Back to basics: NAO issues route one recommendations for Defra and regulators

The public spending watchdog’s audit of Defra, Ofwat, the Environment Agency (EA) and the Drinking Water Inspectorate (DWI) has resulted in a series of recommendations that should be humbling in their simplicity. These include not setting targets before understanding whether they are deliverable and what they will cost customers; delivering a coherent national system plan for water, including balancing trade-offs between different duties; developing a common understanding of asset health; and ensuring the sector is investible at the scale needed (see below).

The National Audit Office’s report, Regulating for investment and outcomes in the water sector, amounted to a blistering criticism of water policy and regulation from PR14 to PR24. The accompanying press release cited a series of failures, including: failure to deliver a trusted and resilient water sector; failure to drive sufficient investment, leaving us exposed now to the cost of multiple catch-up projects; failure to manage risk, ultimately resulting in higher costs for customers; and failure to drive up performance in key metrics including mains bursts, supply interruptions and pollution incidents.

It listed the key challenges facing the sector as: a major investment requirement uplift; environmental and supply resilience ambitions that have not been properly assessed for deliverability or bill impact; a decrease in consumer trust; and patchy operational performance. 

On long term planning, the National Audit Office highlighted:

• There is no consideration of planning solutions at a national level and no coherent national system where integrated decision making can take place. 

• Defra’s regulatory framework for the water sector is complex and there are inconsistencies in approaches and processes, with 12 different plans and planning frameworks that companies must develop and work within. In addition, “delays and changes to guidance, and inconsistent planning assumptions for the most recent price review period, may have affected the quality of water companies’ plans”.  

• The regulators have inconsistent responsibilities and there are gaps in oversight of the sector. 

• The EA has duties to the water environment but is not required to balance them with net zero or cost considerations. 

• The price review process is complex and difficult for investors to understand. “Some companies wait until the planning process and the price review are finished to finalise their funding or operational plans. As a result, company capital expenditure has tended to follow a cyclical pattern within each price review of first increasing and then decreasing, with knock-on effects for delivery of work.” 

• The regulators do not have a shared understanding of the condition of water and wastewater assets, and the level of funding needed to maintain them. 

On balancing incentives for short-term performance with financial sustainability, the NAO noted: 

• Outcome Delivery Incentives (ODIs) reduce returns for companies with the lowest performance, who are likely to need to increase expenditure the most. 

• Performance has not been consistent or significantly improved in recent years. Performance of the median company over the PR19 control period has improved in six out of 12 key ODI measures and decreased in six. 

• The financial resilience of the sector has weakened. 

• Costs are increasing for customers as the credit-worthiness of the sector has declined. 

The NAO’s recommendations are set out below. 

——————————————————————————————————————————

Recommendations on roles and responsibilities across the regulatory framework:  

• For future plans, Defra needs to understand the costs and deliverability of targets and the impact on customers’ bills. 

• Defra should consult on options to ensure delivery of a coherent national system plan for water, including balancing trade-offs between different duties. 

• Defra should address gaps in responsibilities, particularly around the wastewater network, and ensure regulators work together to achieve the same outcomes for the environment and customers.

• EA must understand whether actions in water company plans are being delivered and having the intended impact and delivering statutory environmental targets.

Recommendations to improve future planning and price reviews:

• EA, Ofwat and DWI should align deadlines and limit inconsistencies in planning timelines and assumptions. 

• Given the limited progress in developing a common understanding of asset health, Ofwat should continue to work with the sector, EA and DWI, reach a conclusion, and deliver its Roadmap for enhancing asset health understanding in the water sector on time.

• Before the development of PR29 methodology, Ofwat should consider whether it can act to simplify the price review methodology. This should include evaluating the impact of outcome incentives on company performance, the impact of cost benchmarking on company behaviours and financial resilience, and the impact of price control deliverables on performance.

• Before the development of PR29 methodology, Ofwat should seek to understand whether successful Innovation Fund projects are being taken up across the sector and the impact they have had.

Recommendation to ensure the sector can continue to attract investment:

• Ofwat should develop a view on how to identify and plan for investment needs over the long term, and work with Defra and the other regulators to improve transparency and predictability in light of the recent sector downgrades.