Expert view: The flaws in floors – and in caps

Floors and caps invariably blunt overall incentive power, which is rarely a good thing.

Ofgem’s March consultation on the RIIO2 framework proposed “underwriting” returns in the name of financeability. The regulator’s thinking was driven by its assessment that lower baseline returns envisaged at RIIO2 “may make it more challenging to meet the standard financeability metrics”.

But before considering the merits of any mechanisms to address this, it is worth standing back and asking ourselves the question: “What is the problem we are trying to solve?” There seem to be two possibilities. First, baseline returns are simply set “too low”; or second, the range of incentive mechanisms that collectively influence over and underperformance awards are misaligned.

On the first possibility, it is well understood that setting an “appropriate” return does not guarantee a regulator will meet its financeability duty (because of a mismatch in timings between allowed revenues and required cash). Accordingly, various tools have always existed to address this, including revenue ­smoothing. However, Ofgem now appears to be hinting at a more fundamental tension between the baseline return at RIIO2 and the ability of companies to achieve financial ratios consistent with investment-grade ratings. But, when one considers this in terms of the notional, efficient company, such a concern seems unfounded. That is to say, if the other parameters of the price-setting process are set correctly, then any material incompatibility between baseline returns and achieving financeability would seem to indicate that the return has been set “too low”.

Turning to the second possibility, perhaps the concern is instead founded in the possibility that, via the various incentive mechanisms that apply in RIIO, companies’ returns are unduly influenced by financial rewards and penalties that are not appropriately calibrated to deliver the “right” (efficient) outcomes. Take outputs. It is inherently challenging to measure the customer value or cost of delivering specific service levels. Likewise, it can be hard to know whether under or outperformance is the result of company effort or external factors outside its control. However, if concerns about the alignment of incentives are the issue, then the appropriate solution would be to look afresh at the approach and simplify – recognising that no incentives are “perfect” and focusing on using such mechanisms only when the quality of information and incentive power is sufficient to make them worthwhile.

The above does not imply that “floors” would never be appropriate. They might make sense if one reached the conclusion that revisions to improve the design of other incentives were impractical. However, one must always be mindful that floors and caps invariably blunt overall incentive power, which is rarely a good thing.

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