Turning the tide: 5 key takeaways for companies and investors on Cunliffe’s proposed reforms for the water sector in England & Wales

After months of intense scrutiny and stakeholder engagement, the Independent Water Commission (the Commission), set up by the UK Government and chaired by Sir Jon Cunliffe, has published its final report on reforming the water sector in England and Wales. 

The Commission proposes 88 recommendations representing “a once-in-a-generation reform programme”, covering a wide range of proposals including in relation to the strategic direction for the water system, systems planning, legislative and regulatory reform, ensuring water companies act in the public interest, and infrastructure / asset health.  

The UK Government has already indicated that it will take forward key recommendations, including abolishing sector regulator Ofwat and the system of regulation of water companies is set to be transformed significantly. 

Below we set out five key legal and regulatory themes of particular interest to water companies and their investors.

1. Creation of a single integrated regulator for the water sector 

• New integrated single regulator: the most headline-grabbing point has been the Commission’s recommendation to establish a new integrated regulator in England, combining the functions of Ofwat, the Drinking Water Inspectorate (DWI) and water functions from the Environment Agency and Nature England. The Commission has recommended embedding economic regulatory functions in respect of Wales in Natural Resources Wales. The Commission envisions a single regulator that can oversee a water company’s operations holistically, establishing a ‘whole firm view’ of performance issues and compliance failures.
• A merger will take time to be implemented: structural change requires primary legislation. The Commission notes that, by way of example, Ofcom was established over the course of three years and two Acts of Parliament, combining the duties of five different regulators. If it takes as long as the Ofcom process, the new regulator may barely be constituted by the time the next price control review (PR29) kicks off in earnest. The Commission appears to have recognised this, and recommends considering a short “bridging” price control between the end of the current price control cycle and the next – or extending the current PR24 price controls.

2. Increased regulatory oversight of water company ownership and governance

• The identity of the owners, rather than the ownership model per se, is key: while nationalisation was excluded from the scope of the review, the Commission examined a range of ownership models and concludes that the ownership model per se is not a good indicator of performance, but that the business model of the owners plays an important role in company outcomes. The Commission takes the view that the water industry is likely to be best served by investors that “take a long-term, low return-low risk investment approach”. To that end, and as discussed below, the Commission has recommended (among other proposals) a rationalisation of the outcomes package, intended to reduce the volatility of returns.
• Change of control powers strengthened: the Commission recommends that the regulator should have the power to block material changes in control of water companies, but only for changes in ultimate controller where there are material concerns about risking the water company’s performance of its public duties, “for example, due to the ultimate controller’s financial soundness, reputation, governance or competence”. The Cabinet Office is currently consulting on including water companies within the mandatory notification requirements under the UK’s existing National Security and Investment regime.  While Commission considers this may “provide additional assurance”, it implies it is insufficient as it relates only to national security and proposes that the regulator will have broader grounds for blocking changes of control, such as on the basis of the concerns outlined above. 
• Additional powers to direct owners: the Commission recommends giving the regulator a power to direct parent companies and ultimate controllers which would empower it to prevent owners from taking action that would undermine resilience.
• Increasing accountability in the licences: the Commission recommends that the regulator mirror elements of the Articles of Association in licence conditions, including inserting a public benefit clause. The Commission also states that additional guidance or licence conditions may be needed to reduce uncertainty with a social purpose licence condition. The Commission disagrees with proposals to introduce a dividend cap, instead agreeing with Ofwat’s existing approach, whereby companies must show that dividend levels appropriately reflect company performance.
• New regime for senior executive accountability: the Commission recommends establishing a new regime for senior executive accountability (drawing from, but streamlining, a similar regime applicable in the financial services sector), including introducing a principles based Code of Conduct that includes behavioural characteristics such as acting with integrity. The Commission proposes that the regime would apply to only a “very… narrow set” of senior managers in water companies comprised of the Chair, CEO, and executive level leaders responsible for finance, environmental and drinking water standards, and compliance with licence conditions. 

3. Improving investability and financial resilience 

• Recommendations aimed at improving the attractiveness of the sector: the report identified the key issues affecting the attractiveness of the water sector to investment, including low levels of return, high levels of risk and the impact of regulation, particularly since long-running investigations create uncertainty over the sector’s attractiveness to investment. The Commission consequently put forward a number of recommendations related to investability – for example, that water regulators should conclude long-running investigations and enforcement cases as soon as possible as part of a sectoral reset.
• Recommendations aimed at improving the financial resilience of the sector: the Commission identifies three key issues with financial management: oversight of company finances (given concerns over debt levels), the lack of an effective recovery regime, and questions around the Special Administrative Regime (SAR) as a credible “option of last resort”. To address these issues it makes a number of proposals to improve financial resilience, including that:
  • the regulator acquires power to set minimum capital levels;
  • a formal turnaround regime should be established to support turnaround of poorly performing companies; and
  • the regulator develop and consult on a framework for ensuring companies are prepared for SAR.

4. Proposed sweeping changes to economic regulation to attract investment 

• Water company WACC has been relatively low compared to other sectors: the Commission has recognised that between 2020 and 2024, the weighted average cost of capital (WACC) has been relatively low in the water industry when compared with other sectors, which is at least partly attributable to “issues with Ofwat’s WACC methodology”. The Commission notes that the Competition and Markets Authority (CMA) increased the WACC for the four companies that requested redeterminations at PR19.
• A common WACC methodology: in response, the Commission has recommended that the CMA be given the responsibility to set a common WACC methodology for all regulated sectors in England and Wales for non-sector-specific components. The new water regulator would still apply the sector-specific inputs to the methodology and independently set appropriate gearing levels for companies, but it would be expected to transparently justify its decision-making in following or deviating from the CMA-set parameters.
• Reduced flexibility on spending: currently, companies can allocate spending allowed in price controls rather freely (the “totex” approach). The Commission has recommended that companies should clearly define spending into three buckets: (i) base capex (including asset replacement), (ii) base operational expenditure (such as energy and labour costs), and (iii) enhancement expenditure (investments that improve services) – and under the proposals, companies would not be able to divert allowances from one bucket to another.
• Rationalising the outcomes package: the Commission states that Ofwat’s current approach to outcomes is complex and unpredictable. The Commission suggests a simple framework of around 10 common performance commitments, as well as price commitment levels to ensure that company-specific factors are taken into consideration. The Commission considers that the performance commitments should not overlap with enforcement on environmental and water quality performance, avoiding a duplicative exercise where companies can be penalised twice. The Commission considers that this system would put less investor capital at risk and reduce the volatility of returns.
• Change to the price control dispute process: the water industry currently has a price control dispute process whereby the CMA undertakes a full redetermination, rather than a standard appeal process applicable in other sectors such as energy (which is focused on correcting ‘errors’). The Commission recommends switching from the redetermination to the appeal process for the water sector.

5. Proposed legislative reforms to rework important environmental standards

• Updated legal framework: the Commission recommends a fundamental overhaul of the legal scaffolding that governs the water sector, calling for a modern, integrated legislative framework that supports system-wide regulation, long-term planning, and consistent delivery.
• A single set of wastewater standards: one key example of an area requiring reform is the multiplicity of environmental laws and regulations related to wastewater. For example, the Urban Waste Water Treatment Regulations 1994 (UWWTR) have been the subject of enforcement action throughout the industry. The Commission recommends that the objectives of the UWWTR should be aligned with those of the Storm Overflows Discharge Reduction Plan (SODRP) in England to ensure that there is a single set of standards to establish compliance.
• Further environmental standards: the Commission also recommends that a further review should consider whether there is a need for stricter treatment requirements, given growing evidence on emerging pollutants such as PFAs, microplastics and other micropollutants, and in light of EU reforms to equivalent legislation.

Next steps

The report already appears to have been a catalyst for change. In its immediate response to the report, the UK Government has said it will take forward a number of the report’s recommendations immediately, including abolishing Ofwat, establishing a new consumer ombudsman, enhancing spills transparency, and increasing regional involvement in infrastructure investment and system planning.  The Government will additionally:

• this autumn, publish and publicly consult on a White Paper containing its full response to the report;
• issue an interim strategic policy statement to Ofwat and a transition plan for the establishment of the new regulator; and
• bring forward a new water reform Bill early during the lifetime of this UK Parliament.

Please get in touch with our team of UK water regulation specialists should you want to discuss this report or any related matters in more detail.