PR09 incentives proposals: menu based regulation

1
PR09 incentives proposalsmenu based regulation

• George Day
• Head of Asset Strategy
• PR09 consumer event, 16 November 2007

2
PR09 incentives

• Summary of PR09 proposals
• What is menu regulation?
• How does it work?
• Key issues
• Why use a menu approach?
• Conclusion

3
PR09 proposals summary

• Opex
• Retain broad approach to setting expenditure
  assumptions and incentives for opex
  outperformance in AMP5
• Capex
• Menu regulation
• Retain RCV rolling adjustments
• AMP5 service incentives (son of OPA)
• To be reviewed in context of overall incentive
  package
• Shortfalls for failure to deliver outputs
• Key change menu regulation for capex

4
Why do it this way?

• Opex
• Relatively predictable
• Established methods appear to perform well
• Capex
• Continuing need for sizeable programme and need
  to ensure value for consumers
• More difficult to predict importance of
  business plans
• Case for improving the approach to incentives
• Delivery
• Ensure outperformance is not at expense of
  delivery
• Further thinking on customer service incentives

5
What is menu regulation?

• Traditional approach
• Regulator assesses efficient expenditure take it
  or leave it
• Incentives (30 of long term benefit to
  shareholders)
• Issues
• Companies always have better information about
  their expenditure needs ? need for intrusive
  scrutiny
• Risk of shifting responsibility for investment
  choices
• Alternative approach
• Give companies choice, but with incentives to
  make the right choice (incentive compatible)
  and to out-perform
• Achieved by varying allowances and incentive
  strength
• Used by Ofgem (electricity and gas distribution
  reviews)

6
Why use menu regulation? (Ofgem view)

• Strong message in 2003 to electricity
  distribution companies to move beyond gaming
  and present realistic business plans
• How could we ensure those that did were not
  relatively disadvantaged, and also
• retain an incentive for efficiency throughout
• encourage company ownership of capex
• allow but not encourage overspend
• reduce the possibility of high capex companies
  making very high returns from underspend?

7
How menu regulation works (1)
8
How menu regulation works (2)
9
How menu regulation works (3)
Not incentive compatible best option is
always 140
10
How menu regulation works (4)
Company forecast
100
120
140
Allowance
100
105
110
? Incentive compatible (i.e. best option is to
choose what you expect the outcome to be)
Incentive
40
30
20
Additional income
2.5
0
-3.5
Actual
80
7.5
2.5
10.5
100
2.5
1.5
-1.5
120
-5.5
-4.5
-5.5
140
-13.5
-10.5
-9.5
11
Key issues efficiency incentives

• PR04 incentive rate for capex (roughly) 30
• Stronger incentives for company choosing more
  challenging options
• Issues around slope of efficiency line

12
Key issues baseline setting

• Baseline should be reasonable central estimate
• Balanced view of risk and scope of investment
• Base
• Evidence from out-turn expenditure cost base
• Common framework based assessment of future is
  different
• Capital enhancement
• Scope (cost benefit tests)
• Price (cost base, capital estimating)
• Change
• no continuing efficiency, capital maintenance
  econometrics
• simplified common framework scoring

13
Why do menu?

• Positive incentives for realistic innovative
  business plans
• Stronger incentives for leading companies
• Reduce temptation to pad cost estimates
• Rely less on omniscient regulator
• Reinforce company accountability
• Potential to reduce regulatory information
  burden?
• Focus on value for consumers
• Better value in plans rewards for outperformance

14
Conclusion

• New incentive proposals
• Informed by informal consultations and exchanges
• Combination of evolving our methods and new
  thinking to address broader issues, not just
  regulatory minutiae
• Try to break from ever increasing detail
• Need to consider package as a whole
• Setting expenditure assumptions
• Outperformance rewards
• Regulation of delivery / outputs / service

15
Discussion

• Can menu regulation encourage companies to reveal
  best value business plans and deliver on them?
• Should the regulator offer any choices to
  companies, or stick to a 'take it or leave it'
  approach?