PR19 draft methodology: key point analysis

July 17, 2017

Ofwat, last week, published its draft methodology for the next price control review in 2019. ON the day THE WATER REPORT issued its key point analysis which follows here.

 

Themes
Four well trailed themes set the framework: affordability; resilience; customer service;  and innovation.

 

Business plan assessment

 

Four categories will be used

  • Exceptional status – high-quality plans with significant ambition and innovation for customers.

  • Fast track status – high quality plans, but which are not ambitious and innovative enough to attain exceptional status.

  • Slow track status – plans where material interventions are required in some areas to protect the interests of customers.

  • Significant scrutiny status – plans which fall well short of the required quality and where major interventions are required to protect the interest of customers.

The top two categories will receive their draft determinations in March/April 2019; the bottom two in July 2019. Exceptional plans will also receive a financial reward set at 0.2% of RORE. Significant scrutiny plans to receive disincentives: reduced cost sharing rates (see Incentives package below) and possibly capped ODIs. Not all categories will necessarily be used. 

 

Nine factors are to be prominent in Ofwat’s assessment of business plans: affordability and vulnerability; long-term resilience; cost assessment; customer engagement; outcomes ; risk and return; markets and innovation; past delivery; and confidence and assurance. 

Cost of capital

  • Ofwat to publish its initial view on PR19 WACC in December 17. In this draft methodology, it signals base returns will be significantly lower than at PR14. 

  • Less focus on historic trends in setting the cost of equity.

  • Fixed allowance for embedded debt, with new debt indexed to reduce the scope for purely financial outperformance. 

  • Wholesale cost of capital to be set in reference to an efficient notional structure. 

  • Cost of capital to be consistent across the industry. High bar to be set for any exceptions - eg small company premium.

  • Cost of capital to be set at company level and then a cost of capital set for each wholesale control with reference to this. 

  • Household retail controls to be set with reference to a margin covering EBIT. 

Inflation - CPIH

  • Transition to CPIH index proposed. This is the consumer prices index plus housing costs. Revenues to be linked to CPIH; 50% RCV at 1 April 2020 to remain RPI indexed with the rest (plus all new RCV added after 1 April 2020) indexed to CPIH. 

Incentives package
Ofwat has proposed an overall incentives framework, with the following key financial incentives:

  • Business plan assessment – a financial reward, set at 0.2% of RORE, will be applied to exceptional plans. Plans under significant scrutiny could be subject to a less advantageous cost sharing rate. 

  • ODIs - rewards and penalties within a -3% to +3% RORE range (see details below)

  • Totex cost assessment – menus to be scrapped and instead asymmetric cost sharing rates to be introduced under which companies with the best plans and who subsequently deliver the most efficiencies keep a greater share of outperformance gains. Illustrative RORE range of +/-2% based on 10% cost out/under performance (-3% to +1% for significant scrutiny companies). 

  •  C-MeX and D-MeX (see SIM replacement section below) – overall impact +/-0.5% RORE

  • Financing - less scope for financing outperformance as the cost of new debt to be indexed; still scope for outperformance on embedded debt. 

Interim determinations
High evidential bar set for Notified Items. No presumption that PR14 Notified Items will apply. 

 

Outcomes

  • Significant development of the common Performance Commitments (PCs) consulted on last year. Fourteen common PCs proposed, with far greater focus on resilience (two common PCs devoted to resilience and a further four to asset health). 

  • Additional bespoke PCs permitted but some must-cover areas have been earmarked, including: vulnerability, environmental impact, resilience and the Abstraction Incentive Mechanism.

  • PCs to be made more stretching; at least upper quartile performance expected for some common PCs including on sewer flooding and supply interruptions. 

ODIs

  • Incentives to be beefed up: overall range for value of ODIs to be increased to -3% - +3% RORE. PR14 design restrictions to be removed. 

  • Financial ODIs and in-period incentives to be the default; companies expected to smooth bill impacts. 

  • Earning rewards will challenging; average performance is likely to incur a penalty.

  • Super rewards to be available for frontier-shifting performance on common PCs. 

SIM replacement
Two new mechanisms to replace the SIM:

  • C-MeX – For domestic customers. Companies to be assessed on both performance with customers who make contact and more general customer satisfaction. More contact channels including social media to be factored in. In period incentives to be applied. Higher rewards available for companies which demonstrate upper quartile performance in comparison to other sectors in UK Customer Service Index.

  • D-MeX – To measure developer satisfaction. Mechanism in development. 

No measure to gauge retailer satisfaction with wholesalers at this stage. 

 

New markets and form of the price controls

  • Plans for water resources and bioresources markets confirmed, including separate price controls and information platforms for each market to facilitate trades. RCV to be allocated across the wholesale controls as previously trailed. 

  • The water resources control will be a total revenue control with RCV protected up to 31 March 2020. Companies will be required to propose access prices for each Water Resource Zone. 

  • The bioresources control will be an average revenue control with RCV protected up to 31 March 2020. 

  • Remaining wholesale controls separated into “network plus water” and “network plus wastewater”. These will be total revenue controls, set on broadly the same basis as the wholesale controls at PR14.

  • There will be a separate price control for Thames Tideway. 

  • More detail on plans for direct procurement of the financing, design and delivery of new £100m+ whole life totex assets by third parties. Focus on projects likely to deliver the greatest customer value. Tender model to be decided. 

  • Retail controls to run for three years. Weighted average revenue control to be used for residential retail in England and Wales and business retail in Wales. Ofwat is considering continuing to set business retail controls in England – if taken forward this would follow the PR16 approach.

Customer engagement
Ofwat expects a “step change”  in customer engagement: use of a wider range of techniques; a move towards customer participation; and strengthened role for Customer Challenge Groups. 

 

Affordability

  • Affordability will be assessed in three ways: overall affordability, affordability in the long term, and affordability for those struggling/at risk of struggling to pay. Ofwat will use five principles to assess the affordability of business plans: customer engagement, customer support, effectiveness, efficiency and accessibility.

  • Vulnerability will be an explicit part of the price review for the first time. Business plans will be assessed on how well companies use good quality data; how well they engage with other utilities and organisations to support the vulnerable; and how targeted, efficient and effective their measures to address vulnerability are. Bespoke PCs on vulnerability required. Companies to be required to develop common measures for addressing vulnerability, and to report on the data they gather. 

Resilience

  • Ofwat sets out its understanding of resilience, as “resilience in the round”.

  • It has developed seven resilience principles which set out its expectations for business plans. 

  • It has proposed two specific initial business plan assessment tests on resilience: one looking at the identification and prioritisation of risk and the other at risk mitigation. 

Cost efficiency 

  • High expectations of efficiency improvements. 

  • Menus scrapped and replaced by cost sharing incentives (see Incentives package section above)

  • Efficient cost baselines to be set, using a dual top down and bottom up approach. These will incorporate an element of catch up efficiency and a frontier shift, and will have no glide-path. Adjustments to be made both upwards and downwards for special cost factors and expected improvements in efficiency in the period to 2025.

  • Special modelling provisions for enhancement expenditure to take account of less robust benchmarking.

  • In the retail controls, Average Cost to Serve approach to be scrapped in favour of a benchmarking approach to setting efficient cost baselines, drawing on evidence from other sectors. No indexation to a general measure of inflation.  


Delivering Water2020: Consulting on our methodology for the 2019 price review

 


 

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