Riding the water industry’s regulatory cycle

Ofwat was established as the economic regulator for water companies in England and Wales so that they could levy charges and achieve

reasonable profits to remain viable, while ensuring the delivery of an adequate

service to the customer and providing adequate protection to the environment.

The regulatory cycle managed by OFWAT currently requires water companies to produce business plans on a five-year cycle, so that they can demonstrate the efficient use of the customer’s money to meet the demands placed on them, by use of challenging targets, rigorous monitoring and audit.

Surely then, with all of this regulation in place, we customers must be getting a good deal? Or is there scope for improvement?

OFWAT is keen to further improve efficiency and has recently published a consultation document – Setting water and sewerage price limits: Is five years right? –that probes the issues surrounding the current regulatory regime. A good idea, but is the question the right one?

The main concern is that the current regulatory regime for the Periodic Review

creates a boom-and-bust financial climate for the supply chain serving the water industry in the UK as capital expenditure tends to be concentrated towards the end of the five-year period. Hence the supply chain has a huge hill to climb in providing the right level of resource at the right time.

Increased costs

This situation leads to financial and managerial inefficiencies and instabilities in the supply chain and ultimately to higher costs for consumers.

So as well as possibly paying more than we need to, we customers often have to wait a long time to see the benefits of the increased costs.

Additionally, we have seen the migration of skilled resources out of this sector over the years to more stable sectors, where job security is better, resource management is easier and long-term planning can be better achieved.

The Early Start programme set up to address this problem is widely acknowledged not to have been successful in stimulating any extra investment earlier in the five-year cycle.

Indeed the OFWAT consultation paper acknowledges this, but does little to say what mechanisms are planned to ensure that this will not happen again – it merely states: “We hope that at PR09 companies will be able to propose more work for an early start programme”.

The problem was not that the early start programme was insufficient, but that it did not materialise early enough, although inevitably the programme was focused on projects that could be completed within the year.

A major problem, therefore, is the management of the investment cycle in terms of procurement, irrespective of the length of the cycle adopted, and this is where we would hope that improvements could be made.

Quicker reaction

Many water companies link their procurement strategies directly with the periodic review cycle, using framework contracts for the supply of consultants and contractors to design and undertake the construction of capital schemes.

In most cases these are both expensive and time consuming for both parties

to tender, but in the belief that the costs for the procurement of the resources and services will be driven down.

Given the current shortfall in the resource pool due to the historic boom-and-bust nature of the sector, this belief is likely to be unfounded, as the market reacts to the situation and resource costs escalate.

Supply chain relationships are built up during the cycle, only to be lost when the cycle starts and new procurement strategies are formulated.

Perhaps it is the direct linking of the procurement strategies to the periodic cycle that must be addressed, to allow a quicker reaction to the Early Start programme rather than an early start to the procurement cycle.

Decoupling of the procurement from the regulatory cycle should therefore be an advantage. The advantages of the large five-year frameworks must also be questioned for some areas of work.

Clearly OFWAT has put forward some good arguments for retaining the five-year cycle based on an economist’s perspective. However, the main issue

for the supply chain is not the length of the cycle, but how the supply chain is managed within this cycle.

The needs of the supply chain would seem to have been largely ignored and there would appear to be little account taken of this in the current regime, as though miraculously resources will become available; consequently the supply chain is not operating efficiently and arguably water bills are higher than necessary as result, and the customer is losing out.

The crucial factor to be addressed is the cyclical nature of the demands placed on the supply chain due to the stop-start nature of services procurement.

The challenge, then, is to provide a mechanism for a continuous work programme within a continuum of five-year regulatory cycles.

OFWAT rightly points out that the further we project into the future, the less

accurate our predictions. Although we can be reasonably confident in the demands that will be placed on the water companies within a five-year cycle it would be very difficult to predict what may be required within a ten-year cycle.

On the one hand the water companies face many unpredictable factors such

as the impact of legislation like WFD, and climate change.

On the other hand OFWAT also makes it clear that the OPEX for water companies accounts for one third of the overall costs, and these are likely to be much less vulnerable to major change as CAPEX costs for quality improvements and the like.

So while the water companies have already made major efficiencies, there is recognition of a need for longer term planning to address OPEX efficiencies, capital maintenance programmes and other issues such as the shortfall of

water resources in the South.

Cycle demands

There is a clear difference in the nature of the continuous processes and projects

requiring a long-term execution over say ten years or more, and the shorter projects of five years or less.

Therefore a framework is required in which these projects and processes can be managed despite differing in timescale with the regulatory cycle to minimise impact on the supply chain.

If consideration could be made on effectively bridging this gap, not just on some mere “hope” by OFWAT, then the industry will have made significant improvement in efficient regulation and procurement strategy.

For instance, would it be possible to have six-year plans within a five-year cycle, so that effectively the sixth year becomes the first year of the next cycle, but is adjusted as time passes,say at June Return, so that it does not require ratifying as the first year programme and hence provide a continuum for the supply chain?

Quality resources

Another idea would be to de-couple the OPEX and capital maintenance

programme from the rest of the plan and run this over say ten years.

This may provide the means for the water companies to invest in more innovative techniques to address OPEX efficiencies. This may avoid the need for IDOK determinations to react to significant changes.

Our members want to support our industry as effectively as possible. This means better management of the supply chain by the water companies, but this requires a regulatory framework in which they can manage this.

In order to provide high quality resources, the industry must be able attract high-calibre graduates with a more robust career path than the water industry

currently affords, due to the boom-and-bust cycle the regulatory system currently encourages. Failure to change the current system will inevitably result in more inefficiency, poorer solutions and higher costs to the householder.

Let’s hope someone will take the lead and get the yellow jersey!

Garry Edwards, associate director at Entec UK, is on EIC’s Water Pollution Control Working Group.