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12 | 15TH - 21ST SEPTEMBER 2017 | UTILITY WEEK Policy & Regulation B attle lines are being drawn in the UK water sector. Ofwat has made no secret of its intention to drive down customer bills and limit returns for investors – an intention that runs throughout its pro- posed framework for the next price review, PR19. But water companies say the regula- tor has gone too far, and their responses to the consultation on the framework, which closed last week, warn that the framework as it stands will send investors running for the hills and could ultimately end up costing tomorrow's customers far more. Customer representatives are weighing into the fight too, with the Consumer Coun- cil for Water (CCWater) arguing that finan- cial rewards for outperformance should be linked solely to customer satisfaction and have the explicit backing of customers. Ofwat has received more than 60 responses to its consultation, and will pub- lish its answers alongside the final frame- work for PR19 in December. Here, Utility Week rounds up the main areas of debate in the consultation responses that have been made public to date. Analysis The devil in the detail of PR19 Battle lines are being drawn between the regulator and water companies over the next price review. Utility Week sums up the main areas of contention. Cost of capital The cost of capital, which governs the return investors make, is always the most controversial element of a price review, and for PR19, more so than ever. Ofwat is looking to set the cost of capital at a historic low in response to what is calls the "lower for longer" interest rate envi- ronment. The regulator will also be mindful of accusations that it has previously been too generous in setting the cost of capital, allowing companies to pocket the difference over the current and previous cycles. Macquarie estimates that the plain vanilla real weighed average cost of capital (Wacc) will be 2.3 per cent for PR19, based on Ofwat's published range, which is down 38 per cent on the current asset management plan period. Ofwat will con- firm the Wacc when it publishes the final framework in December. The cost of capital is made up of two elements: the cost of equity and the cost of debt, and it is the cost of equity, or more specifically the total market return (TMR), a key element of the cost, which is causing the most debate. Traditionally, regulators have set the TMR based on historic data, usually within a range of 6.1 per cent to 7.3 per cent. However, Ofwat says this time round, the unique economic environment means that historic data is not the best way of forecasting returns for the price settlement period of 2020-25, and has instead employed consultant PwC to make a forecast using different data, com- ing up with a range of 5.1 per cent to 5.5 per cent real. Water companies have taken serious issue with this approach, with three – Anglian, Northumbrian and Affinity – going so far as to hire a rival consultant, KPMG, to conduct an alternative analysis. KPMG's numbers put the range at 6.25 per cent to 7.3 per cent – or, using the same approach as PwC but correcting what they call "shortcomings in its analysis", at 6.5 per cent. Outcome delivery incentives Outcome delivery incentives (ODIs) are financial rewards or penal- ties that companies receive based on their performance against various key indica- tors. The idea is that if they perform well, they make more money, much as compa- nies operating in a competitive market do. Ofwat is keen to make more use of ODIs in the next price review, to widen the gap between the financial rewards for top per- forming companies and the penalties for underperformers, and to raise the bar on performance – effectively meaning com- panies have the potential to make more money, but they will have to perform much better to do so. This changes the risk profile of water companies for investors, who are conserva- tive by nature and have traditionally been attracted to the low-risk, fixed returns avail- able from water companies. The companies are broadly supportive of the move to make greater use of ODIs, and to make them more challenging. How- ever, they warn that Ofwat has gone too far by proposing that "an average company with average performance would expect to incur penalties on its ODI package, rather than rewards", because this means an average company that improved its perfor- mance over the price review period could still end up being penalised. This, they say, is too tough. Anglian Water also points out that the current framework would see companies that were top performers in certain areas – as Anglian is on leakage – effectively penal- ised, because they do not have the scope to improve at the same pace and to the same degree as lower performing companies. This, they say, is unfair. Companies support ODIs in theory – and little wonder, given the potential upside. Severn Trent, for example, made £47.6 million in 2016/17. But customers, as rep- resented by CCWater, are not so sure, and they ultimately pick up the tab. CCWater says any ODI should have the explicit back- ing of customers, warning that customer backing for the measures was limited in the previous price review, and that greater use of ODIs could lead to "a negative customer reaction, particularly if ODI rewards drive bill increases and inflation also rises". It also suggests that outperformance rewards should be limited to customer satisfaction metrics, so customers only pay more if they clearly receive better service.