Allocation of risk Prepared for Ofwat 18 June 2021 FINAL Important notice This document was prepared by CEPA LLP (trading as CEPA) for the exclusive use of the recipient(s) named herein. The information contained in this document has been compiled by CEPA and may include material from other sources, which is believed to be reliable but has not been verified or audited. Public information, industry and statistical data are from sources we deem to be reliable; however, no reliance may be placed for any purposes whatsoever on the contents of this document or on its completeness. No representation or warranty, express or implied, is given and no responsibility or liability is or will be accepted by or on behalf of CEPA or by any of its directors, members, employees, agents or any other person as to the accuracy, completeness or correctness of the information contained in this document and any such liability is expressly disclaimed. 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The recipient(s) or any third parties may not reproduce or pass on this document, directly or indirectly, to any other person in whole or in part, for any other purpose than stated herein, without our prior approval. 2 Contents EXECUTIVE SUMMARY ...................................................................................................................... 4 1. INTRODUCTION ...................................................................................................................... 13 1.1. Scope ..................................................................................................................................... 13 1.2. Report structure ................................................................................................................... 13 PART A – DEVELOPING A CONCEPTUAL FRAMEWORK FOR RISK ALLOCATION ....................................... 14 2. CONTEXT .............................................................................................................................. 15 2.1. Key definitions....................................................................................................................... 15 2.2. Perspectives .......................................................................................................................... 16 2.3. Identification of risks in the water sector .......................................................................... 17 3. ALLOCATING RISK .................................................................................................................. 19 3.1. Regulatory approaches in practice .................................................................................... 19 3.2. Considerations in allocating individual risks ..................................................................... 20 3.3. Overarching constraints ...................................................................................................... 22 4. RISK-SHARING MECHANISMS ................................................................................................... 24 5. MEASURING RISK ................................................................................................................... 25 5.1. Objectives .............................................................................................................................. 25 5.2. Measurement issues ............................................................................................................ 25 6. ANALYTICAL FRAMEWORK ...................................................................................................... 26 6.1. Themes .................................................................................................................................. 26 6.2. Summary of analytical framework ..................................................................................... 28 PART B – OPTIONS FOR REGULATORY FRAMEWORK DESIGN IN PR24 ................................................. 30 7. POTENTIAL ISSUES TO ADDRESS FOR PR24 ............................................................................... 31 7.1. Summary of potential issues identified through analytical framework ......................... 31 7.2. Shallow dives on potential issues ...................................................................................... 35 7.3. Developing the PR24 regulatory regime ........................................................................... 72 3 EXECUTIVE SUMMARY CEPA was commissioned by Ofwat to provide consultancy advice on the allocation of risk and the effectiveness of the regulatory framework in water in respect of the allocation of risk. The views set out in this report are CEPA's and have been prepared to challenge Ofwat's thinking in the early design of PR24. Scope of work Ofwat highlighted the following tasks within the scope of work: • A review of Ofwat’s approach to identifying and prioritising risks; • Creation of a potential risk allocation framework; • Consideration of the current allocation of risk to identify gaps, consider duplication and assess overall effectiveness of the regulatory framework with respect to risk allocation; • Comparison of Ofwat’s approach to others, including Ofgem; and • Making provisional recommendations, including in respect of options to modernise1. Key definitions Ofwat asked that we focus on first principles. As part of that we defined key terms that we use throughout the document. Our definition of company risk (i.e. incumbent monopoly water company) is how we would expect corporate finance practitioners to think about risk: “Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return”.2 The definition captures both the potential for positive and negative variation relative to an expected outcome or return. The definition also highlights different dimensions to risk; namely the probability of deviation and the magnitude of that deviation. Risk drivers are those factors that influence risk; a risk driver is a different concept to the risk itself. For example, Covid or Brexit are risk drivers rather than risks themselves. Regulated companies are a natural starting point for assessing risk. A cornerstone of regulatory approaches is the ‘notional entity’, a hypothetical company that can be used as the basis for policy design1. While it may be informed by a review of evidence across the sector, it does not correspond to a given company. As such, individual companies will face risks that differ to the risks of the notional entity and from one another. It is from the notional entity’s perspective that we consider company risk. A ‘mismatch risk’ exists where the expected revenue and expected cost for a company are not equivalent (in either direction). We also refer to a ‘risk budget’, by which we mean the overall risk that can be allocated to a company under a balanced risk and reward framework3. Water, in common with other regulated utilities, is characterised as a relatively low risk and low reward sector. The size of the risk budget is constrained in the extent of risk that can be ——————————————————————————————————————————————————— 1 We understood the term ‘modernise’ to refer to updating the regulatory regime, not limited solely to incremental change options for the regulatory regime. 2 Taken from Investopedia: https://www.investopedia.com/terms/r/risk.asp. 3 Given impacts on financeability, the risk budget will include both diversifiable and non-diversifiable risks, though the WACC should only compensate for non-diversifiable risks. 4 placed on companies, given financeability constraints around investment grade credit ratings in licences and links to financing costs that customers ultimately pay. The water sector includes a broad set of stakeholders, as well as companies involved in delivering water and sewerage services to customers. We adopt a definition of sector risk that is consistent with the corporate finance definition of company risk, but it encompasses outcomes for water sector stakeholders (including consumers, taxpayers and broader society). An ‘outcome’ in this context could refer to financial outcomes such as delivery costs or to more general issues of relevance to stakeholders such as service quality. Key findings We do not consider that there are errors in Ofwat’s approach that necessitate extreme change; instead there are lessons learnt from recent price controls, new challenges and from taking a step back that can inform policy setting for PR24. Our analysis of Ofwat’s regulatory regime suggests that its current approach