The race is on to cut costs and improve efficiency

Ofwat has fired the starting gun on a tough new era for the water industry. But will the decision to limit companies' future profits create more problems for contractors? And could necessary investment work be hit too? Dean Stiles reports.

OFWAT'S surprising decision to limit future returns for water companies will put contractors under renewed pressure as water companies seek efficiency and cost savings in the order of 12%. The regulator's challenge to the water companies is average bills reducing around 12%, or £45, by 2015.

Paul Mullord, UK director at British Water, says: "I don't know what the water companies were expecting - and if they did know what to expect they were not telling us - but the underlying issue is that to deliver something like 12% more efficiency you have got to be doing something different to what you did before. You are not going to get a different result by doing the same thing."

He expects water companies to put contractors under pressure to deliver on costs and efficiency savings. "Some companies may adopt a more adversarial way of working as the best way to achieve results; others will expand their partnering arrangements. I expect that we will see every reaction between the two extremes."

Ofwat's announcement on July 23, 2009 triggered a steep share sell-off in the sector with shares down 5% the day of the statement as shareholders feared water companies, which for years have offered a steady flow of payouts well above the market average, would have to limit dividends. Severn Trent was hit hardest, falling 81p to £10.32, with United Utilities dropping 23.25p to 479.25p, Pennon losing 17p at 490.5p and Northumbrian Water down 8.25p to 245.5p on the day of the announcement.

Opening gambit
Regina Finn, Ofwat's chief executive, prompted headline news with her pro-consumer stance but the final settlement may prove less onerous for water companies. Ofwat's announcement is the opening gambit in a piece of regulatory theatre that characterises the AMP process.

There are four months to run before the regulator makes its final decision on prices in November for the new regime that comes into force next April. Despite the brouhaha by water companies, Ofwat's proposed return on capital until 2015 is 4.5% on a post-tax basis; at the low end of expectations but not off the scale. Water companies will challenge this before Ofwat issues its final determination in November and the final figures on permitted bill rises and returns will almost certainly edge higher.

If the industry remains unsatisfied, it can protest to the Competition Commission. Over the past four years, water companies have shown a willingness to challenge Ofwat and have even ignored its rulings, picking up £70M in fines as a result.

Water companies have a case for a more generous deal to reflect tougher trading conditions with falling consumption and rising bad debts.

Severn Trent says demand for water has continued to fall during the early months of its financial year. The company said before the Ofwat decision that although trading has remained in line with its expectations, UK water usage was down by similar levels to last year and this would hit its revenues by £15M to £20M.

Severn Trent described its submission to Ofwat as a "balanced, holistic and robustly justified business plan for the five-year period".

Tony Wray, Severn Trent's chief executive, in response to the Ofwat announcement, said: "We will be carefully and thoroughly reviewing all of its content and conclusions before responding to Ofwat in September 2009."

David Owens, chief executive at Thames Water, says: "We've spent the past two years preparing our plan. We know our region better than anyone else and our proposals are based on sound evidence and, most importantly, what customers say they want. We're not prepared to cut corners on essential work - but we're not 'gold-plating' either."

He adds: "It's early days but initial indications suggest today's draft determination may not allow us to deliver what our customers want in the future. For example, this means that we won't be able to reduce leakage at all over the next five years."

Ofwat's draft determination reduced Thames Water's proposed £5.5B investment to maintain its performance levels and improve pipes and sewers to £4.6B. Ofwat has almost halved Thames Water's proposed water mains replacement programme, meaning no reduction in leakage over the next five years, according to Owens.

He says customers still consider paying higher water bills acceptable in return for essential investment to safeguard and improve services, according to an independent willingness to pay study of 300 customers carried out last month by Nera.

Southern Water's chief executive, Les Dawson, says: "We need to take on board what Ofwat is saying, understand what this means for customers and see how we can continue our commitment to delivering our four million customers the best possible service."

He continues: "We have taken into account the views of our customers and worked hard to balance the need to spend money on improvements with the desire to keep down bills, particularly in the current economic climate. We will continue to do this as we consider Ofwat's report."

Pamela Taylor, chief executive of Water UK, says: "In the present economic climate we know that value for money is more important than ever, but these draft determinations make us wonder if Ofwat has lost sight of the longer term imperative. In the interests of customers, the economy and the natural environment, we should be investing at a steady pace rather than storing up problems for the future."

AMP cycle
Amid the posturing from water companies as they play to shareholders and customers, and jockey for position with Ofwat, it is clear that contractors will be under pressure to reduce cost in the next AMP cycle even with a more generous Ofwat ruling.

Framework agreements will become more important as a means of delivering the required efficiency savings, says Mullord. But to do so the frameworks need to work properly, he says.

Mullord reports that many contractors, after successfully tendering for work are not included in decision-making and not appraised of workflow. This lack of visibility undermines the benefits of the process. "The whole idea of frameworks is that your supplier gets an idea of how much work he is going to get in order to procure materials efficiently, better organise the workforce, and deliver you efficiencies.

"What tends to happen is the supplier doesn't get that visibility, doesn't get any security of orders coming through, and the water company tries to squeeze the supplier for a discount at the end of the contract, when it's too late."

The changed structure of the industry, compared with the last recession in the 1990s, does offer contractors some degree of protection from competition and price-cutting from companies that previously had little involvement in water.

Mullord says: "In the 1990s water companies were able to deliver their business working project by project, tender by tender, and managing each one individually. That was at a time when there were a smaller number of large projects around. Now we have a different type of work; the average size of projects has dropped dramatically and the number of projects has increased dramatically.

"I don't think the water companies will be able to work in the old way of tendering one by one and managing one by one. That's been a big driver for frameworks being established: it's a much easier way doing it."

But frameworks and partnership working will come under stress as some water companies revert to type and adopt a more adversarial approach towards contractors.

"I think it'll be a shame to have frameworks in place then continue working in an adversarial way with someone. I don't think it's the best way to work. You've got more chance of getting more out of a contract working together and collaborating," Mullord says.

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