Future price limits

The aim of the future price limits project is to answer the question:

How should we carry out price controls in the future, in order to achieve our strategic goals?

How we decide to set future price or charge limits is important because some elements of water and sewerage supply chain are natural monopolies and we will need to control their prices for the foreseeable future. The way that we control prices and services will have a major effect on the ability of water companies to meet the challenges of the future.

We completed this project in spring 2012. Our current review of prices will implement the principles we developed.

Developing a framework

The project was not intended to produce a detailed methodology or a model that can be used to set price or charge limits. Instead we produced a framework within which we can carry out a price control. This framework must be robust so that it will work in a wide range of circumstances.

We are unlikely to be able to carry out all our thinking on how we will carry out a price control at the first price or charge review following this project. However, we expect that will make our direction of travel clear.

Elements of price control

Our review consisted of a small number of sub-projects which consider fundamental aspects of price controls. Within each sub-project we will develop a series of options for that element of the price controls and will test those options against our scenarios. One way we will decide between options is how well they deal with the different scenarios, and if an option does not work robustly with a reasonable set of scenarios, we will not pursue it.

The elements we considered in the first stage of the project were:

• Form of control –what types of price or revenue controls will we use?
• Regulated or unregulated businesses – how should we treat regulated and unregulated activities to achieve the objectives we set out for our price controls
• Risk allocation – how should the risks within the sector be shared between stakeholders?
• Incentives – what are the best ways to encourage the behaviour and outcomes that we need to achieve our strategic goals?
• Customer engagement – how should we involve customers and other groups in setting price controls? Including our customer engagement policy.
• Outputs and outcomes – how should we define what price limits will deliver?

We also set out a preliminary model that could be used to set price limits and held workshops on key elements.

In the second and third phases of the project, we have considered:

• Capex bias – are there factors that cause companies to spend capital when perhaps they shouldn’t?
• Capex and opex – which activities should be treated as capital expenditure (capex), or investment and which as operational expenditure (opex), or running costs? We commissioned independent reports that look at tools we could use when we assess these costs.
• Cost of capital and risk mitigates – in what ways can, or should we reduce the level of risk in the water and sewerage sector, and how should price controls ensure investors are appropriately rewarded for their investment in the sec?
• Retail/wholesale package – how could we split price controls between the retail and wholesale elements of supply?
• Efficiencies of scope

Recommendations from previous major reviews

We considered all the relevant recommendations resulting from the recent reviews of water, sewerage and regulatory issues:

• Pitt review: Learning lessons from the 2007 floods
• Cave review: Competition and innovation in water markets
• Walker review: Household charging for water and sewerage services
• Gray review: Review of Ofwat and the Consumer Council for Water

Further information

We completed this project in June 2012. The principles we developed have been applied in our 2014 price review.