Utility Week

16 | 29TH NOVEMBER - 5TH DECEMBER 2019 | UTILITY WEEK Policy & Regulation Analysis O fwat was born as a purely economic regulator but 30 years later its role has evolved significantly. Now it not only directs companies on pricing and sets the cost of capital, but ensures the sector is socially responsible and fair for customers. Only three companies had their business plans for the next five-year asset manage- ment plan period (AMP7) fast-tracked by Ofwat. The rest were required to re-evaluate and resubmit their plans to demonstrate greater efficiencies, higher leakage reduc- tions and lower bills. When dra„ deter- minations were submitted at the end of August, more than one company called PR19 "unworkable" and "unfinanceable". "Companies feel Ofwat is being really tough on them, but the problem is that in the past it hasn't been. Investment has been good and there have been improvements to service, but previous reviews have been too generous for the companies," a senior indus- try source tells Utility Week. "When customers know that, they think it's not fair that the companies have been making higher returns than they should have been over a long time. Ofwat needs to get to grips with that because it's really not sustainable." The generosity of the regulatory sys- tem since privatisation has been painted as contributing to high returns for investors. In a game of Monopoly, holding the utility squares is an unexciting but tactically sensi- ble move. Equally, in reality, the combination of low risk and steady return is the reason many pension funds are invested in utilities. A senior industry figure explains how, in their mind, this generosity has caused sector-wide problems: "The returns for inves- tors since privatisation have not been fair to customers. If you had invested a pound in the water companies, the returns you'd have made would have been much higher than if it had been in the general stock market, despite the fact that water is much lower risk. If you'd have done that at the time of privatisation and knowing water is low risk, you wouldn't expect to make as high a return." They say Ofwat is trying to put this right in the current price review, but in the past there was too much leniency. Tightening the tourniquet The first price review in 1994 was "relatively uneventful", according to Robert Miller- Bakewell, an independent analyst of the sector, but subsequent reviews brought com- panies down with a bump. "The one that started to shake things down was the 1999 price review," Miller- Bakewell says. "Since 1999 we have seen a tightening of the tourniquet at each price review." Each subsequent price review process has been tougher than the last, with the regula- tor asking for more from the companies in efficiency. There has been greater method- ology in terms of detail being submitted at each review, coupled with a reduction in allowed return and tightening of the regime for the companies. Miller-Bakewell says: "Where we are with this price review in 2019 is probably the bot- tom of the cycle in terms of the tightening of the allowed returns. "This is undoubtedly the toughest price review and it is being undertaken in the con- text of a very low interest rate environment, so that allows Ofwat, without changing the methodology, simply to take the latest evi- dence of the cost of capital and to use that lower cost of capital as reflected in the debt capital markets to deliver quite a demanding result from the companies' point of view." Attractive beginnings In 1989 companies were on the whole given a clean slate. Debt was largely written off to make them an attractive investment propo- sition and the privatisation settlement set out the structure of the water market. This included independent economic regula- tion from Ofwat, which set the first round of prices. To further appeal to investors it was agreed that prices would rise 5 per cent above inflation for the first five years, mean- ing customers would accommodate signifi- cant bill increases. And water companies certainly were H3O: Ofwat determined to get tough on price Next month Ofwat will release its final determinations for PR19, widely expected to be the toughest yet. As part of Utility Week's H3O series, we reflect on the changing role of the regulator and why it is taking such a strong stance now.

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