Memorandum from the Office of Water Services
Response to the Environmental Audit Committee's
Seventh Report, Water Prices and the Environment
Ofwat welcomes the recognition in the Committee's
Report that the 1999 Periodic Review achieved "a clear forward
programme with sufficient consultation (para 39) and that the
review process provides a fair and open system for determining
water price limits and thus provides valuable incentives for water
companies to reduce operating costs and to search for innovative
ways of designing and operating new schemes" (para 179).
Ofwat accepts that the process can be improved
by further refinements. It needs to be both transparent and flexible.
It must provide opportunities for Government, regulators, customers,
environmental interests, the water companies themselves and others
to play a full part and ensure that their views are heard. It
is, as the Committee recognises, for Ofwat to lead the process
(para 94), within the policy framework set by Government.
In looking forward to the 2004 Periodic Review,
Ofwat accepts that particular attention should be given to the
development of the basis for determining future capital programmes,
including the extent of further environmental improvements; and
investment in maintaining the infrastructure. Its intention will
be to achieve the optimum balance between necessary new investment,
charges to customers, and the ability of water companies to continue
to finance their functions within a framework that maintains pressure
for continuing efficiency gains.
Further comments on detailed recommendations
are set out below.
The timetable and inputs
39. The Periodic Review is a complex
and necessarily iterative process which needs to be efficiently
planned and managed. It is therefore important that the Director
establishes a clear forward programme with sufficient consultation.
The Committee believes that this was achieved in the 1999 Periodic
Review, despite Water UK's concerns, and that all relevant parties
were given the opportunity to make the case for an alternative
timetable if necessary.
Ofwat welcomes the Committee's confirmation
that Ofwat established a clear programme for the 1999 Periodic
Review and that all parties were given the opportunity to set
out the case for an alternative timetable.
This was confirmed by the consultation exercise
that Ofwat undertook to ask all stakeholders about the way in
which the Review was conducted, although many respondents considered
that the review process was too long. Ofwat will work with DETR,
EA and DWI to develop the timetable for the next review in 2004.
Work on developing the methodology for the review is already underway.
Preparation for the 2004 Periodic Review was
a key issue at the meeting on 16 January 2001 with stakeholders
to discuss the draft Ofwat Forward Programme. Stakeholders sought
greater involvement in the planning of the next review, early
clarity on Ofwat's approach and methodology and careful consideration
of the timing of announcements. Ofwat will be considering these
points and will incorporate them into the final Forward Programme
to be published in March 2001.
Assessing customer needs
50. The Committee agrees that, like any
sensible company, water companies should be constantly undertaking
the necessary market research to assess their customers' views
and needs. However, such work does not obviate the need for a
comprehensive and independent survey of public opinion focussed
on the particular issues relevant to a given Periodic Review.
Ofwat agrees that market research undertaken
by companies in order to understand their customers' views will
need to be supplemented. There are likely to be issues of wider
relevance, which would not necessarily be addressed by companies,
or issues thrown up by companies' work which warrant further investigation.
For example, during the last price review Ofwat undertook quantitative
research into customers' views on how efficiency savings should
be allocated between further investment and lower bills. This
work also explored customers' attitudes to different possible
bill profiles which were emerging from Ofwat's analysis.
52. The confusing plethora of customer
surveys produced throughout the 1999 Periodic Review was not constructive.
The Committee recommends that, in future, comprehensive and independent
surveys should be commissioned by the DETR. These should seek
to establish the public's expectations as water customers and
citizens within the five-year Periodic Review timescale (including
their attitudes to and preferences for environmental improvements).
They should also seek views on longer-term policies which impinge
on the environment. The structure and content of this research
should be discussed within the quadripartite group so that there
is common ownership of the survey and its findings.
Ofwat agrees that for the next Periodic Review
there should be much more co-operation between the parties to
reach agreement on the scope and nature of the research needed.
Although attitudes to environmental improvements will, as in 1999,
be a key issue it will be just as important to understand customers'
views on a range of other issues relevant to the next Periodic
Review. In developing research proposals for the next price review
Ofwat expects to involve the DETR, DWI, the EA and the water and
sewerage companies, in co-ordinating and sharing details of research.
It is important when designing and interpreting
such research, to take account of the impact that regional priorities
and bills have on customers' views. It is also possible that issues
will arise during the formal Periodic Review process which would
benefit from closer examination. National surveys will therefore
not necessarily obviate the need for regional surveys.
Ofwat takes seriously the need to understand
customers' views and priorities. We are committed to carrying
out a range of research projects over the next four years to explore
customers' attitudes. The Ofwat Forward Programme 2001-02, on
which we are currently consulting stakeholders, outlines the first
major project looking at customers' views on various aspects of
the service provided by water companies.
68. The early statement by the DETR regarding
the possible size of the environment programme was helpful and
appropriate. However, the Committee recommends that in future
Ministers should respect the role of the independent regulator,
Ofwat, to determine price limits and not influence customer and
public expectations by publicly announcing its own price expectations.
69. In turn, the Committee recommends
that Ofwat seeks to ensure that its own statements do not "demonise"
environmental and quality investment by portraying it as key upward
pressure on prices without equally emphasising the customer and
public benefits which it delivers.
While the Government determines the quality
and environmental programme it is part of Ofwat's role to challenge
proposals in order to clarify the costs and benefits of quality
and environmental expenditure. In so doing, Ofwat seeks to ensure
that capital investment in improving the quality of drinking water
and the environment is used optimally.
The 1999 Periodic Review delivered a £7.4
billion capital investment programme, for the improvement of drinking
water quality and the environment. These quality and environmental
programmes account for the lion's share of the capital investment
programme. Investment to improve water quality and the environment
also needs to be reviewed alongside other calls upon investment
to improve service to customers, including expenditure to alleviate
sewer flooding. Ofwat will continue to aim for a measured and
balanced approach to the issues, not least in its public statements.
Costing the Environment Programme
90. The Environment Agency must develop
and strengthen its capacity to assess and demonstrate the benefits
of the schemes which it proposes for inclusion in future National
Environmental Programmes and also engage in a more critical examination
of their unit costs.
Ofwat welcomes this recommendation. The methodology
must be in place in time for the next Periodic Review. Ofwat has
been invited by the EA to take part in developing that methodology.
The protocols should be developed soon to appraise the benefits
of environmental improvements for inclusion in the next Review.
Ofwat will also work with EA to provide the complementary information
on the costs of carrying out improvements. These costs must be
reviewed alongside the environmental benefits, to ascertain the
cost-effectiveness of these proposed improvements.
94. The Committee is mindful of Ofwat's
lead role in running the Periodic Review process. However, it
is important that the overall policy objectives are kept in sight
throughout the process by all parties. It is the Government which
provides the policy framework within which the Review operates
and the Committee would like to see the DETR take the lead in
bringing the overall policy "vision" to the fore more
vigorously within the quadripartite process. The Committee recommends
that, in future reviews, the DETR presents a short, overall statement
of existing policy to the quadripartite members at the outset.
As well as key environmental protection goals this should encompass
relevant and economic policy objectives.
Ofwat agrees that the regulation of the water
industry necessarily involves a number of stakeholders:
The Government which sets the overall
framework and standards.
The National Assembly for Wales (NAFW)
in respect of Wales.
Ofwat the economic regulator which
sets companies' price limits.
Drinking Water Inspectorate which
enforces drinking water standards.
Environment Agency which enforces
environmental standards and requirements.
Companies that provide water and
Customers the consumers of water
and sewerage services.
Consumer and environmental groups
which set out their preferred outcomes from price reviews.
Careful articulation of their respective roles
is critically important to successful regulation. Clarity of Government
policy is essential in setting the context for regulation. But,
as the Committee recognises in acknowledging the lead role of
Ofwat, regulation must give primacy to the statutory framework
and duties. Ofwat is a non-Ministerial government department;
it is established by Parliament as the independent regulator and
is accountable to Parliament for its performance.
Within the constraints of the statutory framework,
Ofwat agrees that economic and quality regulators, Government
departments, the NAFW, the companies and other stakeholders each
have an important role to play. In the same context, clarity of
Government policy on the relevant environmental, economic and
social issues guides the regulatory process. Ofwat recognises
that Government policy may evolve during a Periodic Review and
will take such developments of policy properly into account.
100. The Committee recommends that Ofwat
makes the full financial model as used for the Periodic Review,
including equations, publicly available.
Ofwat recognises the emphasis which the Committee
placed on this recommendation.
In October 1998 (RD32/98) Ofwat published a
detailed Rule Book of the financial model (known as Aquarius 2)
which was to be used in the 1999 Periodic Review. An appendix
(on floppy diskette) contained the equations performed in the
financial model; but the software in which Aquarius 2 was encoded
omitted. The Rule Book explains what the financial model does
and how it does it. Deloitte and Touche audited the financial
model. Their opinion statement confirmed that the Rule Book was
consistent with it and that they both fairly interpreted the Director's
proposals in setting price limits for water and sewerage services.
Ofwat considers that this represented a sufficient explanation
of the financial model for the companies and other stakeholders
to assess the price determinations.
However, Ofwat will look at the issue again
in the context of its development of a new financial model, building
on the existing price setting arithmetic. Ofwat will publish a
detailed Rule Book (including all the equations) of the new financial
model. An independent audit of the financial model will be commissioned
and the opinion statement published. When the new model is in
place, Ofwat will consider carefully whether the companies should
also have access to the new software.
101. Water UK also felt that Ofwat had
been rather opaque in relation to the independent business advisers
which Sir Ian appointed in 1998 to address Ofwat's lack of a business
understanding. Their appointment was clearly announced in an Ofwat
press release in January 1998 and their terms of reference are
available from the Ofwat Library. However, the advisers' reports
have not been published and although the Director did refer to
their advice throughout the Final Determinations this was mainly
to reinforce his decisions and it is not clear where the panel
may have held different views. The Director recently established
a policy committee consisting of four independent advisers and
the Ofwat senior management team. The Committee would welcome
clarification of the role of the new policy committee, its role
and relationship with the Director, and its implications for Ofwat's
access to independent business advice.
Ofwat's Regulatory Policy Committee (RPC) was
established in the spring of 2000. It formalised and replaced
the long-standing arrangements whereby the regulator sought confidential
advice from a small panel of business experts. Its role is to
advise the Director General on the broad range of issues affecting
the industry. It consists of the Ofwat Management Board, chaired
by the Director General and, at present, three independent members.
They were appointed on the basis of their knowledge and experience
of relevant business issues. It bears some similarity to proposals
in the recently published consultation paper on a draft Water
Bill for the appointment of a Water Advisory Panel. However, the
RPC is non-statutory; its members are appointed by the Director
General rather than the Secretary of State.
The Director also seeks advice from a wide range
of people and organisations, both within and beyond the water
industry, in carrying out his regulatory duties as necessary.
102. Although Ofwat has made efforts
to address its transparency since the last review, as acknowledged
by the water industry and the Environment Agency, the Committee
believes that the regulator has not yet struck the right balance
between commercial confidentiality and operational transparency.
Ofwat welcomes the Committee's recognition of
its efforts to address the transparency with which it conducts
reviews. It has continually striven to improve the transparency
of its decision making. Very much more information was published
at Periodic Review 1999 than at Periodic Review 1994, most significantly
the draft determinations of price limits. Ofwat's intention is
to be transparent about its activities and place information in
the public domain where it does not breach commercial sensitivities.
In considering its approach to Periodic Review
2004 Ofwat will take into account stakeholders' comments on the
conduct and transparency of Periodic Review 1999. However, companies
also need to play their part and make more of their submissions
publicly available. Ofwat recognises that finding the right balance
between transparency and commercial confidentiality is a delicate
matter, but has to take account of the confidentiality markings
that companies place on their submissions.
104. Ofwat must make further efforts
to involve the full range of stakeholders beyond the quadripartite
forum during the periodic review process in a more effective way.
The Committee recommends that, in considering the merits of various
means to achieve this, Ofwat gives effect to best practice in
this area such as the Environment Council's stakeholder dialogue
Ofwat has joined the Environment Council and
will explore with it its proposals for developing dialogue with
stakeholder groups as a component in the management of environmental
Ofwat agrees that good stakeholder dialogue
is an essential part of good decision-making and welcomes proposals
for effective means to improve that dialogue. Consultation exercises
are a valuable means of determining stakeholders' views and in
planning for Periodic Review 2004 Ofwat will consult on its planning.
Stakeholders were uncertain at Periodic Review 1999 at what stage
of the process it would be helpful for them to make representations.
Ofwat will endeavour to provide more clarity at Periodic Review
109. The Committee welcomes Ofwat's continuing
work to ensure that the data it requires from companies is proportionate
to the regulator's needs. In view of the potential burden (in
both time and money) that such data requirements present, the
Committee recommends that, as a matter of regulatory best practice,
Ofwat accounts for the data which it demands. Companies should
be left in no doubt what data and analysis is required from them
Since 1989 Ofwat has established a tried and
tested annual process of information capture from the regulated
companies in England and Wales. This information, in the form
of the annual June Returns, has been central to monitoring the
performance of the industry and taking any necessary regulatory
action. In addition to the special submissions that are required
for price setting, the information collected in the June Return
also plays an important part in the Periodic Reviews of price
Ofwat published a consultation paper in May
2000 setting out the proposed requirements of the Annual Return
from June 2001 to June 2005. The information collected annually
was updated to reflect Future Water and Sewerage charges 2000-05
and Water Industry Act 1999. Ofwat's review of June Return 2000
aimed to reduce the burden of data capture. The new information
requirements also took into account the separate monitoring carried
out by the quality regulators.
Overall, the information required in June Return
2001 represents a reduction on the information requirements set
out in the June Return 2000, even after taking account of new
information needed arising from the Water Industry Act 1999 and
Periodic Review 1999. For each data item in June Return 2001 there
will be a descriptor for each data item explaining the primary
purpose of the information collected.
The same principles will apply to the special
information submissions that are collected at price reviews. Ofwat
will consult on the information submission requirements in advance
of Periodic Review 2004.
The System of Reporters
115. The Committee recommends that Reporters
should be engaged and paid directly by Ofwat rather than the water
companies and that Ofwat regularly monitors its arrangements with
its Reporters to ensure that:
there is effective scrutiny and
audit of the estimated costs of schemes
water companies identify least
cost solutions to meet environmental standards which take into
account the whole life costs (capital and operating) and the environmental
as well as economic costs of a scheme or programme of schemes.
Building on companies' licences Ofwat and the
water industry have developed the present system for appointing
and paying Reporters over a number of years. Ofwat believes that
it works well. Ofwat is in control of the appointment decision,
but the water companies have a strong say in the process. Both
should therefore have confidence in the professional ability and
integrity of those appointed. Ofwat benefits from the technical
audit and scrutiny of the companies' plans and annual returns,
providing objective views on the quality of the companies' regulatory
information. But it is for the independent Reporter to decide
the level of audit necessary and plan how the audit programme
will be executed.
Ofwat discussed these issues at the stakeholders
meeting on 16 January with companies and Reporters. Ofwat is,
therefore, not persuaded that the present accountability and payment
arrangements should be changed. It will continue to seek to develop
the value of the Reporter system, for example through guidance,
workshops and the assessment of each individual Reporter's performance
and by encouraging companies to maximise the value to them of
the process and outcomes of their Reporter's audit work.
121. The Committee welcomes the Environmental
Agency's proposal to publish an annual report on the progress
of the water companies in implementing the National Environment
Programme. The Committee recommends that the Agency also takes
steps to monitor and report upon the environmental benefits derived
from water company investment.
122. The Committee recommends that a
stakeholder forum is held annually to facilitate the presentation
and discussion of progress on the delivery of the environmental
and quality programme.
Ofwat also welcomes the EA's proposal to publish
information setting out companies' progress in implementing the
National Environment Programme. Ofwat will also continue to publish
companies' progress in its series of five performance reports,
but considers that a stakeholder forum in addition each year is
The price profile
128. The Committee believes that roller
coaster prices confuse consumers as to whether their valuable
water resources are being carefully managed by the industry and
how far they themselves should be bothering about water efficiency.
As metering becomes more widespread, there will be an increasing
price incentive to be water-efficient and clear pricing signal
will be needed.
Ofwat agrees that price fluctuations should
not be greater than necessary. Prices should give clear signals
to customers about the costs and benefits of the service concerned.
Where customers are charged according to the volume of water they
use, price provides an important incentive for efficient use of
water. In 1999-2000 only 17 per cent of households were on metered
charges. Ofwat agrees that clear price signals to customers are
needed, and in approving companies' charges schemes required companies
to apply a greater proportion of the reduction in price to standing
charges, rather than volumetric rates, to underline this point.
However, the sharp initial reduction in bills
was in Ofwat's view essential if customers were to share fully
in the efficiency gains delivered by water companies since 1994.
An alternative of a smaller initial price reduction would have
lead to companies retaining money that rightly belonged to customers.
As part of its market research for the periodic
review Ofwat asked customers in a survey of 1,200 customers whether
they would prefer a sharp initial reduction, followed by a gradual
increase (V shaped) or a smaller initial reduction followed by
stable bills (L shaped bill profile). Over 60 per cent of customers,
in each of the four regions surveyed, said they would prefer a
V shaped profile, with prices, after the initial reduction, rising
gradually to pay for improvements as they are made. But only a
quarter of customers said that they would be upset if their preferred
profile were not chosen.
Size and nature of the environment programme
139. The Director should seek to ensure
that the Final Determinations document makes clear how far changes
in key factors such as the cost of capital have influenced the
final outcome during the review process.
Ofwat agrees that its documents should clearly
state the key factors affecting the outcome of the Periodic Review
process. It sought to do so in the last price review and will
endeavour to do so in future reviews.
Ofwat considers that it did clearly explain
changes in the key factor cost of capital. In Prospects for Prices
(October 1998), Ofwat had a wide range (4.0 per cent to 5.5 per
cent) for the pre-tax cost of capital. For the purposes of producing
illustrative price limits and average bills the value of 5.25
per cent (towards the top of the range) was used. A letter from
the Director to the companies (MD145) sent in March 1999 clearly
stated that market conditions had returned to more normal conditions
and that the cost of capital had moved closer to the mid-point
of the Prospects for Prices range as the range itself had also
narrowed to 4.25 per cent to 5.25 per cent. No further changes
were made to the cost of capital assumed by Ofwat after MD145.
Accommodating new obligations
151. The Committee is concerned that
there is a lack of clarity in the present arrangements for dealing
with the timely introduction of those environmental schemes which
were approved within the National Environment Programme for 2000-05
but which are currently subject to re-evaluation and not included
in the price limits. The Committee recommends that Ofwat reviews
this process before the next periodic review.
The Minister set out his expectations for dealing
with the projects requiring re-evaluation at the time of the Periodic
Review, both in his parliamentary answer on 25 November 1999 and
in his letter of 24 November 1999 to Sir John Harman, Chairman
of the Environment Agency. Ofwat is closely involved in the process.
Once the most suitable solution for delivering
environmental benefits has been identified and confirmed to the
satisfaction of Ministers, Ofwat will (having assessed an appropriate
cost) make the necessary financial agreements. If the costs of
projects are such that this will make a material difference to
financing the functions of the company, the company can ask for
price limits to be reset at an interim determination. The calculations
for dealing with this are set out in the Licence of Appointment.
This process also applies to other obligations, for example, if
any of the projects investigating the environmental impact of
water abstraction demonstrate that remedial action is required,
these will also be subject to a similar process for companies
to be remunerated. The process by which the projects put forward
by companies are assessed for eligibility is set out in Appendix
E of Future Water and Sewerage Charges 2000-05 published by Ofwat
in November 1999.
The interim determination process has recently
been applied for a number of companies. One of the schemes in
Wales, Llangefni in Dwr Cymru's supply area, has been reviewed
and the revised project confirmed by the National Assembly for
Wales. Financial provision for this work is included in the interim
determination of price limits for this company.
If the additional costs are not material, the
company has the opportunity to ask for these additional costs
to be incorporated into price limits at the next Periodic Review.
The process is well established. Over the last 10 years over £1
billion of additional capital expenditure and the associated operating
costs have been recognised and incorporated into price limits
to remunerate companies for such changes between price settings.
Tackling different sources of pollution and ensuring
the polluter pays
159. The Periodic Review is an effective
mechanism for dealing with point source environmental problems
caused by water companies. However, the Committee is concerned
that the DETR and the Environment Agency are disproportionately
relying on the Periodic Review mechanism and the water companies
as the key means to achieve compliance with water quality and
environmental protection objectives and not sufficiently tackling
pollution from diffuse sources.
160. The Committee welcomes the DETR's
intention to encourage the Environment Agency to focus more regulatory
effort on diffuse sources. The Committee recommends that the Department
acts swiftly to ensure that the Agency can demonstrate an overarching
enforcement strategy for dealing with diffuse sources of pollution.
Ofwat welcomes the Committee's support for the
DETR's intention to encourage a greater focus on diffuse pollution.
Any further significant investment by water companies should be
tested in costs versus benefits terms against dealing with underlying
Interface with planning process
171. As well as the attitude of local
planning authorities, the Committee was made aware of concerns
regarding Ofwat's interference with planning matters as expressed
in Appendix E of the Final Determinations document. The Director
suggested that decisions on whether to impose stringent planning
requirements on works necessary to meet quality improvements "should
rest with government rather than local planning authorities and
water companies" (only the cost of reasonable requirements
had been allowed for in PR 99). Local planning authorities are
already subject to Government advice regarding the application
of conditions and CIWEM (the Chartered Institution of Water and
Environmental Management) in particular, felt that this sought
to undermine the role of local planning authorities. However,
the DETR confirmed that it remained the Government's policy not
to interfere with the jurisdiction of local planning authorities
unless it was necessary to do so. The Committee believes that
the Director's statement in Appendix E was inappropriate and his
remit in this area, or lack of it, should have been made clear.
172. Overall, the Committee is satisfied
that there is a suitable framework in place which should provide
the necessary interface between the planning system and the required
outcome provided for by the Periodic Review. However, this framework
is not being utilised as it should be in all cases.
173. The Committee is concerned that
evidence indicates that local planning authorities (LPAs) do not
always seem to recognise the importance of the statutory obligations
faced by the water companies and the extent of the National Environmental
Programme which needs to be delivered with their co-operation.
The Committee recommends that the Government provides the LPAs
with a clearer guidance which is also relevant to the Government's
Ofwat accepts that it is not its function to
interfere with local planning authorities in carrying out their
duties. Its concern is that water companies should not simply
be able to pass through to the customer any costs that may arise,
however extreme, in relation to obtaining planning permission.
There should continue to be an incentive for each company to achieve
the most cost-effective solution consistent with environmental
and other requirements. It is also concerned about the need for
planning authorities to ensure that local considerations are fully
and fairly balanced with national and regional considerations
in particular cases and with considerations about the time and
costs involved in planning decisions.
National and regional planning guidance and
the operation of the appeal and call-in system provide the context
within which those issues may be resolved.
Economic cycles versus sustainability
179. The Committee believes that the
current Periodic Review Process, operated by Ofwat, provides a
fair and open system for determining water price limits and thus
provides valuable incentives for water companies to reduce operating
costs and to search for innovative ways of designing and operating
new schemes. However, we recommend that the DETR, companies and
the regulators ensure that the five year investment programmes
of the Periodic Review are set in a comprehensive, clear framework
of longer term, policies and goals including those relating to
water resources and environmental quality and serviceability goals.
In turn, these five year programmes should be seen as contributing
to the achievement of these goals.
180. The Committee believes that the
DETR should take the lead in setting out the policy framework
and environmental future at the outset of the periodic review
process as recommended in paragraph 93.
See comments in response to paragraph 94.
Ofwat's "no determination" approach
198. It is this "failure" based
approach which concerned our witnesses most. Water UK believed
that, if Ofwat's method was followed, only recent failure would
allow a company to spend more money than had been spent previously.
However, companies were anxious not to fall short of the serviceability
criteria and incur the resulting penalties of breaching licence
conditions. They therefore wanted to secure funds for precautionary
spending. Ofwat, however, argues that companies can choose to
spend more if they think it is necessaryby allocating additional
spending out of their profits. The Committee accepts that ultimately
this option is open to the companies to avoid licence breaches.
However, efforts should be made to ensure that Ofwat's methodologies
for determining funding levels incorporate more forward-looking
Developing a new approach
208. Water companies need to manage and
renew their sewers and water mains in order to develop appropriate
levels of service to their customers on a sustainable basis. The
Committee is not satisfied that Ofwat's "no deterioration"
approach to the maintenance and renewal of underground assets
(sewers and water mains) is a logical or acceptable means of assessing
the amount of investment which water companies need to meet these
requirements. The Committee believes that this approach has amounted
to intellectual neglect of this important problem.
209. The Committee therefore very much
supports the initiative of the DETR, and the agreement by Ofwat,
to develop a new approach. This approach should be forward-looking
and should enable companies to adequately prepare to renew and
repair the cohorts of sewers and mains which will come up for
renewal/rehabilitation simultaneously as a result of historical
peaks in building activity.
210. It is imperative that the new approach
is in place in time for the next Periodic Review, with water industry
support and assistance. The Committee acknowledges Water UK's
recent initiative to develop an agenda for assessing capital maintenance
needs. This is a key area of responsibility for water companies
and the Committee hopes that the industry will now continue to
make a pro-active and positive contribution to developing new
The majority of water industry assets, particularly
infrastructure, have long service lives. Provided that there are
no dramatic changes in maintenance activity, rates of change in
the serviceability of the assetstheir ability to continue
delivering the outcomes sought from themare likely to be
gradual. In recent years, the serviceability of above and below
ground assets has been stable, and in some companies, improving.
This situation is set out in the context of a doubling of investment
in capital maintenance since privatisation.
Ofwat's staged framework for assessing future
capital maintenance needs (see Annex 1) has been developed to
test company projections against recent experience, the changing
state of the asset systems, economics and relative performance
of other companies. We accept that insufficient attention has
been paid to developing a complete and intellectually robust framework
and that Ofwat has a role to play in its development, but the
main responsibility for developing the substance of the approach
lies with the water companies. Ofwat set down in its letter to
Managing Directors (MD161April 2000) its forward-looking
agenda for capital maintenance and the areas where progress needed
to be made by water companies prior to the next review of price
limits in 2004.
Meanwhile the current Ofwat method already allows
for the funding of higher levels of capital maintenance activity
even without a full economic justification where the trends in
serviceability delivered to customers are deteriorating or appear
to be likely to deteriorate. In the recent periodic review three
companies were funded for increases in capital maintenance activity
because of unsatisfactory trends in serviceability.
As part of its work on developing a complete
and intellectually robust framework, Ofwat recognises that there
is a need to improve the indicators it currently uses so that
they may better reflect the level of serviceability to customers
and the environment. For water supply assets, this need is being
addressed initially by a current joint initiative between Ofwat
and the Drinking Water Inspectorate. Consultants have been appointed
to undertake a study and will produce their initial findings at
the end of February 2001. The aim of the study is to refine and
develop a set of robust serviceability indicators for water treatment,
supply and distribution to measure water company performance in
maintaining serviceability of its water supply assets. Once a
trend in these indicators has been established then they will
be used to inform judgements of future capital maintenance needs.
A similar joint initiative is planned with the
Environment Agency to review serviceability indicators for the
In addition, Ofwat is co-operating fully in
a parallel study being undertaken by consultants for UKWIR. Separately,
Ofwat has recently met with UKWIR to discuss future research and
development needs of the industry and has accepted an invitation
to participate in an UKWIR led management team to consider the
research needs in this area.
In developing its approach to capital maintenance
Ofwat will have strong regard to the Secretary of States views
set down in Raising the Quality as well as taking proper note
of the views of the Competition Commission in its determination
of price limits for two water companies. Ofwat looks to take the
issues forward and has in its letter to Managing Directors (MD161)
sought the participation of water companies in the process.
211. The Committee recommends that the
DETR moves rapidly to commission work in this area and examines
the suggestions put forward by Water UK and OXERA regarding the
necessary elements of new methodologies . . .
Ofwat does not consider that DETR should necessarily
take the lead in commissioning this work, but does believe that
it should work closely with Ofwat in its role as the "standard
setter". Ofwat will continue to discuss with DETR the work
that is required. We consider it essential that projects and studies
be co-ordinated to ensure they are complementary so maximising
the value of the work programmes.
211. . . . It is imperative that water
companies and Reporters are fully engaged in the processes of
developing and implementing any new approach and that the latter
receive appropriate training.
Ofwat agrees that it is essential that Reporters
fully understand the overall framework and the approaches to assessing
appropriate future capital maintenance needs developed by the
Regulator and the water companies. Each Reporter must be clear
about the way in which the company on which he reports actually
implements the framework and its approach.
Ofwat will ensure that Reporters participate
with industry and Ofwat staff as the standard framework and acceptable
approaches are developed, and include staff with skills in the
relevant disciplines in their teams at the appropriate time. Ofwat
will seek to take advantage of the expertise and experience of
Reporters by fully involving them in the consultation process
when company information reporting requirements are being drafted.
212. In future Ofwat must make clear
exactly what data and analysis it expects the companies to provide
with respect to their capital maintenance needs.
Ofwat accepts the need for clarity on the data
required. However, flexibility is also needed. Reporting requirements
cannot anticipate every aspect that a company may wish to address
in its business plan. Ofwat would not want a company to withhold
information relevant to its business case simply because it was
not set out in the reporting requirements. In their 1999 Business
Plans companies provided considerable and helpful information
that was not specifically requested in support of their proposals.
Ofwat nonetheless believes that there is room to improve the presentation
of business cases and will work with the companies to achieve
Setting the right framework
220. The Director General of Ofwat should
be directly accountable for ensuring that Ofwat makes a positive
contribution to the Government's sustainability agenda. The Committee
recommends that, in line with the Government's own commitment,
the Director General should have a specific duty to have regard
to sustainable development.
Ofwat has played an appropriate role in contributing
to sustainable development as the economic regulator by incorporating
the largest programme of work yet expected to improve drinking
water and environmental quality within price limits. Ministerial
guidance set out the overall quality and environmental standards
to be achieved at the review.
It is for the Government to decide overall sustainability
strategies. Integrated guidance from Government would facilitate
the attainment of sustainable development throughout the industry.
The current process in which Ofwat requests guidance from Ministers
on the assumptions to make on future water and environmental quality,
and related issues, has established the roles of the Government,
the quality regulators and Ofwat. A provision for Ministers to
issue social and environmental guidance which Ofwat must have
regard to is set out in the draft Water Bill. This combined with
Ofwat's duties under section 3 and 4 of the Water Industry Act
1991 would allow Ofwat, and the companies, to continue to make
an appropriate contribution to the attainment of sustainable development
without the necessity for an additional duty.
225. The Committee acknowledges and welcomes
the number of water efficiency initiatives being undertaken by
the water industry. We believe that companies do not have significant
incentives to promote water efficiency and that there would be
merit investigating the feasibility of setting company-specific
targets for domestic water use, once a robust methodology for
efficiency measurement has been agreed. This would help to focus
efficiency efforts and drive the markets for water efficiency
Companies have incentives to meet customers'
demands for water by the most cost-effective means. As knowledge
of the costs and savings of water efficiency measures improves,
Ofwat and companies will be better placed to consider what level
of water efficiency activity is economic for each water company.
Ofwat is working with the EA, DETR and companies to establish
robust methods for investigating these issues and to promote best
230. The DETR has set up a tripartite
group looking at leakage and water efficiency to facilitate the
exchange of information between itself, Ofwat and the Environment
Agency. The water companies are concerned that they have not been
consulted on this tripartite work. However, the DETR confirmed
that the companies would be involved in the Tripartite Leakage
Study which has been commissioned and funded by the group. This
study is investigating the environmental and economic justification
for further, long-term reductions in leakage (amongst other topics).
The DETR is keen that this study retains its independence from
commercial interests as it will inform future policy on leakage
reduction. The Committee looks to this new study to clarify how
water companies are to investigate the ELL taking account of both
economic and environmental costs and exactly what information
in this regard needs to be provided to Ofwat.
While the water companies were not involved
in the process that framed the terms of reference for the tripartite
study they are heavily involved in the delivery of the study objectives.
The industry has been invited to workshops to share and comment
on the progress made with the study, and the appointed consultants
are working closely with the industry to establish current best
231. The Government should spell out
its long-term aims for leakage reduction in the context of water
resource policy and clarify in particular whether it wants companies
to reduce leakage below their economic levels. If it does, it
should explain its reasons.
In pursuit of the duty to promote economy and
efficiency in carrying out their water supply functions companies
are expected to maintain leakage at levels which maximise economic
benefits to customers and the environment. In Ofwat's view, to
seek to reduce leakage to levels that were not economically based
would result in customers paying unnecessary higher bills and
would divert resources from environmental and other investment.
232. Ofwat should make clear what information
it requires to assess where each company stands at present in
relation to its economic level of leakage.
Ofwat has explained to companies what is necessary
to demonstrate a robust appraisal of the economic level of leakage.
As a result 17 of 24 companies were able to demonstrate a robust
assessment of the economic level of leakage this year.
Ofwat has provided all companies with formal
guidance on the information required to establish leakage levels.
Guidance on how to make and present an appraisal of the economic
level of leakage was in RD16/98, and in instructions for completing
Periodic Review Information Requirement E and the Periodic Review