Initial* summary of key points from the CMA’s provisional determinations

(by Karma Loveday)

*Based on the Summary of provisional determinations published this morning — more detail will be added once the full report is available.

The Competition and Markets Authority (CMA) has made the following provisional determinations (PDs) in the PR24 price appeals of Anglian Water, Northumbrian Water, South East Water, Southern Water and Wessex Water.

Revenue

• Disputing companies asked for £2.7bn extra on top of the £26.6bn allowed to them by Ofwat.

• The CMA allowed £556m (21% of what was collectively sought).

• Table 1 shows total revenue impact by company. All companies benefit from an increase compared to their final determinations (FDs) but this falls far short of their requests in their statements of case. Wessex fares the best, securing over half of its requested uplift; the other companies secure between a tenth and a quarter. While all companies benefit from a rate of return increase, only three (South East, Southern and Wessex) also benefit from a cost allowance lift.

Bills

• The PDs add 3% to average bills on top of the 24% increase made by Ofwat’s FD.

• Table 2 shows bill impact by company. The uplifts range from 1.3% at Anglian and Northumbrian to 4.7% at Wessex.

• Chair of the CMA panel Kirstin Baker said: “We’ve found that water companies’ requests for significant bill increases, on top of those allowed by Ofwat, are largely unjustified. We understand the real pressure on household budgets and have worked to keep increases to a minimum, while still ensuring there is funding to deliver essential improvements at reasonable cost.”

Expenditure allowances

• Higher allowances granted for South East, Southern and Wessex; lower allowances determined for Anglian and Northumbrian.

• Base expenditure:

  • The CMA adopted a different, “simpler” approach than that taken by Ofwat, which it said better reflected different operating environments between companies. The models incorporated most of the cost drivers used by Ofwat and some (not all) of the cost drivers put forward by the companies. The CMA rejected all cost adjustment claims except differences in regional wages, economies of scale at water treatment works, and energy costs. It also changed the assessment of ‘what base buys’ which affected allowances for asset health improvement. This resulted in:

    • A higher catch-up efficiency challenge (where allowances for all companies are based on the expenditure of comparatively efficient companies) than Ofwat’s – the CMA said this was appropriate to ensure monopoly customers served by inefficient companies do not pay for poor operational performance.

    • A lower frontier shift (emulating efficiency improvements expected in competitive markets) expectation of 0.7%, down from Ofwat’s 1%. The CMA said that was in keeping with expectations of the wider economy. Companies requested 0.62%.

• Enhancement expenditure:

  • The CMA made changes to Ofwat’s modelling approach, resulting in changes to some modelled allowances, such as for phosphorous removal schemes.

  • The CMA largely rejected companies’ requests for higher allowances on the basis of insufficient evidence.

  • Where increases were allowed, these tended to reflect issues that matter to customers, notably addressing water supply interruptions, pollution and leakage, or where companies’ ability to invest had been underfunded.

  • Many increases are subject to an efficiency challenge, reducing allowances to 30% of what was requested.

  • Some enhancement schemes have been deemed too uncertain to provide a specific cost allowance for; the CMA said Ofwat’s gated process should be followed for these. That has reduced the enhancement cost allowance at this point in time, but offers the chance of allowances in future as more information becomes clear.

  • Frontier shift applied as for base.

Outcomes

• The CMA made limited adjustments only, citing the time and scope of the redetermination process in explanation. Funding therefore remains tied to defined outputs and levels of performance.

• Changes were made where Ofwat’s data was not deemed appropriate, or where penalties would disincentivise efforts to improve performance.

• The result is a slightly lower risk of underperformance for companies in some areas.

• CMA rejected companies’ argument that penalties for not delivering on time introduced excessive risk. These remain in place.

Risk & return

• The Capital Asset Pricing Model was used, but with updated market data.

• Cost of capital increased from Ofwat’s 4.03% to 4.29%. This reflected:

  • A higher cost of equity – driven by interest rate rises.

  • A lower cost of debt – driven by changes in expected inflation.

• More than half the change related to external market movements, the rest from targeted methodological changes.

• The CMA rejected companies’ argument that the PR24 FD as a whole would likely result in a significantly lower equity return than the specified allowed return – particularly given the downside risks of underperformance and subsequent penalties. It said its PDs offer a ‘fair bet’ — where the risks for an efficient company of earning more or less than the specified allowed return are broadly similar.

• Ofwat’s Aggregate Sharing Mechanism and Outturn Adjustment Mechanism retained.

Context

• The CMA said its decisions had been taken within the confines of the existing regulatory framework, but noted at some length the Independent Water Commission recommendations and wider reset agenda.

Next steps

• PDs open for comment until 6 November.

• The CMA will update its timetable after that date, noting the 17 March statutory completion deadline.