NERA Economists Assess Ofwat’s Funding and Incentive Targets for Leakage Reduction

The Situation

Leakage reduction is a high-profile output provided by water companies and has been given a great deal of prominence in the water regulator, Ofwat’s, “Delivering Outcomes for Customers” regime at PR19. Ofwat expects companies “to propose stretching performance commitment levels for leakage” that go beyond the levels targeted by the industry in the past. These targets impose extra costs on the industry that need to be funded through Ofwat’s price controls (PCs), which limit the prices water companies can charge to customers. Ofwat standardises the definition of leakage targets and prescribes a method for how companies should set their target at PR19 or justify why they have not adopted the prescribed method.

NERA's Role

A NERA team led by Director Richard Druce was commissioned by a group of English and Welsh water companies to create a report that reviews proposals published by Ofwat regarding the funding of leakage reduction measures through the PR19 price control review. The report offers several reasons why Ofwat’s proposed funding for leakage reduction will not result in regulated revenues sufficient for companies to finance the efficient costs of meeting the “stretching” PCs on leakage reduction, which Ofwat itself has asked companies to target.

The Result

The authors suggest a change to Ofwat’s funding package for leakage reduction is required to ensure companies can fund the efficient costs of meeting the industry’s leakage reduction targets. One option would be to develop its cost assessment modelling tools so companies’ base allowances better reflect the growing need for work to reduce leakage. Alternatively, Ofwat could revise its “gated” approach to allowing companies’ claims for enhancement expenditure to reduce leakage in a way that provides funding for them to bridge the gap between their proposed PCs and the levels of leakage reduction activity conducted historically.