Outcome Delivery Incentives Over Multiple Price Controls

Outcome delivery incentives over multiple price controls
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A report prepared by Anglian Water

December 2012
Authors:
Pete Duell, Anglian Water
Martin Silcock, Anglian Water
Contributors:
Melinda Acutt, ICS
Janet Wright, Sladen Wright Associates
Annabelle Ong, Frontier Economics
Andrew Snelson, Anglian Water
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Contents
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2.1 Background.................................................................................................. 3
2.2 Incentives.................................................................................................... 4
2.3 Advantages of outcome regulation .................................................................. 4
2.4 Wholesale incentives consultation ................................................................... 5
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3.1 Assumptions ................................................................................................ 5
3.2 Description of the model ................................................................................ 6
3.3 Expanding the model to multiple measures ...................................................... 6
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4.1 Costs........................................................................................................... 6
4.2 Benefit ........................................................................................................ 7
4.3 Marginal Cost = Marginal Benefit .................................................................... 8
4.4 Multi-period milestones ................................................................................. 9
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5.1 Introduction ............................................................................................... 10
5.2 Assumptions .............................................................................................. 10
5.3 Marginal vs average cost ............................................................................. 11
5.4 Actual costs differ from expected costs .......................................................... 11
5.5 Reputational incentives................................................................................ 12
5.6 Choice of period 1 target ............................................................................. 12
5.7 Marginal cost incentive ................................................................................ 13
5.8 Penalty only incentive.................................................................................. 14
5.9 Conclusions................................................................................................ 14
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6.1 Introduction ............................................................................................... 14
6.2 Assumptions .............................................................................................. 14
6.3 Period 1 milestone equals the optimal target .................................................. 15
6.4 Actual costs below expected costs................................................................. 15
6.5 Actual costs above expected costs ................................................................ 16
6.6 Choice of period 1 target ............................................................................. 16
6.7 Consumer surplus ....................................................................................... 17
6.8 Applying less than 100% of benefit ............................................................... 18
6.9 Marginally diminishing benefit ...................................................................... 19
6.10 Penalty only incentive.................................................................................. 20
6.11 Conclusions................................................................................................ 20
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7.1 Introduction ............................................................................................... 20
7.2 Assumptions .............................................................................................. 20
7.3 Incentive properties .................................................................................... 21
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Page 3 of 24
1 Executive Summary
For PR14, Ofwat will seek to incentivise companies to meet the longer term outcomes that
customers value, in contrast to its traditional approach which has concentrated on the delivery
of outputs within a single price control period.
This paper explores the characteristics of ex ante outcome delivery incentives based on both a
cost principle (the planned cost of delivery) and a value principle (the benefit customers gain
or lose from delivery or non-delivery of an outcome). Understanding the differing
characteristics of these two potential approaches is necessary to understand how suitable each
might be when applied to multiple price control periods.
We have found limitations in both a cost-based incentive, which may encourage sub-optimal
delivery against outcomes but encourages truth-telling when setting milestones, and a value-
based incentive which encourages optimal delivery but also creates a perverse incentive to
under-promise and over-deliver on milestones.
There are however, other considerations when choosing an appropriate incentive mechanism
not considered in this paper, such as the confidence regulators and other stakeholders have in
the derivation of both costs and valuations for use in the incentive.
This analysis assumes a two-sided (penalty and reward) incentive. The potential for a reward
beyond the committed target helps long-term planning because the company may be
incentivised to deliver beyond the target. Therefore, there is less need for specific adjustments
to the incentive framework to encourage long-term planning. A penalty only approach commits
the company to a specific short-term target, therefore to encourage long-term planning a
specific adjustment to the framework may be required. Any adjustment would probably just be
trying to mimic the reward approach, but with potentially increased uncertainty. Therefore, if
an aim is to encourage the company to deliver long-term improvements, not short-term
targets, a two-sided incentive would encourage this. Defras draft Strategic Policy Statement to
Ofwat states that Ofwats emphasis should be on rewarding success rather than penalising
failure1. However, this does not mean a penalty only approach would be inappropriate for
every outcome, if for example, the important thing is to deliver a short-term target.
We conclude that designing an incentive mechanism for outcomes to be delivered over a

number of periods is complex, and the risk of unintended consequences is significant.
Companies can respond to an incentive in a number of ways related to the timing or ambition
of outcome delivery. Principally these include the setting of milestones, choice around whether
to meet or exceed these milestones, and whether to undertake potentially risky research and
development (R&D) to stimulate innovation.
This paper suggests how some of these unintended consequences might be avoided, but
further work would be required to understand if these would be effective.
2 Introduction
2.1 Background
Ofwat has called for companies to support their work developing the price control for PR14. We
have prepared this paper to explore how outcome delivery incentives might function over
multiple periods to ensure that such an incentive would be consistent with the aims of
outcome-based regulation. Given the long term nature of many potential outcomes, it is
particularly important to consider the longer term perspective if companies are genuinely to
plan and make decisions over more than one price control period.
1
Defras strategic policy statement to Ofwat consultation draft, Defra, November 2012, p11.
Page 4 of 24
2.2 Incentives
Incentives are used by regulators in order to influence the behaviour of companies towards a
certain end. This can either be encouraging certain behaviours through a reward, or
discouraging certain behaviours through a penalty. The effectiveness of any incentive depends
on its strength, how well it is understood, and the degree to which it avoids negative
unintended consequences. Companies face a number of incentives, some of which may
reinforce one another, others which may conflict. As the complexity of the incentive regime
increases, incentives are liable to be less effective as clarity is reduced and the risk of
unintended consequences increases.
The need for an incentive to be The role and design of incentives for regulating
understood usually favours the setting monopoly water and sewerage services in England
of ex ante incentives. Ex ante incentives and Wales a discussion paper, sets out Ofwats
are those in which the incentive itself, views on incentive design. A good incentive
and the means by which performance should:
against that incentive will be assessed, have a clear aim,
are defined at the beginning of the price be proportionate to its aim,
control period. In this way, companies be clear and transparent,
understand the potential gains and minimise unintended consequences,
losses they face, and will adjust be robust to change or adaptable.
behaviours during the period in
response. In general, this leads to a http://www.ofwat.gov.uk/future/monopolies/fpl/prs_inf_1010fplinc.pdf
mechanistic incentive, in which little is
left to judgement after the fact.
In contrast, ex post incentives are those which are determined at the end of the price control
period. This might mean that the value of any incentive, or even the means of assessment, is
uncertain. This significantly weakens the power of the incentive to influence behaviours, but
allows for considerably more flexibility and also lessens the risk of unintended consequences.
Some of this uncertainty can however be mitigated if there is clarity ex ante on the principles
to be applied when the ex post judgement will be made (and confidence in how this will be
applied).
Our work in this paper assumes an ex ante incentive.
In the context of outcome delivery incentives, incentives might be used to influence a

companys behaviour in the form of:
a penalty for delivering less than was planned,
possibly a reward for delivering more than was planned (under certain conditions),
no penalty or reward for delivering the planned level.
2.3 Advantages of outcome regulation

Ofwat sets out a number of advantages of outcome regulation relative to output regulation in
its wholesale incentives consultation:
focusing companies more on what their customers want and reducing the companies
dependency on the regulatory framework;
encouraging companies to focus on longer-term planning, which will help deliver better
solutions to customers;
allowing companies greater freedom to innovate and find more sustainable solutions;
and
reducing the regulatory burden. 2
It is therefore important that any incentive scheme is consistent with promoting these
advantages.
2
Consultation on wholesale incentives for the 2014 price review, Ofwat
http://www.ofwat.gov.uk/pricereview/pr14/wholesale/prs_web120825wholesaleprice
Page 5 of 24
2.4 Wholesale incentives consultation

A one-sided incentive provides only a penalty for failure to deliver the planned level of an
outcome. No reward is available for delivering more than the planned level. In contrast, a two-
sided incentive also allows for some reward to the company for delivering more than expected
in the plan.
Trade-offs might be desirable between different measures of success within an outcome or

between different outcomes. In this way, under-delivery on one outcome (or measure) might
be offset against over-delivery of another outcome (or measure), rather than each attracting a
penalty or reward. In fact, under a two-sided incentive, companies would likely make trade-
offs in practice by adjusting behaviours in response to the relative incentives without the need
for explicit trade-offs to be allowed by Ofwat.
In the wholesale incentives consultation, Ofwat has indicated their current thinking is that:
incentives will apply at the outcome level,
incentives should be based on value to the customer rather than the cost to the
company.
Ofwat is still in consultation on:
whether incentives should be one- or two-sided,
whether trade-offs between incentives should be allowed.3
The analysis in the following sections, leads us to believe that the case for a value-based
incentive in particular requires further consideration. Implementing value-based incentives
without understanding the limitations exposed in this paper and providing a means to mitigate
them is likely to lead to potentially significant unintended consequences. We conclude that it
may be easier to mitigate the limitations of a cost-based incentive than those of a value-based
incentive.
3 The model
3.1 Assumptions
This paper uses a model of an ex ante incentive mechanism based on either a cost-based or a
value-based principle. It assumes:
an ex ante incentive scheme (the rules and rewards are determined in advance of the
period),
a single measure of success (for simplicity termed units delivered, but could easily be
improvement in level of service or some other quantitative metric),
customer research has indicated a Willingness to Pay (WTP) for an improvement in this
measure,
increasing marginal costs (the cost of an additional unit) per unit delivered,
constant marginal benefit (the value derived from an additional unit) per unit delivered
(this assumption is relaxed later in the paper),
a two-sided financial incentive is applied to the outcome,
interactions with other incentives do not affect company behaviour,
rewards or penalties are applied at the end of the period (recovered in a subsequent
period),
companies act as rational (profit maximising) agents with perfect information,
choices about targets of delivery against outcomes are within a companys control (e.g.
not required by legislation),
choices about actual delivery against targets are within a companys control,
the long term optimal target is not expected to change (otherwise this expectation
should have been accounted for in determining the target).
3
Consultation on wholesale incentives for the 2014 price review, Ofwat
http://www.ofwat.gov.uk/pricereview/pr14/wholesale/prs_web120825wholesaleprice
Page 6 of 24
We believe that these simplifying assumptions are reasonable and would not materially affect
the conclusions of this paper. However, it should be kept in mind that reality may differ from
these assumptions.
3.2 Description of the model

The company determines an optimal target, which may be over more than one period, and a
milestone for the first period. Penalties or rewards are only applied if the level of delivery
varies from the milestone at the end of the first period. We consider a cost-based and a value-
based incentive in turn. Companies therefore can set their milestone, and determine their
level of delivery against that milestone in the first period, to maximise their expected pay-off
over two periods.
The focus of this paper is on a two-period model in order to understand the choices companies
would make in the first period. This behaviour can then be extrapolated over subsequent
periods to understand the likely effect of the incentive over the longer term.
3.3 Expanding the model to multiple measures

For simplicity this paper assumes a single measure relating to an outcome. In reality there
may be multiple measures of success per outcome. If the incentive is to apply at an outcome
level, rather than at the measure of success level, then performance against multiple
measures of success must be combined in some way or traded off against each other in order
to apply a single incentive. In theory an incentive mechanism could be applied to all relevant
measures of success and through the relative rewards and penalties companies would be able
to trade-off between measures. This paper therefore makes the assumption of a single
measure, but recognises that this is an over-simplification and further consideration must be
given on how to expand any potential incentive to multiple measures.
4 Setting targets and milestones

4.1 Costs
The marginal cost is the cost of delivery of one
additional unit. This model assumes companies face an Marginal cost:
increasing marginal cost (MC) for additional units MC = 2Q
Total cost:
delivered. For simplicity it is assumed that the marginal
TC = MC = Q2 + c (c = 0 initially)
cost curve is linear (see Fig 4.1.1). The total cost (TC) is Average cost:
the total cost for delivery of a number of units. Initially AC = TC/Q = Q2/Q
4
this will be the integral of the marginal costs , although
later we will vary this to allow for a fixed cost associated with innovation (see Fig 4.1.2).
4
Total costs are calculated as the area underneath the marginal cost curve (the integral of
marginal cost) not the sum of the marginal costs. This could be expressed as the sum of the
average marginal costs instead of the integral of the marginal cost.
Page 7 of 24
25 120
100
20
Marginal Cost / Benefit ()
Total Cost / Benefit ()

80
15
60
10
40
5
20
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Units delivered Units de livered
MC TC
Fig 4.1.1 Marginal cost (MC) curve Fig 4.1.2 Total cost (TC) curve
4.2 Benefit
Marginal benefit (MB) represents the value placed on each additional unit by the customer.
Economic theory5 suggests that the marginal benefit obtained from additional units will likely
decrease with each unit supplied. Companies undertake Willingness to Pay (WTP) surveys in
order to derive the value placed by customers on the delivery of additional units of service
improvement, i.e. marginal benefits. Whilst these studies may identify marginal benefits which
vary over the range of service levels which are examined by the surveys, in general the
studies outputs are expressed as a single unit value. In other words
the studies derive a constant marginal benefit (i.e. each additional unit Marginal benefit:
is valued equally) (see Fig 4.2.1 and Fig 4.2.2). This pragmatic MB = 10
simplifying assumption enables the use of WTP values in investment Total benefit:
optimisation. Decreasing marginal benefits are difficult to estimate to a TB = MB = 10*Q
sufficient degree to allow effective investment optimisation.
5
Law of diminishing returns
Page 8 of 24
25 120
100
20

80
15
60
10
40
5
20
0
0
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Units delivered
Units delivered
MB
TB
Fig 4.2.1 Marginal benefit (MB) curve Fig 4.2.2 Total benefit (TB) curve
Companies may assume marginal benefit curves with kinks at different levels. For example,
the company might find that benefits are lower at 10 than at five (see Fig 4.2.3 and Fig 4.2.4).
This could be accounted for in the model by varying the incentive according to where on the
curve delivery took place, but our conclusions would remain unchanged from the simpler
example above which we take forward for further analysis.
25
140
120
20
100
15
80
60
10
40
5
20
0
0
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Units delivere d
Units delivered
TB
MB
Fig 4.2.3 Varying marginal benefit (MB) Fig 4.2.4 Varying total benefit (TB) curve
curve
4.3 Marginal Cost = Marginal Benefit

The socially optimal target for delivery is at the point where marginal cost equals marginal
benefit, giving an optimal target of Q*, the last unit delivered costing and being valued at P*
Page 9 of 24
(see Fig 4.3.1). If the target is set such that the quantity is less than Q*, customers would
value an additional unit more than it would cost to deliver. If the quantity is greater than Q*,
the additional benefit derived is less the cost of delivery. In reality, the exact marginal cost
and benefit curves will not be known. Note from Fig 4.3.2 the optimal point is not where total
costs = total benefits.
25 140
120
20
100

15
80
60
10 P*
40
5
TP*
20
0 Q* 0 Q*
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Units delivered Units delivered
MC MB Optimal Target P* Q* TC TB Optimal Target TP* Q*
Fig 4.3.1 Marginal cost (MC) = Marginal Fig 4.3.2 Total cost (TC) and total benefit
benefit (MB) (TB)
In reality, it will be extremely difficult to accurately define the optimal target, Q*, regardless of
the incentive mechanism adopted. It is assumed here in order to show how incentive schemes
may deliver sub-optimal scenarios, but this assumption does not materially affect our
conclusions.
4.4 Multi-period milestones

Outcomes are likely to be considered over the long term, perhaps up to 25 years or beyond. It
may not be possible to achieve the optimum target within a single price control period of five
years. This could occur because whilst customers value the improvement, the overall package
of improvements limits what can be funded in a given control period. Companies, and indeed
customers, may also prefer to spread the improvement over a longer period if the optimum is
particularly difficult or risky to achieve. In such cases milestones are set on the path to the
optimum, providing interim targets over a number of price control periods. In this model, we
assume a two price control period scenario, where the company may set a milestone at less
than the optimum for the first period (quantity Q1) (see Fig 4.4.1 and Fig 4.4.2).
Page 10 of 24
25 140
120
20
100

15
80
60
10 P*
40
P1
5 TP*
20
TP1
0 Q1 Q* 0 Q1 Q*
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Units de live re d Units delivere d
TC TB Period 1 Target
MC MB Period 1 Target
TP1 Q1 Optimal Target
P1 Q1 Optimal Target
TP* Q*
P* Q*
Fig 4.4.1 Milestone set at less than optimal Fig 4.4.2 Milestone set at less than optimal
target target
5 Cost-based incentives
5.1 Introduction
A cost-based incentive would seek to reward or penalise a company based on the cost of
delivery submitted in their business plan. In theory this should be based on the marginal cost
for each unit over- or under-delivered. Companies therefore do not gain by varying from the
target as exact costs are recovered. This would likely be impractical to implement as there is
asymmetry of information around marginal costs between the company and regulators or
customers. It might therefore be necessary to base a cost incentive on the average cost, which
is observable from the companys business plan.
5.2 Assumptions
A cost-based incentive is applied to over- or under-delivery and it is not possible for the
marginal costs to be used. Therefore an average cost incentive is applied. The reward is two-
sided: there are rewards for over-delivery as well as penalties for under-delivery.
Page 11 of 24
5.3 Marginal vs average cost

The marginal cost curve may not be fully
known. Even if it is known to the company, 20
it will likely be hidden from the regulator 10

and customers. What is observable is the
0
average cost (AC) per unit, calculated from 0 1 2 3 4 5 6 7 8 9 10
Expected company payoff ()

the total cost (TC) and the quantity (Q). -10
This analysis therefore assumes that the -20

value of the incentive is the average cost at
the planned level (AC1) multiplied by the -30
difference between the planned quantity -40
(Q1) and the quantity delivered in period 1

-50
(Q1d):
-60
AC1 = TC1 / Q1 -70

Incentive = AC1 * (Q1d Q1). Units delivered
However, as the average cost is lower than

the marginal cost when marginal costs are Incentive = AC Optimal target
increasing, companies would be penalised
less than the avoided cost for non-delivery
of planned units, and rewarded less than the Fig 5.3.1 Average cost incentive: company
pay-off
additional costs for over-delivery.
It is important to note here that the average cost used in the incentive is the average of the
marginal costs for additional delivery, and does not include fixed costs from shared activities,
which is not observable from business plans. We have limited the incentive to an easily
observable value which could be calculated from any business plan in order that there would
be a reasonable chance it could be practically implemented.
Companies are assumed to maximise their expected pay-off taking into account the amount
funded, their costs and any potential incentive (see Fig 5.3.1). The overall incentive faced by a
company would therefore be: total cost allowed cost incurred + average cost incentive for
variation from target. This can be shown as an expected pay-off from delivering a level which
differs from the plan. Under such an incentive, a companys expected pay-off is maximised by
under-delivery.
With this incentive, over-delivery is effectively penalised since the reward paid to the company
is less than the cost incurred.
Units delivered 0 1 2 3 4 5=Q* 6 7 8 9 10

Allowed 25 25 25 25 25 25 25 25 25 25 25
- Total cost 0 1 4 9 16 25 36 49 64 81 100
+ Incentive (AC1=5) -25 -20 -15 -10 -5 0 5 10 15 20 25
= Estimated pay-off 0 4 6 6 4 0 -6 -14 -24 -36 -50
5.4 Actual costs differ from expected costs

Where the actual marginal costs faced by a company are below the expected marginal costs, a
new optimal point Q* exists (see Fig 5.4.1). This might occur if the company finds a cheaper
method of delivering each unit. The company is incentivised to deliver more, up to the point
where the actual marginal cost incurred equals the expected average cost at the target level
(the incentive unit rate). As above, this will always be less than the new optimum of Q* (see
Fig 5.4.2), but may be above the original target of Q*. This will result in the company
delivering more than it would have done had marginal costs been as expected. On the example
we modelled, it still delivers less than the original target of Q*, but it would be possible, with
low enough costs, for this to be exceeded.
Page 12 of 24
25 20
10
20
0
Actual company payoff ()

0 1 2 3 4 5 6 7 8 9 10
15 -10
-20
10 P*'
P*
-30
-40
5
-50
0 Q* Q*'
-60
0 1 2 3 4 5 6 7 8 9 10
Units de live red
Units delivered
MC Actual MC MB Incentive = AC (expected) Incentive = AC (actual)

Optimal Target P* Q* Optimal target New optimal target
New optimal target P*' Q*'
Fig 5.4.1 Actual costs below expected costs Fig 5.4.2 Average cost incentive: actual
costs below expected costs
Conversely, where the actual marginal costs faced by a company are above the expected
marginal costs, the company will deliver less than in the expected case.
5.5 Reputational incentives

It may be possible to discourage under-delivery through strong reputational incentives. This
could be achieved through the publication of delivery results against the plan by Ofwat.
Customer Challenge Groups (CCGs) may also have a role in holding companies to account. In
particular it is important to remember that Ofwat and CCG support will be required for future
plans, and a company which is perceived to have gamed in the first period by intentionally
under-delivering may lack legitimacy in future. This would also result in procedural costs, as
future business plans might receive greater scrutiny and further ongoing monitoring by the
regulator where planned delivery in a previous control period has not been met.
However, when actual costs are below expected costs, companies are not incentivised to
deliver the new optimal quantity Q*, and it is questionable whether reputational incentives
would be sufficient to correct this.
5.6 Choice of period 1 target

Extending the example above, which considered only a single target at the optimal level, it is
also important to understand what incentives a company faces when choosing interim
milestones. In this scenario, the period 1 milestone, Q1, may be set below the optimal target of
Q*. The average cost incentive in this case is based on the period 1 milestone, Q1. We can
illustrate the effect by examining pay-offs under various combinations of milestone and
delivery choices.
Page 13 of 24
Expected Choice of Period 1 milestone (Q1)

company pay-off Q1 = 0 Q1 = 1 Q1 = 2 Q1 = 3 Q1 = 4 Q1 = Q* = 5
AC1 = 0 AC1 = 1 AC1 = 2 AC1 = 3 AC1 = 4 AC1 = 5
0 0 0 0 0 0 0
1 -1 0 1 2 3 4
2 -4 -2 0 2 4 6
3 -9 -6 -3 0 3 6
Choice of
4 -16 -12 -8 -4 0 4
Period 1
5 -25 -20 -15 -10 -5 0
delivery
6 -36 -30 -24 -18 -12 -6
(Q1d)
7 -49 -42 -35 -28 -21 -14
8 -64 -56 -48 -40 -32 -24
9 -81 -72 -63 -54 -45 -36
10 -100 -90 -80 -70 -60 -50
Under an average cost incentive therefore, a company is incentivised to set the period 1
milestone as high as possible up to the optimum (a good property of the incentive), but then
to under-deliver (a perverse property of the incentive).
5.7 Marginal cost incentive

Now we consider the case where marginal costs are used as the incentive. Ofwat may wish to
encourage companies to reveal marginal costs for use in a cost-based incentive, rather than
rely on average costs as used in the previous example. If a company faces an incentive equal
to the marginal costs incurred or avoided for each additional unit delivered or not delivered,
they will be indifferent (on a financial basis) over the level of delivery against the plan, as the
incentive would match the avoided or additional costs for each unit of variance. As above,
reputational incentives might discourage a company from under-delivery against the plan, but
would be less effective in encouraging over delivery.
It would also be necessary to limit the incentive to only apply up to the optimal target,
otherwise a company might deliver more than this and still receive their costs even though
they exceed the benefit to the customer. This is complicated where companies are able reduce
their costs below those assumed in the plan and it is now optimal to deliver more than the
original optimal target.
Companies might also be incentivised to inflate the marginal costs estimated after the period 1
target in order to maximise potential rewards.
If however the marginal cost at the planned level of Q1 is used (MC1 = P1) for all variances,
the company is incentivised to deliver the planned level of Q1 where actual costs equal
expected costs.

MC1 = 0 MC1 = 2 MC1 = 4 MC1 = 6 MC1 = 8 MC1 = 10
0 0 -1 -4 -9 -16 -25
1 -1 0 -1 -4 -9 -16
2 -4 -1 0 -1 -4 -9
3 -9 -4 -1 0 -1 -4
Choice of
4 -16 -9 -4 -1 0 -1
Period 1
5 -25 -16 -9 -4 -1 0
delivery
6 -36 -25 -16 -9 -4 -1
(Q1d)
7 -49 -36 -25 -16 -9 -4
8 -64 -49 -36 -25 -16 -9
9 -81 -64 -49 -36 -25 -16
10 -100 -81 -64 -49 -36 -25
Page 14 of 24
5.8 Penalty only incentive

We now look at the impact of assuming the incentive is one-sided (penalty only) rather than
two-sided. Under an average cost incentive, where actual costs are the same as expected
costs, companies are encouraged to plan to the optimal target but then under-deliver.
Removing the possibility of positive incentives does not change the effect of the incentive,
since over-delivery is already discouraged.
As shown above, where actual costs are below expected costs, a company may be incentivised
to deliver more than the original plan (although less than the new optimum of Q*). A penalty
only incentive however removes this effect, and a company would only deliver up to the
planned amount.
One way to encourage a company to over-deliver in this situation might be to use a notional
starting point in the second period. In this case, a company would be funded in the second
period to deliver from the period 1 target to the period 2 target, even though they may have
over-delivered in the first period. In this way, the company is compensated for the additional
delivery in the next period, if the company can demonstrate that there is customer support for
the additional units in the second period.
Such a mechanism is however subject to uncertainty over whether additional delivery will be
rewarded, and is therefore probably less effective than an incentive which rewards with
certainty in the current period.
A penalty only incentive would therefore not support long term planning under a cost-based
incentive. Companies gain no benefit from delivering more than planned, even when costs are
lower than expected and more could be achieved for the same cost against a long term target
which customers value.
5.9 Conclusions
Whilst average cost incentives encourage companies to set period 1 milestones as close as
possible to the optimal target, companies are subsequently incentivised to under-deliver on
this milestone.
Whilst this may in part be remedied by coupling with strong reputational penalties for under-
delivery, companies will still be incentivised to deliver less than the optimum if lower than
expected costs would otherwise have allowed for over-delivery against the original target.
These issues are not in themselves sufficient to rule out a cost-based incentive, but these
characteristics should be mitigated within the overall incentive package.
The truth-telling properties regarding setting of milestones could be seen as a significant

benefit.
6 Value-based incentives
6.1 Introduction
A value-based incentive would seek to reward or penalise a company based on the benefit
customers derive from each measured unit associated with the outcome which is delivered.
6.2 Assumptions
We assume that 100% of the benefit lost or gained is used as the companys incentive. This is
a simplifying assumption which in effect leaves the customer neutral over the level of delivery.
We relax this assumption in section 6.8.
Page 15 of 24
6.3 Period 1 milestone equals the optimal target

Companies are assumed to maximise
their expected pay-off, taking into 20
account the amount funded, their costs
and any potential incentive. Starting with 10
a simple example there is only one target

0
for the number of units to be delivered, 0 1 2 3 4 5 6 7 8 9 10

the optimal one at Q*. The value lost or -10
gained through over- or under-delivery of

-20
each unit is P*. The overall incentive
faced by a company would therefore be: -30
total allowed cost incurred + P* x unit

-40
variation from target. This can be shown
as an expected pay-off from delivering a -50
level which differs from the plan (see Fig
-60
6.3.2). Under such a scheme the
company receives no overall incentive to -70
vary from the target. Given that actual Units de live red
costs have been assumed to match

expected costs and the target was set at
the optimal level, this is the ideal property
Incentive = P* Optimal target
for the incentive scheme. In the following
analysis we refer to this as the P*
incentive. Fig 6.3.1 Benefit incentive P*: company pay-off
Units delivered 0 1 2 3 4 5=Q* 6 7 8 9 10

Allowed 25 25 25 25 25 25 25 25 25 25 25
- Total cost 0 1 4 9 16 25 36 49 64 81 100
+ Incentive (WTP=10) -50 -40 -30 -20 -10 0 10 20 30 40 50
= Estimated pay-off -25 -16 -9 -4 -1 0 -1 -4 -9 -16 -25
6.4 Actual costs below expected costs

When actual costs are below expected costs, the P* incentive scheme retains the correct
properties, now incentivising a company to deliver to the new optimal point Q*, taking the full
gap between cost of delivery and value to consumer as an incentive (see Fig 6.4.1 and Fig
6.4.2). Customers therefore receive an increased quantity in this period, but this has to be
paid for through the incentive mechanism. Customers fund additional units for the full benefit
they bring, rather than the cost of delivery (as they do for units delivered up to the target and
for further units if they were to be delivered in future periods). Given the risk companies face
for under-delivery through a value-based incentive, a corresponding upside may be considered
justified, but customers are not better off through the additional units since the company is
rewarded in full up to their valuation, other than through early delivery and the revelation of
lower costs into the next period.
Page 16 of 24
25 15
10
20
5
Actual company payoff ()

0
15 0 1 2 3 4 5 6 7 8 9 10
-5
-10
10 P*'
P*
-15
5 -20
-25
0 Q* Q*'
-30
0 1 2 3 4 5 6 7 8 9 10
Units de live red
Units delivered
MC Actual MC MB Incentive = P* (Expected) Incentive = P* (Actual)

Optimal Target P* Q* Optimal target New optimal target
Fig 6.4.1 Actual costs below expected costs Fig 6.4.2 Benefit incentive P*: actual costs
below expected costs
6.5 Actual costs above expected costs

In this case, the new optimal target Q* will be below the target set Q*. The best pay-off for
companies in this case will still be Q*. Now the company will be penalised because it is costing
more to deliver each unit than planned, but the penalty is minimised at Q*. Customers are
however fully compensated through the incentive mechanism to the value of the un-delivered
units.
6.6 Choice of period 1 target

Extending the example above, which considered only a single target at the optimal level, it is
also important to understand what incentives a company faces when choosing interim
milestones. In this scenario, the period 1 milestone, Q1, may be set below the optimal target of
Q*. The benefit incentive remains at P*. The expected company pay-offs are then as below:

MB0 = 10 MB1 = 10 MB2 = 10 MB3 = 10 MB4 = 10 MB5 = 10
0 0 -9 -16 -21 -24 -25
1 9 0 -7 -12 -15 -16
2 16 7 0 -5 -8 -9
3 21 12 5 0 -3 -4
Choice of
4 24 15 8 3 0 -1
Period 1
5 25 16 9 4 1 0
delivery
6 24 15 8 3 0 -1
(Q1d)
7 21 12 5 0 -3 -4
8 16 7 0 -5 -8 -9
9 9 0 -7 -12 -15 -16
10 0 -9 -16 -21 -24 -25
Under the P* benefit incentive, a company is incentivised to set the period 1 milestone as low
as possible, but then to over-deliver up to the optimal value. This is a major limitation with
value-based incentive schemes where companies are free to set their own milestones. By
choosing a low milestone the risk associated with under-delivery is minimised whilst the
potential gain from over-delivery is maximised. However, financeability would impose some
constraint on a companys ability to over deliver without funding. It is also worth noting that
Page 17 of 24
even removing the potential to earn positive rewards would not alter the effects of a value-
based incentive to set conservative period 1 targets.
This limitation could be addressed through careful scrutiny of a companys justification for
setting a milestone below the optimal target, or even through making any payment of positive
incentives for over-delivery dependent on ex post demonstration that over-delivery was made
possible through innovation leading to lower costs.
One way to encourage truth-telling is to design a menu which transforms the rewards available
to ensure that a company is always better off revealing their true expectations about the
period 1 milestone, and encourages a company to set the period 1 target as close as possible
to the optimum level. This option is however likely to be complex and is not explored further in
this paper.
6.7 Consumer surplus

The consumer surplus is the total difference between the price paid for each unit and the value
placed on this unit.
Under traditional economic analysis, with

downward sloping marginal benefits and 25
upward sloping marginal costs, the gap
between the marginal cost and the price
which is charged per unit (P*) is the 20
producer surplus, i.e. the amount gained

by the producer. The gap between the

15
price paid and the valuation of that unit
by the customer is the consumer surplus
(see Fig 6.3.1). 10 P*
This model differs in two respects. Firstly,

water prices are largely determined by a 5
cost-based regulatory model rather than a

fixed price. This means that the consumer
0 Q*
surplus may be the full gap between the 0 1 2 3 4 5 6 7 8 9 10
marginal cost and the marginal benefit Units delive red
(i.e. both the blue and green hashed
areas). This is due to the way water
pricing is regulated and benefits the
consumer, who under a competitive MC MB Optimal Target P* Q*
market would pay the price P* for all units

consumed. Fig 6.7.1 Consumer surplus (green hash) and
producer surplus (blue hash) in
Secondly, we have so far assumed that traditional economics where company
sells Q* goods at price P*.
the marginal benefit curve is flat,
meaning that P* is set at the constant
marginal benefit per unit. This means that the consumer surplus becomes the blue hashed
area.
Where the price paid is equal to the marginal cost of delivery , the consumer surplus is the gap
between the marginal cost and marginal benefit curves. The consumer surplus is maximised
when Q* is planned and delivered and no incentive is paid to the company. Where the initial
target is less than the optimal target, a portion of this surplus (that attributable to the units
which are not planned) is not available to the customer. The potential consumer surplus from
the unplanned units (Q1 to Q*) becomes the incentive for the company to deliver up to Q*
(see Fig 6.7.1 and Fig 6.7.2).
Page 18 of 24
Under this incentive scheme, the consumer does not gain or lose benefit for any level of
delivery against a given planned level of Q1, since under-delivery is compensated to the value
of the lost consumer surplus, and over-delivery is paid for with the entire surplus for those
units. However, the customer is not indifferent to the level at which Q1 is set. The lower the
company sets Q1, the greater the potential to capture part of the optimal consumer surplus.
25 25
20 20

15 15
10 P* 10 P*
P1
5 5
0 Q* 0 Q1 Q*
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
MC MB Optimal Target P* Q* P* Q*
Fig 6.7.2 Expected consumer surplus (green Fig 6.7.3 In this example, the first period target
hash) when optimal target is first is below the optimal target. The
period target, and this target is expected consumer surplus (green
achieved by the company. No hash) is less because this is a sub-
incentive applies. optimal outcome. The company now
has the opportunity to appropriate the
remainder of the optimal consumer
surplus (blue hash) through the
incentive mechanism.
6.8 Applying less than 100% of benefit

If less than 100% of the benefit to customers is used as an incentive, the characteristics of the
incentive would change.
Figure 6.8.1 shows an example from the model when the optimal target Q* = 5 and the first
period milestone Q1 = 3. In this example, different incentive schemes have been compared for
differing percentages of valuation.
Page 19 of 24
As the percentage of valuation applied 10

decreases from 100%, the incentive to over-
5
deliver also declines (and therefore so would
the incentive to under-promise). This will 0
0 1 2 3 4 5 6 7 8 9 10
continue to an arbitrary point, defined by the

-5
relative cost and valuation curves. In this -10

example this continues until 30%, at which
-15
point the incentive is equivalent to the
average cost incentive. After this, the -20
behaviour of the incentive is the same as a -25

cost incentive, with the propensity to under-
-30
deliver increasing.
-35
Whilst reducing the percentage of valuation -40
used in the incentive weakens the unintended units delive red
consequences found by our analysis, without

detailed knowledge of the relative cost and
100% 80% 60% 40%
value curves, it is not possible to determine 30% 20% Avg Cost
the appropriate percentage to be applied. Any
choice would be arbitrary and could either lead
Fig 6.8.1 Effect of reducing the percentage
to the properties found under a cost based of valuation used in the incentive
incentive or the kind of value based incentive on company pay-off.
detailed above, dependent on the choice that
is made.
Changing the percentage of the valuation used in the incentive also affects the benefit to
customers where delivery differs from planned, with customers receiving less than their
valuation in compensation for under-delivery but receiving some benefit from over-delivery.
6.9 Marginally diminishing benefit

Where the marginal benefit curve is not flat, as has been assumed thus far, but instead slopes
downward (see Fig 6.9.1), the full value lost or gained by the customer for over- or under-
delivery is no longer always P*. It should be calculated instead as the marginal benefit for each
unit. The same difficulties with such an approach for assessing a cost-based incentive apply,
and as such, an average benefit approach would need to be used. In such a case where
average benefit is used instead of P*, a value-based incentive becomes inappropriate as
companies are incentivised to deliver beyond the optimal amount, whilst still being incentivised
to set the period 1 milestone as low as possible (see Fig 6.9.2). This concept is therefore not
explored further in this paper.
Page 20 of 24
25 60
40
20
20

15 0
0 1 2 3 4 5 6 7 8 9 10
-20
10 P*
-40
P1
5 -60
-80
0 Q1 Q*
0 1 2 3 4 5 6 7 8 9 10 -100
Units delivered Units delivered
P* Q*
Incentive = AB Period 1 Target Optimal target
Fig 6.9.1 Marginally diminishing benefits Fig 6.9.2 Company pay-off from average
benefit incentive
6.10 Penalty only incentive

A penalty only incentive would again remove the incentive for companies to over-deliver.
However, they would still be incentivised to be cautious in setting targets to avoid potentially
large penalties if unable to deliver the planned amount. Companies faced with these potentially
large penalties would also likely chose more conservative measures of success which were
more directly controllable, leading to measures which are more akin to outputs than outcomes.
6.11 Conclusions
Using a value-based incentive based on the point where marginal cost equals marginal benefit
(P*) provides an incentive scheme which encourages delivery to the optimum level. However,
it must be accepted that such a mechanism will result in customers paying more for additional
units than their cost when companies find their costs to be lower than expected. The major
draw-back for such a scheme is that a company is incentivised to under-promise and then to
over-deliver in order to minimise the risk of under-delivery and maximise the potential gain for
over-delivery. Additional mechanisms would be necessary to remove this unintended
consequence, although the practicalities of devising and administering such additional
incentives have not been explored here and could present significant challenges.
7 Innovation
7.1 Introduction
In this section, the model is expanded to consider the choice faced by companies over whether
to invest in research & development (R&D) in the hope of producing an innovation which
overall allows the outcome to be delivered at lower cost.
7.2 Assumptions
Companies may invest a fixed cost in R&D in the 1st period (shifting the total cost curve
upwards, but not the marginal cost curve) (see Fig 7.2.1 and Fig 7.2.2). This may or may not
generate a successful innovation (if successful, the slope of the marginal cost curve is
reduced). It is assumed for simplicity that the effect of the innovation takes place in the 1st
period. The 1st period milestone is assumed to be lower than the optimal target.
Page 21 of 24
140 140
120 120
100 100

80 80
60 60
TP*'
40 40
TP*'
TP* TP*
20 20
TP1 TP1
0 Q1 Q*'
Q*
0 Q1 Q* Q*'
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Units delivere d
Units delivered
TC TB Actual TC
TC TB Actual TC
Period 1 Target TP1 Q1
Optimal Target TP* Q*
New optimal target TP*' Q*'
Fig 7.2.1 Successful innovation (enabling Fig 7.2.2 Unsuccessful innovation

lower total costs in first period).
7.3 Incentive properties

When costs vary due to innovation, both the average cost incentive and the P* benefit
incentive provide the same incentives as previously described. The average cost incentive
encourages sub-optimal delivery, although if marginal costs are reduced sufficiently this may
result in delivery of more than Q1. The P* benefit encourages delivery up to the optimal point.
If R&D fails to secure successful innovation, a company may deliver less than originally
anticipated regardless of the incentive mechanism since it may not be able to fund the delivery
of additional units at a higher cost in order to minimise the penalty as it should do under a P*
benefit incentive. This might also be the case where R&D has been successful but the reduced
marginal costs are not sufficient in the first period to allow the company to deliver the planned
amount within the period, but will lead to a higher new optimal point Q* in the subsequent
period (see Fig 7.3.1 and Fig 7.3.2).
Page 22 of 24
25 140
120
20
100

15
80
10 P*'
P* 60
40TP*'
5
TP*
20
TP1
0 Q* Q*'
0 Q1 Q* Q*'
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Units de livered
Units delivered
TC TB Actual TC
MC Actual MC MB
Optimal Target P* Q*
Fig 7.3.1 Successful innovation (marginal costs Fig 7.3.2 Successful innovation, but total costs
are reduced) leading to a new in first period exceed expected costs.
optimal target (Q*) Innovation takes until the second
period to recover R&D investment, but
ultimately leads to a higher optimal
target (Q*).
To the regulator both cases appear similar at the end of period 1. If a penalty is applied at the
end of period 1 for failing to meet Q1, a company would be discouraged from undertaking R&D
where innovation was not likely to reduce costs in the same period sufficiently to offset the
cost.
One approach to resolve this issue would be to allow companies to make a case at the end of
the 1st period if they believe they have lowered their unit costs through innovation but this has
not yet had time to offset the initial investment. If this is accepted, the penalty for under-
delivery in period 1 could be suspended until a subsequent period. This would allow companies
to invest in longer term innovations. Suspended penalties should not however be allowed to
continue indefinitely and a reasonable time-frame should be established for when a company
expects to recover (e.g. at the next milestone or at the end of the agreed timescale for the
outcome).
However, it may be more appropriate to apply a penalty but then to allow for a compensatory
reward in future periods when the innovation allows recovery. In this case customers are not
asked to fund something today that they have not received. There is a risk with such an
approach that companies may not have confidence that Ofwat or Customer Challenge Groups
will approve an incentive in future periods which adequately compensates for the penalty
applied in this period.
8 Other incentives
This paper largely treats outcome delivery incentives in isolation from other incentives for
simplicity. Further work would be needed to identify if the conclusions would alter when placed
within the total package of incentives, particularly value for money incentives or other outcome
incentives (such as the Service Incentive Mechanism). These different incentives will need to
be calibrated together.
Page 23 of 24
9 Caps and collars

It may be possible to reduce the relative strengths of the unintended consequences through
caps and collars on the rewards or penalties available. Under such a system, the company
would be protected by a limit (collar) on the penalty that would be applied, and the customer
would be protected by a limit on the value of any incentive due to over-delivery (cap). Whilst
these may be useful tools in calibrating the incentive to be applied and limiting the risks faced
by either party under different types of incentive, we believe this would not change their
fundamental characteristics.
10 Conclusions
When designing an incentive mechanism to encourage delivery of outcomes over multiple
periods, it must be recognised that companies can influence their expected rewards and
penalties in a number of ways:
choosing milestones to manage the risk they face,
choosing to deliver more or less than planned to minimise penalties and maximise
rewards,
investing in R&D to reduce costs over the longer term.
Cost-based incentives are problematic in that they encourage a company to under-deliver on

the optimal target, but they have the advantage of incentivising a company to set the 1st
period milestone as close as possible to the optimal target. The propensity to deliver less than
planned under a cost-based incentive could be mitigated through a reputational incentive or
through regulator scrutiny where targets have not been met to ascertain if such under-
deliveries had been as a result of gaming.
Value-based incentives encourage optimal delivery, but incentivise companies to under-state

the 1st period target to minimise exposure to the risk of under-delivery, and maximise the
benefit available from over-delivery. It may be possible to mitigate this through scrutiny of
plans or through a menu to encourage truth-telling, but this paper has not looked at the
practicalities of such approaches. Customers also pay more for the delivery of unplanned units
than they would have done had they been included in the plan. This may however be
necessary to offset the risks companies face for under-delivery under such a scheme.
There is also a case for allowing some penalties for under-delivery to be suspended until future
periods, where a company believes that the under-delivery is as a result of innovation which is
not expected to pay-off until a subsequent period.
The degree to which both costs and benefits can be relied upon for use in an incentive is open
to debate. There is considerable asymmetry of information between companies and their
regulators and stakeholders with regards to costs. Whilst there has been an accumulation of
revealed costs for activities which have been undertaken by companies over the last 20 years,
translating these activity and scheme costs into outcomes is likely to be problematic for the
regulator. A similar case could be made for valuations, which have also historically been based
around outputs rather than outcomes. The degree to which outcomes differ between
companies also makes any cross-company benchmarking problematic. In the case of
valuations, such comparisons may also be inappropriate, since each company seeks to find the
value placed on an outcome by their own customers. This paper has not sought to resolve this
problem, but the likely effect on failure risk must also be taken into account, alongside the
findings of this paper.
This analysis assumes a two-sided (penalty and reward) incentive. A penalty only incentive
does not support long term planning and innovation. Companies do not benefit from delivering
more than planned in any given period under a penalty only incentive, even when there is
evidence that customers would prefer more of an outcome over the long term, and the
company has reduced costs to allow more to be achieved than originally planned. Companies
Page 24 of 24
may also be less innovative in the targets they set, the measures they choose and in
potentially risky investments in promoting innovation.
We have found limitations in both a cost-based incentive, which may encourage sub-optimal
delivery against outcomes but encourages truth-telling when setting milestones, and a value-
based incentive, which encourages optimal delivery but also creates a perverse incentive to
under-promise and over-deliver on milestones. This paper suggests how some of these
unintended consequences might be avoided, but further work would be required to understand
if these would be effective.
11 Further information
If you have any questions or comments regarding this paper please contact the authors:
Pete Duell Martin Silcock

Anglian Water Anglian Water
01480 323047 01480 323120
pduell@anglianwater.co.uk mSilcock@anglianwater.co.uk
Contributors:
Melinda Acutt, ICS

Janet Wright, Sladen Wright Associates
Annabelle Ong, Frontier Economics
Andrew Snelson, Anglian Water

Outcome Delivery Incentives Over Multiple Price Controls

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Outcome delivery incentives over multiple price controls

Outcome delivery incentives over multiple price controls

A report prepared by Anglian Water

We conclude that designing an incentive mechanism for outcomes to be delivered over a

Our work in this paper assumes an ex ante incentive.

In the context of outcome delivery incentives, incentives might be used to influence a

2.3 Advantages of outcome regulation

2.4 Wholesale incentives consultation

Trade-offs might be desirable between different measures of success within an outcome or

3.2 Description of the model

3.3 Expanding the model to multiple measures

4 Setting targets and milestones

Total Cost / Benefit ()

Total Cost / Benefit ()

Total Cost / Benefit ()

4.3 Marginal Cost = Marginal Benefit

Total Cost / Benefit ()

Units delivered Units delivered

MC MB Optimal Target P* Q* TC TB Optimal Target TP* Q*

4.4 Multi-period milestones

Total Cost / Benefit ()

Units de live re d Units delivere d

5.3 Marginal vs average cost

it will likely be hidden from the regulator 10

Expected company payoff ()

This analysis therefore assumes that the -20

difference between the planned quantity -40

(Q1) and the quantity delivered in period 1

AC1 = TC1 / Q1 -70

However, as the average cost is lower than

Units delivered 0 1 2 3 4 5=Q* 6 7 8 9 10

5.4 Actual costs differ from expected costs

Actual company payoff ()

MC Actual MC MB Incentive = AC (expected) Incentive = AC (actual)

5.5 Reputational incentives

5.6 Choice of period 1 target

Expected Choice of Period 1 milestone (Q1)

5.7 Marginal cost incentive

Expected Choice of Period 1 milestone (Q1)

5.8 Penalty only incentive

The truth-telling properties regarding setting of milestones could be seen as a significant

6.3 Period 1 milestone equals the optimal target

a simple example there is only one target

Expected company payoff ()

gained through over- or under-delivery of

total allowed cost incurred + P* x unit

costs have been assumed to match

Units delivered 0 1 2 3 4 5=Q* 6 7 8 9 10

6.4 Actual costs below expected costs

Actual company payoff ()

MC Actual MC MB Incentive = P* (Expected) Incentive = P* (Actual)

6.5 Actual costs above expected costs

6.6 Choice of period 1 target

Expected Choice of Period 1 milestone (Q1)

6.7 Consumer surplus

Under traditional economic analysis, with

producer surplus, i.e. the amount gained

by the producer. The gap between the

This model differs in two respects. Firstly,

cost-based regulatory model rather than a

market would pay the price P* for all units

Marginal Cost / Benefit ()

6.8 Applying less than 100% of benefit