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Our Response to Ofwat's Initial Assessment of Plans

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Our Response to Ofwat's Initial Assessment of Plans Our response to Ofwat’s initial assessment of plans April 2019 wessexwater.co.uk Our Response to Ofwat’s Initial Assessment of Plans Wessex Water Executive summary This document sets out the updates we have made to our Business Plan for 2020-2025 following: • Ofwat’s initial assessment of plans which it published in January 2019 • our continued engagement with our customers • engagement with the Wessex Water Partnership (who act as our regulatory Customer Challenge Group) • updated information from environmental regulators about the required outcomes. We understand the need to continue to show great value in the round as well as excellent services to our customers. Our board remains committed to: • putting customers and communities at the heart of what we do • embracing change and innovation through our open systems model • environmental leadership • investing in our people and skills • sharing our success with the wider community. Updates to our plan mean that in 2020 average bills to customers will now reduce by 10% in real terms. By 2025 bills will remain 6% less than today in real terms despite having completed our largest ever set of environmental and service improvements. As a result our customers and the environment will continue to get the best service levels of any water company in the UK. Since September 2018 we have reduced the forecast expenditure in our plan by £43m. The reductions are to take account of new information about our obligations including, at Ofwat’s suggestion, where the performance target level that the industry is required to meet is less ambitious than we had originally proposed. We’ve also lowered our assumed equity return to a level which allows us to maintain sufficient credit quality and which matches Ofwat’s suggested cost of capital of 2.4%. We’ve added new Performance Commitments that cover value for money and contacts about the taste/odour of drinking water. We’ve provided further evidence and clarification on: • how our package of PCs protects customers and give appropriate incentives to deliver better outcomes and are in line with the board’s wider vision for the company and the sector • how Ofwat can be confident that our totex proposals are efficient • how our plan delivers financial resilience. The board has considered and approved any changes to our plan and has approved the submission of our response. We have also provided a new assurance statement from the board. PR19 Business Plan: Our Response to Ofwat’s IAP 1 Our Response to Ofwat’s Initial Assessment of Plans Wessex Water Ofwat’s Initial Assessment of Plans included 90 actions that they advised or required us to make, and they also published their assessment of the efficient level of costs. We set out in this document and the supporting appendices how we have responded to each of these requests and our initial response to the way Ofwat has assessed the efficient level of costs. We do not agree with every judgement that Ofwat has made; in particular we have three key concerns that we would like to be addressed by Ofwat before it calculates a price determination from our plan proposals. These are as follows: 1 – Setting efficient cost allowances We recognise that: • the approach Ofwat has taken to assessing cost allowances is in many areas a marked improvement on PR14 • more than ever we need to show how the industry is delivering better value for money for customers. In this context Ofwat’s proposed 1.5% annual frontier-shift productivity assumption is understandable and could be acceptable as part of an “in the round” assessment of the financeability of our plan and the other parameters. This is despite this being well in excess of the levels of productivity improvement seen in the wider UK economy in recent years and of the forecasts made by expert bodies such as the OBR. We are concerned that some of Ofwat’s other policy decisions mean that the true level of efficiency challenge in its IAP, even for frontier performing companies such as ourselves is well in excess of the 1.5% headline productivity assumption. In particular: • the assumption that there should be no allowance made for input cost increases above CPIH • we disagree that all the opex costs for delivering new obligations are included in the base cost allowance • while we accept there may be evidence that in some areas the base cost allowances include sufficient allowance for historical upper quartile levels of performance commitments there is no evidence that they are sufficient to meet future upper quartile levels of performance commitment levels up to 2025 • the relatively coarse approach to modelling enhancement costs, combined with a policy of funding at the lower of the modelled cost and company’s business plan cost. seems likely to lead to allowances that are systematically too low (as under- estimation of efficient costs in some models is not cancelled out by over-estimation from other models). For Wessex we think that these amount to a further cost challenge of over £200m over the five-year period, equivalent to an annual additional frontier shift target of more than 3% each year, therefore more than 4.5% in total. This is not in our view a credible level and we think is unlikely to be Ofwat’s policy intention. PR19 Business Plan: Our Response to Ofwat’s IAP 2 Our Response to Ofwat’s Initial Assessment of Plans Wessex Water Some aspects of Ofwat’s approach when considering enhancement expenditure also recreate incentives for companies to favour capex-based solutions to delivering outcomes which the totex methodology was designed to remove. The approach therefore does not achieve the aim of rewarding efficiency and innovation. We recognise however that the methodology is currently less developed in its approach to enhancements and there is opportunity for improvements. In this response therefore we provide some practical approaches by which some of these issues can be addressed in time for determinations. We also provide information where we think that simple data errors or misunderstandings about the statutory requirements can bridge the gap between our own view of costs and Ofwat’s. Where we provide additional information on the additional cost allowances required compared to Ofwat’s IAP cost allowance our board has explicitly assured that the investments to which these relate are robust, efficient and deliverable. 2 - The balance and size of incentives on the ODI package for a high performing company Our board supports the need for strong positive incentives in the regulatory framework. We have been pleased therefore that Ofwat has often referenced the availability of incentive payments under ODIs as part of its continued commitment to incentive-based regulation. Ofwat’s own consultation documents back as far as November 2016 have evidenced that it is in the interests of consumers that positive ODI incentives are meaningful and that a symmetric approach is taken. We agree with Ofwat when it said that “a strong additional benefit of the reward and penalty approach is that it is likely to deliver more innovation and a frontier shift in service quality for customers. By a frontier shift we mean a significant step change (a shift) in the quality of service provided by the best (frontier) companies in the water sector. The symmetric approach to ODIs reveals new information…… we can use to challenge companies to set more stretching commitments in future”1 As a comparatively high performing company our September plan proposed a wide and balanced range of incentives on ODIs by applying positive incentive payments across a wide range of measures, limiting the use of caps and collars and proposing enhanced rewards and penalties for some measures to ensure that the power and balance of incentives is maintained. We are concerned therefore that Ofwat’s challenges to our plan ODIs, if followed through, will result in a much narrower range of potential incentives around ODIs that are substantially skewed to the downside as shown in the following chart. Note that this is even 1 Ofwat (November 2016) A consultation on the outcomes framework for PR19 pp.7-8 PR19 Business Plan: Our Response to Ofwat’s IAP 3 Our Response to Ofwat’s Initial Assessment of Plans Wessex Water before accounting for the cost allowance issues considered above which would add a substantial additional downwards skew. We can see a case for a company that is currently performing relatively poorly to have a downwardly skewed distribution. As a comparatively high performing company across the most comparable measures we concur with Ofwat’s view that it is in customers’ interests for us to have incentives to shift the frontier levels of performance above the already stretching improvements we have proposed in the plan. We understand Ofwat’s need for additional evidence that customers support positive incentive payments. We have therefore largely kept our plan proposals unchanged and have engaged further with our customers and commissioned further research. This will be made available to Ofwat and we expect the research to be taken into account in our determination, in particular by: • accepting our proposals for potential outperformance payments on bespoke PCs • continuing to limit the use of caps and collars • accepting our proposals for the use of enhanced incentive payments. And while we understand the context of Ofwat’s request that we undertake to share incentive payments above 3% directly with customers in the form of lower bills we do not think that this is consistent with a balanced package of incentives. It also cuts across our own proposals to reinvest 20% of net incentive payments into community projects and to limit any within period ODI payment to 2% of RORE.
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