AMP6 price setting: what’s changing?

With the price setting process for AMP6 of the water industry's regulatory cycle underway, Ofwat's director of regulatory finance, Keith Mason, is in no doubt that this is "an interesting time" for the industry. WWT's editor, Natasha Wiseman asked for an update.

From the perspective of Keith Mason, economic regulator Ofwat’s director of regulatory finance, there are two things that are shaping the industry – the start-up of price setting methodology 2015-2020, and the upcoming Water Bill and Water Act. He says that the second “will introduce more market mechanisms and potentially more competition” in both the retail end and the upstream end of the industry.

“The price setting is not too much changed,” he says. “We’re still going to set prices for five years. We’re still looking at an approach where the water companies submit business plans and we do the final determination based on those business plans.”

Those determinations are due at the end of November – early December 2014. Mason says that what has changed, in terms of the way Ofwat is undertaking this price review, “is that we are putting more responsibility and accountability on the companies for how they put forward their business plans, what they put in their business plans and how far they have discussed and taken on board the views of customers and stakeholders.”

A major change is the introduction of Customer Challenge Groups (CCGs), which water companies have been asked to set up by the regulator: “They’re there to challenge on behalf of customers and other stakeholders what is in companies’ business plans,” Mason explains. “So when companies put their business plans back to us, we will also get a report from the CCG that says to what extent the company engaged with them … to what extent the business plan has taken on board their suggestions and we will take that into account.”

Some companies are already taking parts of their plans to the CCGs and Mason believes this will get more intensive over the summer and autumn. One area customers cannot affect, though is mandatory targets set by the Government, the Environment Agency (EA) and the National Environment Programme, companies would leave themselves open to challenge if they were to leave out a mandatory requirement.

Mason says that in order to strengthen accountability, Ofwat is suggesting that business plans should be more long-term; and focussed on outcomes rather than outputs; an approach that is supported by the EA and Drinking Water Inspectorate (DWI). He says this will give companies more space to decide how they are going to get to those outcomes, because in past reviews companies have ended up with a long list of outputs.

He explains that giving water companies the space to do things their own way and innovate might allay “some of this criticism about the water industry not being very good in terms of innovation. “People won’t be able to say there’s a barrier because of the regulatory framework. Companies will be able to decide on which outcomes, he explains.”

The industry often asks how Ofwat knows what prices to set, he says that the new approach to business plans should “reduce the gaming idea – where companies think ‘if we put in x, we know Ofwat will shave off a proportion, so are we prepared to live with x minus this shaved off proportion?’

“What we’re trying to say is if the business plan is well put together and shows that customers have an input and are likely to accept it; it deals with all the mandatory stuff; we won’t give that business plan much scrutiny. Whereas if one of those boxes is not ticked, we will have to scrutinise that business plan.

“We are looking for more open business plans. So companies don’t feel they have to put in for more because they feel we will just take something out so they don’t end up with a low number. ”
Ofwat is putting out a document at the end of March to define what a good business plan looks like, this will be finalised in another document in early July.

In terms of methodology, Ofwat is moving towards targeted incentives and is setting four separate price controls for retail and wholesale for the first time, although that will be three for water-only companies. A methodology consultation was put out in February, but the water companies were already well briefed on the change.

“The reasons for having separate wholesale and retail controls,” says Mason, “is this idea that if you’re going to have separate retailers, you need to target incentives on the retail functions. The way you do that is by having control related only to those retail functions, so that separates out for you retail and wholesale.”

Of the retail controls, Mason says, “there’ll be one for the contestable business customer part and one for the non-contestable part, which is essentially household customers.” Of the wholesale, sewerage and water price controls will be separated out.

Mason says that applying the new methodology means ” that you can align incentives on the costs for providing water and sewerage better in relation to the totex approach if you have separate controls. It is all about having the targeted incentive, which is one of the themes of this price review.

Mason believes that the move to a totex – combined capital and operational expenditure will help remove a bias toward capital programmes, however, he does not think that it removes all the barriers.

“There are two things from the regulatory perspective,” he explained. “The first is that capex goes into the RCV [Regulated Capital Value] and is recognised and there is a return and a lot of the finance is lent on the back of the RCV.

“The second one is that it was more difficult to have equal incentives on opex and capex as they were done through different methods, in terms of establishing relative efficiency. I think the third one is if companies had to spend additional opex, the regulatory framework never allowed them to get that opex back.”

Mason explained how ‘logging up’ when a new output or requirement emerged that was not set at the time of the review, distorted the solution to a capital spend over operational.

“Companies could ‘log up’ the capital expenditure related to that output at the next price review and it would go into the RCV, but if there was something that was opex, companies never recovered that money.”

He says that even without some of those biases, water companies are left with others such as a ‘compliance’ bias. He explains that the certainty of solutions can sometimes influence companies’ choices; so if a capex solution gives a more certain answer to a problem than trying an opex-based solution, then the company may chose the capex one – as it does not want to run the risk of failure on something the EA or the DWI is looking at.

By way of example, he says, where a sewage treatment works has consent standards to meet and they face a choice between a solution that is opex-based, or alternatively, they could bolt on a piece of kit to deal with it, the tendency is to bolt on the piece of kit because they know what the piece of kit does.

“Whereas if you’re trying say a SuDS (sustainable drainage) type solution that may or may not work as well in all circumstances, and say the EA is looking at the consent standards around effluent, the company may think, ‘I know what I’m going to get from this kit. It may not be the best thing to do from all sorts of other standpoints, but I know what I’m going to get from it,'” he explains.

Moving outside of the regulatory realm, Mason says that a third cause of bias may derive from the engineering-basis of the sector – companies may simply prefer engineered solutions to softer ones.
“Perhaps [the supply chain] do have sell the softer solutions in a different way,” he says.

However, from Mason’s viewpoint, the upshot of the removal of the capex bias is that water companies “won’t be able to say ‘we can’t do that because the regulator won’t let us, won’t like it’, because the totex approach will not have a bias towards any sort of solution.”

A key area of the draft water bill is the introduction of retail and upstream competition in the water sector. While the former is widely accepted, upstream competition has attracted criticism; not least in a report from the All Party Parliamentary Water Group.

Mason said he thought more work needed to be done with Defra, perhaps with more examples and showing the timescales over which upstream competition might be introduced. However, he was in no doubt that it would improve resilience, particularly in relation to water resources.

He also emphasised the importance of maintaining investor confidence, “because they’re the people who lend the money to water companies to do a lot of these solutions.”

“In terms of regulation, there will be different parties that can choose to enter the water industry. At the retail end, third parties will be able to come in and be retailers of water.

Mason explained that for upstream there would be different varieties of license available for particular areas where people want to enter into the value chain.

“I doubt, because it is economically inefficient, the main distribution pipes and sewers will be anything ever other than a monopoly, but there may be different licences for people to simply introduce water to the network and there may well be people who want to expand the networks, which is a similar thing to what goes on in the electricity industry.

“And there may be people who want to offer treatment services, so it is saying there will be licences that allow people to do certain parts of the value chain where that is more appropriate than simply having a licence cradle to grave. The water bill should allow that to happen, first on the retail end and then focussing on the upstream part.”

Mason explains that in addition to their 25-year Strategic Direction Statements (SDS), they have to do their Water Resource Management Plans. He says that Ofwat is trying to link the upstream ideas in the water bill with the WRMPs by asking companies to consider whether they need future resources of water and if so, where they might come from.

“The five-year plans fit into the context of the 25-year plans that links into outcomes; outcomes are likely to have currency over more than one price review. So you can have outcomes say on security of supply, and companies can set out how they’re working towards that. And if they have deficiencies, they’ll be able to say ‘and this is how we’re doing it over the longer period and you can see this is how we’re doing it over the five year period,'” Mason concludes.

Keith Mason is director of regulatory finance & competition at Ofwat with responsibility for mergers, corporate finance, financial modelling and ring-fencing as well as development of competition policy. He has been with Ofwat for more than ten years and experienced three Periodic Reviews.

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