Regulation of regional water companies and spatial dependence

As water companies in England and Wales are monopolies, their costs and maximum prices are regulated. This involves the regulator (Ofwat) setting efficient base cost allowances for the companies. To calculate these allowances, Ofwat uses non-spatial cost models to benchmark the companies’ cost efficiencies. There are parallels between companies’ supply areas and the spatial dependence between neighbouring European NUTS regions. To account for the spatial dependence between neighbouring companies’ costs, we augment Ofwat’s models with spatially lagged independent variables. In some models a spatial variable is significant. We, therefore, suggest using a mix of spatial and non-spatial models to set the aforementioned allowances. This would change the financial environment some companies face in the next 5-year regulatory period (2025–30). Specifically, this would lead to increases (decreases) in the allowances of some companies and, other things unchanged and in turn, increases (decreases) in the maximum prices they can charge.