Highly critical NAO report warns regulators have failed to deliver trusted and resilient water sector

The National Audit Office (NAO) has today published a highly critical report saying that the Department for Environment, Food and Rural Affairs (Defra) and water regulators have failed to drive necessary investment for the sector, which now faces significant environmental, supply and infrastructure challenges.

The NAO is warning that to tackle the challenges, including an anticipated daily shortfall of 5 billion litres of water by 2050, the sector now needs to attract an unprecedented amount of investment. However, according to the NAO, the need for investment coincides with a period of weakening financial performance, declining public trust and falling investor confidence.

The report states:

“Defra and the water sector’s regulators have not encouraged water companies to spend what they need to deliver the performance expected. The sector now faces significant environmental and supply challenges.

“To meet these challenges, it will need to attract investment and spend at a rate not seen before. The regulators must understand the scale of the challenge in terms of cost and deliverability and the condition of assets across the sector, ensure the sector raises the investment needed and meets government outcomes, and achieve value for money for bill payers.”

"Regulatory framework has contributed to worsening investor perception of the sector”

According to the NAO, while the regulators have taken steps to incentivise companies to improve their performance and align investor and customer interests, both consumer trust and the financial resilience of the sector have declined. “The regulatory framework has contributed to worsening investor perception of the sector”, the report says.

The report examines the following key issues:

• the challenges the sector and the regulators currently face to improve performance and consumer trust.
• how the regulatory framework identifies, plans for and delivers long-term objectives.
• how the regulatory framework incentivises the operational and financial performance of water companies in the short term and consequences for how attractive the sector is to investors.

Both Ofwat and the Environment Agency come in for swingeing criticism in the report.

The report says the regulators do not have a good shared understanding on the condition of water and wastewater infrastructure assets,- they do not have a set of metrics to assess their condition, or an understanding of the level of funding needed to maintain them.

According to the NAO, in the work water companies have done, they have overspent for the last four years (some of these costs will be added to consumers bills) and moved slowly. At the current rate, it would take 700 years to replace the entire existing water network.

Price Review process is complex and difficult for investors to understand

Commenting on the price review process, the NAO describes this as “complex and difficult for investors to understand”, pointing out that Ofwat’s final methodology for the 2024 price review comprised over 60 documents, and around 2,000 pages.

“Investors told us they found the complexity makes the process hard to understand, and they focus their attention on financial performance metrics. Some companies wait until the planning process and the price review are finished to finalise their funding or operational plans. As a result, company capital expenditure has tended to follow a cyclical pattern within each price review of first increasing and then decreasing, with knock-on effects for delivery of work.”

The NAO says that despite the introduction of Outcome Delivery Incentives (ODIs) by Ofwat for the 2014 Price Review, performance has not been consistent or significantly improved in recent years. Performance of the median company over the PR19 2020-25 control period has improved in six out of 12 key ODI measures and decreased in six. At the same time, companies have spent 12% more than the allowances set by Ofwat in the first four years of PR19.

The NAO is recommending that Ofwat should consider whether it can act to simplify the price review methodology before it develops it for the price review in 2029, including:

• evaluating the impact of outcome incentives on company performance
• the impact of cost benchmarking on company behaviours and financial resilience
• the impact of price control deliverables on performance.

In addition, before the development of PR29 methodology, Ofwat should also seek to understand whether successful Innovation Fund projects are being taken up across the sector and the impact.

To ensure the sector can continue to attract investment, it recommends that Ofwat should develop a view on how to identify and plan for investment needs over the long term and work with Defra and the other regulators to improve transparency and predictability in light of the recent sector downgrades.

Gareth Davies, head of the NAO commented:

"Given the unprecedented situation facing the sector, Defra and the regulators need to act urgently to address industry performance and resilience to ensure the sector can meet government targets and achieve value for money over the long term for bill payers."

Click here to download the full report