1. Executive summary

2. Current profit sharing methodology

3. Proposed profit sharing methodology

4. Period between price reviews

5. Voluntary benefit sharing

6. Formal profit sharing schemes

7. Effect of taxation

8. Conclusion

APPENDICES 

I - Glossary of terms

II - Methodology used in calculations

III - Sensitivity analysis

IV - Impact of profit sharing on the glide path and the proposed P₀ methodology

V - Transfer of capital efficiency benefits to customers

1 EXECUTIVE SUMMARY

1.1 This paper compares the current price capping regime of incentive regulation (RPI - X) with various other available options.  

1.2 Under the approach adopted at the last review of prices, the companies on average, share almost 70% of the profits which have resulted from efficiencies beyond those foreseen at the previous review with customers. In addition to this, all the profits arising from future efficiencies anticipated by the Director General of Water Services (the Director) at a review are passed entirely to customers through the operation of the price cap (whether such efficiencies are achieved or not).  

1.3 The method and timing of the transfer of benefits from shareholders to customers is at the discretion of the Director. The methodology that was proposed by the Director in MD124 would result in an initial downward adjustment of real prices in the first year of the new price limit period, 2000-01. If this approach is adopted then slightly over 80% of the past outperformance benefits would be transferred from companies to customers at the forthcoming Periodic Review.  

1.4 A shorter period between reviews (eg a period of 4 years) or a formal profit sharing mechanism would each add less than 5% to the share of past outperformance benefits transferred to customers while undermining the incentives of the current [incentive based] regime. Both these measures could result in customers having a larger slice of a smaller cake.  

1.5 The effect of corporation tax is to make profit sharing less attractive than would be the case without any taxation. The profit sharing takes place after corporation tax whereas the benefits transferred from shareholders' to customers' at a Periodic Review are before taxation.  

1.6 This paper also covers voluntary benefit sharing. Ofwat encourages early voluntary sharing of benefits with customers. At the next Periodic Review, companies which have voluntarily shared past outperformance benefits with customers between Reviews will be no worse off than those which have opted not to share.  

1.7 If incentives to efficiency are diminished, customers may lose more from profit sharing in the long run than they gain from it in the short run.  

1.8 In summary, the benefits of profit sharing are more apparent than real, and would serve more to correct a public perception of water companies as making excess profits at the public expense than in increasing the public good by reducing prices to customers.

RPI - X has incentivised companies to find substantial efficiency savings. The progressively tightening of the formula induces companies to find ever greater efficiencies. The vast bulk of these savings are then passed on to customers.

2 CURRENT PROFIT SHARING METHODOLOGY

 2.1 The current regime is an incentive-based profit-sharing regime. At Periodic Reviews, the Director caps the future prices the companies can charge customers. This motivates companies to cut costs over and above the Director's expectation to be more profitable than envisaged by the Director. At the next Periodic Review the Director would transfer these additional profits from companies to customers through lower price caps. The Director has discretion as to the method and timing of this transfer.  

2.2 The transfer of benefits to customers consists of two elements: the first concerns efficiencies that the Director assumes the companies should be able to achieve between Periodic Reviews. This looks forward into the future, whether achieved by the companies or not, because they are reflected in the future price cap. The second concerns profits that the companies have earned over and above the Director's expectations ("outperformance" benefits). This paper will concentrate on the second element, past outperformance benefits.  

2.3 The methodology adopted by Ofwat during the 1994 Periodic Review passed the outperformance benefits to customers over a ten year period, using a Glide Path. The glide path transferred 80% of the outperformance efficiencies to customers over a 5 year period (1995-96 to 1999-00), with the remaining 20% being transferred over the next five year period (2000-01 to 2004-05). This methodology resulted in a transfer of an average of just under

70% (based on work by NERA, see Appendix II for more details), in present value terms, of these efficiencies to customers. The reason for choosing this methodology was to ensure that the companies had adequate finance for their demanding capital expenditure programmes and to avoid unsettling investors' expectations at the time of privatisation.

3 PROPOSED PROFIT SHARING METHODOLOGY

 3.1 The method proposed for the 1999 Periodic Review would transfer all the past outperformance benefits to customers in the first year of the new price review period, through an initial downward adjustment of real prices, a "P_o adjustment". This methodology would result in a sharp reduction in bills in the first year of the review followed by relatively constant prices for the remainder of the period covered by the review. The use of this approach would result in the transfer of benefits to customers more quickly and thereby increasing the customer's average share, in present value terms, from 68% to 82%.Hence by employing this approach alone, there would be considerable improvement in the percentage of past outperformance benefits that would be transferred from companies to customers.  

3.2 The benefits of operating and capital expenditure efficiency savings would be taken away via the proposed P_o reduction. The mechanism of actual transfer of capital efficiency benefits to customers is discussed further in Appendix V.

4 PERIOD BETWEEN PRICE REVIEWS

4.1 Currently the Director sets prices for water and sewerage in England and Wales for a period of ten years. The prices have to be reviewed after five years if the Director or the companies so desire. The Director has so far always exercised this option.  

4.2 There is a strong argument that all the companies' licences should be amended so that there is a shorter time period between reviews. This course of action would avoid setting price limits for the latter half of the ten year period and remove the uncertainty about the timing of the review.  

4.3 A shorter period (i.e. one less than ten years) between reviews would also be consistent with the approach adopted by other regulators. At present a five year review is carried out by all the regulators except for British Telecommunication, Regional Electricity (Supply) and National Grid, where the period between price review is four years. In MD124 the Director floated the possibility of changing the period between reviews to as short as four years.  

4.4 The companies in responding to MD124 have pointed out that reducing the period between reviews to four years has certain disadvantages. Therefore, in their opinion a period between price review of five years is more appropriate.  

4.5 The time between reviews is shorter than the asset lives and the duration of major capital projects. Too short a period could considerably undermine the capacity to ensure a stable background for investment which is not in the interest of customers.  

4.6 The Director has to strike a balance between the interests of the shareholders and customers. Hence, a decision on how quickly the past profits, which have resulted from operating and capital expenditure efficiencies, are transferred from shareholders to customers would affect this balance. A longer period between reviews would provide extra benefits to the shareholders at the expense of customers and create more uncertainty regarding the factors that are considered by the Director when setting prices, and hence a greater possibility that interim determinations between the review periods may be necessary or desirable.  

4.7 If the period between reviews is reduced from 5 years to 4 years then on average this would result in an increase of only 3% in the outperformance benefits that would be transferred to customers which increases from 82% to 85%, in present value terms. From this analysis it can be seen that a reduction of period between price reviews adds very little to the customers share.  

4.8 In the forthcoming consultation it is likely that the Director will propose that the companies licences are amended to reduce the period between price reviews. It is likely that the current period of ten years between price reviews will be changed to a five year period.

5 VOLUNTARY BENEFIT SHARING

5.1 Voluntary benefit sharing can be in the form of:

• Cash rebates to customers; 
• Partial take up of the full price limit allowed by the Director. This can take the form of either a deferral of price limit for a year or more or a permanent reduction in the allowed price limit; or 
• Investment projects that are supplementary to those allowed for by the Director when setting price limits (provided that these pass the criteria laid down by the Director for recognising such investment). 

5.3 The Director could actively encourage the companies to undertake more voluntary benefit sharing after the forthcoming periodic review by stating that companies that have done so would be remunerated more than those that have not. A detailed mechanism for this could then be constructed which may avoid the need for formal profit sharing mechanism.  

5.4 Voluntary benefit sharing has varied widely in extent. The maximum efficiency benefits that any water company has voluntarily shared with customers, between 1990-91 and 1994-95, represent about 20% of the total benefits. Therefore, in that case about a quarter of the amount that would be transferred at periodic review has already been shared voluntarily with customers.

6 FORMAL PROFIT SHARING SCHEMES

6.1 None of the regulators, at present, uses a formal profit sharing mechanism. An annual profit sharing formula requires fixed rebates based on the actual profits earned in the year. A profit threshold is determined for the company and, if actual profit is greater than the threshold, then a proportion of the additional profit is returned to customers. The introduction of a formal profit sharing mechanism would increase only marginally the proportion of benefits passed to customers; the precise amount depending on the choice of profit threshold and proportion of additional profits shared. However, the resulting attrition of incentives would mean that companies are likely to be making less cost savings in the first place resulting in the customers merely having a larger slice of a smaller cake.  

6.2 Taking the methodology adopted in 1994 profit sharing adds about 6% to the benefits shared with customers (the base case in column 3 Appendix III) while the P₀ approach adds 14% to the benefits shared with customers (column 3 Appendix IV). Adding profit sharing to the proposed P₀ approach will increase the benefits transferred to customers by about 4%.  

6.3 The main advantages of introducing a formal profit sharing mechanism are:  

• It would force the companies to share benefits with customers at the same time as shareholders. 
• The approach adopted by all the companies would be uniform. 
• The Director would have legal powers to force the companies to pass efficiency benefits to the customers earlier, subject to a legal challenge. 
• It might be perceived by the public that the companies are sharing excess profits which have resulted from the abuse of monopoly power.

• Introducing a formal profit sharing mechanism would severely blunt incentives to reduce costs.  
• It would require additional time and resources in policing the system. It is difficult to determine the normal level of profits, and hence the level of threshold above which there is compulsory sharing of profits and the proportion shared with customers. 
• Management would be incentivised to find ways to beat the system rather than concentrating on the business.  
• The companies might be encouraged to invest in low risk, low return projects rather than in high risk, high return ones. This strategy might be contrary to the requirements of the company.  
• Additionally, the companies would have incentives to defer savings to another period if it appeared as if the profit trigger would be breached. 
• The investor's perception of the risks and returns available from the water industry may change which may increase the equity cost of capital and hence customers' bills. 
• It takes time for incentive regulation to work. To change the course at this stage by introducing a formal profit sharing mechanism would undermine the regime. More benefits would be transferred more quickly during the next Periodic Review by employing the proposed P_o approach to transfer benefits from companies to customers. 
• Finally, the change in the current RPI - X regime would mean that the companies would be more reluctant to share benefits voluntarily with customers.

7 EFFECT OF TAXATION

7.1 Regulated water companies, like any private sector companies pay corporation tax on profits at 33%, together with advanced corporation tax on dividends at 20% and capital gain taxes at 33%. The taxes have the counter-productive effect of reducing the motivation and incentives to make extra savings in the first place as can be seen in bonuses and employees share schemes.  

7.2 At a Periodic Review, the transfer of benefits from shareholders to customers is unaffected by tax. That is, the P_o adjustment would not be affected by tax at the next review of prices), because tax would be paid out of shareholders' portion. In a formal profit sharing arrangement both shareholders and customers are taxed on their benefits. In this respect as well profit sharing is less attractive than the proposed P_o adjustment because the former takes place after tax whereas the latter is before tax.  

7.3 Even though taxation reduces management incentives for achieving cost savings, in practice the effect may not be great because they are under pressure from investors to perform. In most instances, the management have an equity stake in the business they are managing. Hence, it is in their interest to find ways to make maximum possible cost savings which would ultimately result in increase in share prices of the company they partly own and are managing on behalf of the shareholders.  

8 CONCLUSION

8.1 If incentives to efficiency are diminished, customers may lose more from profit sharing in the long run than they gain from it in the short run.  

8.2 In summary, the benefits of profit sharing are more apparent than real, and would serve more to correct a public perception of water companies as making excess profits at the public expense than in increasing the public good by reducing prices to customers. RPI - X has incentivised companies to find substantial efficiency savings. The progressively tightening of the formula induces companies to find ever greater efficiencies. The vast bulk of these savings are passed to customers.

APPENDIX I

The approach adopted by Ofwat during 1994 review was to allow convergence of rate of return above the cost of capital (i.e. outperformance of Directors expectations) to the Cost of Capital over a ten year period. Approximately 80% of these excess returns were phased out during the first five years with the remaining 20% being phased out over the last five years.  

1.2 P_o Adjustment  

All the past outperformance by companies are passed on to customers in a single year. For the water industry at the 1999 Periodic Review it would consist of two elements, the first adjustment called P₀₁ which brings the returns that the companies earn down to the glide path and P₀₂ takes the returns down from the glide path to the company's cost of capital. A similar approach of passing on past outperformance to customers in the first year of the price review is adopted by most regulators, notably the Gas and Electricity regulators.

1.3 Depreciation  

It is the measure of the wearing out, consumption or other reduction in the useful economic life of a fixed asset whether arising from use, passing of time or obsolescence through technological or market changes.

1.4 Net present value 

A technique employed to convert cash flow income and expenditure items occurring in various years to a common base using an appropriate rate. This technique takes account of the time value of money.

1.5 Cost of capital  

The weighted average cost of employing the capital of the owners and the lenders in the business.

APPENDIX II

2 Assumptions that are used in calculating the figures in the next two Appendices are:  

• The glide path is assumed to comprise straight lines rather than a curve. The actual glide path used by Ofwat in 1994 periodic review was a curve. 
• Efficiencies occur evenly over time. In practice companies make more efficiencies in the earlier years since they retain these efficiencies for a longer period of time. 
• Efficiency savings occur at the end of each year. 
• Corporation tax is ignored. 

^{2 NERA paper number 17 titled 'Evaluating RPI-X' written by Ivan Viehoff}

APPENDIX III

(1) Assumes 50% sharing of out-performance in excess of 10% p.a., pre-tax compared with actual returns (in 1995-96) of 11.5% p.a. and target rate of 7% p.a.  

(2) The same assumptions as (1) except that there is a 50% sharing of out-performance in excess of 8% p.a.  

(3) The same assumptions as (1) except that customers get 90% of out-performance in excess of 10% p.a.

APPENDIX IV

Impact of profit sharing on glide path and the proposed P_o methodology  

Type of Glide Path	1994 Methodology %	Po adjustment (1) %	Po adjustment (2) %	Po adjustment (3) %
Saving initiated at - beginning - end of Quinquennium	59 77	71 93	76 95	76 93
Average	68	82	86	85

(1) Assumes that the benefits are passed to customers as an initial downward P₀ adjustment in the first year of the new review period.  

(2) Profit sharing regime with a P₀ adjustment. This assumes 50% sharing of outperformance in excess of 10% p.a. pre-tax returns, compared with actual pre-tax returns of 11.5% p.a. and target rate of 7% p.a.  

(3) A P₀ adjustment with a four year period between reviews.

APPENDIX V

The capital efficiency benefits are passed on to customers through a lower annual Depreciation Charge and annual savings in interest costs resulting from not having to borrow the amount that is saved as a result of capital expenditure efficiencies. Therefore it takes considerable time before all of the capital expenditure efficiencies filter through to the profit and loss account. Although capital expenditure efficiencies have an immediate impact on cash flow savings, it affects the profits over a longer period of time and by a much smaller amount than the cash savings achieved. If the capital expenditure outperformance that occurs in 1995-2000 is taken away via the P_o adjustment then on average just over 80% of the benefits would be passed to customers at the 1999 price review.  

Another approach which takes away the capital expenditure outperformance from companies for 1995-98 and pass these on to customers through a P_o adjustment is considered more appropriate. This would leave the companies with capital expenditure efficiency savings for the years 1998-1999 and 1999-2000 until the year 2004-05 giving companies incentive to make these savings in the first place. This methodology would pass on average over 70% of the benefits to the customers at the 1999 Periodic Review.

(1) This analysis assumes an initial downward adjustment in year 11 which is year 2000-01. 

(2) Assumes the average asset life of 35 years and interest rate of 5% p.a. in real terms. 

(3) The average capital expenditure efficiency passed onto customers, assuming a 5 year lag is 61%.  

(4) The average capital expenditure efficiency passed on to customers assuming no lag is 81%.  

(5) The average capital expenditure efficiency passed on to customers using 'short lag' approach is 71%.