Utility Week

UTILITY WEEK | AUGUST 2022 | 11 Policy & Regulation The regulator says this sharing mecha- nism will not apply to payments from the Measure of Experience (MeX) performance commitments – C-MeX, D-MeX and BR-MeX. Ofwat also says it expects companies' business plans to set out their proposals for dividends and performance-related execu- tive pay, with the latter demonstrating a "substantial link to stretching performance delivery for customers, communities and the environment". The regulator is proposing to require companies to hold open challenge sessions both during and a… er the development of their business plans to enable stakeholders to challenge them directly in an open forum. It says these could be facilitated by CCW to ensure consistency between companies. Comment Wendy Kimpton Water regulation expert, PA Consulting T he PR24 dra… methodology embeds the familiar ingredients of stretching improvements in service, challenges on costs, promotion of competitive tender- ing and markets, and continued focus on ‹ nancial structures. However, there are key aspects of the approach that will present a new level of challenge to the industry around overall risk and potential returns. Ofwat's expectation is that everything should be comparable and largely homo- geneous with almost everything already accounted for in base costs. The emphasis is on a comparable view of what customers want with less focus on local and regional conversations, implying that in the water industry "levelling up" has already been achieved. Customers and the three regulatory build- ing blocks around outcomes, costs and the risks/return balance, are still very much in the forefront but the regulator's approach means that companies will need to consider them through a very di' erent lens to that used for PR19. In PR19 companies were expected to create a tailored conversation with their customers to discover what mattered in "The waters may seem familiar but it won't be plane sailing" tion that base costs are su" cient to improve service and maintain asset health. If this is the case, how much capacity is there for future costs be factored in? In addition, the requirement for investments with lifetime totex costs above £200 million to be DPC (direct procurement for customers) by default may have potential impacts on future cost models. The methodology again states an expected range for Return on Regulatory Equity (RoRE) of +/- 1 – 3%. The PR24 proposed design places most of the outper- formance opportunity into service perfor- mance to incentivise companies to focus on delivering service to customers. The stronger focus on common PCs and virtual demise of the bespoke PCs means that for companies, the balance of risk and reward will be di' er- ent in PR24. There are also important changes for returns and ‹ nancial structures. As new debt raised at lower rates gradually replaces embedded debt, Ofwat expects the cost of debt to be materially lower than PR19, con- tributing to a reduction in the allowed return. Furthermore, it is actively encouraging increased equity as a bu' er against uncer- tainties. The notional capital structure may have a higher share of equity and reduced gearing, which, in a period where companies may be facing signi‹ cant investment needs, could put pressure on some companies' ‹ nanceability without equity injections. In many respects the PR24 methodol- ogy is a close cousin of PR19 and therefore largely predictable. However, it is important to recognise that Ofwat still can exercise its judgement around the cost of capital and ‹ nancial structures, choice of service and e" ciency benchmarks, and the overall bal- ance of risk and return. their regions. Although the requirement for customer engagement remains, the role of central research in determining valuations, the greater emphasis on common perfor- mance commitments and the near elimina- tion of bespoke performance commitments will change the nature of that relationship. This approach reduces possible concerns about a postcode lottery in service standards but there will be less opportunity to account for evident regional di' erences. Ofwat's approach to cost assessment is broadly consistent with PR19 but raises the question of whether that consistency allows for signi‹ cant changes in future costs or delivery methods. Ofwat has signalled a cautious intention to consider future costs in cost models and to reŸ ect nature-based solu- tions in future regulatory capital value. These are positive steps, but key details remain to be established, including whether the benchmarks for service and costs will be at upper quartile or beyond. It will also be fascinating to see how the models perform against the observed experiences in PR19 and if they are able to account for future ten- sions in costs releveled during PR24. The regulator has stated its clear expecta- Ofgem says it is working with both water companies and CCW to implement a col- laborative approach to research that a' ects common areas of business plans such as cus- tomers' priorities, their views on a' ordability and appropriate rates for ODIs. To encourage the use of nature-based solutions, Ofwat says it wants to provide increased funding surety to schemes that are more reliant on operational expenditure. It says the options it is considering include capitalising the net present value of the whole-life operating expenditure of nature- based solutions and adding this to the com- panies' Regulatory Capital Value, and setting ten-year operating expenditure allowances to be recovered over two price control periods. It also wants to leverage competition to drive improvements in the delivery of large infrastructure projects and is therefore pro- posing to require companies to use direct procurement for customers (DPC) by default for all projects with a lifetime total expendi- ture value of more than £200 million. Ofwat says it will not provide funding for in-house delivery of DPC eligible schemes, instead providing funding for the procurement process. The regulator says it expects the cost of debt to be "materially lower" than at PR19 and that there is a case for lowering the gearing for the notional company to ensure "equity bu' ers" are su" cient as the water sector faces a more uncertain future. Tom Grimwood, news editor

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