Baringa’s view on opportunities and challenges within Ofwat’s approach to performance commitments.
Within the water sector, there is one date this December that really generates nerves and excitement. After three years of drafting, re-drafting, and, re-re-drafting business plans, water and wastewater companies have finally received Ofwat’s ‘Final Determinations’ on December 16th. These set out a five-year plan for each water and wastewater company, setting out costs, prices, strategy and service targets. Ofwat will argue that their interventions deliver a proverbial clementine at the bottom of the stocking for customers, at a time when the sector faces a perceived crisis of legitimacy, and occasionally stagnant performance. In contrast, some water companies will feel that the Final Determinations are closer to a Christmas morning lump of coal for shareholders, particularly when climate change, population growth and decaying infrastructure demand more investment than ever.
Outcome delivery incentives (ODI) and performance commitments (PC) are a key component of each company business plan. These aim to formalise the incentive between performance and financial risk/reward. Where service is exceptional and customers are willing to pay for an exceptional service, this is allowed to be reflected in increased prices. When stretching targets are not met, the converse is true. So, within the Final Determinations, where will water companies see the opportunity to earn reward? And where might underperformance hit revenues the hardest?
Ofwat has conceded ground on a number of ODIs and PCs since their Draft Determinations, published in July. A number of previously ambitious targets that may have felt out of reach for the sector, are now in touching distance. For example, water supply interruption targets have relaxed from 3 minutes to 5 minutes per property for 2024-5. Furthermore, leakage targets have softened by ~5% for a number of water companies, such as Thames, Yorkshire and Portsmouth. For the mains repair PC, changes in performance benchmarking approach and an increased allowance for the impact of leakage reduction have softened performance targets by 16% for some lucky companies. In addition, Ofwat’s use of the upper quartile performance level to set targets means that some companies will already be starting in the green, with Wessex notably already performing well across a number of areas. Ofwat has set performance commitments for unplanned outages and internal sewer flooding that some companies are already meeting.
Whilst the targets are ambitious, Ofwat has tried to achieve a more balanced incentive package through increasing rewards for outperformance. These potential rewards are not to be sniffed at. For example, interventions regarding internal sewer flooding and leakage will provide potential for significant upside if companies outperform. In addition, Ofwat has looked to increase customer protection through limiting the potential for disproportionate financial risk. ‘Caps’ and ‘collars’ put a finite limit on financial peanlties and rewards. These have been introduced by Ofwat for sewer flooding and pollution ODIs, to allow for companies to play catch-up at a reasonable rate, without incurring disproportionate losses that translate to bill volatility for customers.
Whilst Ofwat has softened its financial incentives in many areas, and introduced additional layers of customer protection, there are a number of areas of significant challenge for many companies. Many will consider targets set for mains repairs to be particularly tough. The ambition of the 16% leakage reduction target speaks for itself, following decades of constancy. For many companies, individual ODIs may stand out as being particularly challenging. For example, Thames Water are likely to find unplanned outages tough, and Southern will have a challenge on the Compliance Risk Index. Yorkshire Water faces an uphill battle for mains repairs and sewer flooding.
Trade-offs between potentially competing outcomes also need to be carefully considered. For example, the leakage target may need to be prioritised, in spite of the mains repair PC. In other areas, the costs required to improve performance might outweigh the potential financial incentive, such as for low pressure. More holistically, there are financial priority decisions which need to be considered at a whole-company level. Water companies will need to consider where the biggest rewards can be gained for the least investment, or where canny innovation will make a bigger difference than simply throwing money at the problem.
So – as the Final Determinations sink in over the Christmas holidays, it is clear that the hard work is yet to begin. The ODI and PC framework is representative of Ofwat’s perceived state of the market, requiring rocket-fuelled focus on innovation, resilience and public service, in order to neutralise any perception of an industry without legitimacy. These are all noble ambitions. However, the true challenge lies in delivering these goals, whilst simultaneously increasing efficiency and squeezing shareholder dividends. The impact of climate change on water companies is also growing, and the unpredictability of floods, droughts and severe weather situations are creating additional challenges on demand, supply, and infrastructure. It’s only when all of these drivers are considered in the round that the true scale of the challenge ahead becomes clear.