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UPDATE: DIRECT PROCUREMENT

FOR CUSTOMERS (DPfC)

Update: Direct Procurement for Customers (DPfC) 01

As part of the 2019 Price Review process, Ofwat requires water companies to consider use of a new model of procurement in respect of certain large and discrete infrastructure projects. This new model of procurement is called direct procurement for customers (DPfC).

Under DPfC a licensed water company procures services on behalf of its customers. Water companies will conduct a competitive tender for and appoint an entity to:

a) design;b) build; c) operate; and/or d) maintain

a service.

The appointed entity will also finance the provision of the service.

The objective of the policy is to make cost savings by subjecting financing costs (as well as all other costs of service provision) to competition. This approach differs to the current model, where large scale projects are financed by water companies remunerated in accordance with their licences, under which Ofwat determines the applicable weighted average cost of capital.

DPfC is also aimed at encouraging innovation by involving new participants in the water industry.

Delivery models

The full details of DPfC remain under development. Further information is due to be published as part of the final PR19 framework in December 2019.

Ofwat is preserving a degree of flexibility in terms of the delivery models that may be used to deliver DPfC. It has set out certain initial principles which may ultimately become requirements.

a) Existing water companies and associated companies will generally not be able to bid into their own tender process.

b) The contract duration will generally be for a period of 15-25 years.

c) The contractor’s revenue entitlement should (generally) start on construction completion.

d) The contractor’s revenue stream should be largely fixed over the life of the contract (Ofwat has stated they expect opex cost allowances to be largely fixed throughout the life of the contract).

Flexibility has been expressly preserved in respect of the following two key areas:

Contracting vs utility model

The documentation published to date preserves flexibility for service delivery either through a utility model (whereby the appointed contractor would be issued with a licence1 and subject to direct regulation and price control by Ofwat) or a contracting model (whereby the contractor would be appointed by way of a contract with a water company).

Ofwat appears to have a preference for the contracting model, stating that in the majority of cases the appointed contractor in a DPfC will be awarded a long–term contract by a water company. Ofwat has however stated that in certain circumstances it may be able to directly issue a licence.

Timing of the procurement

Ofwat has stated that there are three options in respect of the timing of a DPfC procurement, namely:

a) Early tender – The water company tenders outcomes and the tender takes place before early design work.

b) Late tender – Competition focussed on delivering outputs. Tender takes place after planning consents are in place.

1 There are limited circumstances where new licences can be issued under existing legislative powers – see for example the Water Industry (Specified Infrastructure Projects) (English Undertakers) Regulations 2013 (SIPR).

Update: Direct Procurement for Customers (DPfC) 02

c) Very late tender – Competition is focussed on financing and operations. This occurs where construction is completed (or at least construction procurement).

The timing of the procurement process will determine the quantum of costs exposed to competition. It will also determine the level of remuneration required and risk priced in to tenderers’ bids. Investors are usually reticent to take construction risk without considerable mitigation.

Prospect of success

It is too early to judge whether DPfC will be a success, though if structured correctly it has the potential to:

a) create value by attracting low cost capital;

b) stimulate innovation through the involvement of third parties in the water sector; and

c) assist water companies themselves in managing and implementing projects at lower risk than direct delivery.

State of the current market

The timing of the launch of DPfC is positive. Since 2006, £50bn of private capital has been raised (on a multi-source basis) by over 100 infrastructure funds to finance infrastructure assets2. The current low cost of capital makes investment in infrastructure projects attractive. In the water sector specifically, the Thames Tideway Tunnel Project shows that alternative methods of procurement can yield low cost capital that creates value.

Enabling a specific approach

Ofwat’s flexibility in terms of approach to date is welcome. It allows water companies to consider a range of options. Either the utility or contract models could potentially be used successfully to create a stable revenue stream and an arrangement upon which investors can rely.

However there are a number of challenges around some of the proposals made to date. The table on pages 3-4 sets out three examples of proven means of infrastructure delivery in the UK regulatory and governmental sectors and considers whether DPfC would enable such an approach. While it is not necessarily the case that any of these models will be used under DPfC the table shows some of the challenges ahead.

2 UK Infrastructure Market Report (Prequin) (2016)

Update: Direct Procurement for Customers (DPfC) 03

DPfC DELIVERY OPTIONS

Model Summary of delivery model DPfC constraints

Thames Tideway Tunnel

A licensed infrastructure provider with responsibility for designing, constructing, owning, financing, operating and maintaining the Thames Tideway Tunnel.

The infrastructure provider has a revenue stream provided from customers (though received through Thames Water). It has an adapted licence in respect of the construction period that permits automatic log up of construction costs on to its RCV and recovery of revenues based on a one year forward look.

The infrastructure provider also has a government support package which (amongst other things) provides contingent equity in the event of certain cost overruns, enhanced contingent insurance protections and a compensation mechanic in the event of discontinuation by the Secretary of State.

It is not clear at present that the Thames Tideway Model is deliverable under DPfC.

The majority of the DPfC documentation is focussed on delivering a contractual as opposed to a utility based solution. Though, Ofwat does allow for the possibility of a utility based approach.

Where Ofwat agrees to issue a licence to a new entity pursuant to DPfC it is not clear from the documentation that they will follow the Thames Tideway Tunnel risk allocation and regulatory approach.

The Ofwat consultation documentation makes it clear that the appointed contractor’s revenue stream would, in most circumstances, commence on construction completion.

The elements of support provided by HMG to the Thames Tideway Tunnel Project have not been provided for.

PF2 The approach to PF2/PPP projects is largely standardised and is set out in HM Treasury’s “Standardisation of PF2 Contracts” document and the standard equity investment documentation. A PF2 project is likely to have the following features:

• A private sector contractor will enter into a contract, usually with a public sector entity or authority.

• The private sector will be required to construct and maintain infrastructure to deliver the services required.

• The contractor will use private finance, usually a mix of equity and limited recourse debt to fund the upfront construction costs.

• HMG may take a minority equity stake in the project.

• The contractor will be paid a unitary charge, which will include principal and interest payments on the debt, a return to the private sector shareholders and an amount for the services delivered.

• Payment of the unitary charge will be at risk based on performance.

The risk allocation under a standard PF2 contract appears to be largely deliverable within the framework of DPfC described to date (though there may be a distinction between the credit risk of central government and a regulated water company). The exception to this is that it does not appear to be possible for incumbent water companies to provide any equity co-investment in respect of the project.

In respect of the PF2 model the better question appears to be whether it is capable of attracting capital at the cost that will represent value for customers against a water company’s bid WACC.

Update: Direct Procurement for Customers (DPfC) 04

DPfC DELIVERY OPTIONS (continued)

Model Summary of delivery model DPfC constraints

OFTO OFTOs receive a regulated revenue stream from Ofgem and in exchange they take responsibility for offshore transmission assets under long-term (20 year) OFTO licences.

The key characteristics of the OFTO regime are as follows:

• OFTOs receive a fixed and indexed 20 year revenue stream.

• To a certain extent the revenue stream is availability linked but the OFTO’s revenue stream is unrelated to the generating asset’s performance.

• OFTO assets are generally perceived to be benign with the OFTO purchasing the asset following construction completion and taking responsibility for operation and maintenance of assets.

None of the OFTOs let to date include construction delivery risk but instead they were let with financing and operational/maintenance/availability risks.

It is not clear at present that an OFTO model would be available under the DPfC regime.

The majority of the DPfC documentation is focussed on delivering a contractual as opposed to a utility based solution.

While Ofwat leaves itself scope to employ a utility based approach it seems to envisage this is a less favoured approach.

We note that the OFTO model did not implement an equivalent of the “early” model of DPfC. Indeed we note that under the OFTO model, the OFTO bears little if any construction risk. This seems to be incompatible with the requirements of DPfC. In this regard we note that there is an alternative model called OFTO build (where OFTOs take construction risk) to date no such licences have been issued.

Update: Direct Procurement for Customers (DPfC) 05

CHALLENGES FOR EXISTING WATER COMPANIES

Perhaps more significant than the challenges to produce an investable model under DPfC are some of the challenges that DPfC may cause to existing water companies. These are summarised below:

Picking the right project – It may be challenging to pick the correct projects to put out to tender using the DPfC model. Development costs are likely to be significant – this means that DPfC will only be appropriate for large infrastructure projects. However in the case of a multi-billion pound infrastructure project such as Thames Tideway Tunnel, in order to achieve a low cost of capital a wider range of support may be needed (such as a construction period revenue stream and HMG support package).

Ofwat has also clearly stated that DPfC should only be used for discrete projects. It may be difficult for water companies to identify assets and major projects that do not have multiple complex interfaces with existing assets (including in respect of operational dependencies).

Procurement/Project failure – In the event of failure of a DPfC process (either in the tender process or the appointed contractor) water companies may be exposed to punitive action from the regulator and/or may inherit a failing project without sufficient funding set at its price review to remedy the situation. At present there is no clear guidance as to when Ofwat may take punitive action and how failure of the procurement or the appointed contractor would be resolved.

Asset integration and insolvency – In the event of insolvency of an appointed contractor (or termination of its DPfC contract) it will be important to ensure assets (that are to some extent embedded in a company’s wider network) do not become stranded.

Development costs – Development and conduct of the tender processes using DPfC are likely to be bespoke and require considerable resource (particularly in the case of the initial tender processes using DPfC). Ofwat currently proposes to allow these costs as part of a water company’s allowable revenue. It may be challenging for companies to forecast these costs accurately and it will be essential that water companies have sufficient funding to carry out such development.

Duty to consider DPfC – Ofwat has stated that it expects water companies to consider the most efficient delivery model for all of their activities but where a water company is letting new and large scale infrastructure, Ofwat expects water companies to consider using DPfC (as against other relevant options). It is not clear how or what basis future projects should be assessed.

Internal concerns – Whether DPfC is delivered using the utility or contracting model revenues would likely come from or pass through the relevant water company to the newly appointed contractor. This raises a number of concerns, not least in terms of water companies balance sheets, credit rating, financial covenants and broader financial arrangements.

Conclusions

DPfC has huge potential to deliver savings for customers and to de-risk major projects for water companies. However it also raises significant challenges. Sharpe Pritchard has a wide range of procurement and regulatory experience in the public and regulated utilities sectors. We will be analysing further changes and proposals as they are released in December 2017 and will be providing services to our clients in terms of assessing DPfC and whether it represents value for money in respect of specific projects.

Update: Direct Procurement for Customers (DPfC) 06

CONTACT US

Please do not hesitate to contact us if you have any questions about DPfC going forward.

Nicola Sumner – Partnernsumner@sharpepritchard.co.uk

Nicola heads the infrastructure group at Sharpe Pritchard. She has over 20 years’ experience of advising on complex procurements, infrastructure projects, outsourcing projects, PPP and PFI projects, commercial contracts and public law. She is experienced in both PCR and UCR procurements. She is an industry leader

on major procurement for regulated utilities and played a key role on the procurements of the main works contracts and the Infrastructure Provider (IP) for Thames Tideway Tunnel. She continues to represent the successful IP, Bazalgette Tunnel Limited as well as advising on waste and water projects and she has also played a major role structuring and developing the procurement arrangements for another significant infrastructure project in the regulated sector.

Roseanne Serrelli – Partnerrserrelli@sharpepritchard.co.uk

Roseanne is head of strategy and projects at Sharpe Pritchard. She is a highly experienced projects, infrastructure and procurement lawyer who has worked on some of the UK’s most innovative and complex projects for the public/regulated sector. She played a critical role in developing the construction

documentation for the Thames Tideway Tunnel Project and continues to advise Bazalgette Tunnel Limited. Roseanne has also played a lead role in developing the construction and procurement documentation for another significant infrastructure project in the regulated sector.

Justin Mendelle – Partnerjmendelle@sharpepritchard.co.uk

Justin is the head of Sharpe Pritchard’s construction practice. He has a wealth of experience in complex procurements and major infrastructure projects. Justin advises a range of clients, including central government, regulated utilities, developers, funders and project sponsors. His practice spans energy,

waste, regeneration, PPP, EU procurement and dispute resolution. He is currently advising a major utility on a pioneering approach to the delivery of legal services.

Emyr Thomas – Partnerethomas@sharpepritchard.co.uk

Emyr is a Roll A Parliamentary agent and is experienced in drafting primary and secondary legislation whose subjects have included new licensing and registration regimes and which have changed existing enforcement systems. For example, he drafted a highways-related private Act for a local authority and

has drafted highways-related guidance on behalf of London Councils. His planning experience covers planning inquiries, advising at committee, and nationally significant infrastructure projects, including advising on the application documents for the Thames Tideway Tunnel Development Consent Order, acting for the Secretary of State in a special parliamentary procedure relating to an energy park, and advising local planning authorities and other bodies on the impacts of projects on their interests.

Steve Gummer – Associatesgummer@sharpepritchard.co.uk

Steve has a breadth of experience representing utilities, lenders, sponsors and equity providers. He has a history of working in complex regulatory environments – including rail, nuclear, water, electricity. He has worked on a range of infrastructure assets. Steve heads the DPfC workstream within Sharpe Pritchard. He

is currently working on a PF2 project in development.

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