Dr Tony BallanceDirector, Strategy & Regulation, Severn Trent

DELIVERING THE FUTURETHE ROLE OF INCENTIVES

THE ROLE OF INCENTIVES

Does PR19 create the right incentives for the future - and how does this impact on the

resilience of the sector?

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III

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I PR14 – The changes introduced - and how this affects how we operate

PR19 Framework – what does the future hold?

Conclusions on the future role of Incentives

Agenda

PR14 – WHERE ARE WE NOW?

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PR14 saw a paradigm shift - that transformed water regulation - similar to Ofgem’s RIIO (Revenue = Incentives, Innovation & Outputs)

OpexRCV

Capex

Concept of Totex breaking the link between capital spend and RCV

Creation of Customer Challenge Groups and greater customer engagement

requirements

Upside rewards

Base return

Downsidepenalties

Previously PR14

Upside rewards

Base return

Downside penalties

Stronger link between performance for customers and returns to investors through Outcome Delivery Incentives (ODIs)

Retail NHH

Water

Retail HH

Waste

Separate price controls and competition Assessment of plans with benefits from being assessed as “enhanced”

Single price

control

Enhanced

Resubmit

Standard

PR14 IS DELIVERING BENEFITS FOR CUSTOMERS IN AMP6

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We embraced the incentive regime 12 months before AMP6 began –and without a cultural step change, we would be significant losers

All 5,500 employees taken offline and briefed on the need for change - and internal incentives realigned

We also undertook significant structural changes:

➢ empowered people, with more dynamic decision making and less lead time to respond to issues

➢ allowed us to reinvest in additional front line resource and invest in proactive service

• Variable WACC dependent on quality and challenging targets in company business plans

• Past performance taken into account

WE RECOGNISED THE REGULATORY FRAMEWORK NEEDED TO EVOLVE

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• Realistic rewards through sensible application of benchmarks

• Greater use of in-period ODIs• Increased financial power of ODIs• No dynamic adjustment of ODIs

• No caps applied to forecast totex spend

• Cost benchmarks at Upper Quartile (UQ)

• Limited company specific adjustments

ODIsCost Assessment

Output Incentives

Financing

We set out our views on how PR14 incentives could be taken forward at PR19 in “Charting a sustainable course” (April 2017)

All underpinned by excellent customer engagement

• Continued role for output incentives where they relate to large schemes

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PR19 FRAMEWORKOFWAT’S VISION FOR THE FUTURE

Many of the proposals build on PR14 and enhance the incentives for companies to deliver better services to customers at a lower cost

• Continued use of benchmarking• Uncapped ODIs with indicative RoRE

range of +/ 1-3%• Greater use of in-period revenue ODIs• No resetting dynamic adjustment

• Continued use of benchmarking • No capping for companies better

than the benchmark• Two way adjustment for special

factors

• Cost of new debt indexed• Application of CPI(H)• Higher returns for ‘exceptional’

plans

All underpinned by higher quality customer engagement

• Common ODIs linked to asset health

• Potential bespoke measures for specific projects

ODIsCost Assessment

Output Incentives

Financing

Ofwat has sought to strengthen the Performance Commitment (PC) and ODI regime at PR19

• 14 common PCs across a number of areas• 4 PCs (water quality compliance, supply interruptions, internal sewer flooding and pollutions) will be set comparatively by

reference to the 2024/25 UQ • Companies can propose “super charged” ODIs, but they must be delivering UQ or better performance

PLUS:• SIM is replaced with a new customer experience measure that assess satisfaction for those who contacted and did not

contact a company• Requirement for bespoke commitments covering: vulnerability, environment, resilience & sustainable abstractions• The 2% RoRE cap will be abolished with an ODI indicative range of 1-3% of RoRE

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PR19 FRAMEWORKPCS AND ODIS

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PR19 FRAMEWORKCOSTS

• Cost envelop set using econometric models based on frontier companies for wholesale and retail

• Fewer special cost factor claims & symmetrical adjustments

• Potential new approach to cost sharing – asymmetric adjustments, ‘truth telling’ incentive replaced with incentives for low cost plans

The cost assessment builds on the PR14 methodology - with a new approach to cost sharing

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PR19 FRAMEWORKRISK AND REWARD

• Expected reduction in the cost of equity due to lower total market return over 2020-25 compared to historical returns

• Indexation of cost of new debt to A and BBB non-financial 10+ year bonds

• Transition from RPI to CPIH• Tax pass through for significant changes in

elements of tax framework

The risk-reward package is being rebalanced with much greater emphasis on totex and service incentives

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THE PR19 FRAMEWORK IN BRIEF

We support many of the PR19 proposals and consider that they will drive better outcomes for customers:

• Greater emphasis on customer engagement and recognition that customers should be active participants in the sector, helping to develop and deliver solutions to some of the big challenges that we face

• Strengthening cost and service incentives by removing the totex and ODI caps • Greater use of in-period revenue incentives • Proportionate approach to regulation of the non-household retail sector

However, there are two areas where how the methodology is implemented is crucial to deliver the right outcomes for customers - and create a more resilient sector

• Incentivising innovation by ensuring that the balance of risk and reward is appropriate - and not too heavily tilted to penalties – and in due course creating the “right package”

• Ensuring regulatory requirements are proportionate and targeted

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PR19 FRAMEWORKTHE BALANCE OF RISK AND REWARD

We find evidence that an organization’s focus on rewarding success is positively associated with radical innovation while an organization’s focus on penalizing failure is positively associated with incremental innovation

We are sympathetic to the suggestion that the balance of risk and reward is tilted too far towards uncertain and potentially large penalties for failure, with relatively limited rewards for outperformance or innovation

Review of Ofwat and consumer representation in the water sector, 2011. David Gray

Carrots or Sticks? The Effect of Incentive Framing on Radical and Incremental Innovation. Chen, C. X., Lill, J.B, & Lucienetti, L.

Innovation requires a the right balance of risk and reward

This is not to say that targets and efficiency challenges should be easy!

However, a focus on penalties leads to culture of incrementalism - and that won’t be sufficient to meet the challenges of the future, to create a more resilient sector

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PR19 FRAMEWORKTHE BALANCE OF RISK AND REWARD (2)

The balance of risk and reward needs to be coherent - and not weighted too heavily towards penalties

The current proposals infer a stronger focus on penalties – this is likely

to deliver short term benefits but may not deliver more radical longer

term change

• the wholesale cost benchmarks based on the frontier companies

and include a further dynamic efficiency challenge;

• the retail cost benchmark will be set on a similar basis, with

additional challenges through the benchmarking of bad debt costs

against other sectors - and no automatic adjustment for inflation;

• comparative PCs are set on the basis of 2024/25 UQ with no glide-

path;

• non-comparative PCs are set on the basis of a range of stretching

metrics; and

• a UQ adjustment to embedded debt was flagged as being under

consideration at the PR19 webinars.

Set the efficiency challenge based on top 4/5 companies (for water) and use more powerful cost sharing to drive frontier

Incorporate a glide path to make the journey more realistic – which in-turn might promote more challenging targets

Adjust embedded debt so customers share in the benefits of outperformance – but which doesn’t penalise companies for the timing and tenor of existing debt issuance

To create a more balanced package:

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PR19 FRAMEWORKENSURING PROPORTIONATE REGULATION

At the start of the Water 2020 journey Ofwat reminded stakeholders about its principles for setting prices:

The PR19 methodology progresses many of these principles – however, there is an opportunity to go further

There is a risk that regulation which is too prescriptive and promotes a culture of:• Regulator-dependence rather than customer focus• Risk aversion with companies waiting to be told what

to do

To enable companies to respond to the challenges of the future and create a more resilient sector it is important to reduce regulatory prescription where possible

• Targeted price controls

• Effective incentives

• Proportionate price setting

• Ownership accountability and

innovation

• Flexibility and responsiveness

• Transparency and predictability

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PR19 FRAMEWORKENSURING PROPORTIONATE REGULATION (2)

We have identified 3 key changes that we think would enhance the regulatory framework and promote stronger incentives and a culture for innovation

Super-charged ODIs• We are very supportive of the principle• However, innovation involves risk• Mandating that companies share innovations with

competitors is not how markets work• This could undermine the incentive by reducing the

benefits from risk taking

Bio-resources• The incentives appear to be very effective – importers

and exporters stand to benefit from trading • Customers benefit when prices are reset at PR24• Mandating that companies need to submit sludge

trading strategies doesn’t appear to add value • Creates risk that companies become risk averse, looking

for Ofwat to sign off on future strategies

The initial assessment of business plans –innovation test• We support the desired outcome but think there is a

better means – getting the incentives right• Mandating that companies submit information on

“innovations” including the people and processes involved will not promote innovation

• It will however encourage companies to describe lots of things as being innovative without delivering benefits to customers

• Innovation will be reflected in the outcome – lower prices and higher service levels

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THE FUTURE OF INCENTIVESCONCLUSIONS

• PR14 – was a big step forward, linking performance more closely to both customer needs and investor returns

• PR19 Framework – marks another big step forward and includes a clear and sensible set of principles for future regulation

• There is still opportunity to ensure the implementation delivers the right outcomes:– the balance of risk & reward – and the “overall package”– ensuring proportionate and targeted regulation

• This would promote more radical innovation and allow the sector to respond to the challenges of the future – whilst ensuring bills remain affordable