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A better price review

alex mahon | the water report | 1 october 2016

During PR14 the introduction of four separate price controls brought the concept of cost allocation to the fore, with four of the Risk Based Review (RBR) assessments dedicated to reviewing companies’ design of and justification for allocations. As no single company successfully passed every test, it was clear that many lacked clarity about their costs or how to allocate them appropriately.

Some may argue that the industry has now improved its understanding of costs. However, the evidence from Ofwat’s March 2016 and August 2016 targeted review of WaSC and WoC robustness, alongside its work on comparability of revenue reporting data, suggests that there are still areas of inconsistency.

While it is still not clear exactly what will be required in PR19, there are some indications of the approach Ofwat will take. Water 2020 suggested that there will be two additional price controls and an expectation of greater transparency about how the sector is performing to help inform customers and new entrants. At the same time, companies also face the challenge of Ofwat’s plans to implement household competition and pressure from retailers to improve services. All these factors underline that there will be a need for a more granular understanding of costs and services.

The business driver

To meet this need, companies should start by securing a better understanding of their business processes and costs. Without this understanding, they run the risk of finding themselves in the same position as during PR14, where they had to put considerable effort into clarifying proposals that had already been assessed and submitted.

The challenge is complicated because once the final PR19 methodology is published in July 2017, companies will have only 15 months left to produce, test and assure their business plans.

Transaction testing and control reviews

These are a common accountancy practice used to demonstrate compliance and risk management across an organisation’s financial allocations. For PR19, this methodology could also be applied to help companies understand which services are being provided to the end customer and most importantly, the appropriateness of the cost allocation between service lines.

Each service identified can then be overlaid with its associated performance metrics, facilitating better customer engagement with the service. The responses from this engagement can then provide companies with an understanding of whether they are meeting customer expectations.

Cost of service studies

Another key action should be to undertake cost of service studies. These enable companies to bring together the financial and operational aspects of their activities and identify the cost of providing a particular service to an end customer.

The outputs of these studies can then be used to justify the assignment of cost responsibility across the business, either to support Regulatory Accounting Guidelines or by providing the opportunity for companies to challenge them.

The effectiveness of this approach was seen during PR14, when the companies which received an ‘A’ categorisation were those who had appropriate evidence to support their challenge.

Cost out methodologies

Companies could also use cost out methodologies to inform their work. These assessments facilitate the realisation of core efficiency and performance gains across the company by identifying duplicate activities, orphaned processes and those activities which are not directly contributing to continued service delivery or performance improvement.

These methodologies can also be used to deliver performance and quality improvements through an increased understanding of processes and ways of working. A top six energy company used this technique to improve the efficiency of its energy sales to members of the public through rapid process review and improved management of controls and performance metrics.

A crucial benefit of these actions is that the greater level of business insight can be used to test companies’ regulatory position and associated performance commitments and Outcome Delivery Incentives. By starting this work on cost and service assessments early, companies will also have longer to engage with customers and then interpret and incorporate their views within their asset investment plans and more importantly be able to provide evidence of those priorities. They will also be able to demonstrate to customers and Ofwat the actual impact of service changes on bills.

This kind of review of existing operating models means companies can position themselves more effectively to manage changes in the industry. In particular, they will secure an improved understanding of the relationship between the commercial and regulatory drivers of their services and how third party contracts and alliances relate to business process costs. A further advantage is that this ability to quickly respond and adapt to change will allow companies to demonstrate a high level of business resilience to Ofwat.

The end result of implementing this approach in advance of PR19 is that companies will have a clear understanding of service costs and clearly evidenced customer support for their plans. This will enable them to efficiently address any discrepancies with Ofwat’s cost threshold, allowing them to move into higher scoring categories of the tests from the outset.

There will also be wider benefits to these actions than just ensuring success at PR19. Applied correctly these methods will help companies better understand the areas where they are efficient. In an increasingly competitive market, they will be able to identify the sectors where they may choose to compete and the services they may wish to offer in the future. This will be underpinned by a realistic projection of market share and margin gain.

By taking action quickly to better understand their costs and services companies can position themselves at the forefront of the industry, delivering greater value to both their customers and their shareholders.

Alex Mahon is a water expert at PA Consulting group 

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