Select Committee on Environmental Audit Minutes of Evidence


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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