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 shows the timetable companies are working to.
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 worth reading as part of the incentive, not just as administration. 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 own definitions of the four categories are worth quoting in full, because the exact wording is what companies will be assessed against:
That closing caveat matters: exceptional status is not guaranteed to be awarded to anyone, so the dependable prize for a strong plan is fast track treatment, with exceptional as a possibility rather than 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 larger share of each package depended on the company then outperforming its own cost baseline, meaning the real reward for a lean, credible plan came from delivering it. Ofwat's own summary of the package is the authoritative statement of the figures:
Set against wholesale programmes of several hundred million pounds for even the smaller companies, these sums were material to management but small relative to totex, which is context for why the PR19 upside of 0.2 per cent of return on regulated equity reads as protection against downside rather than a jackpot.
MCC Economics & Finance addresses below 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) through the c30 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. Competition from c17 other companies means it is relatively easy to spot material exaggeration. Therefore, great care needs taken if any such strategy is employed.
In fact, the incentive from Ofwat for PR19 now means that companies are incentivised to forecast 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 Appendix 1, Tables 2 to 4 and Figures 3 and 4). We find that the most significant factor for Ofwat's PR14 evaluation of business plan quality is the cost benchmarking test: it was the most significant test for determining which plans were deemed high quality (or, as it was then known, 'enhanced').
Ofwat now propose a mechanical relationship between company bids and its baseline view of costs such that (ex-ante) cost benchmarking determines (ex-post) cost-risk sharing rates. Figure 2 reproduces Ofwat's proposed mechanism.
Table 2: Ofwat's proposed link between business plan position and cost sharing rates at PR19
What this mechanism changes is the duration of the consequence. 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. That converts the bidding decision from a reputational gamble into a five-year financial exposure, and it is why we treat the position against Ofwat's baseline as the single most consequential choice in the plan.
Therefore, if we assume that the cost-efficiency test is a pre-requisite to a favourable categorisation from Ofwat, and given that this view drives cost-risk, it could perhaps also be assumed that Ofwat's cost-efficiency test is more important than its view of ambition or innovation (and that cost benchmarking will be more important for PR19 than it was at PR14) given the long-term financial implications.
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 do 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 challenges to: set out initial plans, consult early, gather feedback, distill and weigh options, and modify and re-consult. Each of the bodies described in Box 3 can help develop a quality plan. The challenge is one of timing, scale, planning and tailoring. Timing means engaging before positions harden; scale means matching effort to the materiality of each issue; planning means sequencing consultation so feedback can still change the plan; tailoring means adapting method, style, depth and agenda to each audience.
Each stakeholder group will have different expectations. Optimal communication with each stakeholder will allow a quality plan to emerge and be evidenced. Combining the overall 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.
Through an overall programme and strategy that anticipates different views rather than forcing early resolution. A quality plan will have many overlapping and cross cutting integration challenges. Within each water company inter-departmental views need 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 undoubtedly have different views; these could be anticipated and challenged in order to find win:win situations. Overall, these types of integration are, in and of themselves, important stories to relay to Ofwat to help explain the tensions which underlay the overall plan.
However, each water company will need a select number 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 practice and prepare 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 great story, built on systematically gathered evidence. A great plan will be underpinned by a great story. This 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:
The factors outlined above will each provide opportunities to document: changes, challenges, issues, ideas, risks, fears and uncertainty. A good process will systematically gather and document issues so that the water company can sell its story.
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, and only Affinity Water came close. Table 2 restates the data from the charts published in the original November 2017 MCC paper, Figures 3 and 4 reproduce those charts, and Tables 3 and 4 set out Ofwat's underlying company-by-company figures.
Table 3: PR14 company bids against Ofwat's initial view of total expenditure
The striking feature of this table is its asymmetry. Seventeen of eighteen companies bid at or above Ofwat's initial view, and the sector as a whole bid roughly 4 per cent 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.
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.
The pounds view shows how much money the bidding decision moves. 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.
Table 4: Ofwat's PR14 risk-based review of wholesale water costs, by company
Read down the score column and the pattern is mechanical: 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. That is the clearest evidence in the public record that at PR14 the number did the talking.
Table 5: Ofwat's PR14 risk-based review of wholesale wastewater costs, by company
The wastewater side tells a harsher story than water. 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 assembling its PR19 wastewater programme, this table is the cautionary benchmark: large environmental programmes invite exactly the enhancement-cost exaggeration that benchmarking is designed to expose.
Ofwat was careful to bound what these gaps meant, and its caveat deserves quoting in full alongside the tables:
The caveat is real but should not be over-read: gaps did not automatically mean disallowed costs, yet as Tables 3 and 4 show, they did map tightly onto the scores that determined 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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