Practical Law

Historically, companies in regulated sectors like electricity, water and rail have carried out the design, build, financing and operation of their own projects. Recently, there has been much talk of a concerted shift away from this practice, as regulators look to replicate the efficiencies of competitive markets. Why? Because various sector regulators see the introduction of competition for major new developments as a means of encouraging regulated utilities to economise and innovate, with the goal of delivering better and cheaper service for consumers.

Various models for competition have been mooted, but the latest answer is direct procurement. This blog, the first in a series of posts on direct procurement, explains what direct procurement is and where it is headed.

What is direct procurement?

Direct procurement means encouraging (in the case of water) or, in some cases, requiring (as in the case of offshore energy) competitive tenders for the design, build, financing and/or operation of projects which previously would have been carried out by the regulated companies themselves.

The resulting intensified competition is intended to reduce cost, spur efficiencies, demand innovative solutions and result in a better outcome for the consumer in terms of price and service. It represents not only a new opportunity at the infrastructure level to design, build and potentially operate plant, but also opens up a significant playing field for potential investors.

Existing direct procurement initiatives

Direct procurement has gained varying degrees of traction in the offshore and onshore electricity, water and rail sectors. Set out below is an overview of its adoption so far. The extent to which it can be used depends on various factors, including the licensing and regulatory regime for the sector and the types of project being contemplated.

Electricity – Offshore transmission owners (OFTOs)

OFTO competition is the flagship example of successful direct procurement. Its success may stem from the fact that offshore transmission is a relatively new and fast developing field, making it an ideal space for the introduction of direct procurement.

Facing challenging renewable energy targets, Ofgem recognised that significant investment in the renewables sector would be required. Accordingly, it adopted a novel approach to the development of transmission with licences granted to new offshore transmission assets via a competitive tender process, partnering energy generators with the most efficient and competitive players in the market.

The first tenders to appoint OFTOs began in July 2009. Since then there have been 15 transmission networks transferred to new OFTOs. The latest phase, Tender Round 5, which started in October 2016, enables bidders to compete to own the transmission assets of five offshore wind farm projects, which are currently being constructed by an offshore windfarm developer. The process will result in the appointment of an OFTO to own and operate the transmission system. Note however that all the OFTOs tendered to date have been of the “late” variety; that is, the OFTO does not design or build the system (and so is not directly exposed to construction risk), but merely takes on the asset once it is operational.

The scale of financial savings as compared to non-competitive tendering are huge, totalling between £683m and £1.1bn for the three tender rounds.

Competitive Appointment Transmission Owner (CATO)

Building on the success of the OFTO model, Ofgem is currently looking at introducing direct procurement to onshore transmission networks.

Since the RIIO-T1 price control settlement in 2013 (which sets out what transmission network companies are expected to deliver for energy consumers from 2013-2021), Ofgem has regulated the delivery of new large onshore transmission projects through its Strategic Wider Works (SWW) mechanism. This allows transmission owners to bring forward large investment projects where funding has not been awarded as part of the price control settlement.

In addition to the SWW mechanism, Ofgem would like to introduce CATO competition for new, separable, high value (over £100m of capital expenditure) projects. Under Ofgem’s current proposals, third parties would be allowed to tender for the build, financing and operation of transmission assets. However, the CATO regime appears to have hit a road-block, in part due to Brexit. New legislation is required to implement the CATO regime but, with Parliament’s focus on Brexit, CATOs are not a top priority for parliamentary time.

However, the introduction of direct procurement is not at a standstill. Ofgem continues to consider alternative methods of introducing competition into the transmission network and is pushing forward the changes required to enable competitive tendering, such as the legal separation of National Grid’s electricity system operator functions from its transmission owner functions to avoid accusations of unfair advantage.

Water

The Thames Tideway Tunnel – the so-called £4.1 billion “super sewer” project – is the first water or sewerage project to utilise a degree of direct procurement. Bazalgette Tunnel Limited (which is owned by a consortium of infrastructure investors) won a competitive tender to finance, build, manage and operate the tunnel, and is owned by a consortium of infrastructure investors.

Ofwat is also seeking generally to promote direct procurement in the water market, in order to unlock combined savings of some £400 million and £850 million over a 5 year period.

In May 2016, in the Water 2020 report and in a recent consultation paper, Ofwat confirmed that direct procurement will be introduced in its next price review. Water companies will be strongly incentivised to use direct procurement for large, discrete, high value capital projects with a whole-life totex (operating and capital expenditure) value of more than £100 million.

Ofwat has not prescribed the detail of the direct procurement model. Instead, it has left it to the water companies to decide whether their proposals for projects subject to direct procurement should include initial design and whether there will be an ‘early’ or ‘late’ tender. Whilst there is flexibility around the model, Ofwat expects regulated companies to operate the tender process and does not propose to regulate developers directly. Rather, the regulated company will procure the services under a contract with the successful bidder.

Rail

For some time, the Office of Rail and Road (ORR) has allowed small-scale infrastructure projects to be delivered by parties other than Network Rail under its third-party investment framework. This has seen significant third party investment in various areas, particularly in station works.

However, the government, the ORR and Network Rail are looking to increase private financing within procurement of larger scale rail infrastructure, with a focus on ways in which major projects can be financed and delivered by companies other than Network Rail. The topic has been considered in various reports, including most recently the Hansford Review. Despite all the reports, there are not yet any developed, clear plans for direct procurement in the sector.

The Hansford Review found there to be significant barriers to third party investment, but that Network Rail could engage third party suppliers to deliver projects at lower cost or better value for money. In particular, it noted that a major challenge will be identifying projects that can attract investors through the promise of their own revenue stream.

Network Rail has responded to the Hansford Review, affirming its commitment to open itself up to competition and list opportunities for outside companies to build and invest directly in Britain’s rail infrastructure.

Final thoughts

There is clearly significant appetite on the part of both government and regulators to increase direct procurement. Given the magnitude of potential savings, as demonstrated by the OFTO regime, objections are likely to be quickly cast aside (or overruled). Direct procurement offers significant opportunities for regulated entities, who may see improved access to finance; for developers and investors, who will be able to participate more actively in the market; and ultimately for consumers, who should benefit from cost savings and improved innovation. Careful planning and preparation will be required to ensure that these benefits are felt across the board.

In our next blog, we will look at the commercial structuring aspects of direct procurement.