Ofwat's PR24 and beyond - what does it mean for the environment?

Ofwat have released PR24 and beyond: Creating tomorrow, together (131 pages), which sets out their initial views on the framework for PR24 and future price reviews.

In summary, the implications for the water sector on the environment include:

• Ofwat see climate change and increased customer interest and expectations on the environment as key divers for PR24
• Partnership working and nature-based solutions will be a focus in PR24, however Ofwat want to see third parties picking up a fair share of the costs (and will likely question where customer money is spent). However, Natural Capital approaches and Biodiversity Net Gain aren't specifically mentioned as tools and more explicit consideration of these from Ofwat will help companies engage with other sectors to deliver nature-based solutions.
• A market operator approach won’t be considered in PR24 for the environment. We need to effectively engage with cross-sector groups from a whole company perspective for PR24 if we want nature-based and joined-up solutions. 
• Ofwat consider price reviews as staging posts. Given environmental improvements (e.g. Net Zero and WINEP) are long term we can expect this to be reflected in their approach for PR24, potentially setting outcomes across AMPs.
• We are likely to see targeted challenges linked to incentives on the environment and will need to continue to engage with Ofwat’s innovation competition.
• Although not able to influence non-discretionary regulatory related spending on the environment, customers may have important views on how we deliver environmental improvements.
• Companies need to ensure they are joined up across the many strategic plans on the environment with their PR24 business plan. Ofwat will join up with other regulators but “will ultimately assess companies’ business plans independently of other regulators”
• Companies will need to consider outputs related to the environment (separate to outcomes) in PR24 and also the potential for some community engagement on the environment to be considered outside price controls. This will be through PCDs (Price Control Deliverables), something Ofgem currently uses.
• Cost assessment for the environment will most likely be benchmarked 
• Companies will need to account for climate change in base and enhancement programmes with an efficient additional cost allowance for carbon reduction. Ofwat want to focus on emissions reduction before offsetting in AMP8.

This summary collates out some of the main details related to the environment and I hope it can help our sector-wide discussions as we progress through the PR24 business planning process. Ofwat are consulting on this document with responses due 22 July 2021.

Facing into the future – what do Ofwat see as the challenges?

• “Climate change threatens resilience, both of our networks and our water supply. We’re already seeing drier summers, more frequent and intense rainfall, more variable river flows and biological changes in water bodies. In England, it’s estimated that there is a 25% chance of the worst drought in recorded history within the next 30 years.
• Customers are increasingly concerned about damage to the environment from taking water from rivers and chalk streams, discharging waste through storm overflows, and addressing carbon emissions and biodiversity pressures. Future targets likely to come from the environment bill”.
• Moment for fresh thinking and real change – focus on collaboration outside the sector, nature based solutions and game-changing innovations. The figure below outlines some of the long-term targets and commitment for the water sector.

Ofwat see climate change and increased customer interest and expectations on the environment as key divers for PR24.

Markets and systems operation

The UK government has outlined a long-term ambition to move towards a system operator approach for managing natural capital and stakeholders such as UU are proposing catchment operators for the water sector. However, Ofwat are going to focus on co-ordination across the sector through regional water resources groups, DWMPs, WRMPs, RAPID and the WINEP Task Force.

We will need to effectively engage with cross-sector groups from a whole company perspective for PR24 if we want nature-based and joined-up solutions.

Increasing focus on the long term

Ofwat are keen for to support companies to develop a long-term perspective. For example, the five year price review should be seen as a staging post within a longer term context. They highlight that “Net zero, in particular, may require a fundamental change in how the sector operates. All areas of company operations impact on net zero – this transition will impact with all other long-term goals and ambitions. Solutions will need to involve significant innovation including within the supply chain, behavioural changes by customers, and the far greater adoption of nature-based solutions”.

Ofwat are working with others to reform the WINEP. They want to move towards a more outcomes focused WINEP that encourages water companies in England to pursue broader catchment management and nature-based solutions to deliver multiple environmental and social outcomes.

Ofwat consider price reviews as staging posts. Given environmental improvements (e.g. Net Zero and WINEP) are long term we can expect this to be reflected in their approach for PR24, potentially setting outcomes across AMPs.

Targeted Challenges and Innovation

Ofwat see business plan incentives remaining in PR24 (reputational, procedural and financial – performance commitments). They are considering targeted challenges given the impact of the 15% leakage reduction challenge in PR19 leading companies to go further. They will initially look at water efficiency and harm caused by discharges from the wastewater network – the first directly affecting us and the second impacting on our raw water quality. They will also consider challenges coming out of targets from the Environment Bill, which is currently being debated in Parliament.

Ofwat will be reviewing the Innovation Challenge. Their priorities have been around the environment and resilience to date. They will consider the innovation fund when assessing the level of productivity improvements and will also look at a future fund in PR24.

We are likely to see targeted challenges on the environment and will need to continue to engage with Ofwat’s innovation competition.

Customer Engagement

Ofwat plan to simplify how companies engage with customers and develop a collaborative national approach. For the environment they highlight that a significant proportion of enhancement spend is driven by schemes that follow directions from Environment Agency, Natural Resources Wales, Drinking Water Inspectorate or Defra (over 75% of funds allocated for enhancement in PR19). In PR24 this non-discretionary spend is likely to increase given statutory requirements from the Environment Agency and further long-term government ambitions. This may limit customer influence on the expenditure but they will still have important views on how it is delivered. 

Although not able to influence non-discretionary regulatory related spending on the environment, customers may have important views on how we deliver environmental improvements.

PR24 in the context of other strategic planning frameworks

The timing and overlap between PR24 and other strategic plans can have major impacts for how well outcomes are delivered. Ofwat are planning to work with other regulators to join-up these processes and input earlier to them to ensure join-up with PR24. There is also a range of evolving government policy and legislative changes on the environment to consider:

• Environmental Land Management Schemes (ELMS)
• Storm Overflows Taskforce
• Environment Bill including Local Nature Recovery Strategies to increase collaboration with local authorities on nature
• Strategic Policy Statement from Defra following the Environment Bill

Ofwat plan to work more closely with other regulators, however “will ultimately assess companies’ business plans independently of other regulators”.

Companies need to ensure they are joined up across the many strategic plans on the environment with our PR24 business plan. Ofwat will join up with other regulators but “will ultimately assess companies’ business plans independently of other regulators”

Long term outcomes – Form PCs to PCDs (Price Control Deliverables) and performance outside the price review

Ofwat have identified environmental outcomes to incentivise: These include outcomes that help protect the environment, such as encouraging water efficiency or enhancements to the environment where these are delivered as part of core water company services. This could include measuring greenhouse gas emissions. The WINEP Task Force is looking to develop more outcomes, however some aspects will continue to be outputs delivered. Ofwat propose to rename these Price Control Deliverables (PCDs) based on the approach Ofgem have taken. Ofwat plan to review common PCs and reduce the number of bespoke PCs, which will impact on the number of PCs we have around the environment in PR24.

Ofwat have also identified some areas that could be outside the price control. For instance, Anglian Water has partnered with Keep Britain Tidy who deliver Beachcare and Rivercare. These schemes helped community led volunteer groups to effect positive change. Anglian Water’s engagement in these schemes was not part of the price control or its incentives, but the company has still continued to support these schemes. This would allow water companies to seize opportunities as they occur, when they work with their communities, better enabling them to deliver core services differently and provide greater value. 

Companies will need to consider outputs related to the environment (separate to outcomes) in PR24 and also the potential for some community engagement on the environment to be considered outside price controls.

Cost Assessment

On the environment Ofwat are asking questions on:

• How we can take into account of key emerging issues such as net zero, public value and partnership working?
• How we can improve our assessment of nature-based solutions, so that they are appropriately incentivised through the cost assessment framework?

For the environment Ofwat use cost benchmarking to identify efficient costs for enhancement programmes. They used benchmarking for most of the environmental programmes, to improve drought resilience and metering programmes, which covered 70% of enhancement proposals.

Moving to Net Zero

Ofwat suggests companies need to consider how each five-year period provides a checkpoint on the route to Net Zero. The sector has started considering operational emissions but will need to consider embedded carbon to meet the UK government commitment by 2050. Ofwat have set out their view on offsetting below – I’ve copied it across in full as it will be key to delivering our Net Zero Action Plan: 

“To achieve net zero, substantive decarbonisation of water and wastewater services is fundamental. Offsetting, where emissions are offset by alternative measures such as tree planting, does not address the root cause of emissions and so should only be used as a last resort when other alternatives have been exhausted at this point in the transition to net zero. We currently consider that the primary focus at PR24 needs to be on driving carbon emissions down, rather than offsetting them”.

And on costs:

“Such a fundamental change of approach to delivering water and wastewater services could mean a change in the costs of providing those services. Seeking opportunities to reduce carbon may reveal opportunities for reducing cost and increasing environmental benefits via nature based solutions. We also recognise that transition to net zero may increase costs of service. Potentially there are some areas where higher upfront costs are offset by lower energy and chemical costs, meaning no higher costs over the whole life of the assets for customers to pay. We recognise that investment required by companies, for example to deliver environmental improvement programmes, can deliver net zero benefits.

Ofwat are considering how best to reflect the transition to net zero in our cost assessment approach. Potential options we are considering include:

• Asking companies to identify the carbon reduction benefits resulting from base expenditure and existing enhancement programmes as part of their business plan; and
• Using the outcomes framework to compensate companies if they go beyond the carbon reduction that can be delivered through base costs and existing programmes; and/or
• Allowing additional or incremental carbon reduction costs where proposals are well evidenced and demonstrate benefits over and above purely carbon benefits alone, and, where feasible, benchmarking incremental unit costs of carbon reduction to provide an efficient additional cost allowance for carbon reduction.”

Cost assessment for the environment will most likely be benchmarked

Companies will need to account for climate change in base and enhancement programmes with an efficient additional cost allowance for carbon reduction. Ofwat want to focus on emissions reduction before offsetting in AMP8, however the industry recognises the wider benefits of offsetting and that it will be required due to process emissions.