On 13 December 2017, the water regulator Ofwat published the methodology for its next five-yearly price review in 2019. For many water companies, these changes will be welcomed and they will certainly help to provide a positive profile for the sector at what is a politically delicate time.
The changes are already driving step changes across the industry, putting water companies under pressure to optimise their investment decisions to improve performance for customers as the means of generating returns to their investors, rather than through financial levers such as beating the challenging 2.4% cost of capital.
The increase in common performance commitments from five to 14, which benchmark water companies and their ability to deliver key services to customers and the environment is certainly a highlight of these changes. A greater scale of outcome delivery incentive outperformance payments and underperformance payments will place water companies in a competitive race to outperform each other, so they can gain rewards.
Water companies should start focusing on those AMP7 performance commitments which provide an optimal financial position, as well as those that will respond fastest to specific solutions. The expectation from Ofwat that companies adopt in-period ODIs means water companies will need to be even more certain that their investments are resulting in increased performance and provide the best value for money.
It will also be essential for water companies to start tracking their investments against performance commitments to gain a better understanding of whether or not they are on the way to achieving their targets. This will enable them to forecast the long-term societal benefits of their investments in financial, manufactured, natural, social, human and intellectual capital, so they can make better-informed investment plans and decisions across their business.
Ofwat also expects companies to align their performance commitment targets with the forecasted upper quartile performance of their peers in year 1 of AMP7, without a transition period. As a result some companies will need to invest more in the latter years of AMP6 to avoid under performance payments in the first year of AMP7. This increased investment could cause many contractors to face an unexpected squeeze on resources. Pressure on resources combined with work needing to be completed potentially faster than previously anticipated are likely to result in contractor tender prices rising in the coming years.
Water companies need to ensure they work closely with their alliancing partners and contractors to ensure they receive the best prices for any increased work in AMP6. Companies should also analyse their procurement processes and look to directly procure their materials and subcontractors for their Tier 1 contractors using increased economies of scale and fixed framework contracts to mitigate cost increases due to greater demand.