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Direct procurement – water companies need to look beyond the cost-of-capital  

By Richard Khaldi, PA water sector regulatory expert

We all know 'direct procurement for customers' will be a key element of PR19, and it will bring a significant shift in the way water companies finance, procure, deliver and operate their high-value assets.

And it's coming in the middle of an ongoing efficiency challenge. When we've talked to water companies and investors they've all said opportunities to deliver incremental efficiency gains are shrinking. That means either companies are already delivering and operating their assets as efficiently as possible – not a position that Ofwat will welcome, as they've made clear in their PR19 methodology consultation. Or, future efficiencies will have to come from doing something radically different. And direct procurement offers the opportunity to do just that.

The problem is water companies are currently focusing purely on the cost-of-capital element of direct procurement. They're assuming that direct procurement will only deliver value by achieving a lower cost-of-capital than they can get themselves. This is based on Ofwat's initial use of Thames Tideway as an example where extremely low capital costs were achieved through a direct procurement-style model. But Thames Tideway was only able to do this because it is a licensed entity with government-backed guarantees. Neither of these conditions are likely to be true for typical direct procurement schemes.

Focusing just on cost of capital is misguided for five reasons:

  • It suggests companies aren't open to true innovation, a key theme of PR19. This is unlikely to be viewed positively by Ofwat. In the worst case, Ofwat could perceive this as complacency or an unwillingness to accept that companies have room to improve.
  • It implies water companies think their assets can't be delivered or operated more efficiently. Companies that take this view risk being caught out by step-changes in efficiency. We know of one supply-chain organisation that estimates they could reduce operational costs by up to 15% on some assets if engaged under a different arrangement. Savings like this will shift the standard on efficiency.
  • It ignores the fact that reduced cost-of-capital is rarely the main driver of direct procurement-style partnership arrangements in other sectors and countries. Firstly, value comes from better allocation and management of risk; largely because of increased focus from debt and equity providers. Thames Tideway is held up as an example of a well-planned and de-risked project, partly due to the intensive due-diligence brought about by the procurement process. Secondly, direct procurement providers are likely to bring innovation from their international and cross-sector experience. Thirdly, more focused long-term incentives encourage better value-driven trade-offs between opex and capex. Ofwat will expect this kind of totex approach to be embedded within PR19 business plans and direct procurement offers a way to show companies have taken this on board. Finally, private investors are commercially incentivised to squeeze every last drop of value from schemes through more rigorous price discovery, consortia expertise and stronger negotiation and contract management.
  • It doesn't consider the benefit of greater clarity and certainty about costs and outcomes. With direct procurement, you know what you'll get and what you'll pay for it. This makes it easier to directly link the services provided by an asset to ODIs and performance commitments. Furthermore, Ofwat have made it clear that they want to use information from direct procurement schemes for cost of benchmarking in future price controls. Companies that develop this information will be able to better stay ahead of the curve. 
  • It forgoes the increase in resilience a directly procured asset or service will bring. Resilience is another of the key themes of PR19 and direct procurement can deliver increased operational resilience through additional flexibility and capacity. It can also deliver additional asset resilience by allowing companies to procure assets for use over multiple AMP periods more efficiently and effectively.
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All this shows how important it is to understand how to drive value from the direct procurement model. Companies need to get a grip on where they can apply direct procurement most effectively within the AMP7 programme and beyond. That's going to need a rigorous, business-case based appraisal to identify areas (including 'non-core' or unfamiliar asset classes) where direct procurement could deliver value. It's also about identifying the capabilities required to design, implement and manage direct procurement schemes successfully, and implementing the plans to put these capabilities in place.

Ofwat's PR19 consultation document reinforces the message that companies will need to change the way they think about their assets to meet the challenges ahead, including the ask of delivering increased resilience. And direct procurement is a great opportunity to drive this change, but only if companies look beyond the cost of capital.

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