CMA bears down on base and reduces draft redetermination allowances

(by Karma Loveday)

The Competition and Markets Authority (CMA) has doled out a tougher final settlement than mooted in its October Provisional Determinations for the five firms disputing Ofwat’s PR24 decisions. Base allowances have been cut, but this has been offset by a higher rate of return and enhancement increases.

Across the five companies, the CMA allowed additional revenue of £463m, equating to an average bill rise of 2.2% on top of the 24% Ofwat allowed. This is just 17% of the £2.7bn the companies sought, and was down from £556m (21%, equating to bill rises of 3%) in October’s provisional decision.

As Table 1 shows, Northumbrian Water actually received a small revenue cut, with higher allowed financing costs offsetting a reduction in funding for running costs. However, there is some funding in uncertainty mechanisms that Northumbrian may be able to access in future, which (if it comes to fruition) would ultimately mean a higher total allowance. The other appellants secured uplifts, ranging from Anglian Water’s 1.6% to South East Water’s 3.7%.

Table 2 shows the average bill impact of these decisions, with the CMA’s figures also taking into account Ofwat’s blind year adjustment.

The CMA emphasised it was concerned to balance interests. Chair of the independent group overseeing the redeterminations, Kirstin Baker, said: “We’ve rejected most of the bill increases water companies asked for but allowed limited extra funding where that’s genuinely needed, balancing concerns about affordability with the need to secure our water supplies and cut pollution. A significant part of this extra money reflects market movements since Ofwat’s decision.”

The Authority also pointed out that by law it was required to undertake the redeterminations under the current regulatory system, rather than to account for the direction of water reform. 

Only a summary of the decision has been published so far. Key points from this are set out below. It will be a minimum of two weeks before the full details are widely available.

_______________________________________________________________________________________________

Expenditure allowances: 

Base expenditure:

• Ofwat’s base allowances were cut by £32m, from £14,524m to £14,492m, reflecting the CMA’s base cost modelling approach and decisions on individual company cost adjustment claims. 

• Extensive criticism of the CMA’s base cost models seems to have cut little ice. It said: “After considering all the responses to our provisional determinations and [base cost models] working paper, we remain of the view that our modelling approach is appropriate for these redeterminations, in particular given our approach’s ability to better explain companies' cost data compared to Ofwat's models.”

• Base costs were adjusted to cover differences in regional wages and energy costs, and the CMA’s interpretation of ‘what base buys’. In terms of other cost adjustment claims: three were allowed (coastal wastewater processing, the cost of operating smaller treatment works and Anglian replacing failed boundary boxes housing customer meters); the remaining four were rejected.

• On asset health, the CMA noted work to investigate this thoroughly via the Water White Paper, Ofwat’s Asset Health Roadmap and PR24 asset health reopener. But for the redeterminations it said: “While we received submissions that more investment is needed, there is currently a lack of robust evidence about the condition of water companies’ assets and the level of investment required… Given this context, and after carefully considering the available evidence as well as these wider mechanisms, we are satisfied that our approach to base costs does not result in a material risk that companies will be unable to fund critical investments over AMP8.”

• The CMA noted: “In future, the approach to setting base cost allowances may be revised to reflect broader changes in the regulatory framework.”

Enhancement expenditure:

• Ofwat’s enhancement allowances were increased by £289m, reflecting the CMA’s enhancement modelling approach and individual company enhancement claims.

• Twenty-eight funding requests were considered, with mixed results. The CMA’s model altered some allowances, such as for phosphorus removal schemes. Some claims were rejected, while others were allowed (“to deliver on issues that matter to customers” such as leakage and to prevent supply interruptions) but with an efficiency challenge of 10%-30% applied. Others still were funnelled into existing uncertainty mechanisms — six for example have gone into the large gated scheme process. The CMA noted: “The impact of this varies by disputing company. For example, we have added Northumbrian’s Suffolk strategic network water supply interconnector scheme to the large scheme gated process, which reduces its immediate allowance by £147m, but allows Northumbrian to access funding for this scheme in AMP8 once it has greater certainty over cost and timings.”

Efficiency challenge:

• A higher upper quartile catch-up efficiency challenge applied than in Ofwat’s FDs.

• Frontier shift set at 0.7% — lower than Ofwat’s 1% and in the range 0.5%-0.8% proposed by the disputing companies. 

• “On the basis of the available evidence, we decided that the overall efficiency challenge [frontier shift and the catch-up efficiency challenge] is reasonable and does not undermine the ability of the disputing companies to carry out their functions and meet their obligations.”

Outcomes framework:

• Only limited adjustments were made to Ofwat’s performance targets and incentives — “either because we consider that Ofwat did not use appropriate data or that the way the penalties were calculated would disincentivise efforts to improve performance”.

• “Our analysis indicates that the overall impact of our decisions is to slightly lower the risk of underperformance for the disputing companies in some areas.”

Risk and return:

• Rate of return increased from 4.03% to 4.20%, driven by market movements (notably interest rate rises) and some targeted methodology changes. This accounts for over half the total allowed revenue increase. This is lower than the 4.29% mooted in October, again reflecting subsequent financial market movements. 

• This comprises a higher allowed return on equity than set by Ofwat (an increase from 5.10% to 5.70%), partially offset by a reduction in the real allowed cost of debt (from 3.15% to 2.97%).

• The CMA said the overall balance of risk and return for each disputing company was a fair bet.

• Both the Aggregate Sharing Mechanism and the Outturn Adjustment Mechanism that Ofwat designed to manage return variation for equity investors will be retained.

• “We are satisfied that each of the disputing companies, under the notional capital structure, can reasonably expect to maintain an investment grade credit rating over the price control.”