Estructura Organizacional de la Empresa

82. In chapter 2, we discussed our duty to secure that efficient companies are able to finance their functions and our interpretation of this duty for price determinations. We intend to continue to interpret our duty in this way for the purposes of setting price limits. But as we develop our regulatory tools and how we apply them, we need to consider our approach in that light.

83. In this chapter, we consider the work we are carrying out on market reform and future price limits and how this might interact with our approach to the issue of financeability.

5.1 Market reform

84. We will set out a possible model of future industry regulation for informal consultation shortly. This will consider the different parts of the water and sewerage value chains and how we might improve the way we regulate them.

85. We have already said that we support the recommendations of the

independent review of competition and innovation in water markets (the ‘Cave review’) for the separation of retail activities as a means of delivering choice for business customers. We recognise that the UK and Welsh Assembly Governments are still to decide on whether and how these recommendations are implemented. And we are carrying out preparatory work to ensure that a framework can be put in place to make them work.

86. We are considering the options for the greater use of market mechanisms where they can deliver value for money. For example, we think there are benefits to making use of market forces in the upstream end of the value chain, including water trading and trading of abstraction rights, both of which will help to reveal a value for water and provide a mechanism and incentives for efficient resource use9.

9

‘Valuing Water – how upstream markets could deliver for consumers and the environment’, Ofwat,

87. The resources and retail parts of the value chain are relatively asset light. Others, such as treatment, transportation and local distribution are asset heavy. In these parts of the value chain, there is likely to be enduring market power, which means that enduring regulation would seem likely. Our

regulation of water and sewerage network assets needs to continue to ensure that efficient investment can be financed readily and at reasonable cost so that the companies can deliver the services and improvements that customers expect.

88. Given that the importance of the financeability assessment reflects the importance of capital investment, and the importance of capital investment reflects the degree of asset-intensity, we would not expect market reform in the retail and resources parts of the value chain to have a significant impact on our approach to financeability for the asset-intensive parts of the value chain. Enduring regulation of the more asset-heavy parts of the value chain will require us to consider financeability for those activities. This would mean the continued performance of financeability assessments in setting price limits.

89. Although our focus is likely to remain on assessing cash flows, we may need to develop our approach for the parts of the value chain that are open to elements of competition. Our approach will depend on:

• the precise nature of separation;

• the way in which prices are regulated;

• asset intensity; and

• whether we are setting price limits for an entity operating in a fully contestable market.

90. For example, an essential attribute of competitive markets is entry and exit. Where markets are open to competition, firms should be allowed to fail. In situations where companies are operating in a fully contestable market, our duty to promote competition may be more important than our financing duty.

91. Where markets are fully functioning, this may mean our emphasis focuses on resolution in the event of failure. But where markets are operating in a

transitional phase, we will still need to have regard to our duty to secure that efficient companies can finance their functions and, as a result, the issues of financeability.

92. It may be appropriate to use different financial ratios and thresholds in the financeability assessment for different parts of the value chain. For example, if we set separate price controls for different parts of the value chain, our

approach should reflect their different characteristics.

93 We will continue to consider these issues as our programme of work progresses.

5.2 Future price limits

94. The RCV and the capital charges allowed for in price limits are a means by which we currently allow the companies to be remunerated for the costs associated with their capital programmes.

95. To date, our approach to remunerating capital investment has been consistent with ‘financial capital maintenance’ principles because we have set regulated charges to be sufficient to allow the recovery of all capital invested

irrespective of the current value of any assets. There have been few assets on which expenditure has been incurred, but not been included in the RCV. It is only when a company underperforms, or on occasions where we have secured additional investment that is borne by shareholders following a service failure that assets have not been included in the RCV.

96. Once investment is included in the RCV, it is remunerated at the cost of capital until such time that it is fully depreciated. The regulatory transparency and certainty associated with the calculation of the RCV is a factor that has resulted in the sectors having a relatively low cost of capital.

97. But a low cost of capital may not necessarily equate to a low end-cost to the customer. If customers are to be provided with the services they need and want in the most efficient way, then investment must be delivered:

• at the right cost (‘productive efficiency’);

• at the right place and at the right time to allow scarce resources to be used efficiently (‘allocative efficiency’); and

• in a way that takes into account new and better ways of doing things (‘dynamic efficiency’).

98. Where investment meets these objectives, it will deliver sustainable outcomes for customers and the environment. Such investment would be seen as

legitimate by customers and support the long-term, stable returns that investors want.

99. Regulation must also seek to enable the companies to achieve innovative sustainable solutions if services are to be provided to customers at a lowest overall cost.

100. So, while customers may be paying a price that allows for returns equivalent to a relatively low cost of capital, that cost of capital may be for the cost of financing sub-optimal solutions. The balance of the trade-off between the cost of capital and optimal investment will depend on the characteristics inherent in the individual elements of the water and sewerage value chain.

101. We are also looking at the way in which (efficiently incurred) costs are recovered through regulated prices. Our aim is to ensure that cost recovery takes place in a way that maintains financeability while sending efficient price signals. We recognise that costs incurred to date – in particular for investment – have done so on the basis of the current approach to cost recovery. We are considering if there are different approaches we could take to the recovery of the costs of both legacy (existing) and new assets. We will consider these issues in documents that we will publish as part of the future price limits project later in the spring.

5.3 Large projects

102. We think there may be a case for adopting a different approach to certain projects where:

• they are individually very large, complex and have timescales that span more than one price review;

• the balance of project-specific risks may be different and can be viewed separately from those facing the company’s business as a whole; and

• a different approach could encourage a cost-effective project-based means of financing the related investment.

103. Such an approach has been a feature of certain Public Finance Initiatives and Public Private Partnership structures, although such structures are far less common in the current economic climate than they were.

104. This is likely to involve a new form of licence, one that is more appropriate than for an infrastructure service provider. The Flood and Water Management Act 2010 recognised this. Such a mechanism would:

• ring fence the delivery and financing of an individual project and its risks from the delivery and funding of other capital projects;

• increase competition in relation to the delivery of the infrastructure by enabling new entrants (that is, project companies that are not water companies) to participate in the delivery of water and sewerage infrastructure;

• reveal the level of risk the investors are willing to bear and at what cost;

• incentivise a market-tested project cost of finance and the single project focus, which potentially offers greater certainty of outturn cost and project timetable reducing the risk of major cost overruns; and

• potentially incentivise strategic and innovative approaches to the delivery of improvement schemes in the water industry.

105. The Thames Tideway project may be implemented using such alternative arrangements.

106. We may consider the use of such mechanisms where future projects exhibit similar characteristics to those set out at above.

6. Regulatory issues arising from the trend in financial