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MD191

TO ALL MANAGING DIRECTORS OF
WATER AND SEWERAGE COMPANIES
AND WATER ONLY COMPANIES

• Additional benefit from April 2010 for further outperformance by the best performing companies from 2005-2010

Many companies lack confidence in our approach to identifying relative efficiency and believe that it fails to provide a sufficient basis for identifying those companies meriting further incentives. We have again considered these objections, which are a matter of long standing debate with the industry. We remain convinced that the basis of assessment is sufficiently firm to identify the best performers. We will therefore introduce the enhanced incentive for the best companies and apply it to operating expenditure for those companies graded as band A in the 2003-04 operating expenditure relative efficiency modelling and for capital expenditure for all companies assessed as band A under the cost base applicable to the current review.

We will apply two levels of enhanced benefit based on the total outperformance in the qualifying years. Companies we assess this year to be at or near the performance frontier will receive an additional benefit equivalent to 50% of the total outperformance in the 2005-10 period. For companies in 'band A' but not at or near the frontier the new additional benefit will be 25% of the total outperformance. We will publish this information in our draft and final determinations.

• Improvements to the current incentive mechanism

We recognise the force of some of the arguments designed to improve and simplify the existing outperformance incentive. We will:

- apply the operating expenditure incentive allowance using the 'additional five years model' as used for capital expenditure;

- calculate the standard operating expenditure outperformance benefit on incremental outperformance in qualifying years [see annex B for an explanation of the mechanism to be used];

- retain the depreciation adjustment in the calculation of capital outperformance.

After considering the objections to some proposed changes which would have introduced greater complexity we will retain:

- the current method of rewarding outperformance in capital expenditure through the regulatory capital value;

- the current arrangements for incentives in the area of infrastructure renewals expenditure; and

- we will not adopt simple smoothing, as originally proposed, for all the mechanisms.

We look to the Water Services Regulation Authority to

- take changes in operating costs associated with 'relevant changes of circumstance' and notified items that were not included in price limits into account when calculating operating expenditure outperformance benefits; and

- apply the outperformance rewards on a post-financeability basis from 2010 (as we do now for the overall performance assessment of companies).

• Exceptional underperformance

We will apply the rule for exceptional underperformance as set out in the paper accompanying MD187. This rule will apply with effect to expenditure undertaken in the period since 2000-01.

We will provide advice on whether proposals for supplementary capital investment would meet our criteria for logging up or specific inclusion in the regulatory capital value.