Gain-share is a term long used by contractors and consultants to refer to a way of securing employee commitment to improving performance. They promise to share the benefits with those involved in delivering the gain, and experience suggests that managed collaboration can have benefits for all.
At the recent City Briefing, and again in his speech a couple of weeks ago at the Royal Academy of Engineering, Jonson Cox, Ofwat chair (see interview page 16), volleyed the ball firmly into the water companies’ court when he said that he expected them to make suggestions on -“how to share pain and gain with customers in the next AMP “. This is consistent with a general move on Ofwat’s part to shift responsibility for key parts of how water firms are regulated away from Ofwat and on to company boards. This aspect of Ofwat’s proposals sparked the greatest interest among investors present at the City Briefing.
The existing system of price cap regulation aims to encourage efficiency by allowing companies to retain savings from outperformance for a period of time. Customers share the risks and reap the benefits when prices are reset. Currently, in net present value terms, the benefits of efficiency outperformance are shared roughly 70:30 between water bill payers and water company shareholders.
When Cox talked about sharing on these occasions, he referred to gains that the companies cannot fairly claim to be within management control – such as those accruing from unexpected levels of the cost of debt and the rate of inflation. These are gains that have not resulted from the skill or effort of the company managers and, crucially, such gains would not be retained over time in a competitive market. As such they are fair game for a regulator who has a duty to protect consumers.
The gain-share suggestion asks companies to be explicit about how they should share pain and gain with customers. Ofwat believes the legitimacy of the sector in the eyes of the public is threatened and that gain-share would help to rectify this. If legitimacy is diminished and customers decide not to pay their bills, investors will suffer. Thames Water recently attributed its financial performance to rising bad debt costs. It is not alone in facing challenges of this kind – customer legitimacy is not something that investors can ignore in the long term. Only if customers pay will investors invest, and only then will customers get the services they want. In principle, a classic case of win:win.
Ofgem has already moved in this direction under its new RIIO regime, having taken the major step of indexing the cost of debt. In addition, it holds out the prize of a fast-tracked price review, giving companies that perform well and make appropriate proposals the chance to benefit from a lighter touch assessment of their business plans. This works for the regulator too, allowing it to reduce and redistribute effort and attention. It is a manifestation of risk-based regulation.
What might this mean for a regulator wishing to promote arrangements that redistribute some of this unearned outperformance to customers? And what does it mean for companies that want to demonstrate they are responding to the challenge?
Some, such as Severn Trent and Anglian Water, have taken the view that they should share gains with customers because “it is the right thing to do”. Frank Grimshaw, economic regulation manager at Severn Trent, describes this as “wanting everyone to feel that it is a fair deal – and this can include doing more than the regulator asks”. Severn Trent reinvested nearly £200 million in additional mains renewal and investment in AMP4 (2005-10) which will deliver future cost savings, and has previously paid rebates to customers – for example, nearly £100 million in AMP2 (1995-2000).
It may be that companies who voluntarily share gain value the reputational benefits without the need for explicit regulatory incentives. Increasingly divergent company business models and financing structures mean that Ofwat could receive a variety of returns of Cox’s volley. This could include at one extreme a “thank you but no thank you” position, possibly from companies that are unconvinced about the regulator’s intentions and commitment to fair play.
Arrangements will have to satisfy reasonable requirements for fairness and legitimacy as well as providing for the interests of shareholders. Some investors have voiced concerns, arguing that since they carry the downside risk of underperformance, they should be able to gain from the upside risk of outperformance. They argue that changes to the existing arrangements may cause the cost of capital to rise. If this occurred it could outweigh any customer gain.
Water UK chief executive Pamela Taylor observed in her speech at her organisation’s recent City Conference that for every 1 per cent increase in the cost of capital, the cost to consumers rises by 5 per cent. Ofwat recognises the importance of the cost of capital. At the Ofwat City Briefing, chief executive Regina Finn declared “we want financing costs to be as efficient as possible”. However, Ofwat might also point to returns to investors in the sector, which have represented much gain and not much pain.
Ofwat and the companies will have to explore a range of approaches and in doing so should look for new arrangements that are more transparent. These should support customers’ willingness to pay, maintain incentives for businesses, and be and be perceived to be fair. Companies might make proposals about how such a scheme could work by answering the key questions set out in the box, above.
It is clear that there are potential benefits, otherwise none of the companies would have adopted voluntary sharing. Only if the regulator works with the sector will it be able to ensure these ideas become the win:win they could be rather than rain stopped play. It will be interesting to see how companies rise to the challenge.
Felicity Furness is a principal consultant at Indepen
Key gain-share arrangement issues
· Should sharing be voluntary or mandatory?
· Under a voluntary scheme, would the regulator differentiate between companies that did and did not volunteer and if so, how?
· How would gains and pain be assessed?
· Should the sharing of gains and pains be symmetrical?
· Would it apply to all gains and all pains or only the unearned sort?
· What would be the proportions of the sharing and would this be dependent on the source of any outperformance?
This article first appeared in Utility Week’s print edition of 22nd March 2013.
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