11 September 2020

The water companies tussle with Ofwat highlights the strength of our regulation

By

The general election result removed any immediate prospect of re-nationalising Britain’s privatised utility industries. This came as a relief to investors – many of whom are major domestic and international pension funds – who were worried about the value of their assets collapsing following a potential re-nationalisation below market value.

The much more significant development now for the UK’s utility sector – and, incidentally, investors in other regulated infrastructure industries – is around regulatory risk. This has been brought to the fore in the ongoing dispute between some water companies and the regulator Ofwat, which the Competition and Markets Authority (CMA) is currently adjudicating on.

Ofwat’s most recent final determinations for water companies are deemed the “toughest” since privatisation. Permitted returns on investment have been slashed, performance targets are more stretching and Ofwat is insisting that bills fall by an average of £50.

Unsurprisingly, perhaps, there are concerns that bill reductions are being pursued to the detriment of long-term investment in resilience. And there is now a very public row between some water companies and Ofwat. The toughest price review on the water companies since privatisation has been met by the most significant rebellion since privatisation. Four water companies have referred the determinations to the CMA – something that is completely without precedent for the industry.

The signs are that this is not going to be resolved amicably. It is reported that Ofwat is not conceding on any of the challenges raised by the water companies, effectively ending hopes of an early resolution.

Ofwat’s attitude towards this price review reflects their view that previous reviews for investors in water and some other regulated industries were too generous, and the regulator is keen to ensure the same mistake is not made again. But the Public Accounts Committee has recently raised questions about whether current regulation will promote enough investment. Meg Hillier MP, the Chair of the cross-party Committee, recently said that “the regulatory regime does not adequately recognise the urgent need for long-term infrastructure investment to improve resilience and the emphasis on price is overplayed”.

Ofgem, the energy regulator, has recently published a draft determination for the energy transmission sector, which is viewed as a tough starting position by investors and suggests it is taking a similar stance to its sister regulator Ofwat. National Grid has argued that the plans will affect the reliability of network and jeopardise progress to Britain’s net zero climate targets. Concerns around long-term investment are also now being raised in relation to energy networks.

It is vital for cities such as London that, alongside driving value for money for consumers, regulatory regimes promote sufficient long-term investment into utilities and other infrastructure. According to the National Infrastructure Commission, the capital has the highest projected increase in risk of flooding and drought of any region in the UK and its water infrastructure needs large levels of investment. Data from Thames Water shows that the average water main in the Thames Water region is 70 years old, and around one eighth of trunk mains are over 150 years old or more. It will also be important that the price review for electricity distribution, due in 2023, allows for adequate investment in infrastructure to ensure a booming electric vehicles market can be facilitated. This will be a critical component to London meeting various air quality and other environmental objectives.

There are also resilience challenges posed by Covid-19. Utility companies in the capital have been working with City Hall to accelerate investment to promote a more resilient city, but many of these plans will still require regulatory approval to go ahead.

It is not clear if the current position being taken by regulators gets the right balance between bearing down on consumer bills and promoting long-term investment. But the very fact that the CMA is providing a “check and balance” by adjudicating on this point in relation to four water companies highlights a great strength of the UK’s regulatory system.

The CMA’s ruling – the provisional ruling is due imminently – will have much wider implications for how the water sector is regulated in the future as well as the way other regulated sectors such as energy, transport and telecoms are treated in terms of returns for investors and the balance struck between short-term prices and long-term investment. So, this “check and balance” should help to assure any would-be investors in economically regulated infrastructure industries about the robustness of the UK’s regulatory system, and re-assure the broader business community – as well as residents – that long-term resilience of infrastructure is being properly accounted for in regulation.

These kinds of checks and balances do not exist in many other jurisdictions, and it is an example of why economic regulation in the UK is internationally respected. So, while it may seem that the conflict between Ofwat and some parts of the water sector highlights growing regulatory risk, it is actually in some ways exactly the opposite. It does not mean that the UK’s regulatory system is without fault, but it certainly shows a degree of robustness and fairness playing out. That’s something that should be welcomed, rather than feared, by investors and the wider business community in London and elsewhere.

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Daniel Mahoney is Programme Director for Economy and Infrastructure at London First.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.