Baringa and Yorkshire Water broach cost and service performance link in Future Ideas Lab paper

Baringa and Yorkshire Water have submitted a paper to Ofwat’s Future Ideas Lab exploring the relationship between service performance and costs, and developing potential approaches for linking the determination of efficient costs with the setting of performance targets at PR24 and beyond.

At PR19, Ofwat determined its totex allowances for companies independently of its determination of Performance Commitment (PC) targets and Outcome Delivery Incentives. Baringa and Yorkshire reflected that this uncalibrated approach to setting targets “raises challenges, as the combined totex and performance incentives are fundamental to the balance of risk and reward for companies”. They pointed out in particular that the assumption that inefficiency underpins differences between companies’ costs on common PCs ignores factors outside of management control and “different asset management strategies across companies including lumpy investments, time lags, and mixes of capex and opex solutions”.

The paper went on to explore approaches to quantifying the cost-service relationship and how it might be incorporated into PR24, including by suggesting the following guiding principles:

• start from the premise that changes in activity and performance are likely to correspond with changes in costs;

• acknowledge the uncertainty in calculating the cost service relationship and consider options for both PR24 and future price controls;

• cost-service trade-offs should be analysed on an individual (or cost area) basis and only incorporated into determinations where robust;

• double counting of stretch and productivity should be avoided; and

• long-term stewardship of assets should be incentivised.

Baringa and Yorkshire also considered the regulatory levers that could be applied, specifically relating to performance target adjustment or cost allowance adjustment, commenting that customer preferences could help determine the appropriate approach.