Severn Trent Water is calling for Ofwat to explore the scope for increasing the scale of Outcome Delivery Incentives (ODIs) in the 2019 Price Review,the possibility of a variable WACC, together with the potential reintroduction of “output type incentives” to address longer term challenges like resilience.

The call comes in a new report by the utility, Designing incentives to deliver for customers, the second in its Charting a Sustainable Course series of publications.

The report specifically addresses how the price control arrangements can be developed to generate incentives that drive companies to deliver an outstanding customer experience, best value services and a sustainable environment.

Severn Trent is suggesting that the financial significance of ODIs should be increased in PR19, arguing that the timing of financial adjustments for ODI performance can have a significant bearing on customer engagement.

“We believe in-period ODI payments can provide a more transparent and timely linkage between performance and bill  impacts, and provide a far stronger impetus to drive improvements in performance.“

The report is also proposing that there should be no caps applied to forecast totex underspend to avoid undermining incentives on companies to develop more challenging plans.

Companies could also be given the opportunity to be allowed a higher Weighted Average Cost of Capital (WACC), ex ante if they have plans with higher exposure to ODIs and lower costs. The report argues that this would reflect the more challenging risk profile being signed up to and/or form part of an explicit reward that incentivises the development of more challenging plans.

Introducing the report, Severn Trent said:

“Designing an appropriate package of incentives that not only allows companies to finance their functions, but also drives leading companies to innovate and drive future efficiency and improved services to customers is not, however, a straightforward matter.”

According to the water company, providing clear and significant upside opportunities is a central part of an overall workable package.

“The overall package needs to be sufficiently challenging to provide a fair outcome for customers in the short term. But it also needs to be realistic, so that there are significant opportunities for company rewards for improvements, given the importance of this for delivering better outcomes for customers in the medium and longer term. “

Developing a workable overall package necessarily involves trade-offs - the report says a key part of this is the balancing of objectives that can pull in different directions.

For example, regulatory efforts to improve customer outcomes in the short-term through the setting of more stringent benchmarks could have adverse effects on customer outcomes over time, if they have the effect of undermining incentives for innovation and improvement.

Output type incentives could be used for longer term investment decisions

When the longer-term nature of decisions associated with areas such as resilience raise difficulties for the development of effective ODIs, the report suggests that “output type incentives” could be applied and that it would be straightforward to identify how this distinction could have relevance to water sector innovation-related decisions. The report states:

“Efforts to innovate will involve some level of cost being incurred but may not achieve the desired outcome improvements and/or cost reductions within the price control period.”

“As the risk of that happening is likely greater for attempts at more radical innovations, such efforts may be difficult to justify unless there is a sufficient prospect of reward if success is achieved within a control period.”

“Importantly, the benefits of making such rewards available would be expected to go beyond outcome improvements and/or cost reductions in the price control period. Innovative effort that does not deliver in-period improvements may nevertheless feed into other future improvements that will benefit customers in some direct or indirect way.”

‘Indirect’  is defined broadly as experimental activity that is ultimately not fruitful but which can nevertheless support desirable learning and cultural change. This suggests the availability of opportunities for rewards is likely to be key to promoting desirable shifts in behaviour that will benefit customers both in PR19 and in the longer term, the report says.

Introduction of ODIs in PR14 succeeded in increasing focus on what matters to customers

Despite not having been a universally popular change, the paper says the introduction of ODIs at PR14 has proven to be a real success in terms of increasing company focus on what matters to customers.

At the same time, however, there were significant differences between companies in terms of the resulting scope of their ODIs. These included the specific performance levels that were being committed to, the overall levels of financial exposure they provided for and when and how the financial implications of rewards and penalties were to be adjusted for.

For PR19, the report says companies should be allowed to increase their exposure to ODIs (including increasing opportunities for financial benefits), subject to appropriate checks. ‘Willingness to pay’ checks would be important, to avoid perverse incentives.

WACC could be used as part of package to incentivise innovation

On structuring the WACC as part of a package that incentivises innovation, the report says that companies could be given the opportunity to secure a higher WACC for higher levels of ODI and cost performance to reflect the more challenging risk profile being signed up to, and/or which forms part of an explicit reward that incentivises the development of more ambitious plans.

More than one category could be used to reward higher quality/more challenging business depending on the level of ambition shown.

The approach to setting the weighted average cost of capital - WACC - has been largely unchanged across previous water sector price controls. However, the process for setting the WACC provides an opportunity to strengthen the incentive framework at PR19, by linking the allowed level of the WACC to the ODI and cost assessment framework, the report says.

Responding to Ofwat’s question of whether the availability of ODI rewards may justify a downward adjustment to the WACC rather than the opportunity to secure a higher WACC, Severn Trent said the case for downward adjustment of the WACC should be treated with caution.

Output, rather than outcome, incentives needed for longer term challenges like resilience

However, the report also makes the key point that the longer-term nature of decisions associated with areas such as resilience can raise difficulties in terms of the development of effective ODIs.

Customer outcomes may only be affected many years in the future by decisions taken in the current price control period, making it difficult to rely on the prospects of future rewards or penalties to provide effective longer-term incentives, the report argues.

“This kind of longer term issue illustrates how the regulatory contract for any given price control period is an incomplete contract. Longer term outcomes will be affected by decisions that are not explicitly captured by the control.”

“ODIs that perhaps resemble something more like output, than outcome, delivery incentives have a role to play. While significant efforts should made to try to develop outcome incentives where possible, output incentives should continue to be treated a useful regulatory mechanism where necessary.”

The report says the future regulatory challenge will be to develop assessment mechanisms that allow resilience needs to be delivered through the use of output incentives where necessary.

Ofwat’s consultation paper published last November seeking views on how to encourage water companies to deliver more of the outcomes customers want made no direction mention of a potential outputs approach for longer term issues of resilience and investment plans covering than one Price Review.

“More radical innovation requires all parties - customers, companies and regulator - jump together’

Commenting on the risks of loss aversion in his introduction to the report, Professor George Yarrow,  Chair, Regulatory Policy Institute, Oxford said:

“Companies could be allowed to earn levels of reward that turn out to look over-generous, which would then attract criticism of the regulator. At that point the regulator’s own loss aversion comes into play and the upside may therefore be over-constrained.”

“ The take-away learning is that all parties - companies, regulator and customers - are loss averse and that small carrots are not attractive, if they come with additional downside risk.”

“ODI arrangements, however simple or complex, can potentially be made more powerful by some form of relativity in their structure. My final thought is that there is a sense in which more radical innovation requires that all parties - customers, companies and regulator - ‘jump together’.”

Click here to download Designing incentives to deliver for customers