The Regulated Asset Base (RAB) model is a framework that is used to set the prices we pay via bills, for regulated utilities. This model also exists in the gas and electricity networks, rail, broadband, and London’s Heathrow and Gatwick airports.
Under their RAB, agreed with the regulator for each sector, utilities recover the borrowing costs of capital and operations over the life of each company’s regulated assets, plus a return on investment. They are guaranteed a profit despite remaining private companies.
In the next five-year spending period, water companies across England and Wales are currently gearing up to place contracts totalling at least 50 billion pounds of work on engineering and infrastructure across the water network. This investment will run for five years from April 2025, following allowed spending of £51bn in the sector in the current five-year period.
The water industry’s own figures claim £160 billion has been spent on water infrastructure in the UK since privatisation in 1989 (CIWEM and Water UK, websites visited on 04/09/2023). Yet we are all aware of the pollution of our seas and rivers in recent years, and that infrastructure, despite upgrades and the costs paid via bills, has not kept up with the adaptations required. Where has the money gone?
A steaming pile of debt
The cost of debt is part of the answer: while sewage has been repeatedly released into the English Channel and the UK’s rivers and coastal waters, most of us have now received a crash-course in water company finances, becoming aware that our drinking water and sewerage suppliers are heavily indebted. Throughout this period dividend payments have continued. Sandra Laville writing in The Guardian quoted a total of £14.7bn taken in dividends between 2010 and 2022, averaging £1.8 billion per year, based on 2022 prices.
Underlying the rising company debt, the lack of investment on the scale needed, and the apparent reluctance to deploy nature-based solutions to water supply and sewage disposal, is the Regulated Asset Base model.
Impact of the Regulated Asset Base model
When, as consumers, we pay our water bill, we pay for the cost of the water and sewerage service we receive, plus allowances, permitted by Ofwat, for various additional elements, including:
- operational costs,
- the cost (under an Ofwat scheme to incentivise customer service) of any reward to the company for exceeding customer service targets, as The Guardian reported recently, and
- the ‘cost of capital’, also known by other names, including the ‘Weighted Adjusted Cost of Capital’ (the ‘WACC’), the financing cost, the cost of money or the borrowing cost.
The physical assets transferred to the water companies at privatisation were given a value, against which the companies borrow. When the regulated utilities were privatised, the companies held little, if any, debt, and the value of the infrastructure transferred into their ‘Regulated Asset Base’ became theirs to provide collateral for debt, that is, borrowing money from banks and investors to run their companies. It is worth remembering, that some of that water and sewage infrastructure was built and funded by the Victorians, and so was paid for, via public investment, over 140 years ago.
Subsequent investment in ‘hard engineering’ – pipes and treatment plants – has added to the value of physical assets, thereby increasing collateral to allow yet more borrowing. Alongside this, the allowances mentioned above, endorsed by the regulators, create guaranteed revenues for the regulated utilities, providing further collateral, and facilitating the high level of borrowing we have seen right across the water industry.
The effect of this, with the water companies granted full reimbursement for their financing cost, is that RAB incentivises them to take on debt.
Bias towards hard engineering at the cost of landscape solutions
Why has the money we have paid through bills not delivered investment with multiple positive social outcomes?
The funding could, in theory at least, be used to reduce sewage discharges by deploying ‘nature-based solutions’ for sustainable urban drainage, flood mitigation and water quality improvement. Natural vegetation could retain water within watersheds, offer natural filtration through freshwater ecosystems such as reedbeds, and water replenishing aquifers. All this would create opportunities for restoration of nature, and offer public amenity space, too.
Sounds idyllic, doesn’t it? Not just a desirable vision, but essential to our survival, as climate change increases flood risks, rising sea levels increase storm surge risk and parts of England become increasingly water stressed. This isn’t far-fetched, either: the water industry is already to some extent using natural water overflows and storage on new developments, but they currently have an extra incentive for ‘hard engineering’: new pumps and centralised treatment plants.
As a society we may prefer ‘soft’ landscape engineering for its environmental benefits. But, even if it could deliver at lower cost, it still wouldn’t happen often enough, because the regulatory model underpinning the regulated utilities fails to counteract this bias towards investment in hard engineering. It would appear that this is at least in part because the companies use the additional collateral which hard engineering provides for yet more borrowing, knowing that the interest on this debt will continue to be met by us, their customers, via our bills.
How does this affect the service we receive?
The RAB model permits what many feel is excessive borrowing and fails to actively support environmentally beneficial approaches to water treatment. It can also lead to inflated spending on infrastructure: utilities have an incentive to overstate the cost of their assets in order to maximise their return on investment.
The model is also inflexible: once prices have been set and agreed by regulators, the model would then require regulators to make detailed assessments of the complex costs, changes in market conditions, in services rendered to consumers and delivery of infrastructure before making any changes. The sewage releases are an example of this: the cost of managing elevated water levels was not delivered by the aggregate infrastructure agreed under previous price reviews, so the water resulting from storm surges is released into rivers and the sea, in the absence of an alternative planned management strategy.
RAB is complex, but its impact is simple. As consumers we pay for both services received and socialised risks: the risk that companies will borrow heavily to increase their physical asset base, continue to pay dividends, and that they underinvest, resulting in failure to deliver sewage treatment, flood defences, and water storage in the landscape to supply water through seasonal drought.
You might ask: why has RAB allowed this level of industry-wide debt to exist? The utility regulators, including Ofwat, and the government, need to answer this question.
Increasing bills, excessive borrowing, and failing services. Under the current regulatory model, utility regulators are required by the government to apply the RAB model. In the water sector at least, it would seem that RAB is ripe for a re-think.