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Investor Meetings Sonia Brown, Chief Regulation Officer Graham Taylor, City Adviser 29 January 2014 1 Water today, water tomorrow
Where we are now Price review final methodology – July 2013 Approach to assessing business plan quality, criteria used to assess plans and incentives for high quality plans (risk-based review)
December announcement – 19 December 2013 Introduced pre-qualification stage to risk-based review. Excluded risk and reward criteria from risk-based review
Risk and reward guidance – 27 January 2014 Further guidance on the risk and reward package
Deadline for pre-qualified company to accept is 17 March
Pre-qualification announcement – 10 March 2014 Use subset of original tests to assess business plans: • Companies assessed as ‘enhanced’ ‘pre-qualify’ • Pre-qualifying companies decide whether to accept 27 January risk and reward guidance • Companies not pre-qualifying categorised as standard or resubmission in April
Enhanced company draft determinations – 29 April
Risk-based review decision – April 2014
Standard and resubmission companies draft determination – 29 August
• Enhanced – pre-qualified companies adopting risk and reward package • Standard – Includes pre-qualified not accepting risk and reward package • Resubmission
Water today, water tomorrow
2
Risk and reward in company business plans Proposed Cost of Capital
Proposed Outcomes
5.1% 4.9% Penalty & Reward
4.7% 4.5% 4.3%
Penalty Only
4.1% 3.9% 3.7%
Ofwat appointee WACC
14% 19% 68%
Ofwat wholesale WACC Dee Valley Sttn. & E. Surrey Bristol Bournemouth South Staffs South East Affinity Portsmouth Welsh Water Thames Anglian Southern Yorkshire Severn Trent Northumbrian South West United Utilities Wessex
3.5%
Wholesale - WoC Appointee - WoC
No Financial Incentives
Wholesale - WaSC Appointee - WaSC
Source: Company business plans and Ofwat guidance.
Source: Company business plans.
Water today, water tomorrow
3
Our risk and reward guidance Issue
Company proposals
Ofwat guidance
Appointee WACC
Exceed market evidence
3.85%
Retail margins: household/ nonhousehold
Wide variation
Retail household margin – 1%
Wholesale WACC
Exceed market evidence
3.7% (appointee return less retail margins)
Outperformance
Level and balance of cost performance and outcome delivery incentives (ODIs) vary
Overall return on regulatory equity (RoRE) range of +/- 3.5% to 4.5%
Retail non-household margin (England) – 2.5%, including 1.5% premium
Upside lower than expected
Resubmit ODIs with meaningful rewards and penalties as part of package
ODIs mostly reputational or penalty-only
Uncertainty mechanisms
Wide variation in approach to uncertainty mechanisms Inconsistent with a single notional industry return
Notified items only appropriate where probability of event or its impact cannot be influenced by company Greater transparency on pain/gain, sharing between customers and other stakeholders
4 Water today, water tomorrow
Composition of appointee WACC WACC inputs
Ofwat (point)
Ofwat range
Industry range
Total equity market return
6.75%
6.25% to 6.75%
6.50% to 7.25%
Real risk-free rate
1.25%
0.75% to 1.25%
1.25% to 2.1%
Equity market risk premium
5.5%
5.5%
5.0% to 5.75%
Gearing (Net Debt:RCV)
62.5%
60% to 62.5%
57% to 70%
Asset beta
0.3
0.3
0.33 to 0.40
Equity beta
0.8
0.75 to 0.80
0.84 to 1.07
5.7%
4.9% to 5.7%
6.0% to 7.9%
75%:25%
75%:25%
60%:40% to 94%:6%
Cost of new debt
2.65%
2.6% to 2.8%
0.6% to 3.5%
Cost of embedded debt
2.65%
2.6% to 2.8%
1.8% to 3.8%
Allowance for debt fees
0.1%
0.1%
n/a
Overall cost of debt
2.75%
2.7% to 2.9%
2.3% to 3.6%
Appointee (vanilla) WACC
3.85%
3.6% to 3.9%
4.1% to 4.9%
Cost of equity (post-tax) Ratio of embedded to new debt
5 Water today, water tomorrow
The importance of outperformance The Gray review noted in regard to PR09,
“…there is also some evidence that the system of incentives applied by Ofwat may be too focussed on penalties and compliance as opposed to positive incentives for desired changes of behaviour.”
Business Plan Proposed RoRE Ranges 12% 10% 8% 6% 4% 2% Range of RORE Forecast
RORE Forecast
Note: Range represents 80% confidence interval Source: Company business plans
Water today, water tomorrow
6
Opportunities for outperformance
Driver
Examples
RoRE guidance
Costs
Where companies find new or more cost-efficient ways of delivering services to customers they will be allowed to share this outperformance with their customers
+/- 2.0%
Performance commitments and ODI targets
Where companies deliver an outcome, supported by customer engagement, to a higher level of satisfaction for customers it should be possible for them to earn additional returns
+/- 1.0% to 2.0%
Service Incentive Mechanism
A relative measure of performance to assign rankings and rewards
-0.5% to +0.25%
Financing
Outperformance or underperformance against the allowed cost of capital
+/- 0.1% to 0.5%
Total
+/- 3.5% to 4.5%
7 Water today, water tomorrow
Categorisation of business plans The risk-based review is continuing to test Company • Costs categorisation • Outcomes • Affordability Enhanced • Board assurance Standard On 10 March, any companies that pre-qualify will be invited to adopt the risk and reward guidance. Resubmission Alternatively, they may choose to rework their business plans more significantly and follow the ‘standard’ price review process. Companies classed as ‘standard’ or ‘resubmission’ will also need to modify their plans in line with this guidance. Benefits of enhancement include • Acceptance of the business plan with few adjustments • A four-month head start, with Draft Determinations in April instead of August 2014 • Explicit financial incentives • Reputational benefits
8 Water today, water tomorrow
Appendix: PR14 Plan v2.3 PHASE 1:
PHASE 2:
Clarification
Restricted Communications Ofwat host company ACTS workshop (26 Sep)
PHASE 3:
Risk-based Review Categorisation Pre-qualification results and reward for enhancement announced (10 Mar) Results of risk-based review announced (4 Apr)
SIM consultation published (14 Oct) Financial model published (17 Oct)
IN Default tariffs (6 Jan) Companies’ updated cost and performance data published (9 Jan) Risk & reward guidance published (27 Jan)
Ofwat
Aug 2013
Sep
Oct
Nov
Dec
Jan 2014
Feb
Business plans submitted (2 Dec)
Prepare business plans
CCG reports submitted (2 Dec)
Company challenge via CCGs
Mar
Enhanced draft determinations and menus published (30 Apr)
Standard / resubmission draft determinations issued (29 Aug)
Standard baselines and draft menus published (30 Apr)
Standard menus published (29 Aug)
Publish default tariffs guidance (early Apr)
Apr
May
Jun
Exploring bringing forward final determinations for companies with enhanced business plans
Jul
Aug
Oct
Nov
Dec
Jan 2015
Re-bids on risk and reward received (17 Mar) Results of risk-based review announced (4 Apr) No change / minor amends to enhanced business plans
Updated business plan deadline (27 Jun) Redevelop resubmission business plans
Companies’ updated cost and performance data submitted (9 Aug)
Consultation on draft determinations Consultation on draft determinations
Consultation on draft baselines
Stakeholder collaboration with companies and Ofwat (eg environmental and quality regulators)
Companies and stakeholders Enhanced business plans
Sep
Refine standard business plans
Companies present business plans
Key:
Publish final determinations (by 12 Dec)
Standard business plans
Resubmission business plans
Guidance publication
Water today, water tomorrow
Plan elements are subject to change
10%
8% 8%
6% 6%
4% 4%
2% 2%
0% 0% Energy retail
10%
Energy¹
Water today, water tomorrow Centrica Energy Energy High HH² NHH³ street retail⁴ Telecoms⁵
Return on Capital Cross-Check: 0.5-0.9% Return on Capital Cross-Check: 0.6-1.1%
Ofwat guidance: 1.0% Ofwat guidance: 2.5%
Business Stream
Business Stream
Rail
Rail
Telecoms
Retail ISP
MVNOs Retail mobile
MVNOs + BT Retail
MVNOs + BT Retail
High street
Supermarkets
EI
NHH Energy Retail
EE
Energy retailer, no volume risk Energy retail w. volume risk
Household
HH Energy retail
Ofgem
Gas retail
Electricity retail
Energy retail adjsuted
PwC
Energy retail
Energy retail (dual) Energy retail
Energy companies
Appendix: retail margins Non-Household Oxera
Rail⁶ Water⁷
10
Appendix: wholesale WACC
Component
Point Estimate
Total allowed return
A
3.85%
Retail net margin
B
1.00%
Revenue requirement (2015-20 year average)
C
£11,194 m
RCV (2015-20 year average)
D
£64,912 m
E = B*C / D
0.17%
F
0.15%
G=A–F
3.70%
Retail return on RCV
Adjustment from appointee to wholesale WACC(1) Wholesale WACC
Source: Ofwat calculations and industry totals (1) We do not deduct the full retail return on the RCV as the legacy retail assets in the wholesale WACC will depreciate away over the AMP.
11 Water today, water tomorrow