Resilience revisited – stress testing after the pandemic – Blog by Paul Horton and Richard Laikin

Much has been made of how the water sector (the water companies and everyone in their supply chains, working collaboratively) has kept water flowing through the Covid-19 crisis with barely a ripple on the surface, through a time of significant changes in domestic and business water consumption, a with very wet spring and dry summer to boot. This is testament to the sector’s agility and responsiveness in the face of extreme operational events.

Fortunately, many companies had already recognised the potential of a pandemic to disrupt their business. For example, in their 2018 Resilience Framework consultation, Yorkshire Water said “Following learning from past events, we have taken various measures to support our agility during emergencies. We have: plans for events where a large proportion of colleagues would be absent, like a flu pandemic; increased the number of Citrix IT licences that enable colleagues to work remotely; options to bring in agency staff or redirect resources with cross-skilling of roles.”

But it wasn’t at the top of companies’ agendas. For example, in their 2020 Financial Statements, Northumbrian Water said “the risk associated with a pandemic has been identified historically within the company’s risk register but has not previously been considered to be a principal risk. This is because the impact had been considered to be relatively moderate.” They weren’t alone in making such an assessment. As we have discussed in previous blogs, from a purely shareholder financial point of view, this was probably correct. But, with the benefit of hindsight, we can now see the wide range of impacts from operational, employee, and customer perspectives.

Inevitably, when we look back at the lessons learned from the current pandemic, we will see variation in companies’ experiences and outcomes and differences in preparedness and agility. The key will be to learn to better identify risks from extreme events and improve preparedness for the future.

Can we benchmark against other sectors? For example, formal “stress testing” of financial resilience has been a feature of regulation for major banks and insurance firms since the aftermath of the global financial crisis. The idea is to test banks’ resilience to make sure they have enough capital to withstand extreme economic shocks, in isolation and combination, using the Bank of England’s “what if” scenarios and assumptions. The results are published and, where necessary, the firms can be required to improve their capital buffers to strengthen their resilience to the shocks that have been modelled.

Insurance firms are required to go further and undertake “reverse” stress tests, which involve a firm identifying and assessing scenarios and circumstances that would make its business model unworkable, thereby identifying potential business vulnerabilities and faults, including from tail risks (ie risks associated with rare events occurring in the future).

Ofwat first consulted on the idea of a formal stress testing approach for the water companies back in 2015, but it was rejected. Instead the companies were required to report annually on their medium term financial viability, looking out between 5 and 10 years. Companies have to consider the potential effects of risk and uncertainties that could have a significant financial impact under severe but plausible scenarios and identify, at a high level, potential mitigating actions and their likely effectiveness. A set of suggested sector-specific factors for risk assessment has been developed and promulgated since – see for example Ofwat’s latest guidance (IN19/07, May 2019).

The introduction of a statutory duty on Ofwat to further a “resilience” objective has encouraged Ofwat and the sector to take this a step further, and in the PR19 methodology each company was required to demonstrate how it was proposing to achieve “resilience in the round” covering not just financial resilience but also operational and corporate resilience. Each company’s resilience framework was assessed and scored by Ofwat as part of the PR19 business plan review process.

Elements of resilience are also tested through the companies’ water resource management plans with stress testing against scenarios ranging from 1:200 to 1:500 year droughts and other planning assumptions. PR19 determinations included common performance commitments designed to test companies’ risk of sewer flooding in a storm and risk of restrictions in a drought and encourage the implementation of plans to improve these over the medium to long term. Companies also modelled and reported to Ofwat their views of the likely range of outcomes against each of their many performance commitments, individually and in combination, taking into account interdependencies.

None of this is intended to be just a set of theoretical exercises. Companies and the sector as a whole need to be clear on the actions that can and should be taken now and into the future to mitigate risks, and to put in place and test plans to respond and recover when extreme events occur.

The National Infrastructure Commission (NIC), in its May 2020 report “Anticipate, React, Recover: Resilient Infrastructure Systems”, recommended that regular formal stress testing should be carried out by firms across all the critical infrastructure sectors, in the same way as for the financial sector, mandated and assessed by regulators against resilience standards set by government. It was great to see that the NIC held up the water sector as an example of best practice relative to other sectors.

Nevertheless, it also pointed out that in spite of there being good plans in place, implementation and outcomes have varied across water companies in the face of actual events, for example the Beast from the East. It also highlighted that, in too many cases, resilience planning has been siloed within companies rather than looking at regional interdependencies or across other sectors (eg power). It is worth noting that the Bank of England has also been exploring interdependencies across sectors and ‘spill over effects’ between financial institutions and counterparties. It has been consulting on how to incorporate different climate scenarios into the stress testing framework.

In spite of there being evidence of lots of good practice in the water sector, we think that the experience of COVID-19 should spur the sector to develop further its approaches to resilience planning and stress testing, whether formally mandated or not. We would like to encourage more collaboration around this area, involving the supply chain. It will make for better resilience planning and better implementation in the future, as well as more innovation, by considering an even wider set of viewpoints. Many firms in the supply chain operate in multiple sectors or countries, or work with multiple water companies, and so potentially have a wider set of experiences and reference points. We are also very attracted to the concept of reverse stress testing (testing the business model to destruction) alongside the more traditional forms of scenario assessments.

Some of things we would like to see include:

  • Openness: Water companies should bring supply chain and other stakeholders into their lessons learned exercises, and vice versa. Explore risks with the supply chain and contractor community, and potential mitigations. Bring honest and open opinions and assessments;
  • Visibility: bring scenarios and practical experiences from other sectors and countries to the table, both risks and mitigating actions. Share your firm’s stress testing with others;
  • Identifying and sharing interdependencies: these can’t always be visible to the water company itself, for example further down the supply chain, or with other sectors that depend on the supply chain. Help the companies and other stakeholders within and outside the sector identify whole system impacts (whether reinforcing or offsetting) and points of instability across sector boundaries and across the water environment;
  • Cross-pollination: Work with water companies and other actors in the water environment to create joined up solutions with partners, government etc. Use enhanced resilience planning and stress testing post-COVID as another spur to innovation and creativity. Examples might include thinking about valuing flexibility and optionality, data analysis and systems modelling, etc and how all these flow into risk assessment, mitigating actions and plans.

We welcome your input on how to improve resilience planning in the sector post-Covid, including how the supply chain can contribute. If you have ideas or experiences to share please do let us know so that we can feed them into the cross-sector debate on this important topic.

* Richard Laikin is a Board member, and Paul Horton is Chief Executive Officer, of Future Water.

17 September 2020

 

 

Contact:

Richard Laikin – email: richard@rlstrategyconsulting.com

Paul Horton – email: paul@futurewaterassociation.com