Water today, water tomorrow

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Outcomes, risk and reward workshop 9 April 2014

1 Water today, water tomorrow

Agenda and timings 1

Welcome and introduction (10.00)

2

Outcomes – risk-based review tests and results (10.10)

3

Outcomes – feedback on ODIs (10.40)

4

Outcomes – Q and A (11.30)

5

Risk and reward – overview (11.50)

6

Process going forward – outcomes and risk and reward (12.05)

7

Q and A (12.30)

8

Next steps (12.50)

2 Water today, water tomorrow

About this workshop Following the announcement of the risk-based review results, we are holding a series of workshops across the elements of the business plan The purpose of these sessions is to provide companies with the opportunity to raise questions with the Ofwat team. We are doing this in a workshop format to allow us, and companies, to use time effectively and efficiently Our objective is to support companies to understand our approach and our requirements. We want to help companies to improve aspects of their plans, to address any gaps identified during the risk-based review, and to continue to take ownership and accountability of their plans The workshop materials will be put on our website, along with the main points/questions and answers, without attribution. There will be no detailed meeting note 3 Water today, water tomorrow

Why outcomes, risk and reward? Outcome delivery incentives are central to ensuring that company’s are incentivised to deliver stretching performance commitments in customer interests

ODIs are a key element of the company’s overall risk and reward package

To develop appropriate set of ODIs, we expect companies to follow requirements of methodology statement and take account of risk and reward guidance 4 Water today, water tomorrow

Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

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Outcomes – risk-based review tests and results Following our January risk and reward guidance, we focused our risk-based review tests for outcomes on two key areas: 1. Customer engagement (CE)/willingness to pay (WTP) 2. Performance commitments (PCs) The following slides: Provide an overview of the customer engagement/ willingness to pay and PC tests (listing the key assessment criteria for each test) Summarise the risk-based review results in these two areas Outcome delivery incentives remain a key part of the price control methodology – the slides in section 3 provide a reminder of the methodology and feedback from our initial checks of company business plans 6 Water today, water tomorrow

Customer engagement and willingness to pay – the RBR test The test for customer engagement and willingness to pay had three key assessment criteria, each of which looks at a number of strands Key is not only to evidence quality of process, but also to demonstrate how the results have been used to shape the outcomes and incentives Key assessment criteria 1.1

1.2

Interpretation of criteria

Customer engagement

Process of engagement Breadth, accessibility and CCG support Link to business plan

Wider engagement

Engagement process Support from other regulators Whether issues addressed

Willingness to pay

Process to gather information Quality of results Other impacts (including inflation) Mapping onto PCs and ODIs

1.3

Water today, water tomorrow

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Customer engagement and willingness to pay – the RBR results Test 1: Customer engagement and WTP results

1

1

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2 3

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ANH WSH NES SVT SWT SRN TMS UU WSX YKY AFW BRL DVW PRT SBW SEW SSC SES

A

B

C

D

Broadly positive picture companies have embraced the importance of customer engagement and worked closely with CCGs Strong performance on customer engagement and WTP test, with almost all companies passing two of three test criteria Evidence on how WTP estimates used to shape details of plan less convincing for some companies However, overall, results do show significant step forward in the sector’s approach to regulation 8 Water today, water tomorrow

Performance commitments – the RBR test (part 1) The test for performance commitments had eight key assessment criteria The first four are about checks that are applied at plan or element level Key assessment criteria

Interpretation of criteria

2.1

Allocation of commitments

Allocation of shared commitments across elements

2.2

Minimum requirements – SIM, AIM and leakage

Compliance with July 2013 methodology statement

2.3

Consistency with statutory obligations

Evidence from other regulators Relevant coverage

2.4

Assumptions regarding anticipated statutory requirements

Uncertainty investigated Reasonable assumptions made

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Performance commitments – the RBR test (part 2) Three of the four remaining criteria are in-depth analytical checks applied to individual PCs The final criteria concerns companies’ plan to measure and assure their performance Key assessment criteria

Interpretation of criteria

2.5

Value for money

Robust CBA used across different options Performance level chosen is most beneficial

2.6

Justification for proposed performance levels

Links to track record (or other explanations if new measure) Explanation of how future level chosen

2.7

Longer-term customer and environmental interests

Whole life options and costs considered Long-term issues and short-term priorities

2.8

Measurement and assurance

Measurement, audit and assurance. Governance and accountability Transparency and independence

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Performance commitments – the RBR test (part 3) In order to ensure that the tests focused on the most important parts of the packages of outcomes, the relative significance of individual PCs and ODIs was assessed Test scores gave a higher weight to high and medium significance PCs Significance was based on three attributes: Customer priority Incremental totex ODI reward Each attribute was assessed as high, medium or low significance The overall significance was the highest of the three individual attributes 11 Water today, water tomorrow

Performance commitments – the RBR results (part 1) Test 2: Performance commitments results (water) 1

1

3

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2

2

2

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2 3

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3

3

2

4 3

3

1

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1 4 3

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2 3

5

5

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3 2

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2 4

5 5

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4 3

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2

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2 1

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2 1

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1

ANH WSH NES SVT SWT SRN TMS UU WSX YKY AFW BRL DVW PRT SBW SEW SSC SES

A

B

C

D

Results show overall promise, but are also more mixed Two companies did achieve the admittedly high bar and pass all tests Performance on the four checks applied at plan/element level was generally good However, on the in-depth analytical checks, performance did vary considerably

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Performance commitments – the RBR results (part 2) 5 companies provided convincing evidence on value for money

Results for in-depth analytical tests and measurement/assurance tests

8 companies provided sufficient evidence on track record 7 companies passed longerterm interests Only 5 companies passed measurement and assurance Two common issues: Failure to evidence Methodology not followed (and alternative not explained) Water today, water tomorrow

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

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ODIs – reminder of the context The need for revisions to original proposals January guidance made clear that original proposals did not sufficiently align the balance of risk and reward with best interest of customers Although we recognise the importance of views expressed by customers and CCGs on financial incentives, we have concerns on how discussions were framed In particular, we also need to consider evidence that companies explored of trade-offs with lower base cost of capital, and explained the benefits of incentives As a result of need for companies to revise proposals, ODI testing not undertaken during risk-based review We have undertaken checks that were precursor to tests and are sharing specific results with each company We will use this session to provide reminders of what our methodology requires, highlight some key themes of concern and provide some illustrations of good practice 15 Water today, water tomorrow

ODI requirements – July 2013 methodology statement Figure 5 Methodology consultation framework for determining incentives (p68)

“The framework summarised in figure 5 recognises the role of non-financial incentives. At the same time financial incentives (without trade-offs) provide the strongest and clearest protection for customers. So we continue to consider it is appropriate that companies need to justify, with evidence, where they propose either non16 financial incentives or trade-offs between incentives.” (page 69 final methodology) Water today, water tomorrow

ODI requirements – July 2013 methodology statement (1) The characteristics of effective ODIs are outlined in the four key assessment criteria for the ODIs test: 1. Conform with methodology, underpinned by strong customer engagement and supported by robust evidence on WTP and costs 2. Appropriate balance of risk and rewards, with rewards earned for delivery beyond STRETCHING performance targets 3. Customers protected with appropriate compensation for any under-delivery 4. Calibration with other regulatory incentives including totex efficiency sharing

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ODI requirements – July 2013 methodology statement (2) Appendix 1 provided worked examples to illustrate detailed choices on incentive structuring Limits on rewards and penalties (caps and collars) Neutral zones (deadbands) Choices to be supported by detailed evidence Our final methodology also made clear that it is possible to depart from methodology, provided strong explanation and evidence

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ODIs – key themes of concern (1) Demonstrating effective outcome delivery incentives Companies should focus on two aspects of ODIs when revising their submissions. Specifically, that the proposed incentives are effective, and that their effectiveness is demonstrated in the evidence presented

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ODIs – key themes of concern (2) The initial checks identified six different themes with the ODIs in company business plans: 1. Overreliance on non-financial incentives 2. Absence of financial rewards 3. Failure to link customer willingness to pay (WTP) with the scale of incentives 4. Inappropriate scaling of incentives 5. Inappropriate use of neutral zones (or dead-bands) 6. Failure to explain how ODIs are calibrated with other performance incentives These themes are described in the slides below, followed by some illustrations of good practice

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Theme #1 – overreliance on non-financial incentives Observed theme Around 68% of all proposed ODIs were non-financial incentives Explanations often focused on other regulatory incentives or a lack of direct WTP estimates. However, in many cases, the justification presented appeared unconvincing Possible approaches If company believes other regulatory incentives are sufficient, it should evidence the sanctions that would occur and show that these would be sufficient to compensate customers for under-delivery If no direct valuation of PC available, use other relevant WTP (modified as necessary) or consider alternatives such as cost based incentive rates Companies must describe what is done and evidence why appropriate 21 Water today, water tomorrow

Theme #2 – absence of rewards Observed theme Only 14% of all proposed ODIs had financial rewards Some instances reflected need to ensure overall plan affordable, but more often, reason cited was lack of customer and/or CCG support Possible approaches Better engagement around benefits of improvements in service beyond stretching targets with explanations of how resulting performance benefits could be shared Better engagement around the overall package of risk and reward and trade-offs available

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Theme #3 – scale of incentives not linked to WTP Observed theme Link between WTP and incentive rate not explained or unclear Lack of detail on how component elements weighted into single measure Possible approaches Companies need to evidence how incentive rate derived – for example its own or other WTP evidence Companies also need to explain any translations – for example, moving from number of supply interruptions to average minutes lost per household Where an ODI relies on performance across a range of elements, the company needs to explain what the elements are and how the incentive is determined

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Theme #4 – scaling of ODIs Observed theme Several examples of companies scaling penalties and rewards to be similar to those currently delivered by SIM Some companies imposed this principle from outset, but presented no evidence as to why this complied with methodology and WTP Possible approaches We recognise that it is important to understand the potential implications of rewards and penalties But where company believes that scaling is necessary, it must provide a clear explanation together with evidence demonstrating consistency with customer WTP evidence and methodology

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Theme #5 – use of neutral zones Observed theme Several instances where companies set very wide dead bands – in some cases at P10/P90 expected performance levels With dead bands effectively “switching off” incentive mechanism, creates potential risk that companies gain financially by delivering less than committed performance level Possible approaches Companies must provide evidence to show how dead bands derived and why they are appropriate Companies should also explain options considered – for example, whether average performance based measure would be more effective

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Theme #6 – explaining calibration used Observed theme It did appear the companies understand calibration with cost incentives But in many cases, companies did not comment or evidence how they applied this methodology to their proposed ODIs Companies also relied on existence of other regulatory incentives to make (silent) case for reputation only incentive – but they did not evidence whether potential sanctions created effective incentives across range of potential performance levels Possible approaches Companies must describe what is done and evidence why appropriate If company believes other regulatory incentives are sufficient, it should evidence the sanctions that would occur and show that these would be sufficient to compensate customers for underdelivery 26 Water today, water tomorrow

Illustrations of good practice #1 Not relying on non-financial incentives where customers are not fully protected ODI parameter AMP6 performance % commitment Incentive rate - penalty £m/year

Presented in BP 99.95

Updated proposal 99.95

Change from BP No change

n/a

0.72

Penalty collar Penalty deadband

n/a n/a

n/a n/a

Annual

AMP6

Set at greater than 3 times the potential annual avoided cost No change We have not included a penalty deadband in the ODI design This will be a pass/fail annual assessment with any penalties rolled up and applied at PR19 as a single adjustment to RCV

% %

Timing of incentives

Source: Affinity Water R and R submission ODI parameter

2019-20 performance commitment Incentive rate - penalty

Presented in BP

Updated proposal

Change from BP

%

85

84.7

More precise figure

£m/year

n/a

0.71

AMP6 penalty collar

%

n/a

79

Penalty deadband

%

n/a

83.7

AMP6

AMP6

Included a penalty based on WTP Penalty collar at current level (metering will not go down) Added in a penalty deadband of 1% The penalties accrue annually but will be assessed at the end of AMP6

Timing of incentives

Source: South West Water R and R submission

Both are examples of companies proposing additional incentives where customers are not fully protected Water today, water tomorrow

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Illustrations of good practice #2 Appropriate use of financial rewards SWT

Wholesale water

Wholesale wastewater

Household retail

Reward and penalty

6

5

1

Penalty only

7

6

0

Non-financial incentive

8

6

3

21

17

4

Total AFW

Wholesale water

Household retail

Reward and penalty

3

1

Penalty only

5

0

Non-financial incentive

3

1

11

2

Total

Based on South West and Affinity Water’s final R and R submissions Rewards are a strong economic tool They encourage innovation and increased efficiency Ofwat has no pre-determined ratio it considers appropriate Water today, water tomorrow

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Illustrations of good practice #3 Good use of neutral zones (or dead-bands)

Source: Affinity Water R and R submission

Company revisions have balanced customer engagement and R and R guidance Company removed deadband on penalty 29 Reward deadband ensures performance is stretching Water today, water tomorrow

Illustrations of good practice #4 Linking customer willingness to pay (WTP) with the scale of incentives Company supported the data with convincing explanatory text Clear evidence of:

Source: Ofwat adaptation of Portsmouth Water document

The source of the raw WTP figure, explanation and justification for any adjustments to this figure, evidence of calibration with the cost performance incentive, visibility of the potential rewards/penalties in each year for different levels of performance

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

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Questions and answers

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

33 Water today, water tomorrow

Risk and reward package Our July methodology statement: Explained that we would use a single notional cost of capital Noted the lower trend in cost of equity and debt Invited company proposals on change protocol Explained we would use scenario modelling to analyse risk, with request for information on company exposure to risk In our risk and reward guidance, we said that business plans proposed WACCs too high along with low levels of incentives for outperformance. We set out our views on the cost of capital, and retail net margins Returns

Point estimate

Appointee WACC

3.85%

Wholesale WACC

3.70%

Retail household margin

1.0%

Retail non-household margin

2.5%

Both enhanced companies – South West Water and Affinity Water – have accepted our risk and reward guidance Water today, water tomorrow

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RoRE range expectations Our risk and reward guidance also set out our views on the return on regulated equity (RoRE) range Range of RoRE Overall RoRE variance

±3.5% to ±4.5%

Cost performance

at least ±2.0%

ODI

±1.0% to ±2.0% (upside at least 1.0%)

SIM

-0.5% to +0.25%

Financing

±0.1% to ±0.5%

The package of incentives in companies’ business plans should be consistent with the evidence on affordability and related to willingness to pay (WTP). The RoRE range is a guide to the development of an appropriate risk and reward package 35 Water today, water tomorrow

RoRE ranges for enhanced companies Developing an ODI range which is consistent with our methodology statement and risk and reward guidance will not result in identical ranges across companies

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Engagement with customers Guidance As stated in the risk and reward guidance published in January, it is important that the risk and reward package takes account of customer preferences and that package maintains legitimacy with customers It is for Boards to decide on engagement with customers and involvement of CCGs Enhanced companies Both Affinity and South West engaged with their customers to gauge support for revised incentive package and presented evidence on acceptability of package to customers in their risk and reward submissions

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Uncertainty mechanisms In their December business plans, companies adopted a broad range of approaches to number of uncertainty mechanisms Guidance Additional risk should only be transferred to customers where are unable to influence the impact on their business Consistent with single notional cost of capital, companies should not have different uncertainty mechanisms unless they face materially different risks Case for uncertainty mechanism for water business rates Enhanced companies Both South West and Affinity have proposed uncertainty mechanism for water rates and have withdrawn other proposed uncertainty mechanism 38 Water today, water tomorrow

Summary Do

Do not

Develop ODIs consistent with methodology statement and explain basis for level of ODIs

Retrofit ODI package to be consistent with risk and reward RORE range

Explain how approach is consistent with risk and reward guidance Explain any departure from guidance Demonstrate acceptability to customers

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

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Next steps Table A1 Minimum requirements for business plan resubmission Companies should: submit updated data tables and commentaries with clear mapping of the changes and additional evidence provided; and include a summary of changes to outcome delivery incentives and how the company consider this meets the requirements for each criterion. In particular, companies should provide additional information in the following areas. For ODIs where no financial incentives are proposed, a clear explanation of how customers are fully protected in the event of underperformance, including, where relevant, evidence that other regulatory sanctions are sufficient to protect customers. Clear explanation for absence of financial rewards on individual ODIs. Clear explanation of the WTP estimate, or other evidence of customer value, and incremental costs used to determine the incentive rate and where relevant how these have been aligned. Use of appropriate scaling of incentives. Clear justification for any neutral zones (or deadbands) based on uncertainty and other relevant considerations. Evidence supporting the general approach to calibration with other incentives, as well as clear explanations where any individual ODIs depart from the standard approach. For any new or updated proposed incentive, the company should provide the same standard of supporting evidence as required as part of the risk-based review. Pages 20-21, Policy and information update

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Table A20 A20 - Scenarios Line description

Item reference Units DPs Price base

2015-16

Table A20 based on one scenario: scenario I, the overall scenario

H Combined scenario - Company specified - High Case 1 Wholesale total revenue impact (water) - High case

A20329

£m

3

2012-13

2 Wholesale total revenue impact (wastewater) - High case

A20330

£m

3

2012-13

3 Retail total revenue impact (households) - High case

A20331

£m

3

2012-13

4 Retail total revenue impact (non-households) - High case

A20332

£m

3

2012-13

5 Total revenue impact - high case

A20385

£m

3

2012-13

6 Wholesale total expenditure (totex) impact (water) - High case

A20333

£m

3

2012-13

7 Wholesale total expenditure (totex) impact (wastewater) - High case

A20334

£m

3

2012-13

8 Uncertainty Mechanisms impact (water) - High Case

A20386

£m

3

2012-13 2012-13

0.000

Key points on table A20:

9 Uncertainty Mechanisms impact (wastewater) - High Case

A20387

£m

3

10 Cost performance incentives impact (water) - High case

A20348

£m

3

2012-13

0.000

11 Cost performance incentives impact (wastewater) - High case

A20349

£m

3

2012-13

0.000

12 Total Wholesale Costs impact - High case

A20388

£m

3

2012-13

0.000

13 Retail operating expenditure impact (households) - High case

A20335

£m

3

2012-13

14 Retail operating expenditure impact (non-households) - High case

A20336

£m

3

2012-13

15 Uncertainty Mechanisms impact (household retail) - High case

A20389

£m

3

2012-13

16 Uncertainty Mechanisms impact (non-household retail) - High case

A20390

£m

3

2012-13

17 Total Retail operating expenditure impact - High case

A20391

£m

3

2012-13

18 Free cash-flow (FCF) impact - High case

A20337

£m

3

2012-13

19 Number of households - High case

A20338

nr

3

20 Volume of water impact (household) - High case

A20339

Ml

3

21 Volume of water impact (non-household) - High case

A20340

Ml

3

This scenario shows a P10 and P90 on RoRE

0.000

Price base – 2012-13 prices Separate identification of cost (taking into account uncertainty mechanisms), ODI, SIM and financing impacts Whole company and element-level RoRE and margin ranges Table A20a – individual outcome delivery incentive impacts

22 Total Wholesale outcome delivery incentives (ODI) impact (water) - High case

A20341

£m

3

2012-13

0.000

23 Total Wholesale outcome delivery incentives (ODI) impact (wastewater) - High case

A20342

£m

3

2012-13

0.000

24 Total Retail outcome delivery incentives (ODI) impact (households) - High case

A20343

£m

3

2012-13

0.000

25 Total outcome delivery incentives (ODI) impact - High case

A20392

£m

3

2012-13

0.000

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The overall risk scenario (scenario I) Overall scenario (I) is made up of: Economic scenario (D) Rainfall (E) Company specific Incentive performance variation (H) Economic scenario – based on PwC assumptions: GDP RPI Industrial production Unemployment Household growth Electricity prices COPI Details set out in ‘Appendix 5: Guidance on business plan tables’ (July 2013), ‘Economic assumptions for risk analysis’ (PwC July 2013) 43 Water today, water tomorrow

Historic annual variation in the return on equity

Source: Water company accounts, water company business plans, Capital IQ, PwC analysis

In examining potential risk and reward we examine what happens at P10/P90 level of probability Water today, water tomorrow

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2012-13 prices versus nominal prices Table A20 and the risk assessment tool are based on constant 2012-13 prices If high and low scenarios include different assumptions on inflation, they should impact on cost and revenue • Wholesale revenue – there should be no change as revenue is indexed to RPI • Retail revenue – this should be adjusted by the change in RPI as the revenue is constant in nominal terms • Wholesale and retail expenditure – the change will depend on whether expenditure is expected to increase by more or less than RPI • ODIs – change will depend on whether incentives are linked to RPI (whether directly or indirectly) • SIM – this should be adjusted by the change in RPI as the incentive is defined is linked to retail revenues which is constant in nominal terms Based on regulatory rather than accounting building blocks Water today, water tomorrow

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Calibration of risk Calibration of risk ranges can take into account a number of factors: Historic performance Other companies Changes in regulatory framework, totex sharing, uncertainty mechanisms Changes in the external environment

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Cost outperformance Outperformance against an ODI may result from extra investment, but it can also be caused by external risk drivers (like the economy or the weather) In that case, the company may respond to ODI outperformance by reducing expenditure on outcomes This means that the relationship between totex and ODI performance is not clear For this reason, we are asking companies to explain separately – outside the business plan tables – how much of their cost performance is related to ODI performance How much of the cost outperformance shown in table A20 is due to reduced spending on ODIs? How much of the cost underperformance shown in table A20 is due to increased spending on ODIs? 47 Water today, water tomorrow

Offsetting risks In preparing table A20a and A20, companies should be careful to consider whether performance on different ODIs is independent If it is not, the risks arising from different outcomes may offset A common outside risk driver (like the economy or the weather), may result in a reward against one ODI and a penalty for another In that case, the ‘high case’ and the ‘low case’ of scenario I should each have a mixture of penalties and rewards They are meant to represent extreme but plausible scenarios

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The risk assessment tool Our analysis of risk is informed by the risk assessment tool

This model takes the data provided in table A20 and produces RoRE ranges and other breakdowns of risk It was discussed in more detail during the Financial modelling workshop on Monday Water today, water tomorrow

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

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Questions and answers

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Agenda 1

Welcome and introduction

2

Outcomes – risk-based review tests and results

3

Outcomes – feedback on ODIs

4

Outcomes – Q and A

5

Risk and reward – overview

6

Process going forward – outcomes and risk and reward

7

Risk and reward – Q and A

8

Next steps

52 Water today, water tomorrow

Next steps As noted earlier, the workshop materials will be put on our website, along with the main points/questions and answers, without attribution. There will be no detailed meeting note Companies wishing to receive an early draft determination in June now need to prepare a ‘gap analysis’ by 17 April. The process for doing this was set out in ‘Setting price controls for 2015-20 – policy and information update’. We are keen to ensure that companies are in the best possible position to complete their gaps analysis so, if helpful, we are open to having further working-level meetings to discuss issues related to the gap analysis. Once we have received the gap analysis, we will meet with all companies as part of the draft determination process Please continue to liaise with your portfolio lead if there are further queries after today Thank you for attending Water today, water tomorrow

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Questions and answers on outcomes Q1. How will Ofwat reach determinations for the outcomes parts of business plans? As we have emphasised throughout, we consider that the best way to develop effective incentives is for the companies to engage with their customers and then use the results of that engagement to develop their proposals in line with ‘Setting price controls for 2015-20 – final methodology and expectations for companies’ business plans’ (our ‘final methodology’) and ‘Setting price controls for 2015-20 – risk and reward guidance’ (our ‘risk and reward guidance’). If for some reason companies are unable to do this, we will ensure that the outcomes included in draft determination continue to protect customers. Q2. Will the next part of the review have an increased focus on ‘stretch’ of performance commitments and their associated outcome delivery incentives (ODIs)? We have already considered stretch as part of the risk-based review tests. In ‘Setting price controls for 2015-20 – policy and information update’ (our ‘policy and information update’), which we published on 4 April, we have emphasised stretch and have challenged the companies, where possible, to benchmark their performance against a stretching (for example, upper quartile) target. It is important that companies explain and provide evidence for the thinking that they have gone through to decide their committed performance levels and the appropriate level of stretch within these. Q3. Do companies need to demonstrate upper quartile performance to obtain a reward? Companies should not ‘invent’ rewards to meet our risk and reward guidance – they need to provide evidence that the proposed level of commitment represents an appropriate level of stretch. Where possible, this should be benchmarked against upper quartile level of performance across the sector

Q4. Are financial incentives more important than reputational ones? Should companies include mainly financial incentives? Our final methodology made clear that we consider that financial incentives provide the strongest and clearest protection to customers. Reputational incentives can have an important role, but companies should explain and provide evidence for the reasons for choosing them, and explain how they continue to protect customers. Q5. As new measures are untested, should they have reputational incentives attached to them? Companies need to explain and provide evidence to show how they have chosen the measures and performance levels. We recognise that in some cases there may be new measures where limited data is available and a non-financial incentive may be more appropriate, but companies should demonstrate this on a case-by-case basis. Q6. Are we supposed to re-engage with customers as part of our revised business plan submission process? The two companies that have been awarded enhanced status have engaged further with their customer challenge groups as part of the pre-qualification process. Companies should consider whether re-engagement with customers is beneficial. Where proposed business plan revisions have significant implications for customers, we encourage the clear communication of these to customers at the appropriate time. Q7. Does the guidance recently published by Ofwat on the abstraction incentive mechanism (AIM) change the approach on outcomes? Only one company did not pass test 2.2 in relation to the AIM – we will discuss this with the company concerned. Appendix 4 of our policy and information update explains that the AIM will no longer be part of the 2014 price review programme and will be taken forward to slightly longer timescales in 2015.

Q8. Is it the assumption that the ODI reward/penalties are paid in year or at the end of the period? In our final methodology, we did not specify any assumptions as to when the ODI reward/penalties would be paid. Companies should justify and provide evidence for their proposed approach as part of their business plan submissions.

Questions and answers on risk and reward Approach to the calculation of wholesale and retail controls Q1. Are the return on regulated equity (RoRE) ranges published in the January 2014 risk and reward guidance prescriptive? As stated in ‘Setting price controls for 2015-20 – risk and reward guidance’ (our ‘risk and reward guidance’), we do not expect all companies to be totally consistent within the ranges outlined in our risk and reward guidance. Companies will need to submit clear and compelling evidence to support departures from the ranges published in our risk and reward guidance. Q2. Is the use of Ofwat’s risk assessment tool mandatory? Use of the risk assessment tool is not mandatory. But we expect companies to show how they have derived their RoRE ranges from business plan submissions, and to provide a reconciliation if a company’s risk modelling results in a different range than the risk assessment tool. Q3. To what extent should the companies take account of portfolio effects: • •

across different categories of costs and across different ODIs; and across different parts of the RoRE range?

In table A20 we expect companies to present an overall RoRE range based on a summation of the P10 and P90 ranges for costs, ODIs, service incentive mechanism (SIM) and financing. This range is comparable to the RoRE range set out in our risk and reward guidance of ±3.5% to ±4.5%. This RoRE P10 and P90 range represents the average over the AMP6 period rather than in incidence year. Where companies consider that there is a material difference between this RoRE range and the net overall P10 and P90 RoRE range over the AMP6 period (for example, due to offsetting effects across elements), companies should identify this in their commentary on table A20. If required, companies may (but do not have to) use a Monte Carlo simulation to assist their analysis of this range. For ODIs, the business plan tables require companies to add up the individual ODI impacts without taking into account any portfolio effects between them. But if different ODIs offset – meaning that they are negatively correlated – then the company should take this into account in deciding whether a given ODI reward or

penalty belongs in the high case or in the low case then table A20a should be completed accordingly, with one ODI with a reward and another with a penalty in the high case. This should provide a P10 and P90 range for ODIs as a whole, taking into account portfolio effects. Q4. What happens where an impact from one area, for example ODIs, impacts on another such as costs? Where performance in one area directly impacts on another – for example, if high ODI performance would result in reduced totex – then these impacts should be separately identified, although both should be counted towards ODI performance rather than the totex saving contributing towards totex (see page 45 of ‘Setting price controls for 2015-20 – policy and information update’). It would be best to present this information in a spreadsheet. Q5. How much complexity is appropriate for the relationship between totex and ODIs? While we have specified the information we are asking for in tables A20 and A20a, the companies have significant discretion about the level of detail of their supporting documentation. We would suggest that companies should submit evidence on risk and reward at the same level of detail as their own modelling – for example, the basis for their calculations and the sources of this information. Q6. What use should companies make of the PwC scenarios? Companies should note the scenarios set out in the PwC paper ‘Economic assumptions for PR14 risk analysis’, which we published alongside ‘Setting price controls for 2015-20 – final methodology and expectations for companies’ business plans’. If a company considers that the economic assumptions of its service area are likely to develop in a materially different way than set out in the PwC paper, it should use its own macro-economic scenario assumptions instead and provide supporting evidence for this approach. Q7. Is SIM linked to retail revenue? The AMP6 SIM rewards and penalties will be calculated as a percentage of household retail revenue – specifically, in line with our most recent guidance on the SIM (see ‘Service incentive mechanism (SIM) for 2015 onwards – conclusions’).

Q8. How informative is the information about historic RoREs, given how these values are affected by expenditure profiling, etc? We consider that companies are well placed to understand the implications of their own historic performance for assessing risks around future performance. Companies should explain how they have taken account of historic information in their RORE scenarios. While we will have regard to RoRE values for individual years as well as the AMP6 average, the primary focus of the risk test is the average RoRE for the AMP. Q9. When Ofwat talks about differential inflation, do you mean different than expected RPI, real price effects, or both? As set out in the slides, we expect companies to have regard both to the possibility that outturn RPI may be different from what we currently expect and that not all costs and revenues vary exactly proportional with RPI. Q10. If an ODI reward is earned in only part of the AMP, and not paid out until AMP7, where should the rewards be entered into the table? ODI rewards and penalties should be included in table A20 in those years when the company has earned or incurred them. For example, if the requirement of an ODI is that performance in the last two years of the AMP exceeds a threshold then the reward should be allocated between those two years, even if it is only paid out at the end of the period. While table A20 requests a total sum for SIM payments, the risk assessment tool spreads the payments across the period. Q11. Do the ODI accruals in year affect the financeability ratios? As the RoRE ranges take into account ODIs and SIMs earned rather than the cash payments, the rates of return will be different from those derived in the financial model and used in the financeability assessment.