Water and sewerage company proposals for
percentage increases in bills
Comparison with the 1999 determinations
At the 1999 review Ofwat was able to transfer
to customers the benefits of significant efficiency gains made
in the previous five years in excess of those assumed in price
limits in 1994. Outperformance since 1999 has been very limited
by comparison. Moreover, the scope for efficiency gains going
forward is unlikely to match those sought at 1999 (see table below).
Ofwat will however continue to use the incentive based price-cap
system to pursue challenging targets for efficiency. But unlike
1999 we will not be able to offset large efficiency gains past
and future against additional expenditure on improvements or maintaining
services.
Table 2
COMPARISON OF BILL DRIVERS IN 2000-05 AND
2005-10
Average household bill
| 1999-2000 | 2004-05[10]
|
| | % change
| % change |
| (1) past efficiency savings and outperformance
| (14) | (3) |
| Less | (2) scope for reduction through future efficiency improvements
| (10) | (4) |
| (3) maintaining base services
| — | 16 |
| (4) maintaining security of supply to all customers
| <1 | 5 |
| Plus | (5) improvements in drinking water and environmental quality
| 12 | 15 |
| (6) improvements in service performance
| <1 | 2 |
Average household bill % change
| 2004-05
(12)% | 2009-10
+ 31%
|
| |
| |
Reference plans
Reference plan A approximates to the package of environmental
improvements in your "clear and essential" drivers categories.
Most companies' preferred strategies are very similar to reference
plan A. Reference plan B includes a significantly larger package
of improvements, but not all the potential improvements. One example
is any work on the Water Framework Directive in advance of identification
of the measures required in river basin management plans.
The advice in this paper is based on reference plan A. The
purpose of requiring these reference plans was to ensure we had
broadly comparable information across companies. Some companies
have included in reference plan A schemes that were not sought
by the quality regulators, others have excluded schemes proposed
by quality regulators but considered by the company to be poor
value for money or not clearly defined.
Cost of capital
It is too early to draw any firm conclusions on the appropriate
cost of capital for the water industry. However, we consider that
there is no strong case for setting a cost of capital below that
used in 1999.
In their preferred strategies companies draw heavily on work
done for Water UK by NERA which suggested a post tax real cost
of capital of 5.75%. We consider that this is likely to overstate
the required return.
Price limits are very sensitive to the cost of capital. Broadly,
each percentage change in the cost of capital is worth around
a 5% change in price limits.
Efficiency
We include an assumption on the scope for future efficiency
in price limits for all companies. At the time of draft business
plans we used a central estimate of 3% per annum reduction for
the industry. Since then we have sought more advice[11]
and companies have explained their own views on future costs.
On the basis of all this evidence the 3% assumption is unlikely
to be sustainable. As we continue to consider the scope for future
efficiency and work on the targets for individual companies we
are mindful of external pressures on base costs that did not exist
in 1999.
Capital maintenance
Companies are proposing significant increases in expenditure
on capital maintenance. We are reviewing each plan on its merits.
The companies will need to justify any major step changes in expenditure
and we will look carefully at any change in the allocation of
risk between companies and their customers.
Supply/demand
Sustaining security of supply and meeting customers' demands
for free meters are also adding to companies' costs and customers'
bills.
Sewer flooding
In their draft business plans companies proposed to make
very significant reductions in the number of properties at risk
of flooding internally from sewers once or more in 10 years and
to tackle the most severe cases of external flooding. The costs
companies propose vary significantly and we will examine them
closely, particularly where the cost of solving problems is very
high. However it is clear that customers and other stakeholders
would like to see significant early progress in tackling this
unpleasant problem. We will also need to consider the implications
of the House of Lords judgement on the Marcic[12]
case for the periodic review.
Running costs
Companies' day-to-day running costs are also increasing,
partly as a result of Government policy. The following factors
all increase costs and will need to be reflected in customers
bills going forward: changes to the tax regime for water companies,
pensions, the ban on disconnection, and the right to a free meter.
So even before we consider enhancing the service already
received by customers, bills can be expected to rise over the
period 2005-10. Many of the costs outlined above will have significant
implications in the first year, and this is the prime reason for
the jump in prices in 2005-06 identified in companies' plans.
Uncertainties
Other Government decisions in the pipeline could also impact
on customers' bills. These include security issues, the adoption
of private sewers, odour and lane rental/traffic management proposals.
There are other areas of uncertainty. These include the implications
of a court case on odour, business rates etc. All these uncertainties
could add to bills. We have mechanisms for dealing with changes
between price reviews and for taking account of significant changes
in costs arising from changes in legislation which have a disproportionate
effect on the water industry or from potential changes which are
identified when we set price limits.
Financeability
The size of the companies' capital investment programmes
since privatisation has meant that, each year, they have been
"cash flow negative" (ie their expenditure has exceeded
their revenue. Companies have had to raise capital from the financial
markets each year in order to deliver the outputs required of
them). This will continue to be the case for at least the next
five years and possibly well beyond.
Given this persistent "cash negative" position,
my duty to act in a way that I judge enables companies to finance
their functions cannot be discharged by simply allowing an appropriate
cost of capital. I must also enable companies, in a practical
sense, to access capital markets in order to raise finance on
reasonable terms. This can be described as setting price limits
that are financeable. We try to achieve this by checking that
the financial profiles of an efficient company are such that they
meet the normal financial tests applied by lenders and investors
before investing. These tests can be a significant constraint
and may mean that, to raise finance for capital programmes, customers
have to pay more in their bills than simply the cost of capital.
One of the key tests used by credit rating agencies is the cash
interest cover. At the last review, eight companies (including
four water and sewerage companies) out of 26 had their price limits
increased to meet these financial tests. The capital programmes
set out in the draft business plans for 2005-10 will mean that
a significant element of the price increases in 2005-10 will be
required in order to maintain an acceptable financial profile
for each company.
Customer survey
The results of a survey of 6,000 water customers in England
and Wales which was commissioned jointly by the periodic review
stakeholders were published earlier this week. Customers were
given details of the service they currently receive and the average
bill in their area. They were shown details of their water company's
draft business plan, and potential associated costs for the period
2005-10, including proposals related to the company's preferred
strategy and reference plans A and B[13],
which were plans with different service levels defined by water
regulators.
Nationally customers confirmed that it is important to
maintain current levels of service, rather than allow reduced
levels. They also wanted to see some improvements. When looking
at the specific costed plans, most support was given to drinking
water quality and supply aspects, followed by maintaining water
and sewerage systems. Less support was given to environmental
and customer service aspects although this was still supported
by the majority of customers.
The majority of bill paying customers stated that they were
definitely or probably willing to pay the price increases associated
with the companies' preferred strategies and with the reference
plans, as illustrated in the table below. However, there was in
each case a significant proportion of customers who were not willing
to pay. The majority of customers were not decided in their views,
with about two thirds only "probably willing" or "probably
not willing" to pay the price increases.
Table 3
WILLINGNESS TO PAY FOR IMPROVEMENTS
| Percentage of all bill paying customers
|
| Company
preferred plan
| Reference
plan A | Reference
plan B
|
Definitely not willing to pay |
14% | 14% | 19%
|
| Probably not willing to pay | 19%
| 20% | 22% |
| Probably willing to pay | 46%
| 46% | 41% |
| Definitely willing to pay | 14%
| 14% | 12% |
| Don't know / can't say | 7%
| 6% | 6% |
| |
| |
Analysis of patterns of responses show that customers' willingness
to pay reduces as bill increases go up. Similar work to identify
whether willingness to pay was linked to the number of improvements
provided showed no such correlation.
Those who were definitely or probably not willing to pay
the increase were asked why not. The majority of these customers
nationally said the cost was too much for the improvements provided
or that they could not afford it. Nine per cent of the whole sample
said they would not pay because they could not afford the forecast
level of bills.
There is a correlation between income levels and willingness
to pay. Lower income customers are less willing than other customers
generally to pay the bill increases associated with companies'
preferred strategies and reference plans, and their willingness
declines more steeply than other groups as bill increases go up.
We know that some customers cannot or will not pay bills
now. The costs of this unrecovered revenue and of debt collection
fall on the customers who do pay. Higher bills could lead to more
non-payment.
It is important to note that the national results mask
variations in the price increases and benefits of plans in different
areas.
At a national level more customers felt the companies' preferred
strategies and reference plan A were fairly to extremely good
value for money rather than fairly to extremely poor value for
money. This view was reversed for reference plan B.
It is with this background that the further enhancements
costed in the draft business plans need to be considered.
Improvements
Our determination in 1999 assumed investment of £7.9
billion (including £5.6 billion for the national environment
programme) in today's prices for quality and environmental improvements
for 2000-05, the largest quality programme ever. The Environment
Agency responded warmly. Its then Chairman, Lord de Ramsay, said,
"By 2005 we will have reached a position where the significant
environmental damage created over the past 200 years will have
been repaired". The companies are progressing with this work
but, with 15 months of the current period to run, a substantial
proportion of this work has yet to be completed. The full benefit
of environmental improvements is not usually apparent until some
time after the completion of the capital works. It is unlikely
that the full effects of schemes implemented before 2000 are yet
being reflected in current river quality figures. That is before
the benefits of the current (2000-05) £5.6 billion national
environment programme add further to their improvements and become
apparent by 2007-08 or some time later.
The Drinking Water Inspectorate, Environment Agency and English
Nature have advised you separately of the improvements they want
to see in the next five-year period. We have worked with them
to understand better the companies' costings of these schemes.
We have also identified schemes that are:
— particularly costly; or
— identified by the companies as being of limited
benefit to customers; or
— within catchments with particularly high levels
of investment.
As a result of these challenges we understand that some schemes
costed in draft business plans will not be included in the quality
regulators' advice to you. It is too early to say what impact
these changes will have on price limits.
Costs of the proposed programmes
We have examined carefully the companies' proposed costs.
Most schemes are designed to meet more than one driver so reducing
the requirements does not always reduce the costs. Table 4 sets
out the costs by driver as included in reference plans A and B
originally costed by the companies and revised following queries
and further information from companies. These costs are for the
water and sewerage companies only, but as the total water only
companies' quality programme only amounted to about £200
million the impact on the industry total is small.
We await companies revised costings in their final business
plans.
Table 4
ESTIMATES OF CAPITAL EXPENDITURE IN PERIOD 2005-06 TO
2009-10 TO MEET DRINKING WATER QUALITY, ENVIRONMENTAL AND OTHER
RELATED IMPROVEMENT DRIVERS
2. Updates of company estimates.
|
| 3. Following queries and further information from some companies (see note 1).
|
Main drivers for drinking water quality,
environmental and other related improvements
| 4. Capital expenditure in 2005-10 £m
|
| 5. Reference Plan A
| 6. Reference Plan B |
| Water Service | |
|
| Water treatment works improvements | 570
| 640 |
| Distribution system renovation | 740
| 740 |
| Lead communication pipe replacement | 370
| 870 |
| Improvements to taste and odour of drinking water
| 210 | 260 |
| Other improvements (includes resilience of water systems )
| 60 | 60 |
| Drinking Water Quality Sub Total |
1,950 | 2,570 |
| Changes to water systems to improve the environment
| 230 | 540 |
| Water Service Sub Total | 2,180
| 3,110 |
| 7. Sewerage Service |
| |
| Urban waste water treatment directive at STWks
| 740 | 1,120 |
| Intermittent discharges from sewerage systems
| 950 | 1,030 |
| Sewage sludge treatment and IPPC requirements
| 90 | 170 |
| Freshwater fish directive (see note 2) |
30 | 1,620 |
| Bathing waters directive | 160
| 390 |
| Shellfish waters directive | 0
| 1,790 |
| Nature conservation (includes Habitats directive & SSSIs)
| 870 | 930 |
| Ground water protection | 660
| 670 |
| Removal of trace contaminants from STWks effluents
| 100 | 220 |
| Endocrine disruptors demonstration project |
0 | 40 |
| Land management schemes | 0
| 340 |
| Local schemes for improving the water environment
| 220 | 870 |
| Completing the AMP3 programme + other (see note 3)
| 450 | 490 |
| Section A (see note 4) | 620
| 620 |
| Sewerage Service Sub Total | 4,890
| 10,300 |
| Total—Quality Enhancements | 7,070
| 13,410 |
| |
|
Notes:
1. These estimates are drawn from the supporting information
submitted by water companies with their Draft Business Plans but
expressed in net terms after the application of the reference
level assumptions for improvements in efficiency.
2. The plan B number includes some companies' estimates
for more work than sought by the EA.
3. At PR99 Ofwat assumed some quality enhancement schemes
would be delivered in the period April to December 2005. The costs
for these schemes will need to be allowed for in setting price
limits for 2005-10.
4. Section A covers improvements falling outside the
formal National Environment Programme and improvement requirements
that have arisen since the 1999 determination.
PROFILING BILLS
Most companies are proposing a significant increase in the
first year of new price limits and smaller changes thereafter.
A few companies proposed a more even (smoothed) increase year-on-year.
The impact on customers' bills presented in this report is
based on price limit profiles that have not been smoothed. The
joint stakeholder survey showed that customers strongly prefer
smoothed bill increases to a step change. I shall need to consider
the case for smoothing in relation to each company. On the one
hand there are arguments for smoothing to help customers to budget
for increases. On the other hand many of the companies are facing
additional costs which need to be financed from the first year
of the period—to defer the increase to later years might
in some cases be imprudent. An increase in 2005-06, followed by
broadly constant bills keeps the average bills at the end of the
period lower than if the price limit profile is smoothed. Our
analysis shows that smoothing price limits to maintain the same
net present value of revenue over the five year review period
would add a further 7% on average to customers' bills in 2009-10.
The effect of smoothing would be different for each company.
Ofwat
19 December 2003
10
Company preferred strategy. Back
11
See footnote 3. Back
12
Marcic -v- Thames Water Utilities [2003] UKHL 66. Back
13
See footnotes 5 and 6. Back
| 
