PR19 - Balance of Incentives and the Cost of Equity

The overall objectives of this work is to:

• Review the overall incentive framework for aligning company interests (including company management and investors) with customers now and in the long term. This includes the setting of the single notional allowed return on capital, ODIs, cost outperformance, financing outperformance, as well reputational and procedural incentives associated with risk based review of business plans to consider whether this is most likely to allocate risk and align returns with best interests of customers.

• Consider whether menu based differential on allowed return on equity would improve the overall incentive framework and what the implications might be for other elements of incentive package including outcome delivery incentives, totex and financing, if a differential cost of equity was to be introduced. Also consider whether a menu based differential in allowed return on equity would need to be modified to fit with overall incentive framework, in particular the outcome delivery incentives.

• Consider desirability and feasibility of setting differential returns on equity for water and wastewater companes on basis of risk and/or ambition of company business plans. If feasible, recommend an approach as to how a menu based approach cost of equity could be best implemented including how an appropriate differential in return could be set. This should include consideration of the impacts on the cost of equity in a 'lower for longer' interest rate scenario.

• Provide recommendations on the overall balance of financial and other incentives to best align company with customer interest now and in the longer term. This should include an assessment of the overall balance of incentive mechanisms. It should consider and provide recommendations on the development of appropriate incentive mechanisms for PR19, which may include the evolution or replacement of, mechanisms that applied at PR14.

• Consider the implications of a lower for longer interest rate scenario on the cost of equity for PR19. This will consider whether the CAPM approach remains appropriate for setting the cost of equity in an environment of extremely low interest rates for total market returns, risk free rate and equity premium and for estimating the equity beta.

We would welcome further suggestions from Contractors on what else should be considered as part of this work.

As part of this work the Contractor will also need to engage with us on outcomes and cost assessment work. The Contractor may also need to engage with companies individually, and potentially in a workshop in developing final proposals. We are separately appointing consultants to consider the future development of performance commitments and outcome delivery incentives and so the Contractor will also be required to liase with the consultants developing our approach to outcomes in developing its work on the balance of incentives and risk and reward.