Ofwat toughens its resolve for PR19

13 December 2017

Ofwat published its final methodology for the PR19 price review on 13 December 2017, continuing to raise the bar on the standards expected from the water industry.  

Its statement that typical household bills should decrease by £15-25 underlines the regulator’s expectation that companies will deliver a step change in efficiency and customers will benefit from financing benefits due to lower cost of capital (WACC).  The regulator has continued to tighten performance targets, meaning companies must simultaneously improve service to customers across a wide range of metrics.

The figure which has attracted most attention is Ofwat’s early view on WACC. This is provided at an earlier point than it was during PR14, providing clarity for companies to finalise their plans. The headline figure is markedly lower than the return used in PR14, dropping from 3.74% to 2.4% (real, RPI) at appointee level (with a 0.1% deduction for the wholesale WACC equivalent). While Ofwat strongly signalled a drop, and the industry has largely anticipated it in the current low interest rate environment, it is towards the low end of expectations.

It is clear that Ofwat wants to reduce the return available to companies for “just being water companies”. To earn higher returns, they will need to outperform customers’ expectations on tougher commitments. Companies that have previously relied on financing gains will find the lower WACC challenging, and those with expensive debt financing, raised when interest rates were higher, will be particularly hard hit. This challenge has been masked in recent years by favourable financing conditions compared with Ofwat’s PR14 assumptions, but some companies will now require a concerted effort to avoid financial restructuring.       

These announcements provide greater clarity, and we’ve noted some of the most important changes from the draft methodology below:

  • Financial rewards for plans achieving fast-track status at +10bps on RORE; with +20-35bps for plans with exceptional status (variable depending on level of ambition and innovation).
  • Ofwat will set efficient cost baselines for companies based on a forward-looking view of efficiency. This is an expansion from PR14 where cost models only relied on historical information. As a result, Ofwat might have more discretion when setting cost baselines at PR19, which could result in a more stringent efficiency challenge.
  • Totex sharing rates that will be linked to relative efficiency and business plan classification (sharing factors range from 35-65% for exceptional, fast track and slow track business plans) rather than mechanistically to upper quartile efficiency.  Plans classed as requiring ‘significant scrutiny’ will receive the lowest sharing factors (25% outperformance retained, 75% underperformance at shareholder risk).
  • Instead of requiring all companies to deliver upper quartile (2024) service levels from the start of the price control, there will be an a year-on-year forecast of upper quartile targets for common performance commitments.  Ofwat and the companies will work together on the definitions of performance commitments, but within the common ODIs,  leakage targets will require a 15% minimum reduction on a 3 year average basis and there is removal of the extreme weather exemption for sewer flooding.
  • Fast-tracked and exceptional companies can benefit from early certainty in specified areas such as cost adjustment claims, performance commitments, and ODIs.  However, companies can choose to opt out of early certainty through a statement in their plans.  The ‘do no harm’ principle used in the last price control (PR14) doesn’t apply (e.g. changes in legal obligations and cost of capital will pass to enhanced and fast tracked companies).
  • There will be materiality thresholds for special cost factor claims, based on a five year price control totex (1% for network plus controls, 6% for upstream controls, 4% for residential retail and 6% for business retail), which may reduce the scope for companies to make some claims stick.
  • The retail controls will run for five years not three.
  • Ofwat has strengthened the requirement for companies to adopt high levels of transparency and engagementment with customers, including through corporate and financial structures.

In the vast majority of cases, Ofwat has confirmed the approach taken in the draft methodology. Retail margins, for example, remain at PR14 levels (1% for residential, 2.5% for non-residential), and Ofwat has confirmed there will be no glide path to efficient wholesale costs.

The methodology will be better for the top performers, who can expect to earn higher financial rewards for out-performance and for the quality of their plans. Poor performers, however, will face greater financial challenges.

Ofwat continues to set very high expectations of customer engagement and use of valuation techniques in their business plan proposals, requiring a “step change” from PR14.  This will now be challenging to meet if any company is not in the very advanced stages.

With much to do before the September 2018 business plan submission date, it is a challenging time for water and wastewater companies. Pressure is mounting to create robust plans in line with the methodology and deliver the quality of evidence Ofwat is looking for.

by Richard Laikin, water sector leader and sector specialists, Nicky Fomes and Nick Forrest. 

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