Ofwat’s outlook is changing. For years it has prioritised keeping down customer bills. “Customers of water and sewerage and water only companies deserve excellent service at a fair price,” the UK water regulator said in 2015. But its message in its draft determination this month was very different. High up in the document it wrote that customer bills are to rise on average by GBP 19 a year over the next five years. It has left a bitter taste in the mouth for some water bosses who have been asking for such rises for years.

The bill rises are doubtless needed to improve pollution, bathing water quality, reduce leakages, and deal with other challenges. Funding major capital projects is also a key priority, particularly its direct procurement for customers programme (DPC), which involves allowing investors outside of water and waste companies competing to build projects.

The regulator expects some GBP 26bn will be invested into 18 such DPC projects, each valued at over GBP 200m, during the next five to 15 years. One such project is the longrunning Haweswater Aqueduct Resilience Programme (Harp) scheme, final bids for which are due at the end of this month. Another potential DPC scheme, which is being considered by Anglian Water and Cambridge Water, is a large reservoir in the Fens region in eastern England.

One question posed for well over half a decade is whether DPC will be value for money for customers. The regulator hopes it will be as bidders compete to win the right to design, build and finance projects based on the lowest cost of capital. “The aim of Ofwat’s DPC scheme is to increase competition in the market and thereby increase innovation and performance in the delivery of major water infrastructure projects – which will have a knock-on effect for customers, in the form of lower prices,” a recent note from law firm Watson Farley & Wiliams says. Sources point to an alleged lack of competition in the current system of water companies going to contractors for their large projects, with the projects typically handed out between the same firms.

But will DPC be cheaper? Back in 2017 KPMG wrote in a report for Ofwat that “generally investors considered that it would be difficult to beat the cost of capital of a regulated water company”.

DPC has seemingly become even less likely to be better value for money today, given the spike in interest rates that has driven up investors’ expected returns. “Unless I’m offered 12-13% returns on greenfield deals I won’t do them,” says one greenfield infrastructure investor. In contrast, Ofwat in its draft determination has proposed a rate of return of 3.72%, split between a cost of equity of 4.8% and debt at 2.84%. Water companies’ allowed return on capital for the current 2020-2025 price review is 2.96%.

One investor says: “I can’t see how the rate of return on the equity for a DPC scheme is less than 10%. Nothing is less than 10% these days. That makes a mockery if water company equity is 6%. It proves how wrong the DPC scheme is.” One water expert says that “water companies I’ve spoken to take the view that a lot of these projects would better sit with them”, largely because of the value for money question.

United Utilities, which is procuring the Harp scheme, did not respond to requests for comment. Ofwat told Infralogic that “we don’t yet know what the WACC, the cost of equity or other elements of the Harp bids are as they are still to be submitted to United Utilities under the procurement process which is underway”.

The Thames Tideway Tunnel scheme, which was akin to a DPC given it was arranged by Thames Water but investors outside water companies bid to develop the scheme, was procured at a weighted average cost of capital of 2.497%, cheaper than the regulated cost if capital at the time. But interest rates and expected returns have spiked since a consortium of Dalmore Capital, Amber Infrastructure, INPP, Allianz and DIF consortium was selected as the preferred bidder for the GBP 4.2bn TTT scheme.

“The TTT scheme was done in a different market when equity risk premium was much lower than what it is today,” says one investor, adding that the project also benefited from a government guarantee that is not expected to be given to DPC schemes.

But others argue the reality is not quite so clear cut. Water companies’ equity returns are unlevered and can be increased by raising holding company debt, point out several industry sources. One outcome of this is that it outperforms regulator assumptions about returns and boosts returns. However, water companies may struggle to raise holdco debt today as they face rising costs. Thames Water’s Holdco debt is in default. Notwithstanding this, water companies’ equity returns will be bolstered given they are inflation linked.

Water companies will also likely make a profit from the sale of these large capital intensive assets, reflected in the often high premium to RAB they have been sold for.

Water companies also are struggling for new capital, particularly Thames Water given it only has sufficient capital to last until next May and is on the hunt for new equity. This is at a time when Ofwat wants water companies to make far greater capex investments than in previous price review periods, and also at the same time deleverage. “There is a limit how much equity you can get into these companies to fund all this,” says one sector advisor. All this suggests water companies would struggle to finance the DPC schemes themselves.

Another advisor points to the “greater risk transfer away from the water companies and customers in a DPC”, adding that the same argument was made for using PFI to fund greenfield infrastructure. To give an extreme example allowing water companies to fulfil large projects themselves could pave the way for the current Thames Water difficulties to be dwarfed by future crises within water companies.

“It might cost slightly more to do DPC but in the long run it could work out a better deal,” the person adds.