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Does regulation discourage improving our water assets?

Water regulator Ofwat is investigating the extent to which regulation is encouraging water companies to build new infrastructure instead of refurbishing or upgrading existing assets.

A potential bias, or a bias with limited effect, is a problem to be corrected. Infrastructure spending comes out of water companies’ capital expenditure (capex) budgets, while refurbs and upgrades are classed as operating expenditure (opex).

Favouring capex over opex

Ofwat uses capex levels to calculate water companies’ regulatory capital values (RCV). This figure is then used by Ofwat to calculate water rates, and is used by investors as — in Ofwat’s own words — “a proxy for the market value of the regulated business”. Moreover, a rise in opex affects Ofwat’s rating of a company’s efficiency.

If opex rises, a company is seen as inefficient — but capex to replace poorly performing assets might lower opex and therefore make the company appear more efficient.

Capex is directly linked to future returns, while opex is associated with inefficiency.

“We now question whether just incentivising capex for capex’s sake is the right thing to do, says Ofwat chief executive Regina Finn.

Ofwat says it is working to understand “the extend to which the [water] companies do in fact favour approaches based on capex over those based on opex”.

“If they do, we want to understand the reasons for this and the implications for the way in which we set price limits,” it says.

Ofwat seems to be taking the position that only if a significant bias is found will reforms be sought.

The existence of that perceived bias is already well establishe. Warwick University centre for management under regulation director Martin Cave’s

This situation has its roots in the regulatory system which was established when the water industry was privatised in 1989. review of cometition and innovation found that the regulatory system “may … encourage companies to adopt capex solutions when considering the need for new of replacement capacity and to seek opex savings for any given level of capacity”. This “could deliver sub-optional solutions”, he reported. Cave said his respondents acknowledged that the bias towards capex “could exist” — although Ofwat “did not consider it to be significant”.

At that time investment in capital projects was a priority after infrastructure was neglected under public ownership.

But that is no longer the case in England and Wales. Observers believe that there are many situations where opex would deliver more efficient, sustainable and future-proof solutions, and there is a danger that those good decisions could be seen as bad business.

The benefits of operational spending

Opex on catchment management to improve water quality could be preferable to capex on a treatment works downstream, or opex to move water between regions could be better than building a desalination plant. Water efficiency retrofit programmes — which are also classed as opex — will undoubtedly become more important as climate change is expected to increase water stress over the coming decades.

Good catchment management can also improve the quality and quantity of raw water used for storage in reservoirs or abstraction from rivers, which in turn “may allow the delay or possibly complete deferral of water treatment upgrading”, says South West Water environmental manager Martin Ross. This type of opex can also have knock on benefits such as retaining soils on agricultural land, reducing flooding peaks downstream, and improving biodiversity, he says.

These outcomes make sense in the long term, but this is not reflected in Ofwat’s current processes, as industry body Water UK chairman Chris Loughlin told the City conference. “If we are only interested in shareholder return we should build a concrete box with chemicals in it,” he said. “But that is not the right way.”

Defra has billed its review of Ofwat as a “one in 20 year opportunity” to make significant changes to how the industry is regulated. But if the review is more concerned with working out whether the bias is “significant” than with how it can be mitigated, that rare opportunity will be wasted — and what might be only a potential bias now could become a very real bias in years to come.

Pressure for reform is growing. Ofwat is under scrutiny as the Department for the Environment, Food and Rural Affairs reviews Ofwat’s role. The results are expected to feed into the government’s White Paper this summer.

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