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Letters to Managing Directors
MD 187 24 June 2003 Dear Managing Director PERIODIC REVIEW 2004 - A further consultation on incentive mechanisms Rewarding future out-performance and handling under-performance of regulatory expectations In chapter 3 of the Setting water and sewerage price limits...(1) we discussed our approach to incentives. We explained that the regulatory incentives had to work to simulate the pressures and rewards to be found in a normal competitive market. Just as these change over time so should the package of regulatory incentives evolve to meet the changing environment. In the paper attached to this letter we set out our approach to rewarding future out-performance and handling under-performance of our regulatory expectations. Ø We set out the existing rules relating to out-performance and under-performance, which were established at the last review in 1999. We will continue to use these rules at this review when we set price limits for 2005-10. Ø We are also consulting on new proposals to enhance, simplify and amend the incentive regime for the future. These new rules would be used to reward out-performance (and deal with exceptional under-performance) from 2005. The new proposals would only affect price limits and bills from April 2010. Our aim with these new proposals is to provide a continued and improved stimulus to managers in the best performing companies to innovate and become more efficient. Other related issues, such as our approach to logging-up, down and shortfalls and the overall performance assessment, have been subject to earlier consultation and our conclusions for this review are set out in 'Setting water and sewerage price limits for 2005-10: Framework and approach'. We shall be consulting in December 2003 on the overall performance assessment for the 2005-10 period to be used at periodic review 2009. We have set out in the paper our assessment of the implications of our proposals for both customers and companies. We propose to increase the incentive for leading companies to out-perform. The rewards need to be large enough to make it worthwhile for a company to invest the time, energy and money to achieve successful innovation. We have concluded that the substantial longer-term benefits to customers, both nationally and in those companies that are directly affected should more than outweigh the additional costs of the rewards. The enhanced rewards for further out-performance will need to be reflected in price limits and so in customer bills in the 2010-15 period in those companies which are successful in leading the search for greater efficiency. In the paper we: · Set down our assessment of the current rules against what we consider to be the key incentive criteria. · Identify the need to re-examine the incentive rewards on offer to those companies operating at or very close to the current efficiency frontiers – the top performing companies. · Make proposals to enhance, through the use of a multiplier, the normal incentive rewards for the current top performing companies to encourage them to strive to set new frontiers. · Put forward a number of proposals to align and simplify the rules and operation of the capital expenditure incentive mechanisms to use as part of the 2009 periodic review. Some of the alternatives could impact on well-established practices, particularly those involving regulatory capital values (RCV). However, we recognise the importance of RCVs in assessing the valuation of individual regulated companies. We shall want to be sure before proceeding that the proposals will not cause unnecessary regulatory uncertainty. · Put forward three further proposals to overcome the 'hidden year' problems associated with the current mechanisms, to rationalise smoothing the delivery of additional rewards and to assess whether the rewards arising from out-performance should be added after any financeability tests. · Set out a new rule to deal with exceptional under-performance in capital expenditure not reflected in the earlier price limit assumptions. This new rule places a limit on the current ceiling on investment by service test we set down in 8.11 to 8.16 of 'Setting water and sewerage price limits for 2005-10: Framework and approach'. We commend the package of measures we are proposing as reasonable steps to take to refresh the regulatory incentive mechanisms to meet the challenges of AMP4 2005-10. We welcome your comments on our analysis, on the balance of our proposals and on each proposal. Some key questions we would find it helpful for you to address are listed overleaf. Your comments should be clearly marked "A further consultation on incentive mechanisms" and sent by no later than Monday 15th September 2003 to: · Mark Hann · mark.hann@ofwat.gsi.gov.uk · OFWAT, Centre City Tower, 7 Hill Street, Birmingham B5 4UA If you have any queries about the document please contact Mark Hann on 0121 625 1437. We will review all your comments and publish our conclusions in December 2003. We will place all responses on our library and on our website. Please mark your response clearly as Restricted if you want it to be treated as confidential. Bill Emery Director of Costs & Performance and Chief Engineer (1) "Periodic Review 2004 – Setting water and sewerage price limits for 2005-10: Framework and approach" – Ofwat – March 2003 MD187 – 24 June 2003 PR04 - A further consultation on incentive mechanisms Rewarding future out-performance and handling under-performance of regulatory expectations Key questions: Q1 Do you agree with us that enhancements to the rolling incentive mechanism for top performing companies are appropriate for the next price review period - AMP4 2005-10? (Refer to sections 1 and 2) Q2 Do you agree or disagree with using a multiplier to enhance the rewards for top performing companies? (Refer to section 2) Q3 Do you agree or disagree with the proposed application rules for the enhanced incentive mechanism set out in sections 2 and 3? Namely: Q4 Do you agree or disagree with the proposed modifications to the capital expenditure incentive mechanisms set out in section 3? Namely: Q5 Do you agree or disagree with the other improvements and simplifications to the incentive mechanisms set out in section 3.2? Namely: Q6 (a) Do you consider we have made the right decision to introduce now for the AMP3 2000-05 period the limit on the ceiling on investment by service? (Refer to section 4)
If you disagree with our analysis or the overall balance of our proposals it would be very helpful if you could explain why and then how you think we could overcome your concerns but still achieve our objectives.  |
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