First published in Cleantech magazine, Volume 6 Issue 6. Copyright Cleantech Investor Ltd
Fiona Griffith (Managing Director) and Craig Gordon (Technology Consultant) of Isle Utilities assess the implications of changes in the UK water regulatory system which seek to remove barriers to innovation.
Innovation, particularly when linked with sustainability and increased efficiency, is a hot topic across many UK business sectors. This is no different for the water industry, with a plethora of water innovation reports having been commissioned by the Government and businesses to examine how innovative the sector is and whether it is well placed to meet the challenges ahead. Studies have shown that innovation creates economic growth, a powerful driver not only for the water companies but also for their customers and the supply chain. With UK water companies drafting their PR14 (Price Review 2014) business plans, technology companies and investors are wondering whether AMP6 will be a good five years for technology suppliers. (Ofwat, the UK water services economic regulator, will set price limits in 2014 for the AMP6 investment period 2015-2020.)Water companies are like any other business: they have income generated from sales of their product and strategic investment, and outgoings such as the cost of producing and distributing potable water, staff wages, maintaining their assets and buying new ones. A business plan put together during the price review cycle is essentially a balance sheet explaining to Ofwat how water companies will generate income and what they intend to spend it on. Ofwat’s primary role is to ensure that the revenue water companies receive from customer bills is spent appropriately.
Innovation in the water sector
The term ‘innovation’ for water industry applications was defined by the Cave Review (an independent review of competition and innovation in UK water markets led by Professor Martin Cave) in 2008 as follows:
“The creation, development and implementation of a new product, technology, service, tariff design or process of production with the aim of improving efficiency, effectiveness or competitive advantage. It includes new ways of acquiring or deploying inputs, such as financial resources. The change may be incremental or fundamental.”
To decide whether any process is worthwhile, according to the Cave definition, it must have measurable outcomes demonstrating the benefit of its implementation versus the cost. Innovation is generally an output from research and development (R&D) activities. Good R&D is able to contextualise its results, providing a viable route forward for the business. In order to do this effectively it is imperative that research is of high quality, with reliable results and firm, comprehensive conclusions, as well as aligning with company policy.
In 2010 the UK Department for Business, Skills and Innovation (BIS) published a report on the level of investment UK and international businesses need to make as a proportion of their turnover to be a ‘top 1,000 R&D performing company’. The total revenue in 2011/12 of the water and sewerage companies (WASCs) in England and Wales was almost £10 billion, with the total amount spent on innovation just £12.7 million1, equating to 0.13% of revenue. With WASC’s 2011/12 individual revenues ranging from £468 million to £1,695 million, they are all a significant step away from being a top R&D company.
R&D costs for the top 1,000 performing UK companies
|Turnover||Number of Companies||R&D expenditure (£m)||Average R&D spend per company (£m)||Turnover (£m)||R&D spend as % of turnover (%)|
|UK 1,000 R&D-performing companies|
|More than £5bn||54||13,755||255||1,161,781||1|
|Between £500m and £5bn||187||6,282||34||280,921||2|
|Between £50m and £500m||340||3,734||11||67,828||6|
|Less than £50m||419||1,491||4||7,167||21|
Exactly how innovation fits into the water industry is murky at best, probably because there are two main issues surrounding how a water company can innovate effectively.
1. Incentives and regulation: Any company needs an incentive to innovate. For most companies, which operate in a competitive marketplace, innovation is a necessity – where would Apple be if it were not for the iPod? Innovations lead to increased sales, which in turn lead to more innovation since a company needs to stay ahead of the competition. Water companies are not seen to to be in direct competition with one another. People living in Swindon, for example, have little alternative but to have Thames Water as their supplier. At present they cannot choose to buy water from United Utilities. Ofwat and the five year AMP cycle were intended to create artificial competition between the companies by adding financial incentives for the best performing companies, However, as the years have gone by since privatisation, water companies have become relatively content with their rankings. Furthermore, the regulatory cycle makes it more difficult for water companies to adopt something new if a return on investment is not achieved within the AMP period. Thus any innovation with a payback of six years or more has looked unattractive, despite being in the customers’ long term interests. As a result the incentive for a water company to innovate has been limited.
2. Cost of innovation versus benefit: The problem for any business budgeting R&D spend is not knowing whether the activity will actually benefit the business compared to the amount it costs. For example, most WASCs in the UK subscribe to Isle Utilities’ TAG forum, where they receive presentations from 20 of the most promising pre-commercial technology companies each year. The technology companies are selected because they have passed through an initial due diligence process and have demonstrated a clear potential to improve performance/reduce operating costs. However, the only way to actually understand the scale of the benefit is for a water company to then trial the technology. The greater the number of technologies trialed, the more likely it is that one of them will significantly improve performance and reduce cost. Allocating funding to an activity that does not have a definitive output within a set timeframe is an area water companies and Ofwat have struggled to quantify since privatisation. This is made even more difficult as the recent recession and faltering recovery is forcing Ofwat to prevent water companies from increasing their bills to customers.
Ofwat’s changes to innovation
Since these issues continue to be raised and published, Ofwat has considered how to promote innovation while maintaining control over the prices that companies can charge. First it dealt with incentives and regulation. In early 20112, Ofwat defined a list of priority targets. It is hoped that by focusing water companies in the direction of specific short and medium term problems and forcing these to be addressed as part of their business plans, innovation initiatives will be incorporated in a structured way.
Another change is the move from a CAPEX/OPEX (capital expenditure/operating expenditure) system to a TOTEX (total expenditure) one. Following consultation, the Government’s view of Ofwat was that the regulatory structure produced a CAPEX bias. The Government found that water companies were overly reliant on direction from Ofwat, creating an industry that is risk averse, particularly when it came to spending on innovation. For water companies to meet the challenges ahead they have to assume more risk, meaning they have to trial and test more technologies and new processes that offer potential. In its conclusion the Government stated that a TOTEX approach similar to the one proposed by Ofgem in the energy sector has “considerable attractions”.
TOTEX, according to Ofwat, would impact on three areas of the regulatory framework:
- Incentive effects – there would likely be some rebalancing between CAPEX and OPEX costs and how Regulatory Capital Value (the value of a water company’s assets) is calculated.
- Cost assessment – how Ofwat assesses the performance and efficiency of a process or asset.
- Cost recovery – how the companies recover costs and earn a return.
Listening to customers equals new technologies
So water companies are to take more risk and be more innovative in the AMP6. But what should be expected from their PR14 business plans? It is anticipated that PR14 will be considerably more customer focused. Ofwat’s SIM (service incentive mechanism) system, which was not present for PR09, will help shape how water companies meet their customers’ needs. It is therefore likely that leakage and demand management will feature prominently - and not just because Ofwat has listed leakage as its number one innovation target. Water companies promote water saving and re-use schemes to customers, and many customers were subject to water use restrictions earlier in 2012 because of drought. The water companies have been heavily criticised for being unable to meet the demand of consumers. Innovation and new technology offer an excellent route to solving problems, as solutions are needed to detect small leaks in an affordable way as well as repairing a trunk main with minimum disruption to customers.
Carbon dioxide emissions and climate change will also play an important part in PR14. Defra/DECC reported in 2011 that water supply and treatment is producing more CO2 each year. Currently only public sector operations are required to report their carbon footprints, but businesses should also be increasingly keen to calculate how ‘green’ they are.
CO2 produced for water supply and treatment3
|Fuel Used||Units||Kg CO2e per unit|
The CO2 footprint is also commonly linked to energy and cost. The role of new technologies will be to improve the efficiency of the water and wastewater treatment processes, while also allowing water companies to meet increasingly challenging quality targets.
Will this benefit technology companies?
There is one question that hasn’t been answered: how will new technology and novel solutions be adopted by water companies in AMP6? In the past Ofwat was seen as a blocker to innovation, with water companies disincentivised to take risks and allocating only small budgets to R&D. However, Ofwat has begun to remove these barriers to innovation, giving the water companies greater financial incentives to provide a service their customers expect and require. While the true value of innovation is still unclear, the water industry at least has a new direction in which to head. The change in tune should help technology companies engage with water companies and undertake trials, which should increase uptake and in turn improve the service received by customers.
1This is just OPEX R&D published in the water companies’ annual reviews. Any capitalised spend has not been included.
2Ofwat, 2011, innovation priorities for the water sector.
3Defra/Decc (2011) 2011 Guidelines to Defra/DECC’s GHG Conversion Factors for Company Reporting, Methodology Paper for Emission Factors.
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