Water Sector Infrastructure using DPC: Does the CAP fit?

The Haweswater Aqueduct Resilience Programme (“HARP”) project achieving initial financial close and moving to the ‘build’ phase, along with the re-publication in May of Ofwat’s Final Determinations for the 2024 Price Review, has focused attention in the infrastructure community on the market opportunity offered by the ‘Direct Procurement for Customers’ (“DPC”) model.  

QMPF has explored the nature and scale of the market and the commercial and financial aspects that participants will need to continue to monitor as opportunities emerge. 

DPC Procurement: the basic structure 

DPC is a procurement process in which a Competitively Appointed Provider (“CAP”) is selected to design, build, finance, maintain, and operate water sector assets. The CAP is appointed by a regulated water company (the “Appointee”) but finances the asset independently and operates outside the Appointee’s regulatory ringfence. This structure is intended to bring new expertise and capital into the sector, while keeping the regulated company focused on its core operations. Ofwat has provided a diagram to illustrate this structure: 

Where is DPC procurement expected to be used? 

DPC is expected to be used for capital projects that meet two main criteria: a size threshold, where total lifetime expenditure (“totex”) exceeds £200 million, and a discrete project test, which requires the project to be distinct and separable from the company’s existing network and operations. Ofwat encourages companies to consider combining smaller projects to meet the size threshold. While the previous requirement to compare DPC with in-house delivery has been dropped, companies must still demonstrate value for money throughout the procurement process.  

Where does SIPR fit in? 

The Specified Infrastructure Project Regulations (SIPR) remain an alternative procurement route, particularly for larger or more complex projects. The delivery of Thames Tideway Tunnel demonstrated the potential of the SIPR delivery route and three PR24 projects have been identified as more appropriate for the SIPR model. The key distinction is that under SIPR, the Infrastructure Provider (“IP”) is directly regulated by Ofwat and holds a distinct license. However, SIPR involves higher setup and regulatory costs, so Ofwat expects most projects to be delivered via DPC, reserving SIPR for cases where direct regulation offers clear advantages. In-house delivery remains possible for a limited number of projects, subject to Ofwat approval.  

What can we expect to come to market? 

With Ofwat’s updated guidance, a significant number of projects are expected to come to market under the DPC model. HARP serves as an early example, and Ofwat has identified 23 projects in its PR24 Final Determinations that are likely to be procured through DPC. This pipeline represents a substantial opportunity for investors and service providers in the sector: 

The pipeline is analysed below: 

Source: QMPF analysis, Ofwat PR24 Final Determinations 

What tender models are being considered? 

Ofwat recognises that different projects may require different approaches to selecting a CAP, referred to as the ‘tender model’. In some cases, the CAP may be appointed early, taking on responsibility for design, surveys, planning, procurement, build, and operation. More commonly, however, the CAP is chosen later, after the Appointee has completed initial design and planning. Ofwat also allows for a ‘split’ model, where separate CAPs are appointed for initial design and for delivery and operation. To date, DPC projects have tended towards later appointment of the CAP, with the Appointee retaining responsibility for initial design, planning, surveys and in some cases both detailed design and initial elements of procurement, with the CAP brought in later. The choice of model has important implications for risk transfer and project delivery and will be shaped by the specific needs and risks of each project. 

Financial structure and risk 

Ofwat’s guidance on DPC leaves room for negotiation regarding financing risk. It acknowledges that, given the long-term nature of water sector projects and current economic conditions, not all funding and cost risks can be transferred to the CAP. The threshold outturn cost approach is used to manage funding requirement risk, allowing the CAP to benefit from cost savings while providing protection against significant overruns, with some risk ultimately passed to customers. Mechanisms for adjusting payments based on the market cost of debt and sharing refinancing gains are also discussed, drawing on lessons from the Thames Tideway project.  

This could result in the CAP retaining the financial benefit where it can deliver the project within the threshold outturn, but has protection, through amendment to the CAP charge payment (and so passing of the risk to customers) where there are significant cost overruns.  It is clear this will remain a critical aspect for the market to understand through the procurement process and to document in concluding the CAP Agreement and will be subject to significant due diligence through the fund raising process and funder engagement processes. 

Similarly, the mechanisms for ‘market cost of debt’ adjustment will require to be negotiated. Again, Thames Tideway may provide guidance; its financing cost adjustment worked on the basis of protecting the IP for movements in the underlying real cost of debt outside of a cap and collar and with a presumption in relation to the proportion of debt and equity in the project. For Thames Tideway the movement was with reference to a benchmark index. The agreement of the relevant index used, the extent of the cap and collar and establishing the timing of benchmarking will be critical for market participants. 

Refinancing risk may be more straight forward. There is an increasingly standardised approach to refinancing gain share that Ofwat anticipates seeing from DPC project: 90% of gains from margin enhancement and 50% of other relevant refinancings, flowing back to customers through a CAP charge reduction. 

Other financial considerations include inflation, requirements of debt funders and payment mechanisms reflecting the nature of the asset and provision (e.g. availability only, or with demand components and reflecting the extent of ongoing maintenance/operations relative to capex and how that manifests in both debt structure and CAP payment indexation). The significant asset life anticipated will require consideration of residual value and handback requirements. As DPC projects emerge we also anticipate further attention on what might be the optimal project duration, both reflecting the asset and financing options, to deliver best value. 

Other risk allocations 

The specific risk allocation is expected to vary by project and will be subject to the negotiated CAP Agreement in order that Appointees have flexibility to achieve best value for customers. However, Ofwat’s guidance to Appointees offers insight into the initial risk allocation that can be anticipated: 

What have we learnt from HARP? 

HARP, and the work undertaken by United Utilities, Cascade Infrastructure (Strabag-Equitix Consortium) and their advisers, demonstrates the potential for the DPC structure to deliver projects to start of construction, in relatively short timescales.  

The commercial positions accepted by each party will likely emerge as the project progresses, but we expect there has been an element of pragmatism to reach this stage and deliver a positive outcome. Should the commercial positions hold water (no pun intended) they may provide a framework for future projects. This is particularly true where those projects may be less complex from a delivery perspective, have lower funding requirements and shorter construction phases. 

However, the HARP project is not without uncertainties. The extent to which funding for the full construction programme is secured remains to be confirmed and the financing cost for all stages is expected to only be known as the project moves forwards. How the changes in market funding costs and construction cost changes are shared, and the extent to which they are passed on to water customers, will only be known with time.  

The reaction to this outside of the infrastructure sector will matter. It will be of importance to all in the sector, including both CAP partners and the water companies, to provide third parties with clarity on the risk transfer achieved and the value for money the DPC approach offers. This will set the platform for further delivery of critical and much needed infrastructure. 

The ability of the DPC structure to move to financial close on complex projects, to share risk appropriately and to recognise that the risks in relation to holding funding costs and construction costs could be shared in a different way, but offer better overall value for money, provides potential lessons across the wider infrastructure sector. 

How can QMPF help? 

QMPF has over 20 years practical experience supporting private sector and public sector clients delivering infrastructure development under a range of financing structures, from PPP/PFI through LIFT, NPD and hub. We understand the commercial complexities to be negotiated, routes to delivering a robust funding club and the financial modelling that underpins equity, debt and procurer analysis. Our experienced team would be delighted to discuss DPC and wider infrastructure opportunities with you.

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