UK water supply infrastructure investment shaped by Ofwat proposals

Last week, Ofwat, the water regulator, published its draft determinations, which address how much major water supply infrastructure projects planned by the water companies will cost, for the purposes of it setting subsequent pricing controls, as well as how those projects should be delivered via existing procurement and delivery models over the next five years.

The draft determinations form part of a broader price review process – price review 2024 (PR24) that Ofwat is currently overseeing - which will ultimately impact on the price water companies can charge customers for all regulated water and sewerage services between 2025 and 2030.

Planning expert Robbie Owen of Pinsent Masons said Ofwat’s proposals arise in the context of political change, with the new Labour government having already outlined plans to ensure there is sufficient investment in water infrastructure and that the amount of money company executives are paid is linked to delivery against stipulated service standards.

Owen said: “The PR24 process was already well underway before Labour came to power, so there was limited scope for Ofwat to influence the outcomes this time round. However, the strong rhetoric from the new secretary of state leaves water companies in no doubt that things will need to change across the sector moving forward. That being said, there is no getting away from the fact that significant financial investment is required across the piece, given the genuinely critical need for new and improved water supply and wastewater infrastructure in England and Wales.”

As part of the price review 2024 process, water companies submitted business plans to Ofwat in October 2023. Those business plans, which are subject to Ofwat approval, requested the largest ever total expenditure for operating costs and capital investment across the sector, to meet targets set by the government and regulators.

The price review 2024 is taking place in a different environment to the previous price review in 2019, known as PR19, which concerned the period 2020 to 2025. The need for capital investment for both water and wastewater assets has become more apparent in the intervening years, but this has happened at time when new regulatory and environmental standards and targets have been imposed on water companies and their operating costs have risen significantly.

Owen said it is now essential that regulators look beyond the short term to secure the long-term capital investment required, as changes to the policy and regulatory framework since the last price review place an increased focus on planning for future uncertainties. In this context, publication of Ofwat’s draft determinations has been highly anticipated by the sector, as it provides the first indication on how Ofwat will approach ambitious plans for investment until 2030 and beyond.

In the draft determination, Ofwat said that “major new investments including large infrastructure projects in particular” are required to deliver on the customer service and environmental objectives.

Recent regulatory changes that tie into the need for long-term capital investment include the requirements for water companies to increase drought resilience and plan for extreme drought events – a one in 500-year event – in their 2024 Water Resources Management Plans (WRMPs).

Water companies have been progressing a portfolio of ‘Strategic Resource Options’ (SROs), being the largest or most complex of water supply projects needed to replace abstractions from sensitive rivers and address long term drought and demographic planning requirements.

SROs progress through a regulatory framework overseen by Ofwat, the Environment Agency and the Drinking Water Inspectorate. This process was newly established in PR19 to accelerate the delivery of these projects outside of water companies’ business as usual operations, recognising that major projects often take many years to design, consent and build – which can span multiple regulatory periods and so require a longer-term approach.

Ofwat also introduced a new procurement model in 2019, called Direct Procurement for Customers (DPC) which, alongside the existing Specified Infrastructure Projects Regulations (SIPR) model, can be used for financing, delivery and operation of SROs and other major infrastructure projects by third parties following a competitive tender process.

In 2019, Ofwat identified 17 SROs in water companies’ business plans to be progressed through this new regulatory framework and that may be suitable for DPC or SIPR. In its draft PR24 determination document, Ofwat renewed its commitment to a long-term regulatory approach for SROs, with an additional four new SROs referenced. It means there are 21 SROs now under consideration by the water companies.  

Ofwat has outlined incentives that could apply to water companies that select the DPC process for their projects, indicating that it is “likely” that each water company will be able to benefit from further incentives that sit outside the scope of the PR24 process “to incentivise both successful development stages and appropriate management by the water company in the construction phases”.

Infrastructure projects expert Sonal Shah of Pinsent Masons said: “The contract design and incentive mechanisms are an important part of making this an attractive market for investors and contractors to play in. As with all contractual frameworks, having an appropriate and balanced risk allocation is crucial. Equally important is the collaboration that is required between the water companies, contractors, investors and the regulator to ensure that the SROs create an attractive proposition for all parties. Given the pipeline of projects which are being considered to be procured through the DPC or SIPR routes, a model that delivers on investability, longevity and value for money is key.”

To align with the identified water supply need set out in the various water companies’ draft WRMPs for 2024-2029, decisions on which are expected by government later this year, many of the SROs are being developed at pace, such that consenting applications are being planned for submission over the next few years. Owen said that the draft determinations on funding therefore provide a welcome element of comfort that the companies developing these projects can continue to progress them and recover the costs of doing so from customers, to seek to ensure these critical water resource projects can come on-line within the required timeframes.

Ofwat is consulting on its draft determinations until 28 August 2024, during which time water companies will be considering the draft settlement against their own operating cost and investment plans. Owen said that a clear final settlement that recognises the need to grow and adapt to changing environmental and operating conditions is essential to ensure the successful delivery of the SROs and to provide market certainty to investors and lenders.

The PR24 final determination is expected on 19 December 2024 and will be Ofwat’s final decision on price control for the next five years. 

Water companies that are unhappy with Ofwat’s decision can refer the matter to the Competition and Markets Authority (CMA), the UK’s lead competition authority.

Under the CMA appeal process, the CMA is required to appoint an independent ‘special reference group’ to conduct a redetermination of the price controls. The group must promote the interests of consumers, consider the long-term resilience of water infrastructure, and ensure the financeability of the water companies.

The CMA appeals process follows a statutory timetable which lasts a year, during which the water companies submit their grounds for redetermination and present to the group. Ofwat then responds to the water companies and presents to the group, following which the water companies reply to Ofwat's response. There are also third-party hearings and submissions, followed by main party hearings and submissions. After approximately six months, the CMA publishes a provisional determination. The CMA gives its final determination after 12 months.

Competition law expert Alan Davis of Pinsent Masons said: “The CMA’s redetermination of Ofwat’s PR19 was positive for water companies, giving each company an uplift in its allowed revenue - in total over £500m above that in Ofwat’s final determination - reflecting increases in WACC and totex allowances. The CMA set the rate of return to investors at 3.2% which, while lower than the 3.6% proposed by water companies, was higher than the 2.96% proposed by Ofwat in its final determination."

"The CMA’s decision to award additional revenues was largely based on its concerns over the financeability of the notional efficient company. This reflects the need for the CMA to balance, on the one hand, the interests of consumers and, on the other hand, the long-term resilience of water infrastructure and the financeability of water companies. Assuming that Ofwat’s upcoming PR24 - which is likely to set prices below what water companies are hoping for - will be appealed, the CMA must again strike this delicate balance,” he said.