Getting the incentives right in RIIO2

“It is vital the output incentives aspect of the RIIO2 framework gives rise to the ‘right’ level of financial risk.”

Incentivising network companies to deliver the outputs consumers value is a key feature of the RIIO framework. Given that Ofgem has been clear that it is seeking to lower overall industry returns in RIIO2, it is vital the output incentives aspect of the framework gives rise to the “right” level of financial risk.

Simple economic theory tells us that risk and reward are closely related. For example, investors will accept a lower level of expected return for a lower level of perceived risk (variance in realised return). Furthermore, the outputs that are delivered by companies over a price control period are subject to a degree of uncertainty – some of that uncertainty is within management control, and some of it is outside of management control. Therefore, the choice of what outputs are defined, what target levels are set, and the financial incentives for outperforming and underperforming, will influence the risk and return that companies face over the control period.

From a company’s perspective, engaging with the output incentives aspect of the RIIO2 framework provides an explicit opportunity to ensure the company faces an appropriate level of risk for the expected level of reward that Ofgem will choose. Setting outputs and incentives is inherently difficult, because it is uncertain as to what the efficient level of service provision is and how best to incentivise companies to get there. If the targets set are too stretching, or the penalties for not reaching them are too severe, inadequate returns may be made.

On the other hand, if targets are set too low, or incentives too high, and companies significantly outperform, the regulator may be tempted to make ex-post adjustments (indeed, one “fail safe” mechanism Ofgem is considering is discretionary adjustments). The danger of this is that the regulatory regime could lose credibility and predictability, which could have a negative effect on the cost of debt over time. This is an issue currently playing out in the water sector, after Moody’s put companies on a negative outlook following Ofwat’s revisions to the methodology for PR19.

More generally, if Ofgem were to go down a similar road to Ofwat in terms of outputs and their associated incentives, network companies could expect to see:

• output incentives contributing up to +/-3% return on regulated equity (RoRE) – much higher than that expected for RIIO-1;

• building on the current outputs defined around the six output categories, numerous company-specific outputs and incentives.

However, Ofgem is yet to provide specific details of what output incentives will looks like for RIIO2.

Achieving the right level of risk will also be strategically and politically important for Ofgem. If there is too much upside risk, outturn performance may be such that companies earn returns far above the expected (and politically acceptable) level of return.

A call to action

There are three ways in which companies can help ensure that the outputs and incentives package for RIIO2 gives rise to appropriate levels of risk.

First, companies should understand the risk appetite and preferences of their current and potential investors. A degree of judgement will be required to identify the acceptable level of risk for a given reward, and preferences will depend in part on market conditions. The outputs and incentives aspect of the RIIO framework is uncommon in that there are a series of explicit formulas that determine, in part, what returns will be in different scenarios. If analysed correctly, investors can be presented with a menu of risk scenarios – with which they can express preferences.

Second, to correctly analyse risk, companies will have to draw extensively on their own engineering expertise. While historical data can be used to estimate variances in outturn performance compared with targets, engineering knowledge will be necessary to form robust views. Through our experience of advising companies, it is all too easy for the analysis of risk from output incentives to fall on the regulation team, with limited engineering input.

Third, a strong conceptual framework and practical approach needs to be taken to analyse risk holistically, both in terms of the output incentives package and the price control settlement as a whole. Any analysis will need to take account of a combination of upside and downside risks, and reflect the fact that multiple individual unlikely outcomes will be even more unlikely to occur all at once.

The outputs that are set for RIIO2 must reflect what consumers value. However, it is also vital that the associated incentives give rise to an appropriate level of risk, given the rewards on offer.