Key points
In October 2024, Ofwat consulted on a new outturn adjustment mechanism (OAM). This would be a major change, late in the PR24 process. But it fits with wider developments in Ofwat’s regulatory framework that have enhanced the role of comparative competition amongst water companies in relation to outcome delivery incentives (ODIs).
With the OAM - or something similar - the regulatory framework would place greater emphasis on water companies’ (perceived) performance relative to other each, with less scope for out- or under-performance riding on assumptions and forecasts made at the price review.
Ofwat’s consultation also helps to clarify what it means in practice to calibrate the price control package by reference to a “notional efficient company”. The OAM can spur clearer thinking on what levels of relative performance should qualify companies for rewards rather than penalties.
A greater emphasis on comparative competition will tend to increase the upside for companies that are seen to be performing relatively well and increase the downside risk (and impairment of company value) for those seen to be performing relatively badly. It may also offer more credible long-term payback opportunities from investment to improve future ODI performance.
In the context of these developments, we have developed an innovative way to visualise companies’ financial performance from ODIs [LINK to chart?], which emphasises the role of comparative competition while keeping sight of industry-level performance improvements over time.
There is much more to say about the OAM, comparative competition and the interactions with other parts of the framework (e.g. totex) but we have kept this article focused on ODIs. This article is not intended to review the benefits or drawbacks of the OAM, or to consider alternatives, but rather to draw out some broader implications from how we see Ofwat’s regulatory framework evolving.
The evolution towards dynamic comparative competition
Ofwat’s price control framework seems to be evolving from one where each water company’s financial returns from ODIs are driven primarily by its outturn performance relative to ex ante regulatory assumptions towards one where the company’s returns are driven primarily by its performance relative to other companies.
This can be seen as a move towards a form of dynamic comparative competition. While comparative competition (or yardstick competition) has been a feature of water industry regulation for some time, it has generally relied on benchmarking of either historical data or of company forecasts. In either case, this leaves the setting of price controls vulnerable to the assumptions of the regulator and/or companies about how (efficient) levels of performance or costs will change over time. Under dynamic comparative competition, data revealed on outturn performance across the industry is used in a way that leads to companies’ relative performance having a larger influence on their financial returns than ex ante regulatory assumptions or forecasts.
Several developments in the regulatory framework have contributed to the evolution towards dynamic comparative competition (see Box 1).
Box 1: Key regulatory developments (click to expand)
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Ofwat uses the language of performance commitments (PCs) to refer to specific aspects of water companies’ customer and environmental performance for which companies report quantitative performance information, with financial “outcome delivery incentives” (ODIs) applying to most of these. Ofwat formally introduced performance commitments at the PR14 review, in the context of a greater focus on outcomes than at previous price reviews. At first there was a considerable degree of company ownership and diversity in the set of performance commitments applied to each company. Since then, Ofwat has taken more responsibility for determining performance commitments, with an increase in the number of these that are “common” across all companies, with companies reporting performance against consistent definitions, and a corresponding decrease in the number of, and importance of, company-specific or “bespoke” performance commitments.
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For each peformance commitment, the performance commitment level (PCL) for a specific company and year represents the level of performance, above which that company would earn a financial reward and below which it would face a financial penalty. Ofwat typically sets PCLs such that these get more demanding over time. Over time, Ofwat has placed greater weight on using comparative information on performance across the industry to set the PCLs, with a diminishing scope for a company’s PCLs to reflect its own recent or forecast performance. Most clearly, there has been an increase in the number of peformance commitments for which Ofwat sets the PCL at the same level across all companies (referred to as a common PCL), drawing on benchmarks of historical and/or projected performance from across the industry. But even where PCLs are not set at common levels, comparative information can play a significant role.
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In October 2024, Ofwat consulted on the introduction of the outturn adjustment mechanism (OAM). In the face of concerns by company and investors about asymmetric downside risk in the package of PCLs and ODIs from the PR24 draft determinations, Ofwat proposed a new mechanism to adjust companies’ net financial rewards/penalties over AMP8, in light of data on companies’ outturn performance during this period. Ofwat has adopted the position that it would be fair for customers and investors if the company with the median level of financial performance on ODIs (over the AMP) was to earn no net financial penalty or reward from the ODI framework, with companies performing better than the median company earning positive net ODI rewards and those performing worse than the median company facing net ODI penalties. The outturn adjustment mechanism is designed to achieve this, by making financial adjustments to each company’s ODI reward/penalty that reflect the net ODI position of the median-performing company.
These developments are closely related. In particular, the move towards common PCs and common PCLs paves the way for an arrangement such as the OAM. It would be difficult to justify the OAM if companies faced a completely different set of PCLs. Furthermore, using comparative information to set PCLs, rather than tailoring PCLs to each company’s recent or forecast performance, can help give companies a credible long-term stake in their performance – providing financial incentives to improve over time, including through long-term investment. Once it is recognised that the incentive power of the ODI framework can come from the use of comparative information, rather than ex ante targets, then an arrangement such as the OAM becomes attractive because its acts to remove unnecessary risk from companies and customers – and in turn from Ofwat itself – without undermining incentives.
At one level, the consultation on the outturn adjustment mechanism is a pragmatic response to a clear problem with Ofwat’s PR24 draft determinations. But the outturn adjustment mechanism is much more than that. It helps shine a light on the idea that, if comparative information – and comparative competition – can provide effective incentives for companies to manage and improve their performance, Ofwat does not need to let so much ride on the accuracy of its own assumptions, forecasts and guesses about the levels of performance that companies can/should achieve in future years. And it helps spur clearer thinking on what levels of relative performance should qualify companies for financial rewards rather than penalties.
At the time of writing, it is not clear whether Ofwat will introduce the OAM as part of its PR24 final determinations. We expect that Ofwat will be attracted to it, because it provides a practical way to address immediate concerns about sector-wide asymmetric risk from its PR24 PCLs and ODIs. But even if it is not adopted right now, a move towards dynamic comparative competition seems a likely direction of travel – at least in the absence of more major institutional changes in the industry.
How dynamic comparative competition is implemented
The OAM is not the only way to move towards a system of dynamic comparative competition across the performance commitments that companies face. In early 2024 we worked with Anglian Water to produce a short paper which Anglian Water submitted to the Department for Business and Trade’s consultation on Smarter Regulation. This paper proposed an approach in which dynamic PCLs or dynamic performance targets would be used: rather than Ofwat setting fixed ex ante PCLs at each price review, PCLs could be determined in light of outturn performance (e.g. the PCL for water supply interruptions could be set as the median level of water supply interruptions observed across companies each year).
We believe that there are likely to be benefits from an approach of updating PCLs annually in light of outturn performance, rather than relying on a single overarching OAM-style adjustment. But we also recognise that, at this late stage of the PR24 process, it may be difficult for Ofwat to implement dynamic PCLs across the full set of performance commitments, in time for final determinations.
Regardless of whether the implementation of dynamic comparative competition is via a mechanism such as the OAM, or via dynamic PCLs, there will be a need for Ofwat to take further steps to level the playing field between companies, in terms of their opportunities for ODI performance. This is likely to involve fewer cases where, for historical reasons, PCLs are set on a bespoke rather than common basis. And to enable fairer comparisons of performance between water companies, we expect to see refinements to the way that some performance commitments are defined and more sophisticated ways to use comparative information set PCLs (e.g. using econometric models to set PCLs that company and take better account of exogenous factors affecting performance).
Interactions with totex and other aspects of
companies’ financial performance
This article concerns the application of dynamic comparative competition to the financial incentives that water companies face under Ofwat’s price controls in relation to customer service and environmental performance. There are also questions about the potential application to other aspects of their performance, particularly in relation to companies’ expenditure, especially base costs, but perhaps also on financing costs.
Ofwat’s consultation on the outturn adjustment mechanism mentioned, but quickly dismissed, the possibility of extending the mechanism to cover companies’ performance in relation to totex. But the consultation seems to raise more questions than it answers about Ofwat’s regulatory approach to totex, and especially to base costs. There is much to say on this topic, but for reasons of space we have kept them outside scope of this article and focus on the ODI framework.
Clarification from Ofwat on the notional company used to calibrate risk and return
Across different aspects of the price control framework, the established approach of Ofwat (and the CMA) is intended to remunerate a notional efficient company. But there has been considerable ambiguity about what it means, in practice, to be a notional efficient company.
With its consultation on the OAM, Ofwat has been make clearer that, in terms of the risk and return package, its intended calibration is intended to provide a “fair bet” for median-performing companies only.
This clarification means that there is limited opportunity at price reviews for each individual company to achieve a neutral settlement that gives it equal chance of under- and out-performance in terms of financial ODIs. For instance:
Companies that have out-performed in the past, relative to other companies, will tend to be well-placed to earn positive net ODI payments in future price control periods.
Companies that have under-performed in the past, relative to other companies, will tend to be more likely to face net ODI penalties than to earn net ODI rewards in future price control periods.
While price reviews provide an opportunity for a reset of price control parameters in light of the latest information, the framework that we have moved towards is not intended to provide for a company-level reset. There is no intention of providing each water company with a genuine “fair bet” over the forthcoming price control period. A company-specific “fair bet” is not compatible with calibrating price control incentives by reference to the net ODI position of the median-performing company. And doing so would act to undermine the incentives for long-term investment in performance improvements that can emerge under a system of comparative competition.
We wonder whether companies, investors, credit rating agencies and other stakeholders may have – until recently - underestimated how difficult it will be for a company that is performing relatively badly compared to the rest of the industry (e.g. significantly worse than median) to achieve a price control settlement that gives it a reasonable opportunity to earn its base return on equity.
“The framework that we have moved towards is not intended to provide for a company-level reset. There is no intention of providing each water company with a genuine “fair bet” over the forthcoming price control period”
Following on from the discussion above, the sometimes-subtle distinction between analysis of notional companies and analysis of actual companies becomes important. Ofwat’s analysis of risk at return, when setting price controls, covers the full range of companies. But this analysis is made under notional company assumptions which mean that it does not necessarily provide reliable information about how the real-world water companies will actually perform. For instance, consider the chart opposite/below from the risk and return appendix to Ofwat’s PR24 draft determinations (page 15). This shows Ofwat’s modelling of risk ranges for potential under-performance and out-performance against the financial ODIs for each water company.
The chart indicates similar levels of downside financial risk and upside financial opportunity from ODIS for most companies. But this representation of risk is not meaningful in any sense for the group of actual water companies operating in England and Wales operating under Ofwat’s price controls. Rather they are RoRE risk ranges for hypothetical versions of these companies, calculated on the assumption that each company has the same the same opportunities for over- and under-performance against the set of PCLs that it faces.
Ofwat has good regulatory reasons for carrying out analysis for these hypothetical companies. But this type of chart may also risk giving the impression that, going into each new price control period, each company has a similar prospect of upside and downside performance on ODIs. That is not the case at all.
Visualising dynamic comparative competition
As reflected in the chart above, the conventional way that water companies’ ODI performance is represented is through a series of bar charts. This is the case for projections of ODI performance (and associated risk ranges) over a forthcoming price control period and for analysis of how companies have performed in recent years.
With the move towards dynamic comparative competition on ODIs, we thought that there might be value and interest in developing new ways to represent outturn and projected performance.
We identified that it would be useful to find a way to visualise companies’ ODI peformance that achieves both of the following:
Reflecting the importance of comparative competition between water companies.
Tracking improvements over time in the absolute levels of performance.
We set out below our initial iteration of a visualisation that we developed with these points in mind.
[Toggle for with and without bespoke ODIs]
