cost of capital. Ofwat is planning to remove the cap on the incentives for outperformance and underperformance. And the incentives will be rebalanced so that “the average company is more likely to incur penalties on its ODIs than rewards”. Although Ofwat has not indicated its view on the PR19 cost of capital, the messaging is clear - Ofwat expects a “significantly” lower cost of equity and cost of debt.
And the companies will need to deliver against challenging performance and efficiency targets from the beginning of the next price review period: Ofwat expects companies to be “on track” from the start - there will be no “glide path” to reach stretching performance commitments and efficiency. If the early indications of performance in this regulatory period continue, some companies may struggle from the beginning of the next review period.
What does this mean for the water companies? We think companies will need to do four critical things:
- Focus on where they can make a real difference in their interactions with Ofwat. Even the best companies will find it challenging to be exceptional across the board. The key to success will be to identify the strengths that the company can capitalise on and the weaknesses it needs to overcome.
- Work hard to identify and emulate best practice outside the industry. This could range from retailers using digital technology to engage customers, through to the way that construction firms manage complex infrastructure programmes.
- Test the resilience of all aspects of the business in an holistic way and engage with customers on the actions it will make to secure resilient supply. This will add a new and important layer of complexity to the business planning processes, including more extensive testing of risk and reward scenarios.
- Be ready to implement their plans with speed - with Ofwat expecting high performance and efficient costs from the beginning of the next regulatory period, there will be no time for reflection after the Final Determinations in December 2018. Companies should be ready to execute their plans before this comes into effect.
Stuart Cook, Hettie Farrell and Nick Forrest worked alongside Ofwat during PR14 as part of Ofwat’s Delivery Partner team.
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