Memorandum from the Office of Water Services
(Ofwat)
SUMMARY
The Director General of Water Services' (the
Director) primary duty is to ensure that companies properly carry
out their functions and can finance them; to ensure that the interests
of customers are protected; and the promotion of economy and efficiency,
by companies, in the carrying out of their functions. In addition,
the Director has certain duties associated with the environment
set out in Section 3 of the Water Industry Act 1991.
It is Ministers who determine the scale and
pace of the environmental and quality programmes, having been
advised by the Environment Agency, the Drinking Water Inspectorate
and the Office of Water Services (Ofwat). Companies must deliver
these programmes within the price limits set by the Director.
The Environment Agency and the Drinking Water Inspectorate monitor
companies' progress in achieving the environmental and quality
objectives and report that progress to the Director annually.
Ofwat welcomes the quadripartite process, managed
by the Department of the Environment, Transport and the Regions
(DETR), which provides valuable opportunities for all parties
to exchange information and assists Ministers in making their
decisions.
In fulfilling its duty to protect customers
and to promote economy and efficiency, Ofwat draws Ministers'
attention to the implication for customers' bills of the proposed
environmental and quality programmes. At the 1999 Periodic Review
Ministers' decisions as to the scope and timing of the environmental
programmes took account of Ofwat's advice.
The 1999 Periodic Review was a three-year process
managed by Ofwat. Ofwat consulted at an early stage on its methodology
and process. It involved stakeholders at all stages of the review
and, in evolving its methodology, took account of the representations
of stakeholders.
The price limits, set by Ofwat assumed a capital
investment programme of £15.6 billion of which £7.4
billion was assumed to be needed to meet the environmental and
quality improvement programmes determined by Ministers. As a result
of the greater efficiency of the companies, Ofwat has lowered
price limits so that domestic customers' bills reduced by an average
of £31 from 1 April 2000.
OVERVIEW
The Outcome of the 1999 Periodic Review of water
prices
On 25 November 1999 the Office of Water Services
(Ofwat) announced the price limits that would apply to the water
industry in England and Wales for the five-year period commencing
1 April 2000. These price limits are a ceiling to the amount by
which water companies may increase the average customer's bill
above the prevailing rate of inflation. The announcement marked
the culmination of the second periodic review (PR99), a three-year
project managed by Ofwat and which entailed the substantial involvement
of the companies, Government and the quality regulators (the Environment
Agency and the Drinking Water Inspectorate).
Efficiencies achieved by companies over the
past five years meant that the final determination of prices for
2000-05 could deliver a price reduction in the first year. For
the first time since privatisation of the industry in 1989, bills
dropped in April this year—by £31 for the average customer
or 12.4 per cent of the previous annual bill. Thereafter prices
will remain broadly stable in real terms despite an assumed capital
investment programmed of £15.6 billion which maintains expenditure
at the levels seen since privatisation.
The final determination was welcomed by Government,
quality regulators and customer groups. The water companies, as
a body, saw the settlement as tough but achievable. Only two companies,
Sutton and East Surrey Water and Mid Kent Water sought referrals
of their determinations to the Competition Commission.
The Environment Agency (EA) responded warmly.
Its then Chairman, Lord de Ramsey said: "by 2005 we will
have reached a position where the significant environmental damage
created over the past 200 years will have been repaired".
In terms of the number of improvement schemes, the five-year environmental
improvement programme funded in price limits is the largest ever.
Indeed, if it were not for the continuing investment in protecting
the environment, the price cut by 2004-05 could have been significantly
greater.
Apart from the environmental improvement programme,
the final determination provides for:
— meeting the requirements of the revised
EU Drinking Water Directive;
— no deterioration in services to customers
or the environment;
— maintaining serviceability for customers
from the asset systems.
THE PR99 PROCESS
At the first periodic review (PR94) the Director
set prices for the ten-year period 1995-96 to 2004-05. Two years
later, the Director exercised his prerogative by announcing that
he would be re-setting price limits for the second five-year period
in 1999. Since then, water company licences have been modified
to allow for the automatic review of prices at five-yearly intervals.
The second review (PR99) began early 1997 with
three main phases. Phase 1, which continued through to late 1988,
was directed towards establishing the framework for the review
and exposing the issues material to price setting. This period
saw Ofwat issuing a steady stream of consultation papers on a
broad range of financial, procedural and technical issues. At
the same time Ofwat commenced an intensive information collection
exercise which involved the companies making a series of submissions
on quality costings, supply and demand forecasts, asset condition
and unit costs. The companies also carried out market research
into their customers' aspirations and priorities. This research
was complemented by other studies and surveys commissioned by
a number of other interested parties including DETR, the Environment
Agency and Ofwat's Customer Service Committees.
Phase 2 was directed at increasing certainty.
It commenced with the publication of Raising the quality
by DETR in September 1998—which set out Ministers' decisions
on quality functions and which was in effect a statement of Government
policy—and drew to a close with the announcement of the
final determinations. Phase 3—Implementation—commenced
on 1 April 2000.
A chronology of the 1999 periodic review setting
out the key actions at each stage is set out in Annex 2.
THE DEVELOPMENT
OF THE
ENVIRONMENTAL PROGRAMME
The development of the 2000-05 environmental
and drinking water quality improvement programmes was an iterative
process that spanned Phases 1 and 2 of the process. Iterative
because the companies could not estimate costs, nor Ofwat bill
impacts, before knowing with a fair degree of certainty the obligations
with which they would be faced and because the Government was
not in a position to confirm the scope of the programme before
knowing what it would all cost.
The first costing exercise carried out between
February and May 1997 was a range-finding exercise and one carried
out in a situation of considerable uncertainty about quality obligations
beyond 2000. There was a wide range of cost estimates. At the
time it seemed likely that the industry would be required to meet
the requirements of a revised Bathing Water Directive the cost
of which had been estimated to be anything up to £4.2 billion.
For the industry the possible cost of environmental improvements
was put at between £2.2 and £7.0 billion depending on
the scope of obligations assumed. This initial exercise highlighted
the major cost drivers and identified the key areas in which guidance
from DETR and the Environment Agency was needed.
The Agency issued guidelines for the second
costing exercise in November 1997. Ofwat issued its reporting
requirements in the same month and the companies made detailed
submissions of costings, largely at scheme level in February 1998.
The range of costs had narrowed slightly. However, it was clear
that Ministers' guidance on a number of issues was required so
that Ofwat could know what to include in setting prices. Such
guidance was requested in Ofwat's Setting the Quality Framework
(April 1998) and given in the Ministers' response, Raising
the quality (September 1998).
The Environment Agency then constructed schedules
of all the continuous and intermittent discharge improvement schemes
deemed to be consistent with Government policy. These schedules
were issued to the companies for costing late in 1998. The third
set of cost estimates were submitted to Ofwat at the end of the
year and summarised by Ofwat in an open letter to the Secretaries
of State in January 1999. This put the likely cost of the quality
programme at £7.6 million of which £5.2 million represented
the environmental improvement programme. The increased certainty
that Raising the quality provided meant that for the first
time in the PR99 process it was possible to quote single figures
rather than ranges.
The fourth iteration of the costing exercises
commenced in March 1999 when the Environment Minister formally
announced his approval of a revised version of the Environment
Agency's schedules. This update reflected Ministers' decisions
as to exactly how far they wanted to go with the intermittent
discharge and river water quality programmes. Most importantly,
it enabled the companies to finalise their business plans that
they submitted to Ofwat in April. Ofwat carried out detailed analysis
of each company's position taking due account of the ministerial
guidance and company business plans. The analysis, leading to
complex financial modelling was summarised in the draft determination
published by Ofwat in July 1999.
Having considered all representations made on
the draft determinations Ofwat published the final determinations
on 25 November 1999. These took into account final guidance from
Ministers as to the assumptions on scope and timing of the environmental
programme that the Director should make when setting prices. This
increased the cost of the overall programme and slightly increased
price limits for some companies compared to the draft determinations.
The cost of the environmental improvement programme
assumed in the final determination was £5.2 billion. Just
over half of this will be directed at improving discharges from
sewage treatment works while a third will go towards improving
the performance of intermittent discharges, principally combined
sewer overflows from the sewerage systems. The remainder represents
the assumed cost of additional and enhanced sludge treatment and
disposal facilities and works addressing the effects of over-abstraction
including the alleviation of low flows in rivers.
CONTRIBUTION TO
ENVIRONMENTAL PROTECTION
AND SUSTAINABLE
DEVELOPMENT
The periodic review was successful both for
customers and the environment. In terms of outputs price limits
allow for the largest-ever five-year programme to protect and
enhance the aquatic environment. The outputs expected from the
programme are summarised on the table at Annex 3. River improvement
schemes are expected to raise the level of compliance with river
quality obligations (RQOs) to 87 per cent by 2005, going a long
way to achieving the Government's target of reducing half the
current shortfall by that date. Bathing water improvement schemes
are expected to raise current compliance with EU mandatory bacteriological
standards to 97 per cent in line with Government's objectives.
The programme will also significantly improve compliance with
the much tougher EU bathing water guideline standards, particularly
at popular resorts.
The Environment Agency has a statutory duty
to promote sustainable development under the Environment Act 1995.
Ofwat contributes to, but is not the main party responsible for,
promoting sustainable development. This was confirmed by the Environment
Minister during the Committee stage of the Water Industry Act
1999. This duty better rests with Government than the economic
regulator. Ofwat believes that Government can further the cause
of sustainable development through the use of economic instruments
for pollution control.
Ofwat recognises that the safeguarding of freshwater
resources and water quality forms a crucial element of a national
overall strategy for sustainable development. The Environment
Agency's stated objectives follow the Government's commitment
to sustainable development. As the 2000-05 environmental programme
includes (according to Agency sources) about 96 per cent of the
schemes that the Environment Agency had wanted, the outcome of
PR99 makes a considerable contribution to sustainable development.
CONSISTENCY WITH
THE POLLUTER
PAYS PRINCIPLE
In striving to achieve the Government's stated
objectives for compliance with river quality objectives and EU
bathing water standards, much effort has been expended on the
identification of every single water company discharge which may
cause or contribute to current failures. The Environment Agency
has not yet addressed, or evaluated to the same degree, the impact
of other sources of pollution on water quality, most significantly
diffuse sources such as run-off from agricultural land. According
to the Environment Agency only about one of the current shortfall
in meeting river quality objectives can be attributed to the impact
of water and sewerage company discharges. It is not clear whether
the amount being paid for by water customers for improvements
is disproportionate. Adherence to the polluter pays principal
demands a more fully integrated approach to river water quality
improvement to ensure that investment in improvement schemes is
being made in the most effective way and offers the best value
for money.
DEALING WITH
FUTURE OBLIGATIONS
The scale of the capital investment programme
(and the associated operating costs) for the period from 2000
will take many of the water and sewerage companies to the point
where the cost of capital is rising in order to maintain key financial
ratios.
For eight of the ten water and sewerage companies,
the investment has been accommodated at the base cost of capital.
For three of the eight companies (Dwr Cymru, Southern Water and
South West Water) adjustment to the timing of a few schemes was
required to avoid situations where price limits might otherwise
need to rise above the longer-term costs for the companies to
be financially viable.
For North West Water and Wessex Water, the price
limits set in 1999 are higher than would otherwise be the case,
to accommodate the financial constraints that result from the
increased scale and pace of the environmental improvement programme.
There are mechanisms within the licence that
can be used to deal with new obligations which arise before the
next price review in 2005. Condition B of the licence allows the
Director to make, in any year, an adjustment to price limits for
certain relevant changes of circumstance where they entail net
additional expenditure (actual or forecast) exceeding, in total
10 per cent of turnover. One of the key relevant changes of circumstances
is a change to the obligations placed on the companies. In these
circumstances the company must submit an interim reference notice
by 1 October in the year prior to that from which it wants new
price limits to take effect. Ofwat has to determine the application
within three months. As for a periodic review, if a company does
not agree with the outcome of an interim determination it can
require the determination to be referred to the Competition Commission.
Should new obligations not be large enough to
trigger an interim determination the costs associated with delivering
the additional outputs can be logged up to be taken into account
at the next periodic review.
Appendix E to the 1999 Periodic Review document,
Final Determination: Future water and sewerage charges 2000-05
provides a description of the protocol for administering changes
to the companies' obligations and consents underpinning the final
determination.
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