On 13 December 2017, Ofwat published the final methodology for its 2019 Price Review (“PR19”). Ofwat’s final determination in December 2019, based on this methodology, will set limits on the prices that each water and/or wastewater undertaking can charge its customers in 2020-2025. This article draws out some of the factors from the review that are likely to have the greatest impact on industry revenues.
Water and wastewater undertakings must, under the conditions of their appointments, set prices for their services such that they comply with Ofwat’s price controls. These controls, reviewed and determined once every five years by Ofwat, provide limits on the revenue that undertakings can obtain each year on their wholesale, household retail and non-household retail services. The limits are bespoke for each undertaking, based on the commitments made in business plans they submit to Ofwat; the factors that Ofwat considers when analysing these business plans to inform the revenue limit calculation are set out in its price review methodology. In the methodology for the 2014 Price Review (“PR14”) under which the current price controls were determined, these factors included customer engagement and the delivery of the resulting customer-focused outcomes, costs of delivery and risks for the undertaking and affordability of services for the customer.
The PR19 methodology builds on the factors set out in the PR14 methodology, with express focuses on customer service, affordability, innovation and operational, financial and corporate resilience. The following are some of the key differences between the PR14 and PR19 approaches:
- Tighter approach to cost and risk – Ofwat wants undertakings to demonstrate a “step change in efficiency”. In particular, the allowance for financing costs (“weighted average cost of capital”) that undertakings can pass on to consumers has been reduced significantly, from 3.74% in PR14 to 2.4% in PR19. While Ofwat states that this reflects a lower market cost of borrowing, the smaller allowance could present particular challenges to certain undertakings, including those with expensive existing long-term debt. The change will also be significant to undertakings that have previously kept their financing costs down through the use of international corporate structures – structures that they are now trying to simplify in response to calls for transparency (e.g. in Ofwat’s 2017 Company Monitoring Framework). Other measures increasing the pressure on undertakings to innovate for efficiency include broader efficiency benchmarking, a requirement to consider procuring external infrastructure services and an increase of the threshold to receive Outcome Delivery Incentive payments on exceeded performance commitments from 2% to 3%.
- Common outcomes – while PR14 gave undertakings freedom to determine (with evidence) the outcomes demanded by their customers, PR19 moves back towards Ofwat’s previous model of specifying the outcomes which all undertakings must work towards (to ensure a level playing field and a consistent set of definitions). The specified outcomes include customer experience, water quality, leakages, pollution incidents and sewer flooding.
- Express environmental focus – eco-system resilience and environmental innovation are prominent factors in the PR19 methodology. Following some undertakings’ high-profile leakage issues last year, Ofwat is challenging undertakings to achieve a 15% reduction in leakage by 2025. Undertakings should consider the government’s twenty-five year Environmental Plan (published on 18 January 2018), which resonates with the PR19 methodology: it states such priorities as reducing wastewater impact, reducing water demand and managing water-efficiency and personal consumption.
- Considering vulnerability – undertakings will be assessed on their ability to identify vulnerable customers and offer them a high quality of support.
- Price controls expanded along supply chain – Ofwat has included new price controls for services in relation to sludge and water resources.
Ofwat is running an ongoing queries process on the PR19 methodology; it published its first Q&A document on 15 January 2018. Undertakings will be required to submit their PR19 business plans to Ofwat by September 2018. Ofwat will provide its initial assessment of the plans in January 2019.