Ofwat’s Methodology Statement – Highlights and Initial Reactions

Ofwat’s Methodology Statement – Highlights and Initial Reactions

Economic and Financial Consulting

July 26, 2013

Ofwat has published its long-awaited PR14 methodology and business planning statement setting out how it intends to set price limits for the 2015-20 period including guidance for companies on how to structure their business plans which are due on 2 December.

The key features of Ofwat’s proposals are consistent with its earlier consultations. There are, however, some important changes to the details of Ofwat’s methodology, described below. Taken with the recent publication of the Water Bill and the announcement that Cathryn Ross will return to Ofwat as CEO later this year, it appears that some much needed clarity around the future regulatory landscape may be emerging.

Important details have yet to be disclosed and, crucially, it is not yet clear exactly how Ofwat will decide whether a business plan is ‘enhanced’ or not, nor when Draft and Final Determinations will be handed down.

Wholesale price control

Ofwat has confirmed the introduction of totex and that it will use totex menus, which it will publish in 2014, as part of its incentive package. However, Ofwat appears to have backed away from the emphasis it had placed on totex econometric modelling to determine wholesale efficiency challenges, appearing instead to advocate applying a range of different models and combining the results in a yet-to-be-determined fashion. Some companies may welcome the decision to reduce the importance attached to totex modelling, but may not be satisfied with Ofwat’s continued refusal to share its totex econometric models with the industry. It is unclear what comfort can be drawn from Ofwat’s indication that it will be making the dataset it intends to use available before the end of 2013 and that it will be “fully transparent” in setting cost baselines in 2014.

“….focus on creating strong incentives for companies to submit high-quality plans and on company Boards to ensure appropriate governance and ownership of those plans”

— Extract from: “Setting price controls for 2015-20 – final methodology and expectations for companies’ business plans” Ofwat

Companies will, as expected, need to submit proposals for how much of their totex they want to capitalise into the RCV – the Pay As You Go (PAYG) ratio – and the rate at which their RCV depreciates (effectively a representative asset life). Although there may be a temptation to determine these factors based on ‘financeability criteria’, companies need to be mindful of how their proposals vary from the positions they may have taken in the past and what their proposals might mean over the long term. For example, consideration will need to be given to what might happen to the ‘steady state’ RCV under their proposals and to the possible implications for long-term debt financing as a result of trying to offset any anticipated reduction in cost of capital by accelerating depreciation, or as a result of assuming straight-line depreciation for several consecutive price periods, which has the potential to create a revenue ‘cliff edge’ in the future. This is especially important given that it is clear from the data requested by Ofwat that the long term projections are likely to be subject to significant scrutiny.

More Info

Share this page