Our response to PR24: Consultation on outturn adjustment mechanism
We welcome the opportunity to respond to Ofwat’s consultation on an option to introduce an outturn adjustment mechanism (OAM) in PR24 final determinations.
Summary of response
CCW agrees that balancing the interests of customers and other stakeholders is imperative ahead of the PR24 final determinations, and actions are needed to protect customers whilst providing the necessary incentives for water companies.
We have concerns about the OAM, particularly the implications of increased uncertainty for water companies, the potential of reduced incentives for performance improvement, and the need for more transparency to build consumer trust. All of which may potentially impact on customers’ experience and the quality of service they receive in the longer term.
Companies’ responses to the Draft Determinations often emphasise the perceived downside risks of Ofwat’s Performance Commitment (PC) targets and associated Outcome Delivery Incentive (ODI) penalties. Coupled with investor concerns about the draft determinations, the OAM appears to be Ofwat’s proposal to address these concerns.
However, Ofwat’s annual Service Delivery Reports for the current price control period reveal that some companies are failing to meet their commitments. Additionally, past financial performance indicates that companies and shareholders may benefit when Ofwat’s assumptions on returns are overly generous, as shown in the National Audit Office’s 2015 analysis.
In this context, whilst we acknowledge Ofwat’s need to balance the protection of customers with securing substantial capital investment for 2025-30 and beyond, it is crucial that companies remain incentivised to deliver – especially as customer trust in the sector is declining. The proposed OAM risks diluting these incentives by potentially shielding lower-performing companies from declining returns.
Delivering for customers and the environment should be a prerequisite for returns, so it is vital to implement stretching, yet realistic, targets for companies to meet customer expectations. Recalibrating PCs and associated ODIs to ensure they are both challenging and achievable may more effectively balance customer and investor needs. CCW does not support the principle of introducing an OAM that adjusts equity returns for all companies. If Ofwat is considering introducing the OAM, then further engagement with stakeholders will be crucial, to explore ways to mitigate the risks associated with the OAM.
Detailed response
As the independent voice for water consumers in England and Wales, CCW acknowledges the importance of ensuring that Ofwat’s regulatory regime balances the interests of customers with companies and their investors. Below are our views on the option to introduce an OAM in PR24 final determinations.
We have several concerns about this mechanism and the extent to which it is a proportionate intervention for customers and the longer-term performance of water companies.
One of the main drawbacks of the OAM is the increased uncertainty companies will face regarding the impact of their performance on equity returns. Since their rewards or penalties will depend not only on individual company performance but also on the performance of other companies, individual companies may find it challenging to predict their financial outcomes. This risks complicating their decision-making. Regulatory certainty is key for both consumers and water companies, however the proposed OAM risks causing companies to adopt a more conservative expenditure approach. If companies decide to hold back on investments due to this uncertainty, it could ultimately result in poorer service outcomes for customers – for example, reduced investment in detecting and repairing leaks.
This uncertainty is further complicated by the fact that Ofwat would not apply the adjustment mechanism until the end of the price control period and not annually as part of the ODI process. A potential consequence is that companies may find it difficult to pursue longer-term multi-AMP approaches to planning investment – for example, the long-term delivery strategies introduced by Ofwat. From a customer perspective, this may challenge water companies’ ability to sequence their investment activities in a way which maximises value for customers.
The OAM challenges one of the fundamental aims of Ofwat’s regulatory regime – to mimic competitive market pressures by rewarding better performance and penalising poor performance. Ofwat must ensure that any mechanism does not dilute incentives for water companies to work towards delivering better outcomes for customers and a more efficient service. If returns are adjusted or smoothed out too much, companies may be less incentivised to outperform (or even improve) because they know returns will be adjusted to meet the median benchmark. This is particularly an issue given Ofwat will apply the OAM at the end of the price control period. As companies become aware of the performance of others, there might be a reduced incentive for improvement in the latter years of the price control period. If a company perceives that their returns are closely tied to the median, they may be less motivated to outperform their competitors. This may impact the overall quality of service for customers. Additionally, due to the design of the OAM, a scenario exists where the entire sector may perform poorly, but some companies would still receive rewards because they were in the top half of poor performers. This risks causing customers to pay for service improvements which may not materialise.
More broadly the consultation does not explore the possible behavioural factors which might influence a company’s decision-making and choices. This raises concerns around the impacts of the OAM, particularly for customers, and the extent to which the OAM could lead to perverse consequences. As an example, and as highlighted above, some companies may make decisions with the aim of achieving a ‘good enough’ result rather than the optimal result – also known as satisficing; equally when faced with uncertainty some companies may experience default bias.
Though the OAM is based on a relatively clear benchmark, the application of the mechanism and its timing risk adding a layer of complexity to the regulatory regime. Should Ofwat decide to implement such a mechanism, it will be crucial for customers to clearly understand how the OAM might influence the bills they pay and the quality of service they receive. The consultation offers very little clarity in this regard. This point is of particular importance as we face the prospect of a sustained period of multi-AMP bill rises. Under the OAM, it would not be inconceivable for a company who has already risen bills for capital investments, to receive an upward adjustment from the OAM which further increases bills. And given the sequencing of the OAM, it may prove challenging for companies to offer clarity to customers on how their bills or quality of service received may change. It is important to consider this point in the context of regulatory capital values. The total RCV across the sector is approximately £100 billion, if for example Ofwat, through the OAM, made an upward adjustment of +100 basis points, this would be equivalent to approximately £450 million (Assuming regulatory equity is 45% of RCV). The financial implications of the OAM will be material – this underscores the need for Ofwat to carefully consider whether the OAM is the right measure to help balance customer and investor needs.
If the OAM is implemented but is not clear or is overly complex, there could be a loss of consumer trust in the regulatory process. Given recent CCW research shows customer trust in the water sector is at a 13-year low, it is essential that any decisions which may impact customers are arrived at and taken in a clear and transparent way.
Response to questions
Whilst we acknowledge Ofwat’s need to balance the protection of customers with securing substantial capital investment for 2025-30 and beyond, it is crucial that companies remain incentivised to deliver – especially as customer trust in the sector is declining. We do not support the principle of introducing an OAM that adjusts equity returns for all companies. If Ofwat is considering introducing the OAM, then further engagement with stakeholders is crucial, to explore ways to mitigate the risks associated with the OAM.
We do not agree. This risks negatively impacting the incentives and spending considerations of companies which consequently may reduce the overall quality of service for customers in the longer term.
Whilst we do not support the principle of introducing an OAM that adjusts equity returns for all, if the OAM is implemented, it should be applied after the ASM.
Yes. Ofwat should consider the implications of increased uncertainty, the potential of reduced incentives for performance improvement, and the need for more transparency to build consumer trust. See section 3 for more detail.