CMA draft water findings cause ripples into energy

When Ofwat published its draft PR19 price control determinations in March 2019, the proposals reflected a step-change from its PR14 decisions. The regulator argued that changing market conditions, relatively high dividend payments and lack of progress in areas such as leak prevention merited a significant reduction in allowed revenues, both from the previous price control period and from the business plans submitted by the water companies themselves. As a result, four of the companies – Anglian Water Services, Bristol Water, Northumbrian Water and Yorkshire Water Services (hereafter referred to as the disputing companies), rejected Ofwat’s draft determinations and requested the price controls be redetermined by the Competition and Markets Authority. The case was referred to the CMA in March 2019, and its provisional findings were released in late September.

While the CMA agreed with Ofwat that the disputing companies should face tough performance targets, it argued in favour of a small increase in network resilience funding, an increase in the allowed rate of return to ensure continued investment in the sector and a rebalancing of incentives to reduce exposure to financial risk. Notably the CMA proposed that the cost of capital (used in turn to calculate the profit required to satisfy investors) be increased from the Ofwat draft determination value of 2.96% to 3.50%, as a result of new information and an adjusted methodology. Although recommending the increase, the CMA flagged that this was still well below the levels seen in the previous price control period. It argued that, even with the upward adjustments, consumers would still see a 9.3% decline in average annual water bills.

The CMA did not proffer more favourable conditions from Ofwat in all regards and rejected the disputed companies’  requests to change expenditure modelling, allow greater allowances to fund service improvements or additional enhancement projects where funding had not been fully demonstrated. The CMA’s provisional report was open for consultation throughout October, and BEIS has now published the stakeholders feedback received in response to the provisional findings document.

In response to the provisional report, Ofwat expressed concerns that the CMA recommendations did not strike the correct balance between incentives and consumer protection. The regulator particularly objects to the increase in the rate of return for all disputed companies, and the additional £93mn leakage allowance allocated to Yorkshire Water. It states that the current proposals would increase consumer bills without guaranteeing improved performance.

In contrast, the responses from the disputing companies carry a common theme. They welcome the transparent and thorough approach taken by the CMA and applaud the direction of travel, but ultimately conclude that the revisions would still leave an extremely stretching set of price controls under which to operate through to 2025. Responses from other water companies that did not contest their price control draft determinations were more mixed, with some defending Ofwat’s original approach but most warmly welcoming the CMA’s proposed changes. One company stressed how important it was to secure clarity and consensus now to guard against mass appeals for the subsequent price control in 2026-30.

The implications of this contested process are being felt in adjacent industries such as electricity and gas currently undergoing their own price resets. For example, Cadent responded that the CMA’s provisional findings strike a good balance between customer value and future investability, highlighting that attracting investment at the current time is essential against the backdrop of net zero delivery and the economic recovery from the pandemic. National Grid, covering National Grid Electricity Transmission and National Grid Gas, also agreed that the CMA’s recommendations set a better balance that will allow investment in climate change resilience while still reducing customer bills.

No doubt the phase 1 energy network companies reference this tug-of-war between affordability and future investment given that the RIIO-2 final determinations are due out in mid-December. We know that the high instance of uncertainty mechanisms has left network companies concerned about how they will finance essential network upgrades in a timely manner.

Sensing the industry tension however, Ofgem’s response to the provisional findings report flagged that the CMA plays a different role in contested energy price controls and only has the scope to investigate specific grounds of appeal, rather than a complete reassessment. It expressed concern that the CMA investigation “may be relied upon by our stakeholders to attempt to influence or challenge the RIIO-2 regulatory process.” The general stance was that the proposals would allow profits that are “out of line with market comparators and international returns.”

Given that Ofgem is due to publish its final views ahead of the CMA’s final recommendations, it seems unlikely that any concessions will be included in the RIIO-2 decisions on the basis of the CMA provisional findings alone (though it will up the ante on its proposals on cost of capital). But the energy regulator will be very nervous about how this might translate into push-back by its companies. If the phase 1 network companies wish to refer their own price controls to the CMA, they would need to do so by mid-February.

And of course, there are the phase 2 companies, the electricity distributors, who are two years lagged from the gas and transmission companies. They’ve yet to produce and submit business plans to Ofgem but they will be scrutinising the Ofwat draft determination and the follow up very closely indeed.