Annex 3
FUTURE WATER AND SEWERAGE CHARGES 2000—2005
DRAFT DETERMINATIONS
THE IMPLICATIONS FOR CAPITAL MAINTENANCE
EXPENDITURE
REPORT BY
PROFESSOR CHRIS
BINNIE F R ENG
Executive Summary
INTRODUCTION
This report deals with Ofwat's draft price determination
of July 1999. In the draft determination funding for capital maintenance
has been cut to £6.2 billion for 2000-2005 from the current
level of £7.1 billion. Company business plans requested funding
for maintenance of £8.3 billion. The proposed Ofwat funding
therefore represents a 25 per cent cut in capital maintenance
on plans.
This report is based upon documents from Ofwat
and water companies. In preparing this some water company documents
have been rejected as being insufficiently supported. The result
I believe represents a balanced review that takes into account
the long term interests of society which we, as professionals
serve.
Traditionally—and very rationally—the
view has been taken by the industry that the provision of a water
supply and sewerage service should be undertaken in such a manner
as to avoid failure wherever possible, especially where this could
lead to risks in public health and to the environment.
ASSETS
In all companies, the age of assets has increased.
Whilst age is not a barometer of performance—some 100 years
old cast iron pipes perform better than much younger 30 year old
ductile iron pipes—the older an asset gets, the more maintenance
it is likely to need. No account has been taken by Ofwat for the
need for increased capital maintenance for ageing assets.
Ofwat states that "there has not been a
measurable increase in the amount of assets in poor condition
over the last five years . . . No allowance has been made in the
draft price limits for additional capital maintenance to meet
a specific objective to improve assets."
However, in March 1998 12 per cent of water
pipes were classified as being in a poor condition—an increase
of 3 per cent since 1993 despite large capital investment. A one
third increase in "poor condition" assets amounting
to £1 billion of modern equivalent asset, hardly constitutes
"no evidence of significant deterioration".
Bursts on water mains have apparently remained
largely stable. During this period there has been appreciable
expenditure on pipe renewal for water quality reasons and much
pressure reduction for leakage control, both of which would have
lowered bursts. The scope for further such measures is limited.
Thus there is an underlying deterioration.
The design life of sewers is of the order of
100 years. Current allowance for replacement would produce lives
of the order of 500 years to 1,200 years. Funding available does
little more than allow for repair of sewer collapses.
An overall asset condition survey shows there
is a need for increased investment by many companies merely to
reach the "no deterioration" position let alone start
to meet the expectations of customers for progressive improvement.
COMPANIES' APPROACH
Companies have prepared asset management plans
incorporating a forward looking assessment of their assets, with
risk analysis, to identify the capital maintenance funding required
to meet serviceability criteria. All of these have been challenged
and certified by Ofwat Reporters. However they have effectively
been rejected by Ofwat.
OFWAT APPROACH
Instead Ofwat have taken the historic average
of capital maintenance over the last six years, looked at levels
of service which do not well reflect asset conditions from which
they assess that performance is largely stable, and have then
applied future capital efficiency factors.
Historic capital maintenance does not take into
account the higher capital maintenance in recent years, the recent
shorter life assets which have been constructed in recent years
and which will need capital maintenance during AMP3, assets to
meet new obligations, or sufficient increased spending on capital
maintenance to allow capital schemes constructed for quality requirements
to be fulfilled.
For instance over the last decade there has
been a great emphasis on improving quality in terms of drinking
water and effluent discharges. To achieve these higher standards
there has been a heavy investment in more sophisticated plant
with a higher electrical and mechanical content and featuring
complex control and instrumentation systems and automated operation.
Although these newer assets have produced the improved operational
efficiency sought by Ofwat and others, they also have a much shorter
life and require higher capital maintenance or earlier replacement
than the assets they replaced. No allowance has been made by Ofwat
for increasing capital maintenance of these shorter life assets.
The conclusion must be that the historical capital
maintenance figures assumed by Ofwat do not adequately reflect
the levels of capital maintenance activity needed in the future.
Ofwat should take into account the increase in asset value, the
changes in asset life, the higher maintenance required for short
life assets and explain where its purported overlaps and synergies
occur.
In terms of customer serviceability for the
water supply and sewerage services, Ofwat reports that, industry
wide, performance trends are stable or showing a slight improvement
and has reduced the allowance for capital maintenance. The Ofwat
serviceability criteria are backward looking levels of service,
are failure based, several are fairly meaningless from an asset
viewpoint, and many demonstrate need for capital enhancement or
improved management rather than capital maintenance.
It is hardly a tenable proposition to base capital
maintenance on funding criteria that could allow problems to build
up unnoticed resulting in a spate of failures that cause real
disruption of services to customers. This has occurred recently
with the railways where serviceability testing failed to pick
up the potential problem with broken rails that is now adding
appreciably to the frustrations of delayed passengers.
The Ofwat Cost Base is not a robust basis for
setting capital catch-up, the amount of catch-up has been selected
arbitrarily, and has been applied in full from April 2000, even
to contracts already placed. Future capital efficiency assessment
has not been robustly justified.
CUSTOMER VIEWS
Water Companies, DETR, EA and Water UK carried
out customer surveys. These were mostly, large, statistically
valid and robust, and generally supported current bill levels
and investment to increase the reliability of supply. Ofwat carried
out a minimal survey of 48 people which was not statistically
valid or robust, held discussion with its CSCs and decided that
bills should be lowered, ignoring the much more robust surveys
by others.
CONCLUSIONS
Companies' views are that there are too many
places where the Ofwat process and numbers are far from transparent.
There are also many places where the decisions appeared to be
arbitrary.
The object of privatisation was to ensure proper
funding of the water systems not starve companies of the funds
they need.
The net result of the draft determination is
that against the £8.3 billion requested by the Companies,
Ofwat has allowed £6.2 billion for 2000-05 which is likely
to cause deferment of important capital maintenance.
Ofwat has a statutory duty to ensure that the
companies are able to finance the proper carrying out of their
functions. There must be doubts as to whether this draft determination
does so.
It is ironic that a company with poorly performing
assets could lose its licence because the regulator has refused
funding to bring these assets up to an acceptable standard of
performance.
It is also ironic that at a time when the regulator
of Railtrack is urging that more should be invested to bring the
rail network up to an acceptable standard that Ofwat should be
refusing funding for the water industry to do likewise with its
networks.
Inevitably all stakeholders could be losers;
customers who though paying slightly less for water and sewerage
services find standards falling and not meeting their expectations;
the companies who could no longer meet their obligations; their
investors (many of whom are customers and employees who bought
shares at the time of privatisation) who could find their returns
reduced and, last but not least, the environment which could become
more exposed to risk of breakdown of the sewerage system and pollution
from sewage.
October 1999
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