Author: Mintel Group Ltd.
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Potable Water and Sewerage - UK - April 2015
Executive Summary 
 
“For the current asset management period AMP6 2015-20, water and sewerage companies have opted for alliances and framework agreements when procuring work from the supply chain. A number of new contracts also contain an option to be extended beyond the five-year period, with the longest collaboration in the industry potentially lasting up to 15 years. This trend reflects changes in the regulatory framework, which puts increased emphasis on long-term outcomes, asset life cycle management, delivering customer value and efficiencies. This has prompted the industry to work more collaboratively with delivery partners to meet new regulatory requirements and achieve greater efficiencies in delivering their business plans.”
-Claudia Preedy, Industrial Analyst

The market
Capital expenditure tends to be cyclical and determined by the five-year spending periods
Total UK capital expenditure on water and sewerage has fluctuated in recent years, with spending tending to fall at the start and end of five-year spending cycles. Capital spending initially dropped by 4% in 2010/11, but increased by a strong 17% in 2011/12 as capital investment projects planned for the AMP5 spending cycle in England and Wales got off the ground. In 2012/13 and 2013/14, capital spending rose moderately, but is projected to fall by 10% in 2014/15 as companies start to shift their focus to preparing work for AMP6 2015-20.

Workloads during AMP5 continued to be cyclical, despite the industry tendering contracts early for the period to counteract the usual delay at the start of a five-year spending cycle. However, the downturn at the start of AMP5 was not as severe as in previous periods.

Few major capital projects undertaken during AMP5 (2010-15)
Capital spending during AMP5 in England and Wales has focused on networks, capital maintenance and small projects to improve operational expenditure and energy efficiency, with a relative lack of major projects and new builds. The largest capital projects during AMP5 were undertaken by Thames Water as part of the London Tideway Improvement Programme, including the construction of the £635 million Lee Tunnel.

FIGURE 1: UK capital expenditure on water and sewerage services, 2009/10-2013/14
  
Source: Ofwat, individual company annual reports and MBD estimates

Non-infrastructure maintenance spending dominates sewerage capital expenditure
Expenditure on non-infrastructure maintenance accounts for the highest proportion of sewerage capital expenditure in England and Wales, representing 35% of the total in 2013/14. Investment in sewerage infrastructure enhancements increased by 20% in 2012/13 and 26% in 2013/14, partly reflecting the construction of the Lee Tunnel by Thames Water.

Non-infrastructure maintenance spending accounts for nearly 40% of water-related capital expenditure in 2013/14
In 2013/14, water and sewerage companies in England and Wales invested £656.2 million in water-related infrastructure renewals, accounting for 30% of capital expenditure during the year. Spending on infrastructure enhancement projects represented a further 15% of capital expenditure, at a value of £321 million.

FIGURE 2: Analysis of sewerage capital expenditure in England and Wales by water and sewerage companies, by type, 2013/14
  
Source: Individual company annual accounts

FIGURE 3: Analysis of water capital expenditure in England and Wales by water and sewerage companies, by type, 2013/14
  
Source: Individual company annual accounts

Move towards total expenditure in AMP6 2015-20 to reduce bias towards capital programmes
For the current asset management period, running from 2015 to 2020, Ofwat has introduced a move towards total expenditure (totex), combining capital and operational expenditure. Ofwat believes this will remove a bias toward capital programmes, as capital expenditure has often been preferred over operational expenditure in delivery solutions due to the design of the regulatory framework. The move towards totex should encourage companies to deliver solutions as efficiently as possible.

Shift in industry focus towards asset management and maintenance
High expenditure on capital projects in recent asset management periods reflected a focus on replacing and upgrading a largely antiquated asset base and investments to meet new EU legislation, such as the Urban Waste Water Directive. This has increased capital expenditure on building new facilities, including treatment works, interceptor sewers and outfalls. Many of these capital projects have now been completed and the industry is shifting its focus towards operating, maintaining and managing these assets, and ensuring that inefficiencies are minimised during such activities. With the shift towards totex, effective asset maintenance will become increasingly important as prolonging the life of existing assets will be favoured over capital replacement.

Total capital expenditure projected to reach £23.4 billion during AMP6
Total capital expenditure by water and sewerage companies is projected to reach £23.4 billion over AMP6, equivalent to 58% of the totex allowance. Annual capital expenditure is expected to peak in the middle part of the five-year spending cycle at almost £5 billion in 2017/18. Spending is expected to then fall in the following two years to £4.2 billion in 2019/20, a decline of 14% compared with 2017/18. 

£4.2 billion Thames Tideway Tunnel to represent largest capital project over next decade
The largest capital project during the next decade will be the construction of the 25km Thames Tideway Tunnel (TTT) by Thames Water. This major £4.2 billion project is designed to tackle the problem of London’s sewers overflowing into the tidal River Thames and is necessary to secure compliance with the Urban Waste Water Treatment Directive. The government gave the project the official go-ahead in September 2014. The main construction period of the tunnel is expected to start in 2016 and be completed in 2023. In February 2015, three joint ventures were selected as the preferred bidders to build the west, central and east sections of the tunnel, with the contracts expected to be formally awarded in the summer.

FIGURE 4: Capital expenditure in the water and sewerage industry during AMP6 in England & Wales, 2015/16-2019/20
  
Source: Ofwat and individual company data

Market factors
The driving force for capital expenditure programmes in the water and sewerage industry in the last two decades has undoubtedly been legislation, mainly EU directives. These required the implementation of substantial capital expenditure programmes by all of the UK’s water and sewerage service providers, as well as by other bodies, such as the Environment Agency, which is responsible for environmental regulation and regulating drinking water quality under the Drinking Water Inspectorate. Key directives affecting the industry are listed below.

Water Framework Directive (WFD)
The WFD took effect from December 2000 and was put it into law in the UK by December 2003. The directive requires the water industry to meet environmental quality standards, and in some cases, higher water quality standards. This has increased investment in sewerage treatment plants by the water and sewerage industry to meet its stringent regulations. Defra estimates the total cost of implementing the Water Framework Directive at around £30 billion over 43 years. It is estimated that 40% of the cost will be from water companies in direct infrastructure and management spending.

Urban Waste Water Treatment Directive (UWWTD)
The directive was adopted in 1991 and member states are required to implement it through national legislation. The directive is designed to reduce the pollution of freshwater, estuarine and coastal waters by domestic sewage and industrial wastewater – collectively known as urban waste water. The directive also sets minimum standards for the collection, treatment and discharge of urban wastewater, and establishes timetables for the achievement of these standards. The legislative requirements of the UWWTD have resulted in significant capital enhancement investment in sewerage treatment plants in the last two decades. However, capital spending associated with the directive has slowed in recent years as most major projects have been completed.

FIGURE 5: Sewerage treatment enhancement expenditure driven by UWWTD in England & Wales, 1990-2015
  
Source: Defra

Revised Bathing Water Directives to necessitate further investment by water & sewerage companies

The Bathing Water Directive aims to preserve, protect and improve the quality of the environment and protect human health while bathing in all relevant waters. The latest revision of the bathing water directive will be fully implemented by 2015 and will set higher standards for bathing waters, which are likely to prove challenging for the water and sewerage industry to meet. A number of companies have included investment in their AMP6 business plan to help ensure compliance with the higher standards. United Utilities plans a £100 millionplus programme of work over the next five years to upgrade the sewer network along the Fylde Coast and clean up the sea off the coast of Blackpool.

Water retail market to open up to all business customers in England & Wales in 2017
The Water Act 2014 is a major step in the government’s liberalisation of the water industry and its provisions. A key area of the act is the introduction of retail and upstream competition in the water sector from 1 April 2017. From that date, all businesses, charities and public sector customers in England will have the freedom to switch suppliers, and different parties will be able to enter the water industry as retail providers. Changes under the act should also make it easier for new providers of water sources and sewerage treatment services to enter the upstream market with the aim of stimulating efficiency and innovation. These changes, however, are not expected to be introduced until after 2019, following the opening of the retail market. The government has not expressed any intention to expand competition to include household customers.

Companies
There is a clear move towards long-term thinking across the water and sewerage industry, largely driven by changes to Ofwat’s approach to five-year asset management periods and the integration of 25-year strategic plans into companies’ five-year business plans.

The move towards long-term thinking has changed the way water companies are procuring firms to deliver work during AMP6, with many opting for alliances or frameworks that run beyond the traditional five-year AMP period. Although a number of companies started to embrace alliances and frameworks during the last spending cycle, AMP6 requires water companies and their supply chains to be even more integrated and collaborative to achieve desired outcomes through the most efficient solutions possible. 

During 2013, some water and sewerage companies appointed delivery teams for AMP6 so they could hit the ground running when Ofwat signed off the funding. Thames Water formed an alliance to deliver AMP6 work in May 2013, while Severn Trent and Yorkshire Water extended contracts with their current delivery partners to AMP6 during 2013. A number of framework agreements and supply chain contracts now also include the option to be extended beyond the five-year review period, with the aim to maximise collaborative working and efficiency. For example, Anglian Water’s new supply chain contracts, which started in April 2015, are expected to run for 15 years, with a review every five years. This represents one of the longest collaborations in the industry. 

AMP6 investment plans also tend to be designed with a consistent profile of expenditure, rather than the ‘boom and bust’ profile that has traditionally characterised water companies’ investment plans. This should enable the supply chain to resource and plan work more efficiently and, in turn, deliver cost savings.

Successful partnerships between water companies and their supply chain will depend on building close integrated relationships and having fully aligned long-term goals with a strong emphasis on collaborative teamwork, innovation, efficiencies and long-term outcomes and values.

What we think
For the current asset management period (AMP6 2015-20), a number of changes have been introduced in the regulatory environment, which will shift the industry’s approach to infrastructure investment. The most significant is a focus on total expenditure (totex) rather than capital expenditure, which means effective asset maintenance will become increasingly important, as prolonging the life of existing assets will be favoured over capital replacement.

For AMP6 and beyond, there is also an increased emphasis on outcomes rather than outputs and a more long-term approach to strategic planning. This changes the way the industry procures firms to deliver work, with an increased emphasis on collaboration and integration across the supply chain. The industry has already started to move towards long-term alliances and framework agreements that last longer than the five-year regulatory period. Many signed supply contracts for AMP6 include options for extensions beyond the five-year period. For example, Anglian Water’s supply chain contracts are expected to run for 15 years, with a review every five years, representing one of the longest collaborations in the industry. 

Changes to the regulatory environment will also force the industry to become more customer focussed and focused on delivering customer value, with water companies having to interact and engage more with customers and local communities. Water companies will also have to justify their investments in terms of how they benefit customers.

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