Setting up for success in price reviews

Even veterans of regulated companies can make simple errors in navigating the price control process. Simon Oates, director at Fingleton, sets out some fundamental steps to getting the best out of price reviews.

Price reviews are serious business. They may only come round every five years, but they establish the key financial parameters within which regulated businesses must operate. They dictate the returns shareholders will receive and the budgets management teams have available to deliver and improve committed levels of service to customers. Price reviews are commercially consequential, time-consuming and complicated for any regulated business.

Increasingly, regulators are driven by a desire to address information asymmetry and are making greater use of financial incentives / penalties linked to the quality of data, supporting analysis, and customer consultation underpinning business plan submissions. Ofwat’s Risk Based Review assessment at PR19 and Ofgem’s Business Plan Incentive framework in RIIO2 are the most recent examples.  Both incentive frameworks linked tens of millions of pounds of up/downside risk to an assessment of the quality of evidence in company plans.

Executive teams, and increasingly boards, of regulated businesses face pressure to navigate price reviews correctly or risk the added cost, complexity, and uncertainty of appealing the outcome to the Competition and Markets Authority (CMA).

Utility regulators approach price reviews as the guardians of customers. The money that regulated businesses spend ultimately comes from captive customers, who have no choice other than their designated monopoly supplier. Regulators exhibit a healthy degree of scepticism about a business’s future plans and performance promises. So strong evidence, as always, is a prerequisite to success.

Even so, regulated companies with years of experience of price review processes can still run into difficulty. Here are some simple rules that all regulated businesses should follow in order to most effectively navigate the price review process.

1. Start planning early

Successful companies start planning for the next price control as soon as the previous one has ended. Regulatory processes are demanding, data hungry, and resource intensive, and light touch or temporary corporate processes will not cut it.

Regulators expect to receive business plans supported by high quality data and analysis which provide genuine insight into business performance. They want to see that businesses and their leaders understand the drivers of performance, where they have learned lessons from poor performance, articulate and evidence the interventions used to fix them, as well as demonstrate how feedback from customers amends the approach to service delivery. Data helps tell this story. It can be used to illustrate progress in company productivity and performance. Nothing is more effective in building credibility with a regulator than reliable data and robust analysis to support investment needs.

Building a coherent regulatory business plan, therefore, takes time. It requires iterative thought to shape the customer and regulatory proposition and build the disciplined and structured processes to demonstrate managerial effectiveness, establish the key content of the evidence base, and collect the necessary data.

High quality, curated, data on business performance, service, cost and customer preferences must be collected and assessed over the duration of the review period to support the new business plan against the regulator’s scrutiny. This cannot be pulled together effectively in the 18-24 months of the formal review, when the business will be stretched and forced to make decisions against the regulator’s timetable.

2. Make it a senior team focus

Regulation is the single biggest influence on the value and profitability of regulated businesses. The regulator sets the allowed revenues, level of returns, and the scale and scope of regulated businesses investment programmes. So, the settlement a business gets from its price review is, more often than not, the biggest single driver of shareholder value and profitability for years to come.

Therefore, it is important that regulation and the regulatory strategy sits firmly on the executive and board agenda. It should not be considered a specialist activity, left to a small team of regulatory experts to be looked at by the Board for a few months only, every five to eight years.

One of the biggest frustrations for regulators is what we call the “say and do gap”: the gap between what a business and its senior leaders say it will deliver versus what it actually does. Regulators heavily scrutinise business performance and benchmark companies against their peers. The regulator does not appreciate those businesses whose performance persistently lags in the sector and those who don’t prioritise investment to close performance gaps in the areas most valued by customers.

An easy way to address this is at the beginning of each new regulatory cycle. The board and executive should agree and sign off a clear and durable regulatory strategy which identifies the package of core business targets, service improvement priorities and associated milestones to best position the company for the next regulatory review.  Continued monitoring of delivery against these priorities by the board is key – with rapid intervention to course correct if performance falters.

3. Get shareholders on board

Shareholders are a key constituent on the board, but they don’t always have a good understanding of how regulators think and more specifically how they assess evidence and take decisions. It is therefore essential to engage shareholders early in business plan development so they understand the task at hand, gain an awareness of what good looks like, and understand the evidential bar that must be met to secure a regulator’s support.

Engaged well, shareholders can bring a different and valuable perspective to the necessary process of iterative challenge and scrutiny that goes into a well thought through and evidenced plan.

4. Align with the core strategy

Regulatory business plans should be built from, and tightly aligned to, the core business strategy. There is no room for divergence between the business strategy and regulatory strategy. The board should ensure that they form a single unified strategy for the company.

A regulated business can actively manage regulatory risk by taking the operational and investment decisions that will maximise regulatory value. This is the most certain route to maximising profitability.

5. Substance is critical; a bit of style can also help

Sound bites and straplines should only be advanced where there is clear, compelling and robust evidence to support them.

The whole purpose of the regulatory review process is to subject companies’ plans to challenge and forensic scrutiny to assess how much money they should be allowed to charge, typically, captive customers. An ambitious and compelling business plan narrative will amount to very little unless it is backed by hard evidence and analysis.

That said, once the substance is there, do give thought to the audience in the regulator and associated stakeholders. Business plans that are well written, interesting to read, well-designed and easy to navigate will pay dividends. Ensuring the delivery of a well-designed plan must not be overlooked.

6. Ensure claims match performance

Conduct within the current price review period is also a big influence on the regulator’s view of future plans. Painting a sunny picture of future performance and service delivery for the regulator, when current business performance is deteriorating, with no clear narrative for transformation, won’t convince anyone. The incongruence makes the plan come across as disingenuous.

Regulators have long memories. Businesses need to make sure plans don’t fall foul of the “say and do gap” because it can hurt the business’s efforts in the longer term.

Payment of special dividends, data misreporting, missing key customer targets, and poor management of, or recovery from, inevitable operational events will all colour the regulator’s (and the CMA’s) perception of company competence.

A straightforward way to avoid this is that when key Board decisions are being taken within a price control period, the question that must always be asked is – “What are the regulatory consequences that may follow?”  Too often this does not happen

7. Be aware of, and responsive to, the regulatory agenda

In competitive markets the most successful businesses are, typically, the ones which deliver what their customers want. For regulated businesses, understanding what regulators want – on behalf of consumers who cannot vote with their feet – is critical to success.

For right or wrong, most CEOs / chairs of regulators want to leave their mark on their sector. They want to leave some legacy for their time in office. As such they typically arrive in office with a pretty transparent agenda. Examples include accelerating activity to progress decarbonisation, driving up investment in innovative / R&D or seeking greater use of market mechanisms to drive efficiency and service quality. Businesses must know what these are and ensure they demonstrate how the business plans deliver the regulators’ agenda.

A successful business plan is therefore one which secures the outcomes regulators and government policy expect to see. Increasingly, this is no longer narrowly focused on productive efficiency, but embraces wider policy objectives, from environmental sustainability to consumer vulnerability, and complex trade-offs between these.

Ongoing proactive engagement with the regulator on policy issues helps shape how it will solve those trade-offs at the next price review round.

8. Learn from past price reviews

Undertaking a ‘lessons learned’ exercise, shortly after the previous review has concluded, to bank what has gone well and drive improvements elsewhere is an important discipline. In this, a business should consider everything from how efficiently the company set up its internal processes and the quality of evidence available to inform decision making, to how efficiently decisions were made, whether key decision makers were brought in at the right time, and how effectively broader stakeholders were engaged..

Regulation is, in many ways, a ‘repeated game’. A business gets a chance every five (or so) years to implement learning from past reviews and make recompense for past weaknesses.

Lessons should also be taken from what has happened throughout the previous price control. For example, what profile of investment programme maximises delivery efficiency, what type of contractor alliance is right for the business in light of its specific delivery priorities, how much work on a capital programme is best outsourced versus how much in house. These are all important considerations for businesses when compiling their regulatory business plan.

Finally, in the event that the regulatory determination on a company business plan isn’t acceptable, there is always the option of appealing or seeking redetermination from the CMA, depending on the sector specific arrangements.

How to get the best outcome from a CMA process deserves its own piece entirely.  However, it is worth noting that a CMA appeal or redetermination process differs significantly from a price review.  It is more focussed, faster paced, and more intense than any regulatory review.

To be successful at the CMA, starting preparations early, focussing – where possible – on a narrow set of grounds where change to the regulator’s decisions are required, and being brutally honest in assessing the quality of evidence you have to support regulatory error and a more preferable alternative are the core ingredients.

Simon Oates is the head of the infrastructure practice at Fingleton. Prior to joining the consultancy last year he spent seven years at Southern Water, latterly as director of corporate strategy, regulation and corporate affairs. He also spent two years at Thames Water.