Allocation of risk

A range of external factors impact on water company costs and outcomes. These include, for example, changes input prices and wages, the impacts of the weather and inflation. Internal management can also impact directly on costs and outcomes, by affecting the efficiency of the business, and can also act to mitigating some of the impacts of external factors.

Ofwat's price review framework has a number of mechanisms to share these risks between companies and consumers. This aims to encourage companies to control costs and outcomes where they can, but also to limit their exposure to risks where they have limited control over them.

The mechanisms currently in use in PR19 include:

 Interim determination provisions in companies' licences, which allow us to change revenues in certain circumstances if particular thresholds are met including IDoKs (Interim Determination of K), SFE (Substantial Favourable Effect) and SAE (Substantial Adverse Effect)

 Reconciliation mechanisms which, for example, pass through changes in real price effects and tax to consumers.

 Inflation indexation of debt, revenues and the RCV (Regulatory Capital Value) which aim to pass through inflation impacts to consumers

 Cost sharing arrangements which share the impact of any cost overruns or underspends between companies and consumers.

 The outcomes framework which provides incentives for companies to hit their Performance Commitment Levels (PCLs) and to go further which incentivise companies to manage the impact of external factors (for example by improving resilience). In some cases, deadbands can be used to limit companies' exposure over a certain range. Collars also mitigate companies' exposure to very rare events, while caps limit customers' exposure to increases in bills.

 The gearing sharing outperformance mechanism aims to align incentives of company to take account of consumers' interests in financial structures and better protect customers from risky structures.