In July 2017, Ofwat published its proposed methodology for PR19, the price review covering 2020 to 2025. MCC Economics & Finance examines four questions every water company faces at PR19: should companies overestimate costs, who should they consult, how can they bring multiple contributors into one plan, and how can they present their business plan to Ofwat?
PR19 is the next price review run by Ofwat, the economic regulator of the water companies of England and Wales, and it will set the prices companies may charge, the service levels they must deliver and the incentives that apply from 2020 to 2025. In July 2017 Ofwat published a consultation regarding its methodology for PR19 (the supporting appendices and models are collected on Ofwat's consultation page). The water networks of Great Britain now face a major challenge to produce quality business plans for that period.
Figure 1: The PR19 timetable, from draft methodology to final determinations
Timeline graphic of the PR19 price review. Key milestones run from the draft methodology consultation in July 2017, final methodology in December 2017, company business plan submission in September 2018, initial assessment of business plans with early draft determinations for exceptional and fast track plans in spring 2019, draft determinations for remaining companies in July 2019, final determinations in December 2019, and new price controls applying from 1 April 2020.
The timetable is part of the incentive. Plans are due in September 2018 and Ofwat categorises them within months, so an exceptional or fast track plan buys its company an early determination and a full year of regulatory certainty that slower plans do not get. It also means the consultation and evidence-gathering that shape a plan must be largely complete by mid 2018; a company that starts engaging stakeholders after the final methodology lands in December 2017 has already given away much of its runway.
Ofwat will classify each business plan into one of four categories based on its view of the plan's quality, ambition and innovation. The proposed categories are exceptional, fast track, slow track and significant scrutiny. Exceptional status goes to plans that are high quality, significantly ambitious and innovative. Fast track goes to high quality plans that need no material intervention but fall short of exceptional. Slow track goes to plans needing material intervention in some areas to protect customers. Significant scrutiny goes to plans that fall well short of expectations. Exceptional and fast track plans earn earlier determinations and financial benefits. Plans under significant scrutiny face the toughest treatment, including less favourable cost sharing rates.
The incentive for a high quality plan may be larger under PR19 than under the previous review, PR14. Ofwat's definitions of the four categories are quoted in full below, because that wording is what plans will be judged against:
The closing caveat means exceptional status may not be awarded at all. The prize a strong plan can count on is fast track treatment; exceptional is a possibility, not a target. Box 2 sets out how the two reviews differ and why the comparison matters for companies preparing their plans, and Table 1 shows what the PR14 prize was actually worth.
Table 1: What enhanced status was worth at PR14
Two things stand out from this table. The prize scaled with company size, so the incentive to compete for a top rating was roughly proportionate across the sector. And only the initial award was guaranteed; the remainder of each package, around a third of it for South West Water and nearly half for Affinity, depended on the company then outperforming its cost baseline, so part of the reward for a lean, credible plan came from delivering it.
Even the smaller companies run wholesale programmes of several hundred million pounds, so these sums mattered to management but were small against total expenditure. That is why the PR19 upside of 0.2 per cent of return on regulated equity looks like protection against downside rather than a prize.
We address four key questions for this part of the PR19 review.
Probably not: inaccurate cost forecasts, whether inflated or artificially low, feed directly into Ofwat's assessment and can undermine the credibility of the whole plan. The age-old strategy of exaggerating costs (maintenance, enhancement or finance) and risks is well known (and popular) throughout the roughly 30 years of economic regulation in water and other sectors. However, in the water sector, exaggeration can be exposed either through benchmarking or simple comparisons with other companies. Comparison with around 17 other companies means it is relatively easy to spot material exaggeration. Therefore, great care is needed if any such strategy is employed.
In fact, the PR19 mechanism now rewards companies for forecasting low, even if a low forecast is inaccurate, inefficient or inappropriate, while simultaneously influencing Ofwat's benchmark baseline upwards.
Historically, we can see the scale of over- or under-bidding, relative to Ofwat cost forecasts, by looking at the previous review by Ofwat (the 'risk-based' assessment; see Tables 3 to 5 and Figures 2 to 4 below). We find that the most significant factor for Ofwat's PR14 evaluation of business plan quality was the cost benchmarking test: it did more than any other test to determine which plans were deemed high quality (or, as it was then known, 'enhanced').
Ofwat now proposes a mechanical relationship between company bids and its baseline view of costs such that (ex-ante) cost benchmarking determines (ex-post) cost sharing rates. Table 2 reproduces Ofwat's proposed mechanism.
Table 2: Ofwat's proposed link between business plan position and cost sharing rates at PR19
The mechanism changes how long the consequence lasts. At PR14, a poor benchmarking result cost a company its shot at enhanced status, a one-off outcome. Under the PR19 proposal the same result also worsens the terms on which every pound of cost overrun or underspend is shared with customers across the whole 2020 to 2025 period. The bidding decision stops being a one-off gamble on reputation and becomes a five-year financial exposure. That is why we treat the position against Ofwat's baseline as the most important choice in the plan.
Therefore, if the cost-efficiency test is a prerequisite for a favourable categorisation, and given that the same test now drives cost-risk sharing, it is reasonable to conclude that Ofwat's cost-efficiency test matters more than its view of ambition or innovation, and that cost benchmarking will matter more at PR19 than it did at PR14.
Thankfully, Ofwat published its initial benchmarking models for PR14 (albeit in read-only format): one might reasonably expect that the PR19 benchmarking will yield similar results, although Ofwat does say they are developing new models for PR19.
Every relevant stakeholder, and as early as practical: getting the right information to the right parties at the right time will be central to a successful PR19 business plan. Many business plans from regulated monopolies suffer from repetition, lack of transparency and lack of depth. In PR19, water companies face a sequence of tasks: setting out initial plans, consulting early, gathering feedback, distilling and weighing options, and modifying and re-consulting. Each of the bodies described in Box 3 can help develop a quality plan. The difficulty is in the timing, scale, planning and tailoring of the consultation: engaging before positions harden, matching effort to how much each issue matters, sequencing it so feedback can still change the plan, and adapting method, depth and agenda to each audience.
Each stakeholder group will have different expectations. Effective engagement with each stakeholder will help produce a more robust business plan. A combined communication strategy will allow each water network to demonstrate the process that has been undertaken, how the business plan reflects it, and how it maps to the final business plan documents. However, unnecessary or 'token' communication with stakeholders is in itself a risk to credibility, resources and on-time business plan delivery. Engaging stakeholders is the easy part. The hard part is working their contributions into one coherent plan.
Through an overall programme and strategy that anticipates different views rather than forcing early resolution. A comprehensive business plan will have many overlapping and cross-cutting integration challenges. Within each water company, inter-departmental views need to be combined although perhaps not (in the early stages) 'resolved'. The water industry supply chain can help provide solutions and help manage or avoid risk. Stakeholders will disagree. Anticipating and testing their views early is how a plan finds answers that work for more than one party. These types of integration are, in and of themselves, important stories to relay to Ofwat to help explain the tensions which underlie the overall plan.
However, each water company will need a small group of individuals to lead and decide on the appropriate balance and prioritisation of the integration issues, while considering the inevitable and imminent challenge and scrutiny from Ofwat (and others). An early draft plan and an early communication roll-out will help a company rehearse and refine the integrating features of the plan.
Economy and value should be the overriding factors throughout. Consulting early, often and widely seems to be the best strategy to ensure integration can be obtained and evidenced.
With a clear story built on evidence gathered along the way. That is not spin: Ofwat's own definition of a high-quality plan asks for "a focused and persuasive vision for the future", and the full definition is worth setting beside any draft plan as a checklist:
In Ofwat's definition, presentation and substance are one test: the narrative has to be backed by evidence that the outcomes can be delivered. Each of the steps above produces that evidence, in the changes, challenges, risks and choices recorded as they arise. A good process keeps that record so the final plan can show its working. The discussion above suggests several practical principles for preparing a successful PR19 business plan.
That companies bid above Ofwat's initial view of total expenditure far more often than below it. Of the 18 companies, only South West Water bid materially below the baseline, with Affinity Water and Portsmouth Water the only others below it. Table 3 restates the data from the charts published in the original November 2017 MCC paper, Figures 2 and 3 reproduce those charts, and Tables 4 and 5 set out Ofwat's underlying company-by-company figures.
Table 3: PR14 company bids against Ofwat's initial view of total expenditure
The table is lopsided. Only three of the eighteen companies sat in bands wholly below Ofwat's initial view; the rest of the sector bid at or above it, confirming that overbidding was the habitual strategy even in a review where cost position determined the top rating. In Ofwat's words, "against our necessarily high bar, only South West Water and Affinity Water have pre-qualified" for enhanced status. The dividing line that mattered in practice sat around 6 per cent below the baseline, which is the figure that anchors our headline recommendation.
Only three of the eighteen companies sat in bands wholly below Ofwat's initial view; the rest of the sector bid at or above it.
Figure 2: PR14 totex bids against Ofwat's initial view, in £ million
Bar chart showing how far each of the 18 water companies bid above or below Ofwat's initial view of total expenditure at PR14, in pounds. South West Water sits alone in the band £100 million or more below Ofwat. Affinity, Northumbrian, Portsmouth and Bournemouth sit between £100 million below and £10 million above. Seven companies (Welsh, Thames, Yorkshire, South Staffs, South East, Sutton & East Surrey and Dee Valley) sit between £10 million and £120 million above. Severn Trent, Wessex and Bristol sit between £120 million and £230 million above. Anglian sits between £230 million and £340 million above, Southern between £340 million and £450 million above, and United Utilities £450 million or more above.
In pounds, the bidding decision moves a great deal of money. The gap between the most and least aggressive bidders spans well over half a billion pounds, and because the sums scale with company size, a large company weighing whether to bid below Ofwat's view is weighing hundreds of millions of pounds of requested expenditure, not a rounding adjustment.
Figure 3: PR14 totex bids against Ofwat's initial view, in percentage terms
Bar chart shows how far each of the 18 water companies bid above or below Ofwat's initial view of total expenditure at PR14, in percentage terms. South West Water sits alone at 6 per cent or more below Ofwat. Affinity and Portsmouth sit between 6 per cent below and 1 per cent below. Six companies (Welsh, Northumbrian, Severn Trent, Thames, Yorkshire and South Staffs) sit between 1 per cent below and 4 per cent above. Four companies (Anglian, Wessex, Bournemouth and South East) sit between 4 and 9 per cent above. Sutton & East Surrey sits between 9 and 14 per cent above, Dee Valley and Southern between 14 and 19 per cent above, and Bristol and United Utilities 19 per cent or more above.
The percentage view is where the threshold for success becomes visible. Both enhanced companies occupied the two leftmost bands, and no company above Ofwat's view came close to enhanced status. This is the chart behind our estimate that a top PR19 rating probably requires bidding around 6 per cent below the baseline; the pounds equivalent of that percentage, from around £5 million for Dee Valley to over £400 million for Severn Trent, from applying that percentage to each company's expenditure.
Table 4: Ofwat's PR14 risk-based review of wholesale water costs, by company
The score column follows the bids: the three A scores belong to the three companies bidding 10 to 16 per cent below their thresholds, the B scores to companies within a few per cent either side, and the D scores to companies 10 per cent or more above. Notably, Ofwat's separate assessment of evidence quality (not shown here) rated almost every company B, so it was position against the threshold, not the persuasiveness of the supporting narrative, that separated the scores. At PR14 the number decided the score.
Table 5: Ofwat's PR14 risk-based review of wholesale wastewater costs, by company
Wastewater was worse. The sector collectively bid 14 per cent, or £2.6 billion, above Ofwat's thresholds, no company earned an A, and the largest gap, United Utilities at 46 per cent above, illustrates how far a plan can drift from the regulator's view when each obligation is priced generously. For a company building its PR19 wastewater programme, the warning is that large environmental programmes are where enhancement costs get exaggerated, and where benchmarking catches it.
Ofwat put limits on what the gaps meant, and its caveat belongs next to the tables:
The caveat is fair. Gaps did not automatically mean disallowed costs, but as Tables 4 and 5 show, they lined up closely with the scores that decided which plans were treated as high quality.
Figure 4: Ofwat's PR14 initial 'risk-based' tests, average scores
Bar chart of average company scores, out of 4, across Ofwat's approximately 13 initial risk-based tests at PR14, ranked from best to worst. South West Water scores highest, followed by Anglian, South East and Affinity. South Staffs, United Utilities, Yorkshire, Northumbrian, Severn Trent, Portsmouth, Sutton & East Surrey, Thames, Wessex, Bristol and Bourn
That cost benchmarking mattered more than any other test. Although Anglian Water and South East Water both performed better than Affinity on the 'risk-based' tests (Figure 5), the impact of the totex cost benchmarking test meant that neither company was enhanced. Tables 3 and 4 make the mechanism visible: the companies scoring A on the cost test were those bidding well below Ofwat's thresholds, while every company materially above its threshold scored C or D regardless of how well it performed elsewhere.
A company aiming for a top rating from Ofwat during PR19 will probably need to bid around 6 per cent below Ofwat's baseline (Figure 4). For a small company like Dee Valley this could be around £5 million, but for a large company like Severn Trent this could be over £400 million.
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