Facing up to Water Industry Challenges

Article Summary

Whilst the UK water industry undergoes its next price review (PR19), which will conclude next year in 2019, the sector is facing some major challenges for the next investment period (AMP 7, 2020 to 2025) and beyond. The industry regulator, Ofwat, will build on key principles agreed for PR14 and look to develop upstream competition in Sludge (BioResource) and Water Resources. At the heart of the regulatory framework for water and wastewater services is the desire to strengthen the approach to customer engagement and outcomes to ensure a continued focus on current and future customers. This blog attempts to provide an overview of the direction of travel and the challenges facing water companies.


In an industry that has invested over £130 billion in Water and Wastewater infrastructure since its privatisation in 1989 (delivering massive improvements in drinking water quality, environmental standards and customer service, driven by ever increasing challenges from both Economic and Quality Regulators, backed by legislation and consumers demanding a much more responsive and improved service from their water company); you might be forgiven in thinking that things might be less challenging for the UK water industry at the next price review.

On the contrary, the challenges facing the water industry are massive as it moves through the current investment period, to the next price review (PR19) and beyond. The sector faces a range of challenges, such as water scarcity and the environment, with the combination of climate change and a growing population that is projected to increase to 69.4 million people by 2015, alongside the continuing challenge of affordability.

PR19 Strategy Consultation

To address the challenges ahead, the industry regulator Ofwat has developed a strategy of ‘Trust in water’, which is about a shared vision for the water sector. Very early in the current AMP (Asset Management Period) in summer 2015, Ofwat published their first document ‘Towards 2020 - Meeting the Challenges for Water & Wastewater Services’ as an initial step to gaining a common understanding of the challenges facing the sector, how it can help respond to the many issues it faces and how to build trust and confidence in the water industry.

A further document ‘Framework for Wholesale Markets and Price Review 2019’ was published by Ofwat in December 2015 and used to consult the industry on their thoughts on the price review and plans for 2020. Many of the companies responded to the consultation with their feedback taken into consideration as part of formulating their decision document ‘Water 2020 Regulatory Approach for Water and Wastewater Services in England and Wales’ published in May 2016. This document clearly sets out Ofwat’s decisions on the design for the regulatory framework to deliver a vision where customers and the wider society have trust and confidence in their water and wastewater services – to ensure these are of a high quality, provided in a sustainable way, resilient and affordable.

At the last price review (PR14) Ofwat introduced a new and much more challenging outcome driven approach for companies delivering their business plans. These included four price controls – Wholesale Business linked to RPI (Retail Price Index), Average Cost to Serve (ACTS) for Retail, Lower Wholesale Weighted Average Cost of Capital (WACC) plus risk and the introduction of an additional set of penalties and incentives known as Outcome Deliver Incentives (ODI’s), on top of retaining the Service Incentive Mechanism (SIM) with penalties and incentives for customer service.

There was also a requirement for water companies to establish independent Customer Challenge Groups (CCG’s) comprising of a range of stakeholders and customer champions such as the Drinking Water Inspectorate, Environment Agency, Consumer Council for Water, Confederation of British Industry, Public Health England and Natural England; as well as importantly, engaging with customers through research and focus groups to understand their views and priorities as part of the process for developing an acceptable business plan. Ofwat also mandated to ‘open up’ the Non-Household market to competition that was launched in April 2017.

PR19 Principles

So, what will be different for the PR19 price review?

At PR14 Ofwat developed a set of principles to guide the design of the price review methodology.  Those principles were reviewed against the new statutory framework and in doing so, recognised the importance of consistent and stable principles. The key principles being better customer engagement – to encourage an even greater involvement from customers, CCG’s and outcomes, and a total expenditure (totex) approach to cost assessment.

Priorities and Risk Based Review

In total, Ofwat have developed four priorities – Great Customer Service, Affordable Bills, Innovation & New Ways of Working and Long-Term Resilience – and the following nine risk based review tests for PR19:

  • Engaging customers
  • Addressing affordability
  • Delivering outcomes for customers
  • Securing long term resilience
  • Targeted controls, markets and innovation
  • Securing cost efficiency
  • Aligning risk and return
  • Accounting for past delivery
  • Securing confidence and assurance.

Key Changes for PR19

  • The price review will move from four to five price controls to include separate binding price controls for Sludge (BioResource) and Water Resources. This will also include part-allocation of the Regulatory Capital Value (RCV) to provide a level playing field within these and wider markets.
  • Common ODI’s previously based on historic performance will now be based on forward looking projections of upper quartile performance, with no glide path, targets to be achieved in the first year with financial penalties for non-delivery.
  • Company specific ODI’s attracted limited scrutiny at the last price review. This will be replaced with multiple evidential requirements to demonstrate stretching targets. Dead-bands and exceptions will be discouraged or disallowed and whilst rewards and penalties are un-collard, companies should not expect to take undue reward.
  • In regards to SIM, PR14 looked at quantitative and qualitative measures of customer service performance for customers contacting their water company. This will change to a qualitative only survey which covers customers who have not contacted the company as well as those who have. A new measure for property developers has also been introduced as this is an area where Ofwat have given a lot of focus to improving the industry performance over the past few years. Rewards and penalties will now be symmetrical.
  • Modelled expenditure allowances for Wholesale will be based on forward looking upper quartile levels of spend with an assumed future stretch, augmented by cross-sector efficiency comparisons. With any ‘over and under’ spends now being asymmetrical and less favourable to companies.
  • Estimates around the WACC are likely to be influenced by the longer experience of a low interest rate environment.
  • Wholesale Indexation will no longer be linked to RPI. Instead, it will move to CPI-H (Consumer Price Index including Housing costs) which the regulator considers to be a more appropriate method and aligns water with what’s happening in other utility sectors and wider government policy. Revenues will be indexed to CPI-H from the start of PR19 and indexation of the RCV will transition as it stands on 1st April 2020. 50% of the RCV will be indexed at RPI with the remaining 50% and any new RCV added after 1st April 2020 to be indexed at CPI-H. The treatment of indexation for the RCV post 2025 will be covered by a statement of principles, as the regulator doesn’t believe it desirable to set transition of the RCV indexation beyond 2025. Any decision on the speed of transition beyond 2025 will need to be taken by looking at relevant factors at the time, analysis based on up to date information and consultation with stakeholders.
  • RCV growth will be restricted by the requirement for external ‘Direct Procurement’ for large projects, with an expectation that direct procurement will be used for all projects valued at more than £100m.
  • Retail businesses will move from cost allowances based on ACTS to econometric models with cross-sector efficiency comparisons, with no glide path and a three-year control period.
  • Significant focus on business plan details for affordability, resilience and vulnerable customers to assess the plan quality.
  • Special factor claims will now need to be submitted ahead of the business plan submission and claims will need to be considered as two-sided adjustments. For example, any extra allowance awarded to one company for deprivation will need to be offset by reduced allowances for others. Too many claims will attract additional scrutiny and may impact the assessment of the plan quality.

Closing Remarks

The face of the UK water industry is changing and the PR19 price review will accelerate change. The inclusion of and proposals for upstream competition (BioResource and Water resources), changes to ODI’s, CPI-H Indexation, levels of WACC, direct procurement and special factors will probably make this the most challenging period yet. The introduction of the risk based review adds another dimension to the price review process where company business plans will be categorised as Exceptional, Fast Track, Slow Track or Significant Scrutiny – all delivering known consequences both financial and reputational.

The water industry has been extremely resilient and responsive to change brought about by regulation, customer expectations and companies just wanting to do better and improve their performance and ranking in industry league tables. There has been much more tangible engagement with customers inside and outside the price reviews and the relationships built up with the CCG’s has been extremely productive, benefitting customers, regulators and companies.

We have also seen low levels of water industry consolidation with the acquisition of Bournemouth Water by South West Water (Pennon) and Dee Valley Water by Severn Trent. The only question from me is – will other companies now look at acquisitions in an attempt to deliver synergies that ultimately deliver against the further efficiency challenges from the regulator by acquiring smaller Water Only companies or other Water & Sewage companies, or even build super water or wastewater only business delivering economies of scale by having a larger customer base?

After many years of trying, we have also seen Retail competition introduced in the water sector this year. It’s still early days in the business customer market with only a few new entrants in the market and fewer than 60,000 customers switching in the first 5 months. We have also seen a number of incumbent water companies who didn’t want to enter the competitive business retail market selling their NHH Retail customer base to new entrants. Thames and Portsmouth water both sold their business customers to Castle Water and Southern Water business customers were acquired by Scottish Water Business Stream who following the loss of customers in Scotland where the market opened in April 2008 are desperate to get a foothold into the English Retail market.

The opening up of the Non-Household market was always set to be a challenge with limited available margin to that compared with the opening up of other utility markets (e.g. electricity and gas) giving little capacity to fund attractive customer discounts, acquisition and business operating costs. Prior to opening the market, there was much play made of water being added to existing portfolios of other utility companies, resellers and energy consultants and deals with multi nationals, supermarket chains and group businesses to deliver economies of scale (i.e. one supplier, one point of contact, consolidated billing etc.), so again, it will be interesting to see if significant deals will be closed in the first year of competition in water and what the future holds for competition being introduced for Household customers. One thing is very clear, Non-Household competition needs to deliver for customers and in sufficient numbers before I see any prospect of further competition in water – my guess is that will not happen before the end of AMP 7 in 2025.

As someone who has spent over 17 years in the water sector I look forward to seeing how the industry responds to the challenges ahead on what changes will ensue over the next five years.