Ofwat commit water companies to market testing of large infrastructure projects

Direct procurement for customers (DPC) is a new delivery model being introduced in PR19 to the UK water sector by the economic regulator Ofwat, for large scale enhancement projects with a whole-life Totex of more than £100m. In its PR19 methodology, published today, Ofwat sets out further guidance on how companies should implement this new approach.  Ofwat is forcing companies to competitively tender the design, build, financing, operation and maintenance of large scale infrastructure that would otherwise have been delivered by the incumbent water company and expects DPC to drive better value for customers.

Ofwat has set a strong expectation that companies will need to robustly assess projects to explore potential benefits for customers and will equally need well evidenced and well-reasoned arguments where the company decides not to apply the new approach.  The latest guidance from Ofwat provides some clarity on the suitability of projects and the expected benefits. 

Water companies can learn from Public Private Partnerships to help shape DPC contracts

Direct procurement represents a shift in how water companies design, deliver and operate water assets but is not a totally new concept. Public-private partnerships (PPP) can offer lessons for companies considering DPC, in particular some of the painful lessons that have given PPP a chequered reputation.  PPPs, when delivered well, are a proven way of achieving cost and outcome certainty, as well as bringing innovation and a stronger focus on value. PPPs that include finance, such as private financial initiatives (PFIs) also introduce competition to the financing aspect of the asset value chain. 

Despite the reputational issues with PPP and PFI over the years, experience suggests real benefits have been realised through these arrangements. For instance:

• Thames Tideway (a major wastewater infrastructure programme currently underway in London) is an example of where competition for financing led to an extremely low cost-of-capital, driving cost savings for customers.
• The Greater London Authority (GLA) introduced the innovative RE:FIT London model under which private providers work to make public buildings more energy efficient (including via micro generation initiatives); guarantee energy savings for public bodies; and make their return through sharing the resulting lower energy bills.

Ofwat believes DPC will introduce innovation and efficiency into the water sector in that DPC investors are more likely to adopt and finance innovative solutions. This is particularly true where providers are prepared to stand behind their solutions and guarantee outcomes. This approach transfers risk to the provider, for instance in the example above, if the RE:FIT model fails to save energy, the customer does not pay.

The Five Case Model can help companies choose the right projects for DPC

The guidance published today recommends the use of a structured business case approach to assessing DPC suitability and benefits.  The Five Case Model, developed by HM Treasury, has been widely used to deliver a consistent decision-making approach.  The approach requires companies to consider a set of options, viewed through each of five filters: the strategic case; economic case; commercial case; finance case; and management case. Ofwat are suggesting that water companies (or their affiliates) will not be able to bid in competition for their own projects, thus they will need to rigorously demonstrate upfront whether they can deliver the project more efficiently through traditional routes or through DPC. It is therefore in the company (and customers) interest to follow a robust business case process so as to reveal objectively whether a scheme drives best value for customers. 

Whilst the guidance provides some further certainty, companies who find themselves with “qualifying” projects should expect a number of challenges to the implementation of DPC.  The commercial arrangements surrounding PPP type contracts are necessarily complex and take many months to procure.  Companies will find themselves committing to the DPC route without having fully tested the market or having DPC deals fully in place.  The length of effective PPP deals also means companies have to commit to long term defined outcomes, or face the risk premium associated with retaining commercial flexibility.  But the biggest challenge is the “mind shift” required. The test of DPC schemes is “value for customers” rather than for shareholders or the company itself. Sometimes “value for customers” may well be value eroding for those same stakeholders – this is likely to generate the most interesting discussions at board meetings.