A new dawn for the industry?
The Government’s review of Ofwat is set to bring fundamental reforms. Dean Stiles hears how the regulator needs to change – and why that should be good news for both the companies and contractors alike.The pressure to reform the water industry regulatory system that has shaped the privatised water industry over the past 20 years is too great to resist. The Government’s review of Ofwat, and the Water White Paper to follow next year, is likely to produce fundamental change to the current regime.
Higher water charges that better reflect the full cost of managing water sewage and flood control must surely follow. Defra, which is overseeing the review, has appointed David Gray, the former managing director of energy industry watchdog Ofgem, to carry out the review due to be completed early next year.
The review is a 20-year health check, says a Defra spokesman. “The water industry has changed considerably since Ofwat was set up, not least in terms of the future challenges it faces such as climate change. The review is intended to ensure the regulator is fit to address these challenges.”
The review team will seek comments on Ofwat’s current role and performance from customers, water companies and investors, and is expected to address whether the watchdog plays a sufficient role in preparing the UK's water infrastructure for the increased flood and drought risks associated with climate change.
Ofwat has played a pivotal role in the privatised industry. Like any referee, Ofwat has won few friends among water companies or consumer groups but it has struck a fair balance between ensuring investment in water infrastructure and protecting consumers from excessive charges. Investors have been comfortable with the regulatory regime. Craig Bonthron, investment analyst at KBC Asset Management, which runs a €700M global water fund and invests in United Utilities, Severn Trent, Pennon and Northumbrian Water, says: “We view the Ofwat regulatory mechanism as one of the better regulatory models in the world.”
Since the early 1990s, the level of investment in the UK water infrastructure under the current regulatory regime has been significant. But although the industry has gone through an extended period of “catch-up”, much more investment is still required, and over the longer term, says Bonthron.
“We are comfortable with the theoretical methodology that Ofwat uses to achieve that aim. However, UK water prices, particularly in England and Wales, still significantly lag other regions of the world.
“The household water bill is a tiny percentage of monthly household spending and the value of water is not fully appreciated. We do not think that full cost pricing has yet been achieved under the Ofwat regime,” Bonthron says.
Full cost pricing means that the fees paid by the consumer cover the total cost of operating, maintaining and investing in new connections and infrastructure such as dams, pipes and treatment facilities. It is not an easy calculation in the water industry where assets are often hidden and in some cases, such as underground pipe networks, not fully known. Water companies are fiercely critical of Ofwat, accusing the regulator of jeopardising essential infrastructure investment programmes designed to make the UK more resilient to climate change by rejecting requests for price hikes. In April, Severn Trent spoke out – a rare but welcome occurrence for a UK water company – and warned that the UK water industry was currently “unsustainable” and required £96B of investment over the next 20 years to make much needed infrastructure improvements and prepare for rising climate change risks.
The company criticised the existing “risk-averse” regulations which, it says, favour capital intensive rather than sustainable solutions. It also called for a review of the current price-setting processes and the UK’s proposals for implementing the EU Water Framework Directive.
“In order that the industry can continue to fund this investment while also addressing new challenges such as rising carbon emissions, it is now essential that we make significant changes to the policy and regulatory framework to ensure a sustainable future,” Tony Wray, chief executive of Severn Trent, says.
The demand for the review has been met and it seems the Government is equally sympathetic to Seven Trent's arguments. In addition to regulatory reform, Severn Trent recommended implementing a water trading market to encourage greater levels of national and regional competition between utilities and ultimately deliver reduced bills, it said.
"Inter-company transfers of bulk-treated water could be an economic means to move additional water to water-stressed areas," the report said. “If this allows investment in new resource schemes to be deferred, then the costs of increasing water supply to adapt to climate change and supply a growing population will be lower."
The report calls for companies that reduce carbon emissions to be rewarded, and calls for the Environment Agency to bring in a more flexible approach to consenting new infrastructure projects that rejects the existing "prescriptive" system.
“This would widen the scope for more cost-effective and less energy-intensive approaches to treatment to be taken, but still meet water environment objectives," it said.
Severn Trent said its proposals would save the industry more than £10B during the next 20 years and reduce carbon emissions by 13%, compared with the current business-as-usual scenario. “By passing on these efficiencies to customers, average bills could be 11% lower than they would have been otherwise,” the report added.
The water industry opposed Ofwat’s most recent round of pricing decisions and has long maintained that with areas of the South-east facing levels of water stress similar to those found in Mediterranean regions, and the industry seeing flood risks climbing at a rapid rate, it needs more freedom to increase investment in water infrastructure. There is almost unanimous support for the Ofwat review and, by implication, for changes to the regulatory regime.
David Nickols, chair of the Institution of Civil Engineers (ICE) water panel, welcomes the review: “As ICE’s recent state of the nation report stated, the world we are living in now is very different to that when Ofwat was first set up and the regulatory framework must be reformed to reflect today's environmental and societal challenges.
"The current investment plans do not do enough to address long-term needs, especially climate change issues including reducing carbon emissions and driving down demand. ICE fears that without significant change in the regulatory regime to drive long-term investment in sustainable infrastructure, our water security could be severely jeopardised."
Ofwat has struck a fair balance in the last two regulatory reviews, and things are moving in the right direction, says Bonthron. However, a faster shift to full cost pricing would clearly be desirable for investors, he says. The recent regulatory review was not the huge shift towards a more consumer protectionist stance that many investors had feared, he says.
"We like the position that most of the UK utilities find themselves in at the moment going into the next five year regulatory period.
"Longer-term, we see the global trend towards full cost pricing continuing. An extended period of under investment in developed world water infrastructure over the last 70 years is coming to an end.
"Water quality regulations on the drinking water and wastewater treatment side are becoming increasingly stringent and driving new investment water technologies," Bonthron says.
Emerging economies such as China and India are building new water infrastructure networks to meet the huge demand of their vast and rapidly urbanising populations.
"These huge demographic shifts cause massive stress on the water infrastructure. Water investment is critical in such economies, because water borne disease is such a huge killer," Bonthron says.
He points out that investments in hospitals and schools have diminishing returns on investment, for example, if the former is full and the later empty due to an outbreak of EColi. "We see water metering, UV disinfection, membrane filtration, testing and measuring techniques, desalination, water reuse technology, infrastructure asset management technology and pumping efficiency all being subject to increasing research and development and longer-term investment," he says.
A water industry, under a reformed regulator, and capable of funding such developments bodes well for contractors able to deliver the new technologies.