Economic Insight advises Thames Water on regulatory options for complex projects

Economic Insight is advising a number of water companies in developing their strategic priorities for engagement with Ofwat in the next price control, PR24. Most recently, we advised Thames Water in examining the case for differential regulatory treatment of large and complex infrastructure projects and identifying practical options for deploying a differential approach. Our report has now been shared on Ofwat’s Future Ideas Lab page.

We find that there is both an ‘in principle’ and ‘in practice’ case for differential regulatory treatment of large and complex infrastructure projects. Most importantly, given the high degree of risk and uncertainty typically associated with these projects, there is a need to limit overall risk exposure to protect bill payers while ensuring vital investment is delivered at the right time. Likewise, in considering the practical options for a differential approach, it is important to recognise the high degree of risk and uncertainty, whilst also recognising the desire to maintain incentive power. Therefore, under any approach, the ‘option’ for sharing risk with taxpayers (on a contingent basis) is likely to be important.

Taking a pragmatic approach, we have proposed two models that could be taken forward (though they are not mutually exclusive). Firstly, a phased price control model could be employed, where the incumbent remains responsible for identifying needs and options; the design; construction; and operation of the relevant asset. However, the asset in question is subject to a separate price control (and, optionally, separate price controls may apply to each ‘phase’). Under this option, total risk exposure is mitigated by setting overall ‘limits’ on the rate of return that can be earned from the asset in question (both minimum and maximum thresholds). Alternatively, an integrated open competition model could be used, wherein a single open competition is run in relation to the design; build; and operation of the assets (including financing costs) between incumbents and alternative suppliers. Here, overall risk is limited through the application of ‘equity tramlines’ (an enhanced version of Ofcom’s ‘fair bet’ framework), whereby the winner of the competition initially levies prices in line with their tender, but if returns fall outside of the agreed tramlines, prices are able to be adjusted up or down (but only sufficient to return within the tramlines).

To read our full report, please click here.