ICS do a CSI on Ofwat’s CIS......

It is a little known principle of economics that choices are really bad for you. Put another way it is a popular myth that choice is good and we are all better off if we are confronted with lots of competing options. But the reality is that while some level of choice in almost all aspects of our daily lives is certainly a desirable thing, too many choices are really really bad for you. One reason is transaction costs. There just aren’t enough minutes in the day to acquire and examine all the things relevant to any decision we make. Another reason is bounded rationality. Our brains just aren’t wired in the way that the rational economist assumes. So we inevitably form habits – or heuristic decision rules – that stop things becoming really really really bad.

So imagine you are someone that has to make a choice from an infinite number of possibilities. No such thing you might react. But you would be wrong. Ask any FD or RD of a water company who has had to grapple with Ofwat’s new Capital Incentive Scheme (CIS).

The CIS is a new part of Ofwat’s regulatory tool-kit which it believes “provides strong incentives for companies to put forward challenging and efficient business plans and to strive to beat our eventual price limit assumptions.” So how does it do this and where does the infinite number of possibilities come from? The table below is an extract from Ofwat’s recently published Draft Determination and comes with the rather grand title of “CIS Matrix”:1

1 We understand there is no truth in the rumour that this Ofwat innovation has inspired the Wachowski Brothers to add to their Matrix movie franchise the new blockbuster “The Matrix Incentives” starring once again Keanu Reeves as Neo who in this instalment is revealed to be “The Director”.

Table 1: Ofwat's CIS Matrix for the Draft Determinations

Source: Ofwat, Future water and sewerage charges 2010-15: Draft Determinations, Chapter 4, Table 24

Pause for a minute and just ponder on the table. Now reach for the Nurofen and be thankful. To “simplify presentation” the table only shows 120 combinations (the cells in the red box) and not the infinite number that actually exist.2 If you don’t believe us here is Ofwat’s smallprint:

“The matrix is continuous calculated using the following functions (sic: we have spared you those), and could be applied beyond the range shown here. It is shown as finite options for CIS ratios within the 80 to 130 range to simplify presentation.”3

This could mean that Ofwat actually does appreciate that too many choices are really really bad. But even if we restrict our attention to these 120 possibilities – a possibility here is defined as a combination of a CIS ratio (the company view of expenditure compared to Ofwat’s view), its associated efficiency incentive and a level of actual (capital) expenditure – what kind of choices does this variant of

2 And that is before even looking at how this might be compounded by considering how capital expenditure inputs translate to outputs and service performance. When you start thinking about compounding infinity you know its time for some Nurofen, hence best to note rather than pursue that point.

3 The continuous functions are actually two concave functions: one that applies when CIS ratio >100 and one that applies when CIS < 100.

Menu regulation actually offer and therefore what kind of behaviour does it encourage?

Well it could be that collectively the water company FDs and RDs quickly ran out of Nurofen because they all submitted plans that put them to the right of the column of cells headed by CIS = 100. CIS =100 means a company proposes to spend what Ofwat thinks it should spend. So here is evidence of habit or heuristic #1: companies never really thought it likely Ofwat would take the view that companies should spend more (to deliver the same services) than the company view. Ofwat’s own explanation is:

“no company has achieved a CIS ratio below 100, reflecting our view that in general they have not taken a balanced view of risk across all cost drivers in putting together their business plans.”

An alternative view is that companies did take a balanced view of risk and in their minds the plans they put together should imply for each of them CIS = 100. In other words the lack of CIS ratios at or below 100 is not of the companies' making – it is of Ofwat’s making. And this point is rather critical to determining whether the CIS as implemented is actually encouraging a new regulatory approach on capex.

Back to the table (and grab the Nurofen on the way). Whatever explanation you believe we observe that everything in the matrix to the left of CIS = 100 is redundant.

Pheeewwww....... That gets the 120 down to 120 -48. We can also ignore the infinite number of possibilities to the right because as Ofwat quietly explains in Appendix 1 for CIS ratios beyond 130 efficiency incentives become “inappropriately low” (Ofwat’s emphasis not ours). Hence, Ofwat is imposing its own constraint on the new CIS incentives available to some companies which it also acknowledges amounts to a “moderate disadvantage”. But is this “punishment” soundly based?

Table 2: Ofwat view of efficiency versus Ofwat view of CIS ratio

If you are sitting toward the upper left of this table, then we rather think you are possibly feeling ok4 with Ofwat’s Draft Determination. But there is clearly some noise over toward the right. Those companies in the +130 territory on the CIS ratio span the full range of Ofwat’s efficiency assessment. So the more efficient Portsmouth (Ofwat’s view remember not ours) and the least efficient Three Valleys (again we emphasise Ofwat’s view) are both sharing Ofwat’s “moderate disadvantage” by virtue of being in the +130 territory.

Did companies choose to be in the +130 territory? Were they numbed by the prospect of so many choices or did the Nurofen supply run out? We suspect neither because as we have suggested above these outcomes don’t reflect company choices at all. They are Ofwat’s judgements and that simple observation rather undermines the Ofwat claim that the CIS “provides strong incentives for companies (our emphasis) to put forward challenging and efficient business plans”. And maybe there is a secondary point here. The CIS is new and comes in the form of something called a matrix, it is untested and hence there are many unknowns. Here perhaps is evidence of habit or heuristic #2: wait and see. Combine that with #1 above and perhaps the observed CIS ratios start to lose their credibility.

4 We mean ok in the sense of “ok can live with that” rather than “ok, things are going quite well actually. Thanks for asking”.

But let's consider if you do want to make a choice based on the CIS, albeit only a limited one because unlike the possibilities the Nurofen budget is finite. Remember in the Ofwat matrix a positive number in a cell is a reward (more money) and a negative number is a penalty (less money). And remember through their behaviours the industry in reality is really sitting somewhere within the region highlighted in the black oval.

The whole point of the CIS is that it is supposed encourage companies to submit planned levels of expenditure that are an honest and well-founded view of what will actually be required. If it worked in this way then the CIS would mean that Ofwat no longer has to act like the suspicious school-teacher who adopts the view of guilty until proven innocent (i.e. companies will always try to pull the wool over the regulator’s eyes). The CIS means that honest Joe should make more money than devious Dan.5 But does the Ofwat CIS actually do that? Let’s try to be an honest Joe.

Joe starts with the number he knows best. His best view of actual expenditure. Let’s say that is actually 110. Remember 110 is actually a % figure – its means Joe’s views of the actual expenditure required will be 10% above Ofwat’s view. Joe now needs a number for the Ofwat plan and so scans across the row labeled 110. The choices aren’t great as all the numbers are negatives (penalties) – Ofwat thinks Joe is inefficient after all. The smallest penalty is associated with CIS =110. So the reward for Joe’s honesty is the smallest penalty. Showing some leadership by aiming for CIS=100 isn’t worth it as the penalty is bigger if 110 still ends up being the expenditure. The risk just ain’t worth it. And living with a CIS of 100 and actually delivering 100 only gets you back to zero.

Whereas devious Dan knows in his heart of hearts actual spend of 95 is achievable and while aiming for a CIS=95 would be better he notices a CIS = 110 would still give him a positive reward of 1.00. So Dan’s dishonest CIS=110 (which he gets by inflating his expenditure plan) gets rewarded while Joe’s honest 110 doesn’t.6

So the point is that perhaps in all likelihood the CIS is not really about honesty in business planning at all. The thing that drives rewards and penalties in the regulatory game is still what Ofwat thinks a company should spend. And maybe what the CIS ratios reveal more than anything is that companies realised this very

5 We should of course caveat by noting this is merely for literary purposes. In the same way that we can’t confirm Dan was also desperate, we have no idea if all or any Dans are actually devious. It just sounds good.

6 We think it is a reasonable assumption that devious folk are pretty good at delivering ex-post on their dishonesty.

early on. They realised not only are choices really bad but that the CIS was offering bad choices. The choices on offer were false choices – the trick is still to make the regulator think you are more efficient than you actually are.

Concluding thought

On the evidence of the draft determination, perhaps the only safe conclusion is that the jury must still be out on the CIS. From our experience at PR09 we know that a good number of companies have invested heavily in their investment planning capabilities and will continue to do so in the next AMP. This makes sound business sense with or without a regulator or a CIS matrix to deal with. The challenge is on Ofwat. How do they take a good idea – which the CIS is – and make it do what it should do – reward companies with good processes, data and systems and who put together honest plans.

Case Studies

South West Water
Thames Water
Irish Water