Regulators in focus: a major shake-up for the water sector

In this piece, drawn from our forthcoming Regulators in Focus report, Graeme Young gives an overview of impending regulatory reform for the water sector in England and Wales, and highlights five things to watch as we enter a period of change for the water sector that will have profound consequences for investors, customers and suppliers, as well as for the water companies themselves. 

Our Regulators in Focus report will be published in November, looking at the UK’s evolving regulatory landscape in the context of a cross-section of key regulators. If you would like a copy, please email [email protected].

Ofwat is off – what next for water?

In July this year, the then environment secretary, Steve Reed, declared that the water industry was “broken” and that Ofwat – the economic regulator for the privatised water and sewerage industry in England and Wales – will be abolished and replaced by “a new, single, powerful regulator”.

In England, this new regulator will combine the water-related functions of Ofwat, the Environment Agency, Natural England and the Drinking Water Inspectorate. In Wales, Ofwat’s economic regulatory responsibilities will be integrated into Natural Resources Wales.

This announcement was made following the findings and recommendations made in a report from the Independent Water Commission (IWC), led by Sir Jon Cunliffe. The report called for a fundamental reset of the regulatory model governing the water industry, making a total of 88 recommendations.

The government intends to publish a white paper this autumn giving its full response to the IWC’s report and launching a consultation. Following that, a new water reform bill will be brought forward. The industry is therefore set for a potentially long transition period during which this new regulatory framework takes shape. Realistically, this will take at least a couple of years, and not be completed until well into the PR24 price control period (2025-30).

The IWC’s other recommendations include creating a national water strategy and regional water authorities, rationalising the legislative framework, relaxing statutory duties that constrain regulatory flexibility in individual cases, simplifying the price control appeal process and the performance incentives system, and reducing the number of plans that water companies produce.

While we don’t yet know exactly how many of the IWC’s recommendations will be adopted, the new regulator will clearly be overseeing a significantly different system. In the meantime, Ofwat will continue operating under the current regulatory framework. It will also have to help prepare the ground for the new regulator, which may include implementing some recommendations which do not require primary legislation.

Five things to watch

A period of uncertainty

A key issue will be how the new regulator is structured and how its new “integrated teams” with the current Ofwat, DWI, EA and NE personnel will operate and function. There will inevitably be a period of uncertainty, which risks being disruptive and potentially impacting on predictability and effectiveness. It is also a process that is likely to take time. As the IWC observed, the creation of Ofcom through the combination of five different regulators took three years and two pieces of primary legislation.

Major legislative reform

In the IWC’s view, the piecemeal development of the legislative and regulatory framework for the water system over a long period has resulted in an overly complex regime, which is outdated in places and where an unduly prescriptive approach limits innovative solutions. To reduce complexity and increase clarity and focus, it recommended that this legislative framework be reviewed, with a particular focus on the Water Framework Directive and the Urban Wastewater Treatment Regulations. As it noted, this “would be a major exercise requiring public consultation and considerable scientific and technical expertise.” Interested parties will want to be sure they are on top of the details, and that the government fully appreciates the implications of what it proposes. They may also want to engage through industry groups, many of which have already begun lobbying.

Improving investability

Attracting investment into the sector was a key concern for the IWC. On price control the IWC recommended the CMA adopting a common weighted average cost of capital (WACC) methodology, a longer-term approach to capital investment planning as part of the five-year review periods, and making CMA appeals a standard appeal process rather than a redetermination. The IWC also recommended that the current water regulators conclude their long-running investigations and enforcement cases as soon as possible as part of a sectoral reset. While PR29 still feels some way off, there are therefore some important features of the price control process that will be up for discussion now.

Performance against current price controls

Ofwat made its final determinations for the next five-year price control period in April this year, PR24 (2025-2030). Although it approved record levels of investment, five water companies appealed to the CMA. In October, the CMA issued provisional determinations that they could seek to recover an additional 3% (c.£556m). An immediate thing to watch is therefore how this process concludes and how the water companies then begin to deliver on these plans, and in particular the projects needed to redress some of the chronic underinvestment in water and wastewater infrastructure.

Increased corporate scrutiny

The solution found for Thames Water will be watched closely by the sector. While there may need to be some relaxation of Thames Water’s current targets and Ofwat’s enforcement action, the sector can expect increased regulatory oversight of water company ownership and governance (a major focus of the IWC’s recommendations). The government is also considering including water companies within the mandatory notification requirements under the UK’s National Security and Investment (NSI) regime, further increasing the regulatory scrutiny of corporate ownership and governance.