Ofwat has launched a new consultation on possible approaches to setting outcome delivery incentives for the 2024 price review (PR24).
Ofwat has launched a new consultation on possible approaches to setting outcome delivery incentives for the 2024 price review (PR24).
The water sector has published a discussion paper which considers how to set outcome delivery incentives (ODIs) for PR24. The ODIs provide financial payments to water companies from customers for performing beyond their committed levels of service – known as outperformance payments, or from companies to customers for performing below their commitments - underperformance payments.
The ODIs are linked to performance commitments (PCs), the metrics that measure the service that water companies deliver for their customers and the environment.
Each PC has a committed level of performance set by Ofwat in the price reviews, known as a performance commitment level (PCL).
The focus of the discussion paper is on Ofwat’s approach to ODI rates for common PCs, together with a focus on PCs based on the delivery of outcomes rather than mechanisms that hold companies to account for the delivery of specific schemes or outputs.
Ofwat has suggested calling the mechanisms Price Control Deliverables (PCDs) and will cover them separately in the PR24 draft methodology.
The water sector regulator uses financial ODIs provide incentives to deliver key outcomes through the prospect of underperformance and outperformance payments. The water companies also have reputational incentives to meet or exceed their PCLs.
Ofwat says in the discussion paper that the use of ODIs can help to:
- balance competing incentives, such as those to reduce expenditure, which could otherwise encourage companies to reduce their levels of service and not meet their PCLs;
- compensate customers where they receive below committed levels of service by returning the foregone value to customers through underperformance payments;
- incentivise companies to go beyond their PCLs where there are clear benefits for customers (i.e. where the costs of delivering better service levels are less than or equal to the benefits from such an improvement); and
- encourage stretch and innovation where companies seek returns by finding better ways of delivering and improving their performance, which improves outcomes for customers within a price review period and also enables Ofwat to set more stretching PCLs in future price reviews
In developing its approach for PR24, the paper says there are a number of issues the regulator needs to consider, including two challenges in terms of marginal costs, which Ofwat used to set ODI rates
in the 2019 price review.
1. Availability and reliability of marginal costs estimates
The paper says that during PR19, Ofwat observed wide variations in companies' submitted marginal costs - which it found challenging to assess. For example, one company estimated the marginal cost of a sewer collapse to be £106m per 1,000km of sewer while another estimated £0.083m per 1,000km of sewer. “We do not expect significantly improved marginal costs data will be available at a PC level for PR24, and we are likely to face similar challenges in assessing it”, the paper states.
2. Reliability of marginal benefit estimates
Ofwat also observed wide variations in companies' estimates of marginal benefits at PR19 for the same PC and performance increment, which “could not easily be explained by customer preferences or local circumstances.” For example, Ofwat found one company's customer valuation for water supply interruptions was 42 times greater than that of another company.
For PR24, the paper says that Ofwat is expecting collaborative customer research with the water companies to provide “more accurate and consistent estimates.”
Options for standard ODI rates
The paper also consider two broad approaches to setting ODI rates:
- bottom-up approaches, set at the level of each PC, primarily based on estimates of customer benefits, or potentially using cost estimates where necessary; and
- a top-down allocation approach, where ODI rates are derived from a company's overall potential payments informed by customers' priorities and regulatory judgement.
Ofwat discusses both approaches separately in the paper because they are in principle distinct, “though there may be potential for using both approaches at PR24, for example using a top-down approach for a subset of ODIs where there is weak evidence of customer benefits or costs.”
The rgulator says it could also take different approaches for outperformance and underperformance rates, for example setting a higher share of marginal benefits for underperformance rates compared to outperformance rates. According to Ofwat.this would provide strong incentives on companies to meet their PCLs and would provide greater compensation for the customers of companies that underperform their PCLs.
Asset health-related PCs are more challenging
Ofwat also explores asset health-related PCs, which it describes as more challenging. The paper says:
“ In principle, the existence of customer-facing PCs, and our commitment to maintain them over time, should incentivise companies to maintain their asset health to avoid underperformance payments in future years and price review periods.
“However, as we note in our November 2021 consultation on PCs, we are concerned that companies may not put sufficient weight on the long-term consequences of poor asset health and so consider it necessary to directly incentivise asset health through more short-term PCs, such as mains repairs and sewer collapses, as at PR19.”
The paper says that a bottom-up approach to ODI rates for asset health-related PCs could be based on:
- direct customer valuation of asset health – from customer willingness to pay research;
- inferred marginal benefits – by allocating valuations from relevant customer-facing metrics to asset health-related PCs; or
- marginal costs.
Ofwat will consider responses to the consultation ahead of publishing its draft methodology for PR24 in July 2022, with the final methodology due to be published in December 2022.
The regulator will then specify ODIs and their relevant PCs as part of setting price limits for the 2025-30 period in the PR24 final determinations.
Deadline to submit responses to the discussion paper is 25th March – click here to download the paper in full.
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