May 2020 Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case www.ofwat.gov.uk Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case Contents 1. Executive summary 2 2. General issues 16 3. Securing cost efficiency 27 4. Delivering outcomes for customers 72 5. Overall stretch across costs and outcomes 94 6. Aligning risk and return 106 1 Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case 1. Executive summary Our response to Northumbrian Water’s statement of case In reaching our final determination for Northumbrian Water,1 we considered the company’s business plan in line with our statutory duties. We are satisfied that our final determination ensures that the company has adequate funding to carry out its regulated business, including meeting its statutory and regulatory obligations, to deliver the outcomes within its final determination and thereby provide for the long-term resilience of its systems in the interests of current and future customers. Overall, our final determination for Northumbrian Water allowed a reasonable return to investors (based on market evidence at the time of our determinations); allowed efficient funding for all costs that were well evidenced (including for resilience proposals, for which Northumbrian Water was allocated the largest allowance of all water companies, relative to its size); and protected Northumbrian Water’s customers from inefficient spending plans whilst delivering outcomes and service levels that they consider to be priorities. On 2 April 2020 Northumbrian Water provided us with a copy of its statement of case to the Competition and Markets Authority (CMA) in respect of its reference of the 2020-25 price controls for redetermination.2 In its statement of case, Northumbrian Water challenges a broad range of elements in our final determination. It alleges that we have failed to allow Northumbrian Water’s efficient costs. It objects to the distribution of under- and over-performance penalties and rewards in its outcome delivery incentives (ODIs), claiming that these introduce ‘perverse incentives’. It contends that we have – in particular, by disallowing funding for two schemes – failed to meet our statutory duty to further the resilience objective. It objects to our cost of capital. It also alleges that the final determination is not financeable. We disagree with the company and consider that Northumbrian Water misinterprets how our statutory duties have framed the development of our final determination.3 In this document, we explain our position on the key issues arising from Northumbrian Water’s submission. Across the full suite of 1 PR19 final determinations: Northumbrian Water final determination, December 2019 2 Northumbrian Water, 'NWL Statement of case – PR19 CMA redetermination', April 2020 3 See Ofwat, ‘Introduction, overall stretch on costs and outcomes – response to cross-cutting issues in companies’ statements of case’, Chapter 3 2 Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case documents which constitute our response, we have endeavoured to respond to the company’s statement of case in its entirety. We note that in support of some of its arguments and proposals, Northumbrian Water has raised a number of points that were not raised at prior stages of the price review process or represent issues that have arisen since publication of our final determination, including requests for additional cost allowances. We make clear, in the following sections of this document, where a point raised by Northumbrian Water is new. Some of the requests, though, relate to information that the company did not share with us during the price control determination process (for example, in relation to the business rates adjustment). Northumbrian Water submitted new information to Ofwat, in relation to its statement of case, on 28 April 2020. We have not had opportunity to review this late information in preparing our response to the companies’ statement of cases. If necessary, we will set out our thoughts on the new information in later submissions to the CMA. We summarise below what was included in our final determination for Northumbrian Water, and outline the key issues that the company raises in its statement of case. Our determination for Northumbrian Water Our final determination for Northumbrian Water allowed efficient wholesale and retail costs of £2,933 million, which is 5% more than Northumbrian Water’s historical expenditure for PR14. 4 5 This includes the highest amount of resilience expenditure of all companies (£104 million) relative to company size. Under the performance commitments that we have set, by the end of the 2020-25 price control period Northumbrian Water’s customers will be benefitting from improved service levels such as a 22% reduction in pollution incidents; a 43% reduction in internal sewer flooding incidents; a 26% reduction in external sewer flooding incidents; and an average water supply interruption that is no longer than 5 minutes. The company will also deliver by 2024-25 an 4 PR19 final determinations: Northumbrian Water final determination, December 2019 5 Reference of the PR19 final determinations – Explanation of our final determination for Northumbrian Water, March 2020, p.3 3 Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case 18.5% leakage reduction for Essex and Suffolk region, and 11% reduction for the Northumbrian region, on a three year average basis. It should be noted that, as a leading company on two of the three performance commitments for which we set a common level across all water companies for 2020-25,6 Northumbrian Water’s own business plan from September 2018 forecasts performance that goes beyond the common levels we have set. If achieved, this performance will enable it to receive outperformance payments (£4 million on the pollution incident performance commitment and £7 million for water supply interruptions).7 8 Over and above the costs allowed for day-to-day delivery, our final determination for Northumbrian Water allowed funding for improvements to service, resilience and the environment, including £152 million to improve the environment by efficiently delivering its obligations as set out in the whole Water Industry National Environmental Programme (WINEP) and £104 million to deliver improved resilience at critical areas of its infrastructure. Our final determination allowed £3,371.1 million of revenue, across all price controls, that Northumbrian Water can recover from its customers. We set an allowed return of 2.96% (on a CPIH basis) which we consider provided a reasonable return for an efficient company based on the market evidence at the time. Northumbrian Water’s Regulatory Capital Value (RCV) growth in 2020-25 is 6.4%. We bring forward £25 million of revenue from future periods. By 2024-25, Northumbrian Water’s average residential customer bill will be 26% lower than during 2019-20, before allowing for inflation.9 The majority of the increase in affordability of customers’ bills is due to a reduction in the allowed cost of capital in our final determination and a change in the natural pay as you go rates, which means a larger proportion of costs are recovered from future customers (see chapter 2 of this document). Taking into account 6 Namely, pollution incidents and water supply interruptions performance commitments. 7 Reference of the PR19 final determinations – Explanation of our final determination for Northumbrian Water, p.22, paragraphs 2.46 and 2.47 8 In chapter 4, ‘Delivering outcomes for customers’, below, we explain that: if Northumbrian Water maintains its 2018-19 performance on pollution incidents it will receive outperformance payments of £15.9 million over the 2020-25 period, and; if the company achieved the performance it delivered in 2016-17 for water supply interruptions over the 2020-25 period it will receive outperformance payments of £20.0 million over the 2020-25 period. 9 We note that in its statement of case Northumbrian Water has recalculated the overall bill reduction based on its own methodology (see NWL Statement of case – PR19 CMA redetermination - 2 April 2020, p.2, footnote 10). Our final determinations use a common methodology for calculating average bills across all companies to ensure comparability across companies. 4 Reference of the PR19 final determinations: Response to Northumbrian Water’s statement of case inflation we would expect to see average bills decline in 2020-21, gradually increasing each year whilst remaining below 2019-20 levels.10 We consider that Northumbrian Water’s final determination is financeable on the basis of the notional structure, based on a reasonable allowed return on capital and revenue advanced through pay as you go (PAYG) adjustments. The determination is sufficient to deliver its obligations and commitments to customers. Our determination in context Northumbrian Water is broadly delivering average levels of performance to its customers, in comparison with other companies. That having been said, its relative performance has deteriorated recently: in 2017-18, it met 76% of its performance commitments; in 2018-19, it met just over one half. It is a lower quartile performer on internal sewer flooding; however, it delivers upper quartile performance on pollution incidents and its leakage performance is improving. Northumbrian Water is underspending