PR24: A challenging approach in challenging times

Ofwat today confirmed that the final methodology has relatively few changes from the draft proposals published in July. We commented then that while much of the approach may seem superficially familiar to that used five years ago, there are some critically important differences in the detail which will create very substantial challenges for all companies. As the introduction makes clear, that is exactly the design intent. Ofwat is already concerned about the current levels of service against existing company plans. This combined with increasing societal expectations and environmental requirements will inevitably lead to a tough review.

In contrast to PR19 with its focus on ensuring customers benefitted from the lower cost of debt, the PR24 methodology recognises that in some circumstances future bills may need to increase to fund higher levels of investment. But Ofwat are very clear in their view that current base expenditure is – and has been – sufficient to allow companies to improve performance and maintain the health of assets. So, companies will need to robustly justify the need for increased investment, demonstrating the cost efficiency of their proposals, the benefits they will deliver and why these have not already been funded by base expenditures.

Nor have Ofwat pulled their punches regarding their expectations of company shareholders. They explicitly state that where future financial pressures are created by large investment programmes, they will expect shareholders to make fresh equity contributions to help meet these pressures. Shareholders will also be concerned that while there has been a modest increase in Ofwat’s early view of the cost of capital compared to PR19 – 3.29% against 2.92% – it appears to be substantially below the view that Ofgem recently expressed for Electricity Distribution. Combine this with Ofwat’s decision to reduce the notional level of gearing from 60% to 55% and the expectation that companies will need to adjust in response to this before 2025, and the investor community will need to consider its response.

The immediate challenges

Companies have just under 10-months to prepare their business plans and will have to run hard to achieve the standards that Ofwat will demand. Near term challenges will likely be dominated by a very demanding expanded set of common performance commitments (PCs) (15 for water and a further eight for wastewater). These will feature much greater emphasis on environmental performance as well as the familiar asks regarding stretch and ambition.

Ofwat has also decided to “power up” the customer experience incentive, increasing the range of penalties (and in theory rewards) by no less than 50%. At the same time, bespoke PCs have been limited to perhaps two or three per company, reducing the scope for outperformance there.

Ofwat have also very clearly reiterated their view that all of this performance will have to be delivered from the efficient base costs that they determine. Given that a good number of companies are having problems in meeting a number of current performance commitments, this aspect of their plans will undoubtedly be a major challenge. However, Ofwat has provided some support in the form of increased innovation funding to £300m and will create a new £100m water efficiency fund.

Looking further ahead

In the longer term, companies have to develop their business plans in the context of a 25-year delivery strategy, with strong emphasis on maintaining and increasing resilience. Ofwat has recognised that there will need to be some proposals for enhancement expenditure. But it will require robust evidential standards to be met and the financial expectations on shareholders to contribute further noted above.

There is broad support for placing PR24 into a long-term context. Ofwat is aware of the potential need for big investments leading to upward pressure on bills. Ofwat expects a good part of that pressure to be alleviated by companies finding new answers to existing problems.

There are now even bigger expectations around companies’ abilities to innovate, increase productivity and deliver more. The pressure is now clearly on companies to understand what can be achieved and to balance the needs of todays and tomorrow’s bill payers.