Ofwat: Bonuses should be tied to environmental performance

Water company boards have been urged to consider executives’ performance on pollution and the environment, both good and bad, when setting and awarding bonuses.

The regulator has written to the chairs of their remuneration committees ahead of reward packages being determined for 2021-22 and performance targets being set for 2022-23, warning that they should be mindful of the “high level of scrutiny and concern” surrounding environmental performance.

Interim chief executive David Black said executive pay must be demonstrably linked to delivering against the stretching performance targets for customers and the environment in each companies’ five-year business plans.

At PR19, the regulator wrote to company boards reminding them that bonuses must reflect good and bad performance for executive directors, including any regulatory non-compliance. Explanations about any bonuses should be accessible to all stakeholders, the letter stated.

“Given the current concern about environmental performance, including the current investigations into compliance with environmental permits, we urge remuneration committees to give particular consideration to the clarity of reasoning for any awards made in this area,” Black said in the latest correspondence.

Limiting bonuses to executives if companies fail to drive down pollution incidents was recommended in a report into river health in January.

Black added that boards must be open about any use of contractual clauses or provisions and that each company’s approach to remuneration will be assessed by Ofwat against the points raised in the letter.

The steer by Ofwat came after the regulator launched a consultation into changes to the way output delivery incentives (ODIs) are calculated for the next price review in PR24. ODIs reward or penalise companies financially or reputationally for their performance against certain targets during an asset management period.

Ofwat said it wants simplify the way ODIs are calculated and has suggested removing the reliance on marginal cost estimates, which were highlighted as problematic due to inconsistencies in the costs provided by companies.

Another suggestion by the regulator was to set ODIs as equal to the estimated benefits.

For customer-facing and environmental commitments, Ofwat said there is “a strong case to use a marginal benefits-based approach to setting ODI rates”. Doing so would give companies incentives that are proportionate to the impacts on customers.

For environmental targets, Ofwat noted the scale of improvement required meant that diminishing marginal benefits would be unlikely to be seen at the next price review. It suggested setting the same underperformance and outperformance rates for customer-facing and environmental commitments.

In the current price review, nine companies have enhanced ODIs related to sewer flooding, leakage, per capita consumption (PCC), supply interruptions and pollution incidents. For PR24, Ofwat said these ODIs may be altered if they are kept in the next price review.

At the moment, enhanced ODIs are only in place for companies that requested them but they could become a requirement on certain standard performance commitments as an incentive to “achieve frontier-shifting performance”.

Ofwat’s consultation is seeking views on the approaches to setting ODIs and how useful they have been since first being introduced in PR14. The responses will inform the draft methodology for PR24 due to be published in July and the final methodology due in December.