January 2014


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Investor Meetings Sonia Brown, Chief Regulation Officer Graham Taylor, City Adviser 29 January 2014 1 Water today, water tomorrow

Where we are now Price review final methodology – July 2013 Approach to assessing business plan quality, criteria used to assess plans and incentives for high quality plans (risk-based review)

December announcement – 19 December 2013 Introduced pre-qualification stage to risk-based review. Excluded risk and reward criteria from risk-based review

Risk and reward guidance – 27 January 2014 Further guidance on the risk and reward package

Deadline for pre-qualified company to accept is 17 March

Pre-qualification announcement – 10 March 2014 Use subset of original tests to assess business plans: • Companies assessed as ‘enhanced’ ‘pre-qualify’ • Pre-qualifying companies decide whether to accept 27 January risk and reward guidance • Companies not pre-qualifying categorised as standard or resubmission in April

Enhanced company draft determinations – 29 April

Risk-based review decision – April 2014

Standard and resubmission companies draft determination – 29 August

• Enhanced – pre-qualified companies adopting risk and reward package • Standard – Includes pre-qualified not accepting risk and reward package • Resubmission

Water today, water tomorrow

2

Risk and reward in company business plans Proposed Cost of Capital

Proposed Outcomes

5.1% 4.9% Penalty & Reward

4.7% 4.5% 4.3%

Penalty Only

4.1% 3.9% 3.7%

Ofwat appointee WACC

14% 19% 68%

Ofwat wholesale WACC Dee Valley Sttn. & E. Surrey Bristol Bournemouth South Staffs South East Affinity Portsmouth Welsh Water Thames Anglian Southern Yorkshire Severn Trent Northumbrian South West United Utilities Wessex

3.5%

Wholesale - WoC Appointee - WoC

No Financial Incentives

Wholesale - WaSC Appointee - WaSC

Source: Company business plans and Ofwat guidance.

Source: Company business plans.

Water today, water tomorrow

3

Our risk and reward guidance Issue

Company proposals

Ofwat guidance

Appointee WACC

Exceed market evidence

3.85%

Retail margins: household/ nonhousehold

Wide variation

Retail household margin – 1%

Wholesale WACC

Exceed market evidence

3.7% (appointee return less retail margins)

Outperformance

Level and balance of cost performance and outcome delivery incentives (ODIs) vary

Overall return on regulatory equity (RoRE) range of +/- 3.5% to 4.5%

Retail non-household margin (England) – 2.5%, including 1.5% premium

Upside lower than expected

Resubmit ODIs with meaningful rewards and penalties as part of package

ODIs mostly reputational or penalty-only

Uncertainty mechanisms

Wide variation in approach to uncertainty mechanisms Inconsistent with a single notional industry return

Notified items only appropriate where probability of event or its impact cannot be influenced by company Greater transparency on pain/gain, sharing between customers and other stakeholders

4 Water today, water tomorrow

Composition of appointee WACC WACC inputs

Ofwat (point)

Ofwat range

Industry range

Total equity market return

6.75%

6.25% to 6.75%

6.50% to 7.25%

Real risk-free rate

1.25%

0.75% to 1.25%

1.25% to 2.1%

Equity market risk premium

5.5%

5.5%

5.0% to 5.75%

Gearing (Net Debt:RCV)

62.5%

60% to 62.5%

57% to 70%

Asset beta

0.3

0.3

0.33 to 0.40

Equity beta

0.8

0.75 to 0.80

0.84 to 1.07

5.7%

4.9% to 5.7%

6.0% to 7.9%

75%:25%

75%:25%

60%:40% to 94%:6%

Cost of new debt

2.65%

2.6% to 2.8%

0.6% to 3.5%

Cost of embedded debt

2.65%

2.6% to 2.8%

1.8% to 3.8%

Allowance for debt fees

0.1%

0.1%

n/a

Overall cost of debt

2.75%

2.7% to 2.9%

2.3% to 3.6%

Appointee (vanilla) WACC

3.85%

3.6% to 3.9%

4.1% to 4.9%

Cost of equity (post-tax) Ratio of embedded to new debt

5 Water today, water tomorrow

The importance of outperformance The Gray review noted in regard to PR09,

“…there is also some evidence that the system of incentives applied by Ofwat may be too focussed on penalties and compliance as opposed to positive incentives for desired changes of behaviour.”

Business Plan Proposed RoRE Ranges 12% 10% 8% 6% 4% 2% Range of RORE Forecast

RORE Forecast

Note: Range represents 80% confidence interval Source: Company business plans

Water today, water tomorrow

6

Opportunities for outperformance

Driver

Examples

RoRE guidance

Costs

Where companies find new or more cost-efficient ways of delivering services to customers they will be allowed to share this outperformance with their customers

+/- 2.0%

Performance commitments and ODI targets

Where companies deliver an outcome, supported by customer engagement, to a higher level of satisfaction for customers it should be possible for them to earn additional returns

+/- 1.0% to 2.0%

Service Incentive Mechanism

A relative measure of performance to assign rankings and rewards

-0.5% to +0.25%

Financing

Outperformance or underperformance against the allowed cost of capital

+/- 0.1% to 0.5%

Total

+/- 3.5% to 4.5%

7 Water today, water tomorrow

Categorisation of business plans The risk-based review is continuing to test Company • Costs categorisation • Outcomes • Affordability Enhanced • Board assurance Standard On 10 March, any companies that pre-qualify will be invited to adopt the risk and reward guidance. Resubmission Alternatively, they may choose to rework their business plans more significantly and follow the ‘standard’ price review process. Companies classed as ‘standard’ or ‘resubmission’ will also need to modify their plans in line with this guidance. Benefits of enhancement include • Acceptance of the business plan with few adjustments • A four-month head start, with Draft Determinations in April instead of August 2014 • Explicit financial incentives • Reputational benefits

8 Water today, water tomorrow

Appendix: PR14 Plan v2.3 PHASE 1:

PHASE 2:

Clarification

Restricted Communications Ofwat host company ACTS workshop (26 Sep)

PHASE 3:

Risk-based Review Categorisation Pre-qualification results and reward for enhancement announced (10 Mar) Results of risk-based review announced (4 Apr)

SIM consultation published (14 Oct) Financial model published (17 Oct)

IN Default tariffs (6 Jan) Companies’ updated cost and performance data published (9 Jan) Risk & reward guidance published (27 Jan)

Ofwat

Aug 2013

Sep

Oct

Nov

Dec

Jan 2014

Feb

Business plans submitted (2 Dec)

Prepare business plans

CCG reports submitted (2 Dec)

Company challenge via CCGs

Mar

Enhanced draft determinations and menus published (30 Apr)

Standard / resubmission draft determinations issued (29 Aug)

Standard baselines and draft menus published (30 Apr)

Standard menus published (29 Aug)

Publish default tariffs guidance (early Apr)

Apr

May

Jun

Exploring bringing forward final determinations for companies with enhanced business plans

Jul

Aug

Oct

Nov

Dec

Jan 2015

Re-bids on risk and reward received (17 Mar) Results of risk-based review announced (4 Apr) No change / minor amends to enhanced business plans

Updated business plan deadline (27 Jun) Redevelop resubmission business plans

Companies’ updated cost and performance data submitted (9 Aug)

Consultation on draft determinations Consultation on draft determinations

Consultation on draft baselines

Stakeholder collaboration with companies and Ofwat (eg environmental and quality regulators)

Companies and stakeholders Enhanced business plans

Sep

Refine standard business plans

Companies present business plans

Key:

Publish final determinations (by 12 Dec)

Standard business plans

Resubmission business plans

Guidance publication

Water today, water tomorrow

Plan elements are subject to change

10%

8% 8%

6% 6%

4% 4%

2% 2%

0% 0% Energy retail

10%

Energy¹

Water today, water tomorrow Centrica Energy Energy High HH² NHH³ street retail⁴ Telecoms⁵

Return on Capital Cross-Check: 0.5-0.9% Return on Capital Cross-Check: 0.6-1.1%

Ofwat guidance: 1.0% Ofwat guidance: 2.5%

Business Stream

Business Stream

Rail

Rail

Telecoms

Retail ISP

MVNOs Retail mobile

MVNOs + BT Retail

MVNOs + BT Retail

High street

Supermarkets

EI

NHH Energy Retail

EE

Energy retailer, no volume risk Energy retail w. volume risk

Household

HH Energy retail

Ofgem

Gas retail

Electricity retail

Energy retail adjsuted

PwC

Energy retail

Energy retail (dual) Energy retail

Energy companies

Appendix: retail margins Non-Household Oxera

Rail⁶ Water⁷

10

Appendix: wholesale WACC

Component

Point Estimate

Total allowed return

A

3.85%

Retail net margin

B

1.00%

Revenue requirement (2015-20 year average)

C

£11,194 m

RCV (2015-20 year average)

D

£64,912 m

E = B*C / D

0.17%

F

0.15%

G=A–F

3.70%

Retail return on RCV

Adjustment from appointee to wholesale WACC(1) Wholesale WACC

Source: Ofwat calculations and industry totals (1) We do not deduct the full retail return on the RCV as the legacy retail assets in the wholesale WACC will depreciate away over the AMP.

11 Water today, water tomorrow