Memorandum from the Office of Water Services
(Ofwat)
SUMMARY
1. We are now entering the final stage of
the price review. Each water company will submit its final business
plan to us in April. We will scrutinise all the plans thoroughly
and plan to publish our draft decisions on price limits, for consultation,
in late July. We will listen carefully to all representations
made on our draft decisions and publish final price limits for
each company for the years 2005-06 to 2009-10 in November. We
will explain fully the basis of both our draft and final decisions
consistent with the principles of good regulation that we follow
in all matters. Each company has a right to appeal our final decisions
to the Competition Commission.
What should be the key components of the environmental
programme allowed for in Ofwat's price limits?
2. It is for Ministers, on the basis of
advice from the quality regulators, to provide guidance on the
key components of the environmental and the drinking water quality
improvement programmes at this review. These enhancements need
to be set in the context of the very substantial improvements
that have been delivered by the industry since 1990 at considerable
continuing cost to customers. The full benefits of the current
improvement programmes will not be realised until well into the
next period. We will not countenance any deterioration of performance
achieved to date.
3. A number of factors are pushing up water
company costs; for example increasing levels of asset maintenance,
changes to taxation, rising power costs, rising pension costs,
rising levels of bad debt and servicing the statutory "free
meter" scheme, all of which must be reflected in customers'
bills. The water companies are becoming more efficient and we
will expect this to continue year-on-year; however this will not
be sufficient to offset the upward cost pressures. This is likely
to mean that customers' bills will now have to rise between 2005-10
even before the impact of additional drinking water and environmental
quality and other service improvements.
4. The water companies need to raise finance
from the financial markets each year in order to pay for the improvements
required. Ofwat will set price limits that allow companies to
raise finance but, as investment programmes increase, this will
become progressively more expensive. Customers' bills may consequently
need to rise disproportionately. This could be mitigated if improvements
could be undertaken over a longer time frame.
5. Our guidance to Ministers in December
set out for illustrative purposes the impact on price limits,
and hence bills for customers, of constraining all capital investment
in the period 2005-10 to £15 billion, roughly the level of
investment assumed for 2000-05.
Has the guidance given by the Environment Agency
and Defra to date on the size and scope of the environmental programme
been adequate?
6. Yes, from the standpoint of enabling
us all to gauge the implications of meeting a very ambitious improvement
agenda. "Directing the flow: Priorities for future water
policy" (November 2002), the Secretary of State's initial
guidance on the periodic review (January 2003) and the subsequent
schedules of potential improvements prepared by the Environment
Agency, English Nature and the Countryside Council for Wales have
guided the content of companies' draft business plans. The draft
business plans indicated that that on average price limits could
rise by 6% per year in real terms, a 30% real term increase to
customers' bills over the five-year period. This is before the
effects of inflation.
7. We await Ministers' principal guidance
that, together with the appropriate schedules from the quality
regulators, companies need to prepare their final business plans.
The late delivery of this guidance may impact on the timetables
for producing the draft and final determinations.
What is the extent of the environmental achievements
delivered as a result of the 1999 periodic review?
8. Since privatisation water companies have
invested over £1 billion per year in improving the water
environment. The improvements delivered have been impressive.
For example, in 1994 only 84% of rivers were of good or fair biological
quality compared to the latest figure of 95%. On drinking water
quality 99.87% of tests now comply with the standards laid down.
Thus where in 1990 tests at the tap failed one in 100 times, it
is now one in 800 times.
9. In January, with the Environment Agency,
we set out an assessment of the progress companies are making
towards completing the current five-year National Environment
Programme. The industry is confident that the vast bulk of this
programme will be completed by April 2005. The improvements arising
from this year's tranche of investment will start to be reflected
in the performance statistics in 2005, but will not be fully realised
until two or three years later.
BACKGROUND
1. Ofwat is the economic regulator of the
licensed water and sewerage companies that operate in England
and Wales. Our role is to oversee the regulated water companies
and to set price limits that enable a well managed company to
deliver services in a sustainable and efficient way.
2. On 28 July 2004 we plan to set draft
price limits for the water and sewerage companies in England and
Wales covering the period 2005-10. We will consult on these throughout
the summer and make our final decisions in November 2004. Our
decisions will be based in large part on the companies' final
business plans, which they will submit in April 2004.
3. We must set price limits that are high
enough to enable well managed companies to finance their businesses
and deliver services in line with related standards and requirements;
and provide incentives for each company to improve its efficiency
and service delivery. But, to protect the interests of customers
of these monopoly companies, prices should be no higher than they
have to be. We are also committed to regulating in an efficient
and transparent way.
4. In considering our approach to the review
we have taken account of the findings of the Environmental Audit
Committee as set out in its report "Water prices and the
Environment" (November 2000). For example, at this price
review customer research has been conducted jointly to avoid the
"confusing plethora" of customer surveys produced for
the 1999 price review. And we have with the companies developed
the approach needed to ensure that capital maintenance is not
neglected.
Companies' draft business plans
5. Each company submitted a draft business
plan in August 2003. These plans set out each company's preferred
strategy for the future and the price limits that could result
from these. In addition, the companies also included the costs
of set packages of improvements for illustration.
6. The draft plans have exposed a large
number of issues as well as illustrating the implications for
costs and prices of a series of potential ways forward. If the
companies' preferred strategies were followed then this would
lead to large increases in customers' bills, over 30% in real
terms for the period 2005-10. The company plans highlighted that
price increases are needed simply to maintain the huge improvements
made over the last 15 years.
7. There are other upward pressures on bills
at this review as well as those resulting from new requirements
to improve drinking water and environmental quality. These include:
— Taxation—Companies will experience
a step change in tax charges in 2005-06.
— Capital maintenance—A number
of companies are already spending more than was allowed in price
limits in 1999 to maintain their infrastructure. Companies' draft
business plans indicate that more will be required in the next
five-year period.
— Financing—For some companies
a significant element of the price increase sought in 2005-06
is required in order to achieve what, in their view, is an acceptable
financial profile. This is both to allow them to maintain an adequate
financial profile to provide assurance to investors, and to allow
them to secure finance to fund new capital expenditure projects.
8. The companies set out in their draft
business plans the increases to bills they expect to need to finance
their preferred strategies. The following table shows the factors
driving these increases in bills. One half of the net increase
in bills is accounted for by improvements to the environment and
drinking water quality.
Table 1
CHANGE IN AVERAGE WATER AND SEWERAGE BILL
2004-05 TO 2009-10 ARISING FROM COMPANIES' PREFERRED STRATEGIES
Average household bill in 2004-05
| 234 |
| (1) past efficiency savings and outperformance
| (8) |
| Less | (2) scope for reduction through future efficiency improvements
| (10) |
| (3) maintaining base services
| 37 |
| of which (a) changes in revenue resulting from reduction in revenue yield from the customer base
| 3
|
| (b) increases in operating costs
| 6
|
| (c) increases in capital maintenance
| 19
|
| Plus | (d) increases in taxation
| 9
|
| (4) improving services
| 41 |
| of which (a) drinking water quality
| 10
|
| (b) environmental improvements
| 26
|
| (c) service performance
(mostly sewer flooding)
| 5
|
| (5) maintaining security of supply to all customers
| 12 |
Average household bill in 2009-10
| 306 |
| |
|
9. After 15 years of progressive improvements the scope
to offset increases by further substantial efficiency savings
is less than at previous reviews. We know there are hard choices
to be made ahead if we are to limit the cost pressures on companies
to those that can be appropriately financed and set price limits
that customers perceive as necessary.
10. In making our decisions on price limits we must consider
customers' interests. We have conducted joint customer research
into customers' opinions and priorities for investment. This research
was published in December 2003. Nationally customers confirmed
that it is important to maintain current levels of service. They
also wanted to see some improvements.
11. The majority of bill paying customers stated that
they were definitely (14%) or probably (46%) willing to pay the
bill increases associated with the companies' preferred strategies.
However, a significant proportion of customers were probably not
(19%) or definitely not (14%) willing to pay.
12. Analysis of patterns of responses shows that customers'
willingness to pay reduces as bill increases rise. Not unexpectedly
there is a correlation between income levels and willingness to
pay. Bad debt levels are already rising for various reasons. The
costs of this unrecovered revenue and of debt collection falls
on the customers who do pay. The Environment, Food and Rural Affairs
Committee in its report into Water Pricing (December 2003) drew
attention to the difficulties some customers already face in meeting
their water and sewerage bills.
Advice to Ministers—December 2003
13. In our "Advice to inform the principal guidance
on scale and timing of further quality enhancements" (see
annex) we set out our view that we expect significant overall
bill increases at this price review. These are needed to ensure
continued good service and accommodate capital programmes.
14. We also set out for illustrative purposes the impact
on price limits of limiting the total capital investment programme
for 2005-10 to £15 billion, approximately the same scale
as for 2000-05. The total capital investment programme included
in companies' draft business plans for their preferred strategy
is £19.9 billion.
15. There are longer-term implications for customers'
bills arising from significant increases to companies' capital
expenditure. Already some one third of customers' bills represents
payments needed to service the dividends and interest payments
on financing the capital expenditure incurred by the companies
in carrying out the large scale and successful programme of improvements
made since privatisation in 1989. The further programme will add
permanently to that burden.
16. Once additional capital expenditure has been allowed
in price limits expenditure it forms part of companies' ongoing
costs. If no additional enhancement capital expenditure were allowed
at PR04 there would be no deterioration to the current water environment
and drinking water quality. There would continue to be improvements
as investment now leads to longer-term improvements. The benefits
of investment incurred do not always happen immediately. For example
investment to improve sewage treatment works takes time to have
a beneficial effect on the aquatic environment.
17. At this price review financeability is an issue for
some companies. The water companies need to raise capital from
the financial markets each year in order to deliver the environmental
improvements required from them. We will set price limits that
should allow efficient companies to do this but, as investment
programmes increase, this will become progressively more expensive
to finance. Customers' bills will consequently need to rise disproportionately
to meet the higher costs of raising finance.
Progress with the current investment programme
18. In January, with the Environment Agency, we set out
the progress that companies are making towards completing the
National Environment Programme for 2000-05. We are generally satisfied
that that this programme will be substantially completed by April
2005, with a few schemes planned for delivery by December 2005.
18. To reduce problems with the uneven profile of investment
experienced following price reviews we have asked companies to
identify schemes to be completed early in the next five-year period.
We have made allowance for these so that companies can begin to
undertake preliminary work to set these schemes up ahead of the
new price limits coming into effect—the "early start
programme".
Next steps
19. Once Ministers' principal guidance is available the
next step will be for companies to submit their business plans.
We will scrutinise them and publish our draft determinations setting
out what price limits we think the companies need to finance their
functions. We will consult on our draft determinations.
20. In September we expect Ministers to fine-tune their
guidance on the drinking water quality and environmental programme.
We plan to make our final decisions in November. The companies
then have two months in which to decide whether they wish to refer
our decisions to the Competition Commission.
February 2004
Annex
Letter to The Rt Hon Margaret Beckett MP, Secretary
of State for Environment, Food and Rural Affairs from Philip Fletcher,
Director General, Ofwat
ADVICE TO INFORM THE PRINCIPAL GUIDANCE ON SCALE AND TIMING
OF FURTHER QUALITY ENHANCEMENTS
In your initial guidance to me, last January, you set out
a list of potential policies to be investigated. You indicated
that the Government would require the water industry to meet domestic
and European statutory requirements, but you also emphasised that
there is room to explore how best and to what timetable to meet
these and other improvements. You stressed the need for cost effective
solutions taking into account what is practicable and affordable,
both in its effect on customers' bills and on the financeability
of the industry as a whole, and the benefits of stability both
for companies and customers. You asked me, with fellow regulators
and the companies, to explore all the potential improvements listed
in the initial guidance and in particular their costs and benefits,
before decisions could be taken on whether, how and when they
should proceed.
This letter sets out my views on the way forward. I will
be writing to the Welsh Assembly Government along similar lines.
I attach a paper, which takes up some of these points in more
detail.
Draft business plans
As part of the preparations for the 2004 review of water
company price limits I asked each company to develop a draft business
plan setting out its preferred strategy and, for comparison, reference
plans drawn up on common assumptions provided by Ofwat. The preparation
of these business plans has been a considerable task for each
company. I believe it has been well worthwhile. We now have the
information we need to advise you on the decisions you need to
take as part of the review process.
In their draft business plans companies proposed significant
increases in bills, before inflation, to maintain their services
and to finance further enhancements to the environment and water
quality. Companies proposed investing a further £19.9 billion
in the five-year period on top of the £50 billion of investment
between privatisation in 1989 and 2005. In their preferred strategies
companies propose significant increases in bills by 2009-10 (on
average +31%, maximum +70% proposed by United Utilities[4]).
The companies' preferred strategies proposed an average increase
of £72 by 2009-10, from an industry annual average household
bill of £234), driven by:
— continuing to run the business day-to-day +£37—this
includes maintaining assets (+£19), the impact of taxation
(+£9), changes in operating costs (+£6) and changes
in revenue (+£3);
— sustaining security of supply and the right to
"free metering" +£12;
— improvements in service +£41—this includes
environmental improvements (+£26), drinking water quality
improvements (+£10) and improvements in service performance,
largely sewer flooding (+£5).
These increases are partly offset by projected efficiency
savings past and future—£18.
We recognise your need for appropriate information, on company
investment projections, as a robust basis for your guidance to
me. At the last review, concerns in this area led us to require
an update of the costs of the possible quality improvements in
December 1998, before decisions were taken by Ministers in February
1999. Learning from this experience we have structured the information
requirements differently for draft business plans, including an
earlier requirement for comparative capital costs (March 2003).
We reviewed the comparative capital costs and provided feedback
to each company (May 2003) well before its draft business plan
submission (August 2003). Going forward we will continue to test
vigorously the cost assumptions. In line with a recommendation
from the Environment Food and Rural Affairs (EFRA) Committee[5]
of the House of Commons.
Following examination of the draft business plans, I believe
they are sufficiently robust to use for the guidance you intend
to issue at the end of January 2004. The draft business plan costs
supersede the numbers used by the Environment Agency in "A
good deal for water", published in September. We note that
the EFRA Committee welcome the introduction of the draft business
plans, which provide greater scope for scrutiny and debate at
this stage in the review.
Cost pressures
It is too early to signal the outcome of the review. Our
analysis shows that there will be hard choices to make if we are
to limit the cost pressures faced by companies to those that can
be appropriately financed and to set price limits that are perceived
by customers as necessary. If we are to limit the increases in
bills, we must test the basis of each of the upward pressures.
Some of the proposed increases arise from Government policies,
which affect the day-to-day running of water companies, for example,
known changes in taxation policy, optional metering and the ban
on disconnection for non-payment of household bills. Half of the
net increase arises from enhancements to drinking water quality
and the environment proposed by the Drinking Water Inspectorate
and the Environment Agency/English Nature.
After 15 years of progressive improvements the scope to offset
these increases by further substantial efficiency savings past
and future will be less than at previous reviews. We have commissioned
a number of studies to inform our view in this area. The latest[6]
suggest that the scope for future efficiency savings, beyond the
performance of the economy at large, is less than we assumed when
we set reference assumptions for use in the draft business plans.
I expect the companies to provide revised costings in their
final business plans in April 2004 taking account of our challenges
and we will review again the costs provided by companies at that
stage.
Other uncertainties facing the companies are not reflected
in the company proposals. These include possible changes arising
from Government policy, for example:
— the cost to companies of adopting private sewers;
— further changes in taxation; and
— requirements on the water and sewerage companies
as a result of traffic management legislation.
We have just received the House of Lords' judgement on the
Marcic sewer flooding case. The judgement clarifies the existing
regulatory responsibilities but does raise issues about compensation
arrangements where customers experience sewer flooding.
We have looked for but not found changes that could significantly
reduce costs and customers' bills.
The financeability of large capital programmes can also be
a constraint, which increases customers' bills across all aspects
of their draft business plans. The EFRA Committee recognised the
difficult balance we will need to reach between minimising the
costs of financing the investment and providing an adequate cost
of capital. My view is that significant overall bill increases
are going to be needed to ensure continued good service and accommodate
capital programmes on the scale signalled both for capital maintenance
and enhancement.
Customers' views
Customers, and WaterVoice, have expressed concern at the
scale of potential price increases. WaterVoice, in its submission
to you, recognises the need for some price increases, but expresses
alarm at the scale proposed. It also acknowledges that the draft
business plans may in some areas understate the potential bill
increases. Customer research jointly commissioned by periodic
review stakeholders[7]
shows that although a majority of customers are willing to pay
for the proposed investment, 30-40% were probably or definitely
not willing to pay for the proposals. They were slightly more
willing to pay for their company's preferred strategy and reference
plan A than reference plan B. About half of those not willing
to pay said the cost was too much for the improvements provided
and about a third said they could not afford it. Customers on
low incomes, in socio-economic groups D or E and living in rural
areas were least willing to pay for any of the plans.
Affordability
The law requires me to set price limits, which will allow
efficient companies to finance their businesses. I cannot set
limits with regard to affordability by assuming implausibly low
levels of costs for the delivery of all expectations. So bill
increases will place real pressures on low-income customers. We
note the EFRA Committee's concerns in this area. WaterVoice is
also very concerned about this and so am I. Outside of the vulnerable
groups' regulations, companies may not set tariffs that subsidise
poorer customers. Any support for poorer households would be a
matter for Government, either by reducing pressures on companies
or in terms of social support.
Options
I particularly seek your guidance in relation to the quality
improvements to be made for drinking water and the environment.
As you indicated in your initial guidance to me there are choices
about how best and to what timetable even statutory requirements
are to be met. As with all aspects of the companies' activities
I shall want to seek to provide as much assurance to customers
as possible that increases in price limits will reflect value
for money. It is important that any scheme put forward in final
business plans meets all of the following criteria.
— It is required by the quality regulators, and
confirmed by Ministers, or is a new obligation under current legislation.
— It delivers a measurable defined output, which
is enforceable.
— It has a clearly defined timetable and due date
for delivery in line with regulations or other legislation.
— There are defined asset improvements or changes
to operational procedures to deliver the output.
— The costs are identified and the proposed solution
has been challenged and validated by the company's reporter (an
independent professional who scrutinises and gives his opinion
on the company's business plan to Ofwat).
If, for example, the total capital investment programme could
be limited to £15 billion, to a similar level to that assumed
for 2000-05, it would, by my estimate, reduce price limits by
around 5% over the five year period against reference plan A[8]
and by around 10% against reference plan B[9].
And there are longer-term implications for customers' bills. Already
some one third of customers' bills represents payments needed
to service the dividends and interest payments on capital expenditure
incurred by the companies in carrying out the large scale and
successful programme of improvements made since privatisation
in 1989. The further programme will add permanently to that burden.
For my part, I shall be seeking to ensure, as I must by law,
that well managed companies have sufficient revenues to carry
out and finance their functions. If, as seems likely, it is not
practical to include all possible improvements in the next five
years, we need to establish our priorities. In reaching decisions,
Ofwat's priorities will be as set out at the start of this review,
to allow the companies to:
— run their businesses day-to-day to meet all service,
quality and environmental compliance obligations;
— maintain asset systems for current and future
customers;
— ensure a sufficient balance between supply and
demand for both services;
— meet drinking water quality and service improvements
required to safeguard public health;
— meet obligations on environmental improvements
decided by Ministers; and
— make other desirable drinking water quality, service
and environmental improvements, for example reducing the number
of homes at risk of sewer flooding.
Next steps
I look forward to receiving your principal guidance on the
scope and pace of the drinking water quality and environmental
improvement programmes you will be expecting from the water and
sewerage companies for the period 2005-10. This will enable me,
with the quality regulators, to give the companies clear guidance
on the schemes they should cost in their final business plans
on 7 April 2004. I will assume these schemes are required when
I set draft determinations on 28 July 2004. You will have an opportunity
in September 2004 for fine-tuning the programme for inclusion
in the final package of drinking water quality and environmental
improvements each company will be expected to deliver with the
price limits I will determine on 25 November 2004.
19 November 2003
4
These numbers are not adjusted to take account of the interim
determinations for Northumbrian Water and United Utilities announced
on 11 December 2003. Back
5
House of Commons-Environment, Food and Rural Affairs Committee-Water
Pricing, 18 December 2003, HC121. Back
6
London Economics, PR04-Scope for efficiency studies (November
2003) and Europe Economics, PR04-Scope for efficiency improvement-uncertainties
and measurement issues (November 2003). Both reports are available
on our website-ww.ofwat.gov.uk. Back
7
Customer research 2003: Periodic review commissioned by the Department
for Environment, Food and Rural Affairs, Welsh Assembly Government,
Ofwat, WaterVoice, Water UK, Environment Agency, Drinking Water
Inspectorate, English Nature and the Wildlife and Countryside
Link. Back
8
Reference Plan A included a defined package of environmental improvements
approximating to your "clear and essential drivers". Back
9
Reference Plan B includes a significantly larger package of improvements-but
not all the potential improvements. Back
| 
