Supplementary memorandum submitted by Mr Philip Fletcher, Director General, Office of Water Services (OFWAT)
At the Public Accounts Committee hearing on Wednesday 8 May in response to a question from Mr Barry Gardiner MP (Q92) I agreed to provide the Committee with a note on how the regulatory capital value (RCV) for a company is calculated. This is set out below.
The RCV is one of the critical components underlying price limits. It is the capital base upon which the company earns a return on investment. We have recently published the value of future RCVs. This was in response to a view expressed by the investment community that doing so would increase not only the transparency of regulatory decisions but also their consistency and predictability. In the past we have only published historic RCVs each year in our annual report `Financial performance and expenditure of the water companies in England and Wales.'
Basis of calculation
The initial calculation of RCV starts with a direct measure of the value placed on each company's capital and debt by the financial markets following privatisation. The initial RCV is calculated as the average market value of each water and sewerage company for the first 200 days the shares were listed plus the total value of debt at privatisation. A proxy was used for the initial market value of the water only companies that were already private companies in 1989, as no market information was available. This initial value was taken as the opening RCV value for 1990. The initial value is rolled forward each year. RCV is recalculated annually in outturn prices. The closing value from previous years is adjusted by the movement in RPI. The inflated figure then gives the opening value for the year.
Capital expenditure to enhance and maintain the network which is assumed in setting price limits is added to the RCV (net of capital grants and contributions). Current cost depreciation is deducted from the RCV each year.
Capital expenditure to maintain and replace infrastructure assets (IRE) is not added to the RCV but combined with the infrastructure renewals charge(IRC). The balance is added to or deducted from the RCV each year. This reflects the extent to which more or less money has been spent maintaining the asset base than was assumed in price limits, thus increasing (or decreasing) the value of the capital base to be remunerated.
The RCV is also adjusted for any disposal of land by the regulated business. When land is sold, the licence requires the proceeds to be split equally between shareholders and customers. The mechanism to do this is through the RCV. The customers' share of any proceeds is deducted from the RCV.
For 1990-1995, net additions to the RCV were based on assumptions made by the Secretaries of State in setting price limits for the period immediately following privatisation. From 1995 onwards, movements in RCV are split between capital expenditure, infrastructure renewals expenditure and the infrastructure renewals charge, grants and contributions and current cost depreciation.
The RCV is the mechanism used to reflect past capital outperformance (efficiency savings) and hence transfer the benefits of this to customers through lower prices. The outperformance adjustment is deducted from the RCV. In effect the benefits of efficiency are passed to customers five years after they have been made. This gives companies a clear incentive to outperform irrespective of the date of a periodic review of price limits. Where total actual expenditure for the period exceeds that assumed in price limits the actual expenditure over and above the amount assumed is not as a rule included in the RCV.
In calculating the opening RCV for a new price setting period a number of further adjustments are made. Where a company has faced new legal obligations since price limits were set (and this has not been accounted for at an interim determination of price limits) then any reasonable net additional costs are added to the opening RCV. This has been termed `logging-up' in the industry. Similarly where a company has failed to meet outputs determined when price limits were set this is `logged down' and the RCV is reduced to reflect outputs not delivered. We are due to consult on the logging up process shortly, in preparation for the next periodic review.
We also adjust for actual inflation. When we calculate the opening RCV for the price setting period we adjust for the difference between the movement in Construction Output Price Index (COPI) assumed at the last periodic review and the actual movement in COPI over the period.
Office of Water Services