Utility Week

UTILITY WEEK | 2ND - 8TH FEBRUARY 2018 | 11 Policy & Regulation Market view M ore than a month since Ofwat pub- lished its PR19 final methodology, the significantly lower weighted annual cost of capital (Wacc), at only 2.4 per cent, has continued to hit the headlines – and understandably so, as the industry gets to grips with a record low figure for a regulated utility. However, looking beyond the surprising Wacc, and digging deeper into Ofwat's meth- odology – a blueprint setting out how it will regulate the English and Welsh water indus- try for five years 2020-25 – there are three significant areas it's important to observe. Resilience in the round Resilience emerged as a key theme of PR19, focusing on "resilience in the round". This examines not just the capacity of an organi- sation's infrastructure to cope with disrup- tion, but also that organisation's financial arrangements and corporate governance. As set out in September 2017's Resilience in the Round paper, Ofwat is taking a sys- tems-based approach and those objectives are touched on in the PR19 methodology and performance expectations. It now includes specific commitments on resilience to drought and flooding, the environment and long-term sustainability and better engage- ment with customers. It is in line with the Water Act 2014, which introduced a statutory duty on Ofwat to further the "resilience objective", promot- ing long-term planning and investment, the use of a host of measures to manage water resources in sustainable ways, increase effi- ciency in water use, and reduce the demand for water to minimise pressure on resources. Direct procurement for customers PR19 introduces a model for larger water infrastructure projects to secure competitive financing: direct procurement for customers (DPC). It mimics the offshore transmission operator model used by Ofgem in the energy industry, where infrastructure connect- ing offshore windfarms to the mainland is owned and operated by a separate company following a competitive process. However, there are significant differences, which raise questions as to how the model will work. Any project with a total expenditure of more than £100 million and classed as dis- crete (little overlap or complex interaction with other infrastructure) can be considered for DPC. Under the model, the incumbent water company tenders the project and the winning contractor designs, builds and oper- ates it, in return for a fixed revenue stream for 15-25 years. The incumbent water company must prepare an economic case showing that the costs and benefits of putting the project out to DPC outweigh those of building and oper- ating it in-house, which, given the lower Wacc, might be difficult to do. There are two models of DPC: the con- tracting model, where the incumbent retains the licence and contracts out its obliga- tions to the contractor, while retaining licence responsi- bility; and the utility model, where the contractor obtains its own licence – the Thames Tideway Tun- nel being an example of this in practice. The contracting model of DPC is an untested approach, and in the discussions surrounding PR19 there have been concerns about how protected the incumbent water company would be if the contractor defaulted on its contractual obligations, given that the water company remains accountable to Ofwat as the licence holder. The Thames Tideway Tunnel is a success- ful example of DPC, but it is based on the utility model, which has its own licence, and was backed up by various government sup- port mechanisms, which are unlikely to be replicated in future projects. Market opening and competition The last price review, PR14, only separated the water and wastewater wholesale mar- kets in its revenue control. PR19 goes further, adding water and bioresources, because increasing transparency and accountabil- ity should act as a spur to innovation and more prospect for competition, which in turn should improve resilience. By setting a separate revenue control for bioresources, Ofwat wants to encourage more trading between water and wastewater companies for the treatment, transport, recy- cling and disposal of sludge, and also trade and collaboration with firms operating in other waste markets. Similarly, there will be a separate revenue control for water resources, detached from "network plus water", for England only. This may encourage trading of water across com- pany boundaries now, and looking to the future, the Water Act 2014 allows business retailers to procure water resources from third parties directly, when the relevant pro- visions are brought into force. Ofwat's work- ing assumption is that this bilateral mar- ket entry will be imple- mented in 2022, although the government has not yet decided when, or indeed whether, to implement it. Our take on the three significant areas of PR19 we have examined here is that resil- ience in the round clearly has commend- able objectives, but how those are translated effectively into companies' business plan- ning in response is yet to be seen. DPC is in many ways a reworking of pri- vate finance initiative ideas – with all their pros and cons. A balance must be struck between allocation of risk and more competi- tive financing for larger water infrastructure projects, but it will be a challenge. In the absence of more from the Department for Environment, Food and Rural Affairs, the measures to encourage competition between water and wastewater companies and bio- resources are relatively modest, but an incre- mental approach is welcome as the change of the last few years is absorbed. Rona Bar-Isaac and Andrew Walker, partners, international law firm Addleshaw Goddard The key changes in PR19 Rona Bar-Isaac and Andrew Walker dive deep into the water sector's next price review, PR19, to explore the three big changes to previous settlements, and what they will mean for companies. "PR19 introduces a model for larger water infrastructure projects to secure competitive financing"

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