Northumbrian Water Ltd Response to PR09/02 Menu Regulation Proposals for PR09 Overview We welcome the opportunity to provide an initial response on this specific proposal ahead of our main response to the draft PR09 methodology and look forward to participating in the menu regulation workshop to be held on 5th December. We note that to date experience of menu regulation is limited and, as Ofwat acknowledges, there is no precedent for applying menu regulation on such a scale. Although we believe that menu regulation has some potential benefits, we are not convinced that it can achieve all of the objectives that Ofwat has identified. In particular, we do not consider that it does provide an opportunity for each company to choose its own risk/ reward trade-off. We are also concerned that the complexity of the proposed approach creates significant potential for unintended consequence. We believe that in this case the devil really is in the detail. Unfortunately it would appear that much of the detail remains to be developed. We are keen to work with Ofwat on the detail to support a more fully developed proposal. We are concerned that as presently formulated, Ofwat‟s proposals would appear to offer greater penalties and lower rewards than the approach adopted by Ofgem. A further factor to consider is that the complexity of menu regulation means that, regardless of its theoretical merits, it will be difficult to explain to customers. This may be argued to run counter to the objective of increased regulatory transparency and may damage the legitimacy of the regulatory framework in the eyes of customers. Water UK has submitted a comprehensive response which we broadly support. Attached to this was a paper by First Economics which raises some interesting questions and serves to illustrate some of our concerns regarding complexity and unintended consequence. We are keen to help Ofwat in any way we can to develop its thinking on the detailed application of menu regulation. It is important to stress that in the absence of a fully developed proposal, and given the concerns regarding unintended consequence and the need to clarify linkages with other regulatory mechanisms, we reserve judgement as to whether Northumbrian Water supports the introduction of a menu regulation approach for capex at PR09.
Ofwat‟s objectives Ofwat sets out a number of benefits that menu regulation can bring (see City Briefing presentation by Philip Fletcher). We believe that some of these benefits are more real than others. reducing incentives to inflate business plans
We support this objective. We agree that menu regulation has the potential to contribute to this objective although it may also be achieved by other means. It may be more realistic to adopt the label used by Ofgem, “Information Quality Incentive”, and to focus on this as the primary objective of menu regulation. revealing private information about expenditure needs
We understand Ofwat‟s interest in this objective. We feel Ofwat may be overstating the potential of menu regulation in this regard. Also the extent to which this benefit may be achieved is critically dependent on the design of the menu options. ensuring accountability and responsibility for choosing and delivering the right level of expenditure falls on companies
We agree that companies should not expect the regulator to make their business decisions (and would add that regulators should avoid any temptation to do so). Menu regulation may be of some assistance in reinforcing accountability but we would argue that this responsibility has always been and remains with companies regardless of whether menu regulation is adopted. each company can choose its own risk/ reward trade-off
We are not convinced that menu regulation actually addresses this objective. The incentive properties of the menu are designed to ensure that it is always best to reveal a true assessment of investment requirements (this is what is meant by “incentive compatible”). As such there is no risk/reward trade-off to be made. there is scope for simplification in benchmarking
We would welcome such simplification but believe that there is scope for this regardless of whether menu regulation is adopted. In practice, Ofwat appears to be only offering limited simplification. Additional comments Symmetry We strongly support the proposal to create a symmetric approach to over/under spends of capital expenditure. The current approach is asymmetric and can penalise companies for making decisions that may be in the long term interest of customers. We consider that the introduction of symmetry in rewards/penalties has potential
benefit for both companies and customers as this allows greater flexibility to adapt to changing circumstances. We agree that the existing system can result in intrusive and burdensome challenge by the regulator and for companies to become fixated on the regulator‟s actions in setting the „right‟ level of investment. We support the objective to encourage companies to take ownership of their investment plans. Unintended consequence The complexity of the menu regulation approach raises a significant risk of unintended consequence. The First Economics paper referred to above indicates some areas where incentives to invest and efficiency incentives may be distorted. We are also keen to understand what consideration Ofwat has given to the interaction of this change with other regulatory mechanisms such as the OPA and operating efficiency assessments. The fact that Ofwat is proposing to simultaneously change a number of key areas in the price setting methodology, including introducing a revenue correction mechanism, potentially indexing the cost of debt, and radically overhauling the OPA, increases the risk of unintended consequences arising out of a combination of these actions. This is not in itself a compelling argument for the status quo but it does suggest that considerable attention needs to be given to the potential for unintended consequence and perverse incentives arising. New obligations We do not believe that menu regulation is an appropriate mechanism for dealing with new obligations that give rise to the requirement for significant capital investment. Such situations should continue to be dealt with by the existing interim determination process. It would not be reasonable to expect companies in their business plans to second guess future changes in legislation or other new drivers of investment which are beyond their control. Such an approach would not incentivise better business planning but would significantly increase business risk and therefore the cost of capital. This would not be in the interests of customers. We believe Ofwat should state clearly that it does not regard menu regulation as replacing interim determinations for dealing with significant new obligatons. Setting the baseline Most of the criticism regarding the current approach has been in relation to the process of setting the benchmark used for comparative efficiency adjustments. However, it appears that Ofwat intends to use essentially the same basis to calculate the baseline for the menu.
Ofwat holds out the prospect of simplifying regulatory reporting. We welcome this objective in principle and the potential to discontinue econometric modelling and ongoing efficiency assumptions in particular. However, we wonder whether for the most part the regulatory reporting required to establish a robust baseline will differ significantly from that currently used to calculate the benchmark. It would appear that the reduced regulatory burden is quite uncertain and would mainly arise from PR14 onwards. We would also stress that menu regulation does not mean that the level of the baseline „doesn‟t matter‟. It will still be important to set the baseline at a realistic central level. If the baseline is set too low, then in making their menu choice, companies will simply be „revealing‟ that the baseline is too low. Commitment and process The menu regulation approach requires a credible commitment from Ofwat to follow the process through both at PR09 and at PR14 when reconciliations are made. We believe that the final step should be the company choice of menu option and not Ofwat‟s re-setting the baseline. It is essential that the regulator does not respond opportunistically to companies‟ menu choices. For instance. if a company makes a final menu choice in October 09 that is lower than the baseline, Ofwat must not make adjustments in the Final Determination to lower the baseline Implementing penalties and rewards – alternative methods It is unclear to us why the assumed expenditure should only be adjusted by a quarter of the menu choice variation from the baseline. This implies that Ofwat considers that the baseline capex is considerably more valid / ‟accurate‟ than the menu choice. We would favour the alternative suggestion that PR09 capital assumptions should be based on each company‟s menu choice, with the appropriate menu reward/penalty implemented in full through ex post reconciliation at PR14. This is more consistent with companies owning their plans and would probably result in smaller adjustments being required at PR14. Transparency of process Menu regulation takes us a long way from the original concept of medium term price cap regulation. The additional complexity hinders transparency and could have an adverse impact on customers‟ views regarding the legitimacy of the regulatory process. This could become significant in relation to explaining movements in prices at PR14 when the ex post adjustments are made. It is not clear how public the process itself will be. For example, will benchmark capex levels and the companies‟ menu choices be made public? Will this be at each draft stage, or just at the final choice stage?
Accounting Issues As with other changes proposed by Ofwat (such as revenue correction) menu regulation will create potential accounting issues relating to the transparency of information in the accounts. For instance, should a company show a direct comparison between actual and assumed capex in the regulatory accounts? Should it show the „accrual/prepayment‟ that is likely to rolled out as part of the next Periodic Review? It is not clear that Ofwat has given any consideration to this issue. We would urge Ofwat to consult with the accountancy profession and to clarify the implications for regulatory and statutory accounts as a matter of urgency. Presentation One of Ofwat‟s objectives for PR09 is to remove “gaming” by companies. Menu regulation is perceived to contribute to this end. We have previously noted that “gaming” can apply to regulators as well as regulated businesses. The avoidance of gaming requires mutual acceptance by both parties that game playing is unacceptable. We fully support the intention to avoid gaming. It is important in this context that the menu regulation process is not described in game playing terms. Terms such as “bid” or “bidding process” should be avoided. It is equally important that Ofwat does not approach the process as a game. Risk Ofwat asserts that menu regulation reduces risk. It is far from clear that this is the case. Indeed, given the uncertainty surrounding precisely how it will be applied at present it would appear to introduce risk. We are doubtful as to the extent to which menu regulation can reduce risk but this is critically dependent on the detailed design and application of the menu structure, as well as interactions with other regulatory mechanisms. Comparison with Ofgem approach The menu regulation approach has been used to a limited extent by Ofgem. However, we are concerned that Ofwat‟s proposed approach would appear to involve more penalties and fewer rewards than that applied by Ofgem (see First economics paper). It may even be argued that in some circumstances it reduces incentives relative to the current approach. We are not clear if this was Ofwat‟s intention – in which case we would welcome an explanation – or if this is an example of unintended consequence. Developing detailed proposal It is essential that Ofwat develops its detailed proposal for menu regulation as soon as possible. Companies cannot take an informed view on the merits of menu regulation without this. In our view, it is not possible to take a view “in principle” on the
proposal when much of the detail is not fully developed. In these circumstances to accept menu regulation becomes a leap of faith. We are concerned that Ofwat is considering very significant changes to the methodology at a relatively late stage in the process (about 9 months before submission of Draft Business Plans)with a limited understanding how they would be applied in practice or interact as a package. Considerable progress needs to be made in a short space of time. Specific areas requiring further clarification and development include the following: setting the baseline establishing the breakeven point strength of incentive (slope of line) symmetry of penalties / rewards regulatory commitment
We are keen to assist Ofwat in any way we can in developing its detailed thinking. The workshop on 5th December is an important milestone. Our Financial Regulation Manager, Crawford Winton, will be attending this event.
Northumbrian Water November 2007