From Wendy Kimpton, energy and utilities expert, PA Consulting
LONDON, July 7, 2022 /PRNewswire/ -- The challenge for companies is substantial as Ofwat has raised the bar on performance, efficiency, collaboration and competition. The lower cost of debt and lower levels of gearing for PR24 will be demanding. The proposals on the base service levels required, long-term investment needs, growing pressure on customers' pockets and company financeability will all be tough for companies to meet.
Ofwat has set a clear direction of travel but the exact destination and the impact on companies remains to be seen. There are few surprises in the headline areas of focus around increasing environmental and social value, better understanding of customers and further improvements in efficiency and innovation. However, there are important changes in the three key building blocks (outcomes, costs and risk & return) that companies may find concerning.
Ofwat's view that base expenditure is already sufficient to improve outcomes and maintain asset health will place pressure on companies. In particular, the demands and targets for significant improvement in sewer discharge frequency and river quality are ambitious and require significant investment ahead of PR24.
Two key changes to enhancement costs will mean a change in approach. Firstly all schemes with a whole life totex above £200m must make use of direct procurement and no funding (other than procurement costs) will be included in the price control. Secondly, Ofwat intends to encourage the development of nature-based solutions by using a tailored approach to cost assessment for these.
On risk and return the broad framework is familiar, but a number of expectations will be contentious. Ofwat intends to move completely away from RPI indexation and expects the cost of debt to be materially lower than PR19 contributing to a further reduction in the allowed return. The regulator's concerns about some financing structures and exploration of a reduction in the level of notional gearing will have implications for companies.
A streamlined process with an intent to drive up quality and ambition. The assessment process has stronger incentives to get plans right first time, focusing on quality and ambition. There are penalties for those who fail to meet the necessary quality standards. Rewards are in play for those who demonstrate high levels of ambition. Innovation and collaboration remain important.
While PR24 is a less radical set of changes than PR19, the methodology proposes significant challenge for companies across all three building blocks (outcomes, costs and risk & return). There will still be significant challenges ahead to deliver stretching performance from base funding. There is a potential shift in the risk and return balance that will require careful analysis and companies will also need to focus hard on financial resilience.
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