Ofwat’s Final Methodology is innovative … but companies will struggle to meet the regulator’s high standards

Ofwat published in December 2022 its Final Methodology for the next price control for water and wastewater companies, PR24. Having had the opportunity to review the full suite of documents, we think Ofwat should be applauded for stretching the boundaries of regulatory thinking. However, we also think they have significantly increased the regulatory burden and left a lot of important work to be done. 

Innovations 

Ofwat has continued its track record of pushing the boundary of regulatory thinking.  

Long-Term Delivery Strategies 

Perhaps, the most significant innovation is the requirement for companies to set out their five-year business plans in the context of a 25-year long-term delivery strategy (LTDS).  

Companies have been asked to identify a core plan or “pathway” along with alternative pathways that they may follow in response to an uncertain future, as illustrated below.   

Figure 1 - Illustration of adaptive planning for long-term delivery strategies

Source: Ofwat

Ofwat considers this will help ensure what is delivered in the short-term maximises long-term value for customers, communities, and the environment. It will also lead companies to design more resilient and flexible plans.  

Adaptative planning is already used in the water sector in the Water Resources Management Plan and Drainage Waste Management Plan frameworks, but it is the first time it will be explicitly implemented in a price control. The approach has not yet been adopted in energy and it will be interesting to see whether Ofgem builds on Ofwat’s approach for its next series of price controls (RIIO3).  

Business plan assessment 

For PR24, Ofwat has introduced a two-stage process for assessing business plans. The first stage considers whether submissions are of sufficient quality across a range of areas. The second stage will assess the level of ambition demonstrated by companies across a sub-set of areas.  

Companies which fail the quality assessment will see their business plan graded as “inadequate”. Companies that fail the ambition assessment will not do better than “lacking ambition”. This is summarised in the figure below.  

Figure 2 - PR24 business plan assessment framework 

Source: Ofwat

This approach extends what Ofwat did at PR19, but also simplifies the assessment. It sets a high bar for business plans and strong incentives to deliver high-quality business plans, which should materialise in better outcomes for customers.

Collaborative customer research

Ofwat is working with the Consumer Council for Water (CWW) to conduct collaborative customer research to inform common areas of business plans, in particular customer priorities, Outcome Delivery Incentive (ODI) rates, and affordability and acceptability testing.

Ofwat expects that this will generate more robust and comparable results and avoid the need for companies to commission wasteful and overlapping research.

Standardised methodology for affordability and acceptability testing

Ofwat has issued a standardised approach for companies to test the acceptability and affordability of their business plans and their long-term delivery strategies.

This standardised research includes deliberative research to explore participants’ views on the acceptability and affordability of water company’s proposals for PR24 submissions, including their views on the phasing of outcome delivery over the longer term. A quantitative survey will further explore participants’ views of the affordability of the company’s proposals.

The guidance should ensure that the plans are tested in a consistent way with customers.

Fewer and common performance commitments

Ofwat has stated its intention to use common performance commitments for most areas of companies’ performance, but with a focus on the outcomes and outputs which matter most to customers. Overall, there will be 23 common performance commitments for each water and wastewater company in England and Wales.

Coupled with this, Ofwat does not expect to allow more than three bespoke performance commitments per company.

This means there will be around half of the number of performance commitments in PR24, compared to PR19.

Price Control Deliverables

Ofwat plans to introduce Price Control Deliverables (PCDs) for the first time. PCDs are a mechanism which tie the level of funding to the delivery of an outcome or output. The funding is returned to customers in case of non- or under-delivery.

Ofgem introduced PCDs in 2021 in the second price control for transmission and gas distribution – “RIIO-GD&T2”.

Regulatory burden

A proliferation of requirements

There is a significant increase in the number of requirements companies need to satisfy.

It might appear that Ofwat has kept things simple by defining a list of just 26 minimum overarching requirements companies need to meet to pass the quality assessment of the business plan. However, a closer look at the final methodology reveals that it is not this simple.

As we went through the appendices and guidance documents, we have identified over 400 requirements spread across the documents, which often work as extensions of the minimum requirements. The guidance for the LTDS is a prime example. Ofwat set a single minimum requirement for the LTDS … which is then translated into more than a hundred sub-requirements in the 67-page long LTDS guidance. 

We think it will be challenging for companies to deliver on all of these requirements.

Unfinished business

The quality/ambition assessment framework together with the proliferation of requirements set a tough challenge for companies.

This challenge is further compounded by the fact that Ofwat plans to issue further instructions during 2023. We have identified over 7 missing elements in Ofwat’s PR24 guidance. These are:

• Cost models, to be released for consultation in Spring 2023;

• Proposed ODI rates, as informed by the collaborative customer research, to be provided “early 2023”;

• Historical performance data sets for PR24 performance commitments, to be provided “early 2023;

• A cost adjustment claim publication in summer 2023;

• Modifications to the dividend policy licence condition, to be published alongside the decision on strengthening the regulatory ring fence expected “early 2023”;

• Guidance to assess the discreteness of large projects to inform the assessment of the suitability of large projects for Direct Procurement for Customers, to be provided “early 2023”; and

• The process and requirements for queries around data tables and models, to be set out in early 2023.

In the meantime, companies will need to develop their business plans – due in October 2023 - without these crucial inputs.

Whilst Ofwat should be applauded for being innovative, we think asking the companies to hit a more challenging, moving target will prevent many from attaining Ofwat’s high standards.