Ofwat moots mechanism to mitigate downside skew on outcomes returns
Ofwat is consulting until 4 November on a new idea for potential inclusion at the PR24 Final Determinations that could address downside skew in the price review’s outcomes package. Downside skew has been raised as a concern by multiple parties in their representations on the Draft Determinations.
The proposed Outturn Adjustment Mechanism (OAM) would be applied at the end of the period to all Outcome Delivery Incentives (ODIs), including those measuring customer experience. It would adjust the realised equity returns for all companies, based on the outcome performance of the median company, measured as a proportion of regulated equity.
Ofwat explained the OAM would ‘rebase’ the sum of positive and negative returns for the median company so that they netted out overall, meaning the base return would be earnt at the median but no more or less. This would have the effect in turn of rebasing the sum of returns for all companies: half earning positive returns to add to their base return, and half incurring negative returns that subtract from their base return.
The regulator also offered an alternative: it could make an adjustment scaled to, say, 50% that would mitigate variations from the base allowed returns, but not fully correct the distribution.
Ofwat said the aim of the mechanism would be to ensure that, “across the sector, there is a spread of out and under performance against the base allowed return, minimising the risk of systematic upside or downside skew in the calibration of the outcomes package. This should ensure the overall impacts are fair to both customers and investors.”
However, it highlighted the drawbacks too. These included increased uncertainty associated with the impact on equity returns of outturn performance. “Put simply, under the OAM, the ultimate reward or penalty for performance by a company will depend not only on its own performance but also on the performance of other companies. Companies will not know this in advance. Therefore, they will also not know in advance the impact of their performance on their returns. This may make it challenging for companies to make investment or other management decisions.” Furthermore: “As companies become aware of the performance of other companies, it may impact their incentives to improve performance in the latter years of the period.”
Ofwat called for views. Investors at Moody’s conference last week are understood to have been positive about the proposal.
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