Annex 2
Letter to the Managing Directors of all
water only companies and water and sewerage companies from the
Director General, Ofwat (MD 161)
MAINTAINING SERVICEABILITY TO CUSTOMERS
In the Final Determinations—Future water
and sewerage charges 2000-05 (November 1999), I said that
when considering the need for expenditure on the maintenance of
assets, companies generally did not set out an economic analysis
of the options available for maintaining serviceability to customers.
The purpose of this letter is to expand on these comments, explain
some general concerns and illustrate how these concerns could
be allayed at future price reviews.
Maintaining serviceability to customers is part
of each company's statutory duties. The onus is on each company
to plan its asset management to meet this statutory duty and carry
out these plans effectively and efficiently. Overall, serviceability
trends over the last 10 years have been satisfactory. The broadly
stable trends in accounting charges suggest that companies believe
that sufficient capital maintenance has been carried out. Companies
have also put much effort into improving the systems of information
for asset management, resulting in more effective direction of
capital maintenance activity. Revised versions of Information
Notes 35A and 35B, which contain summaries of the latest assessments
of serviceability to customers, are attached (Annex 3 and 4).
Some companies discussed the implications for
serviceability to customers in their1999 Business Plans and presented
their arguments in a framework of an asset management strategy
encompassing both operational and capital maintenance activity.
Even these justifications could have been improved to validate
the future levels of capital maintenance being sought, be they
higher, the same, or lower than current levels.
Each company needs to demonstrate how the flow
of services to customers can be maintained at least cost in terms
of both capital maintenance and operating expenditure, recognising
the trade off between cost and risk, whilst ensuring compliance
with statutory duties. Appraisals of capital maintenance, operating
expenditure and risk can be compared using discounted cash flows.
All such appraisals would need to be set in
the context of the framework of maintaining serviceability to
customers. Such an approach should have been used to justify the
future levels of capital maintenance included in the business
plans.
It would have been helpful to include commentary
on the material elements of the economic appraisals undertaken
such as the:
— cost of any potential loss of serviceability
to customers, including consideration of risk scenarios and their
probabilities as well as illustrations of how serviceability to
customers would decline, if the activity was not undertaken;
— impact on operating costs of capital
maintenance activity, before and after assets are renewed;
— circumstances surrounding the timing
of asset replacement;
— impact of obsolescence and new lower
cost technology; and
— any terminal values and the discount
rates assumed.
This list is not exhaustive. The economic appraisals
would also need to be balanced and justified against a strategic
top down approach used to assess, for example, the impact of alternative
scenarios on company financing, including an analysis of past
and prospective accounting charges. Setting out examples of economic
appraisals in this way would go a long way towards demonstrating
why companies have taken the view that the levels of capital maintenance
since, say 1980, have been sub optimal. This approach could also
indicate the extent to which levels of capital maintenance should
change, up or down, for future capital maintenance to be economic.
In advance of the next price review, a better
understanding is needed of the economic case for the levels of
capital maintenance expenditure that are to be financed by customers
through accounting charges. For the next Periodic Review, we will
need systematic information on all the issues set out in the points
above. Meanwhile we are considering what information we would
need to have relating to the assessment of economic levels of
capital maintenance, necessary to deliver stable serviceability
to customers, in advance of the submission of your business plans.
12 April 2000
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