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UTILITY WEEK | 8TH - 14TH JANUARY 2016 | 19 Policy & Regulation Market view O fwat's initial Water 2020 consultation continues its regulatory reform jour- ney, moving focus on to cautious mar- ket opening for upstream services. It hopes to maximise consumer benefits but limit risks to low-cost finance. Ofwat's paper pro- poses some key pillars on which to lay the foundations for further reform. Pillar 1: retain PR14 fundamentals Ofwat proposes to retain key elements of the PR14 framework including: • separate retail controls; • five-year caps on regulated revenues; • customer challenge groups (CCGs); • incentives reflecting customer values; • use of total expenditure plus return on regulatory capital value (RCV) for whole- sale revenue caps; • flexibility over RCV recovery. This stability is important. Ofwat is not proposing deeper reforms, such as separate regulation of "system operator" functions, as used in energy. Pillar 2: update PR14 tools While retaining PR14 basics, Ofwat is updat- ing some tools for 2020, proposing to: • update its commitment to remunerate capital invested in the RCV to 2020 in later price reviews; • strengthen the effectiveness of the cus- tomer voice; • broaden evidence on efficiency and the values of company outcomes; • move to CPI indexation, given wider regu- latory trends; • increase sharing of performance risks with customers between reviews. Pillar 3: separate water resources and sludge controls Ofwat wants to restart the paused PR14 jour- ney to separate binding price controls for water resources and sludge from 2020, sup- porting more effective competition. It expects to consult on enabling licence changes this year. It expects more supporting information from companies, including more accounting separation (previously signalled in PR14), and more published information via sector information exchanges to improve the water resource and sludge markets. Pillar 4: competitive procurement for network enhancement Ofwat proposes companies use more com- petitive procurement for major network enhancements, using the same £100 million threshold as Ofgem where it expects schemes potentially to war- rant long-term contracts with third party infrastructure providers, simi- lar to Thames Tideway. Pillar 5: upstream service pricing Government policy on abstraction and upstream reform, Welsh regula- tory boundaries, and English domes- tic retail competition could all affect PR19. But Ofwat proposes access charge rules in 2016, aligned with its price control proposals, future-proof- ing them for further reform. Ofwat expects geographically- averaged charges to retailers to con- tinue, but to improve local incentives for new water resources. It proposes this circle is squared via access charge adjustments to encourage efficient entry where new water resources cost more than the costs used to cap incumbents' water resource revenues (recovering depreciation and return on allocated RCV). Network revenue adjustments, along with the forms of control and policy state- ments on 2020 RCV, could limit investor risks, regardless of RCV allocations. How- ever, customers could be exposed if charging rules encouraged inefficient entry and trad- ing, or created tension with competition law. Incremental costs used for Ofwat's charging framework should be consistent with com- panies' water resource management plans, where earlier guidance is expected. Updated trading incentives could then take account of the government's wider reforms. For sludge, Ofwat expects to promote a level playing field by requiring publication of standardised cost and non-price informa- tion for contract negotiations, versus spe- cific untreated sludge prices. It proposes to increase WaSCs' exposure to this level play- ing field, while retaining the RCV to cap expected returns from contestable activi- ties. It estimates this extra exposure could increase companies' average wastewater asset "beta" by around 15 per cent, though notes that impacts would be geo- graphically patchy, and could be mitigated by control details. Ofwat's paper identifies dif- ferent dependencies, with some illustrated below. Some need extended debate before the methodology in December 2017, including those affected by gov- ernment policy, and areas with greatest estimated PR14 impacts. PR14 timetable pressures were compounded by licence change delays. So Ofwat proposes earlier licence changes for PR19, affect- ing three key proposals: separate upstream controls; CPI indexa- tion; and in-period risk sharing. Ofwat expects to quantify rele- vant impacts in May: for separate controls, its initial assessment stressed information benefits over other impacts such as risks (expected to be lim- ited, particularly in water resources). Indexation debate may focus on CPI transitioning, and weighted average cost of capital (Wacc) consequences. Unlike pension deficit funding (where transitions were company-specific), Ofwat proposes an industry-average approach for indexa- tion transition. Companies with higher RPI- linked debt could thus face unfunded costs. Ofwat expects to consider other Wacc issues, including debt indexation, later on. Ofwat also proposes that customers share cost and delivery risks via bills within price control periods, not just at price reviews. The bill impacts will be affected by Ofwat's wider safeguards, including charging rules. Robin Pratt was Ofwat's chief economist during PR14. He is now a senior affiliate of Charles River Associates Upstream reform: 2020 vision Robin Pratt runs through the key points of Ofwat's Water 2020 consultation, which lays out the foundation blocks for further reform of the water market. "Stability is important – Ofwat proposes to retain key elements of the PR14 framework"