Ofwat assesses its regulatory role for the future

Ofwat is proposing a fundamental review of how it regulates the water industry in England and Wales – with the informal period of consultation closing next month. Dean Stiles investigates what this could mean for the sector.

Ofwat has launched a discussion document as part of its informal consultation on future price limits. The document, “Future price limits – a preliminary model: informal consultation”, describes how Ofwat might set price limits.

Ofwat considers it “appropriate to carry out a review now of the way we use our tools, and our framework will need to reflect the policy decisions taken by government”.

The UK Government will respond to the Cave and Walker reviews, and the more recent review of Ofwat, in its White Paper on water policy although publication has been delayed from this summer until autumn.

Ofwat’s consultation describes a possible preliminary model of how it might set price limits. The new model considers the different parts of the water and sewerage value chains and how Ofwat might improve the way in which they are regulated. The informal consultation builds on the work of previous reports by Ofwat and the feedback already received from the industry – some of which has included requests that Ofwat makes clear its thinking about future price limits while it is still at an initial stage. Some water companies say that it would be helpful for them to see a high-level model of how Ofwat could set prices, if only for illustrative purposes, in order to further the debate.

Ofwat identifies five major challenges for the water industry in England and Wales: population growth, population distribution, building on flood plans, life style changes and climate change.

“The regulator has never before talked so explicitly about the challenges of population growth, demographic shifts (especially in the South -east of England) and the future impact of climate change. The latter was indeed out of bounds some years ago,” says David Lloyd Owen writing in Global Water Intelligence.

To meet these challenges, Ofwat proposes a fundamental review of how it regulates “with a view to reducing the overall regulatory burden considerably”. It is moving to a more risk-based approach that will allow it to focus and prioritise its resources where they deliver the most benefit, says Ofwat.

“One way we can make our approach more targeted and flexible is to make more use of accounting separation information but reduce the information we require to be delivered to us considerably in other areas. Our regulatory compliance project is our main driver for reducing the burden of regulation, but all other projects will also look for ways to reduce the burden on the companies. When we consult formally in the autumn, we will set out our thinking on how future price limits can contribute to reducing the regulatory burden. We would welcome views from stakeholders on how we might do this,” Ofwat says.

Ofwat suggests looking at the sector in terms of resources (licences and water abstraction), “network plus” (the actual business of transporting raw water, treating it and distributing water along with sewerage, sewage treatment and sewage sludge treatment and disposal) and retail (customer services, including new meters).

While it stresses that the proposed “business units” do not necessarily mean the setting up of “functionally separate” activities, the principle of accounting separation, where these business activities could have distinct incentives, reporting requirements and price limits makes a future split along these lines much easier to contemplate.

If price limits, retail (0.4% of assets), water resources (5.2% of assets), network plus (water, 31% of assets) and network plus (sewerage, 63.4% of assets) can be separately reviewed, this separation could also mean different price review periods and life spans, perhaps eight to ten years for the network plus side. Ofwat points out that this would have a positive impact on innovation and efficiency since there would be more time to benefit from any additional out performance generated. The potential for retail activities to market their services by offering water efficiency and demand management is interesting, especially if it could lead to new services designed to increase the efficiency of a network, such as off-peak water provision.

“We need to start the process of change now. The decisions we take in 2014, when we will review price limits and set the new controls, will influence what the companies do up to at least 2020,” says Ofwat. It is best to act now to put a sustainable framework in place for the long term to avoid crisis management and potentially more severe measures and corrections at a later stage, it says, proposing to evolve its regulatory approach to avoid unnecessary disruption and provide a clear, long-term path to sustainable outcomes.

Formal consultation on Ofwat’s framework for setting price limits in future will take place in the autumn. Feedback from the informal consultation – and on other published discussion papers – will be used by Ofwat to shape and influence the contents of the formal consultation. Ofwat will then publish a final statement describing the framework in spring 2012, before work on the next round of price limits begins.

As part that work, Ofwat says it expects to publish the methodology for consultation in autumn 2012 and a final methodology document in early 2013. The informal consultation will close on 28 June: it heralds the start of significant change for the water industry.

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