FTI Consulting – Utility Week: Unequal Retail

Economic and Financial Consulting

December 13, 2013

Ofwat’s proposed retail framework for 2015-20 tries to apply a one-size-fits-all formula to companies with very different circumstances, warns Anthony Legg.

In October Ofwat launched a consultation on its approach to the Service Incentive Mechanism (SIM) for the 2015-20 period. The Sim is a measure of customer satisfaction with water companies’ performance, and it is one of the key performance indicators Ofwat wants companies to sign up to at PR14. One of Ofwat’s main proposals is to retain the range of potential rewards and penalties attached to SIM performance at -1 per cent to +0.5 per cent of total integrated revenue (which it suggests equates to around -12 per cent to +6 per cent of household retail revenues). While companies would be free to propose stronger SIM incentives, it is likely that most will adopt Ofwat’s proposed uniform approach.

This might sound like treating all companies the same, but it isn’t: companies will have different incentives to deliver good customer service if this proposal is taken forward. The importance of performing well against the SIM will vary between companies because the potential rewards and penalties on offer will impact returns to investors by different amounts.

Water-only companies have a much higher exposure to SIM than water and sewerage companies, but there are differences within these groupings too.

Ofwat could be forgiven for trying to take a simple, what it might describe as “proportionate”, approach to the SIM, even if this causes small distortions in the incentives companies face to provide good customer service. However, these distortions may not be small.

There may also be knock-on effects for the rest of the outcome delivery incentives companies propose for themselves: other penalties and rewards might have to be watered down or beefed up to achieve a range of potential returns to investors that strikes the right balance between shareholders and customers.

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