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UTILITY Week 16 05 14

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UTILITY WEEK | 16Th - 22nd MaY 2014 | 15 Policy & Regulation Market view Going beyond the day job A balance of rewards could encourage water companies to innovate, be more efficient, and go the extra mile, says Sonia Brown. C ompanies should not be entitled to additional rewards for "simply doing the day job". "Simply doing the day job" is a phrase that I've heard a number of times now in this price review – most recently in these pages from the Consumer Council for Water's chief executive Tony Smith. The base allowed return of 3.7 per cent for the wholesale business remunerates com- panies adequately for this day job. Water and wastewater companies have important statutory responsibilities that they must con- tinue to deliver for their customers. And they must continue to maintain an overall level of service that customers expect. What we are seeking to understand is if there may be the case for companies deliv- ering more than the day job, where going further would be valued by customers. This could be in the form of greater inno- vation, which benefits customers both today and tomorrow. To gain additional financial rewards we would want to see companies really stretch- ing themselves, with challenging targets, benchmarked against the sector's leading performers. The potential benefits of rewards linked to the outcomes that customers value come into focus when you consider the alterna- tive. Historically, companies and investors have been overly focused on beating the cost of capital, and have not been able to achieve financial benefits from delivering real improvements in service for customers. Do we really want management teams to be primarily focused on a clever treasury func- tion? Or is it more sensible to have a balance of potential rewards through which we can encourage innovation, stretch companies to become more efficient, and go the extra mile to improve the services that matter to customers? This would represent a real win- win between the interests of customers and investors. We must not forget that rewards for out- performance are nothing new. Since priva- tisation, companies have been incentivised to outperform on costs. This has delivered rewards to efficient companies, but also big benefits to customers – bills are a third lower due to the resulting stretch on efficiency. Increasing the emphasis on rewards for out- performance on service could drive similar long-term benefits to customers. This all sounds great in theory, but the big question is, do customers actually buy into this? Research showed that custom- ers were initially uneasy with performance rewards – especially when combined with a higher base cost of capital – but if you dig deeper you get a richer picture. The conclu- sion of a programme of extensive research by South West Water showed that once you set rewards in the context of a whole package of risk and rewards, customers were willing to pay for enhanced performance in certain areas. The rewards package South West Water has proposed is quite rightly not a one-way bet. If it underperforms on its targets, there are financial penalties as well. Companies are best placed to manage risks in this area, so it's only right that when they under- perform on service, it is they, not customers, who pay out. There must of course be adequate assur- ance processes and companies should be transparent with their customers on the delivery of outcomes and any financial con- sequences. This is essential to preserve the legitimacy in the sector around outcomes and this will continue to be a strong focus of our scrutiny going forward – for PR14 and beyond. Put simply – our aim in encouraging companies to look at risk and reward not only through the cost of capital but also through money at risk, as part of the wider set of incentives around what they deliver for customers, is not about re-distributing the returns. It is about a fundamentally different approach to rewarding excellent manage- ment teams in the water sector, really push- ing out the frontier in terms of service and efficiency, which will benefit all customers over time. Sonia Brown, chief regulation officer, Ofwat land Bridge (UK) Limited v Whessoe-Volker Stevin Joint Venture [2010]. In North Midland v Lentjes, North Mid- land was employed as the enabling works contractor by Lentjes. Disputes arose and North Midland applied to the court for a declaration that the contract was not excluded by the Act. Ramsey J agreed. In Cleveland v Whessoe, Cleveland was contracted by Whessoe to undertake works at a liquefied natural gas plant near Mil- ford Haven. Ramsey J was again the judge and applied the same approach as in North Midland, but with a different conclusion. Cleveland was acting as main contractor. In doing so some, but not all, of its works were excluded by the Act. Therefore, Cleveland was entitled to adjudicate in relation to the parts of its works that were not excluded by the Act. This leads to the position that parts of the works on site may be caught by the Act, while others may not be. Worse still, a single contractor's (or sub-contractor's) works may be partly under and partly not under the Act. Take for example a steelwork sub- contractor. The steelwork that supports gen- erators or boilers, or even forms the basis of a reactor's casing, is either support steelwork or absolutely key to the plant's operation and therefore excluded. However, the steel- work that forms the building surrounding is not. This leads to two potentially difficult situations. First, how do you deal with a contract that is part in and part out of the Act? Do you contractually allow adjudication in relation to the whole of the works or split the works into packages and have some contracts that fall within the Act and others that do not? The second issue is, what a contrac- tor should do if the main contract does not permit adjudication, but its sub-contractor, whose works are caught by the Act, decides to adjudicate. A contractor has two options. It can try and have adjudication written into its head contract. This would at least mean that if it is adjudicated on by its sub-contractor it can try to pass the loss up the chain (though there is no guarantee a second adjudicator will reach the same decision). Or it could try and price in the risk. Whatever your position, it is important to understand both your own rights and those of your employer, contractors and sub- contractors. Not doing so could lead to significantly increased costs and more time spent in dispute resolution. Michael Bennett is an associate at national law firm Weightmans LLP

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