Ofwat will be presenting water companies with capital maintenance, enhancement, efficiency, and risk management challenges, say Mott MacDonald’s Andrew Heather and Bill Hume-Smith.
On Thursday, Ofwat and the Water Industry Commission for Scotland announce prices for 2010-2015. Before accepting the determination, companies will want to be sure the package is deliverable. Mott MacDonald’s Andrew Heather and Bill Hume-Smith have suggested some points to look for.
Often described as maintaining assets, capital maintenance is more properly about maintaining current levels of service. Most of the expenditure is taken up with replacing worn out assets and so broadly does not add to the asset base. Companies were challenged to balance cost and risk, finding the most efficient way to maintain service. Directors will want to be sure they have enough money to manage risks for the five years, but also to finish the period in good shape for the longer term. With falling construction prices and low inflation, some might also worry that the asset base could lose value.
This involves water and wastewater quality improvements, supply-demand balance, and enhanced service. Enhancements are subject to cost-benefit assessment and many have been discussed with Ofwat, so companies have a good idea what to expect. Enhancement works involve construction of new facilities and so add to a company’s asset base, representing a small growth opportunity.
Ofwat presumes that it’s always possible to find a more efficient way to build assets. Its challenge to companies is in two parts: All will be challenged to deliver a continuing improvement in efficiency. Individual companies have also been ranked in an efficiency ‘league table’ and the least efficient will be challenged to improve based on this cost base comparison, while the most efficient will be rewarded. Directors will want to be sure they can deliver working assets for the costs that are allowed.
Capital Incentive Scheme
This is new for the 2009 review and a source of much debate. Ofwat reviewed company plans and their forecast risks, and set a capital expenditure ‘baseline’. The idea is to reward companies for balancing risk and return, encouraging them to plan for and undertake work that’s necessary but not surplus to requirement. But being new, it’s an unknown quantity and could push some companies hard, especially if they feel they can’t work at the baseline expenditure.
The recent volatility of energy prices makes operational expenditure critical to the management of financial risk – it’s worth remembering that five years is a long time in the energy market. Ofwat assumes innovation can reduce water companies’ operating costs over the course of the period. Operations directors will have included ideas for future efficiency in their business plans, but will want to have room to manoeuvre. Ofwat may push them out of their comfort zone. So the challenge: companies must try to cut costs without falling short on service. This will command boardroom time over the next few weeks.
Companies have until the end of January to decide whether they can deliver service for the price Ofwat and the Water Industry Commissioner offer. If not, then the whole package goes to the Competition Commission for review, in which prices could go down as well as up. Watch this space.