Memorandum from the Campaign Against Monopoly
Abuse (CAMA)
PREAMBLE
It need hardly be said that the first requirement
for sustainable water and sewerage operations in England and Wales,
with due regard for water quality and environmental protection,
is that the licensed operating companies should be adequately
financed. This was recognised in the 1991 Act and now in the 2003
Water Bill which, in paragraph 2A (c) requires the regulator:
to secure that companies holding appointments
under Chapter 1 of Part 2 of this Act as relevant undertakers
are able (in particular, by securing reasonable returns on their
capital) to finance the proper carrying out of those functions
NOTE
Indeed, the requirement for securing "returns
on capital" might even be considered as "over-financing"
since, as Ofwat informs us, customers are actually financing the
capital investment programme so that this gives a double benefit
to the shareholders who would otherwise have to find the investment
capital themselves. It also inflicts a double penalty on customers
since those who are financing the biggest capital investment programmes
will also be required to provide the most generous "returns
on capital".
As well as requiring that water companies are
adequately financed, the 2003 Water Bill perceptively requires—as
did the 1991 Act—that the money is not wasted, diverted
or otherwise misspent. These duties are given in the "Conclusions"
below but essentially the regulator is required to promote economy
and efficiency and to prevent expenditure not attributable to
the licensed operations in particular by ensuring that the companies
present proper accounts. Some notion of the extent to which these
statutory requirements are being respected by the regulator may
be gained from the 2002-03 aggregate "profit and loss"
account given in Table 2 below.
The aggregate net debt at 31 March 2003 stood
at nearly £19 billion which accounts for the £992 million
interest payable. Interest charges alone can be expected to add
at least a further £1 billion to the debt in the present
financial year—even at current low interest rates—so
that the total debt by the end of this 5 year period, in March
2005, will no doubt be well in excess of £20 billion. It
will also be seen that the dividend taken by the parent companies
in 2002-03 is a total of nearly £1.5 billion or 22% of the
total revenue and an absurdly generous return for routine utility
operations by monopoly companies with assured revenues and no
commercial exposure. This expense is clearly a major contribution
to the colossal debt and a massive, but not necessarily the only,
cash transfer to the associate group. The group auditor will not
be particularly concerned, if at all, about licensed company revenues
funding activities which might not be attributable to the licensed
operations. By Act of Parliament this remains the statutory obligation
of the Ofwat Director whose notions of strict accountability will
be evident from a comparison of Tables 1 and 2 below. The 20%
or more of revenue regularly taken from licensed company funds
by way of dividends should raise serious questions as to whether
the Ofwat policy of "arm's length regulation" (sic)—a
peculiar interpretation of the statutory duties imposed by Act
of Parliament—is really giving water and sewerage customers
anything like a square deal. In pursuing this policy, the Ofwat
Director also shows a remarkable lack of concern about the persistent
overspend and the escalating debt which is hardly a recipe for
sustainability with the creditworthiness of at least one licensed
company being questioned in 2003.
In the interests of the financial sustainability
of the licensed water companies, it is essential that any guidance
should take account of the implications of the Ofwat policy of
"arm's length regulation". It is also highly desirable
that the public should be properly informed so that they might
sensibly join the debate. The debate should also consider whether
customers are to continue to finance the capital investment programme
when the shareholders take such extravagant dividends.
ARM'S
LENGTH REGULATION
(SIC)
"concerned with outputs not inputs—outcomes
not expenditure"
There can be no serious dispute about the fact
that, since 1989, the public has been given to understand that
water and sewerage charges by the private companies were high
because of the high additional cost of the quality improvement
programme. The Ofwat Director even put a figure on the costs in
his 1999 report Future water and sewerage charges 2000-0-:
"In the 15 years from 1989 to 2005, water
companies will have invested £50 billion to improve water
quality and to protect the environment, all financed by customers.
"
The same report also gave the total costs included
in the 2000-05 price limits as £15 billion and set out the
total projected capital and operating costs allowed in the price
limits by type of expenditure. The average annual figures derived
from these projections are given in Table 1 below. The 1999 Ofwat
report also details the annual average capital expenditure allowed
in the price limits for each company, in absolute terms and on
a £ per property basis. These figures are given in columns
1 and 2 of Table 3 below which also shows the average projected
annual household bill for each company in column 3 and the percentage
of the household bill attributed by Ofwat to quality charges in
column 4. It is worth noting from the figures in Tables 1 that
the allowance for the projected capital expenditure of £3,123
million a year included in the 2000-05 price determinations represents
no less than 55% of the total revenue for the period and confirms
the Ofwat Director's assertion that the quality improvement programme
is "all financed by customers".
Despite this huge provision for funding the
investment programme, prices in 2000-01 were reduced by an average
of 12%, attributed by Ofwat to improved company efficiency but
probably also bearing some relation to the outrageous reported
profits. As the Ofwat Director also noted:
"Customers will now benefit from lower
bills for the first time since the industry was privatised in
1989. They can look forward to a higher quality water service
and an improved environment within a frame work of falling
prices, thanks to the growing efficiency of the water companies."
In promising this framework of falling prices,
the Director may have had in mind the statement by the Chairman
of the Environment Agency, also quoted in the report, that:
"By 2005 we will have reached a position
where the significant environmental damage created over the past
200 years will have been repaired."
These comments by the Ofwat Director and the
Chairman of the Environment Agency indeed confirm the general
expectation, encouraged by reports of individual water companies,
that much of the capital investment programme, which is blamed
for the high water and sewerage charges, is now nearing completion.
They appear to signal the probability of a substantial reduction
in capital expenditure from 2005 onwards which could then be reflected
in a dramatic reduction—even as much as a 55% cut—in
household water and sewerage bills.
Having submitted their spending proposals for
2005-10, the water companies are now looking for substantial price
increases amounting to 30% or more. The reasons given include
past under funding, infrastructure renewals and the need to further
improve environmental standards. There has been no reference,
by the water companies or by Ofwat, to reduced capital expenditure
as the 2000-05 capital projects are completed so we must assume
a massive expansion in the capital investment programme—a
more than 60% increase in real terms over the £15 billion
expenditure originally projected for 2000-05. This level of projected
expenditure, will have such a heavy impact on customers, in particular
those with low incomes, that it must be properly detailed and
justified as an essential function of the price review. It is
even more important than previously that the actual expenditure
is adequately and properly accounted for.
Concerning the present regulatory accounts,
it might be expected that companies would be required to submit
their financial reports under the same sub-headings as the capital
and operating expenditure budgets on which the Director's price
determinations, and therefore the company revenues, were based.
However, this is not the case as can be seen from the aggregate
profit and loss account for 2002-03 which is given in Table 2.
The "Operating expenditure" is accounted as a single
item and is deducted from total revenue along with the depreciation
charges and virtually the whole of the remainder is then booked
as "Operating profit" from which no less than nearly
£1.5 billion is taken by parent companies by way of dividends.
These dividends amount to 22% of total revenue (see Table 6) and
are a spectacular return for a low risk operation, with assured
revenue and low operating costs. A further item of expense that
is worthy of note—the Ofwat Director being required by Act
of Parliament to secure that companies are able to finance the
proper carrying out of their functions—is the nearly £1
billion interest charges that had to be paid in 2002-03. This
expense relates to the net debt of £19 billion which includes
the £2.6 billion borrowed in 2002-03 and presumably spent
on capital projects although there are no detailed accounts.
From a comparison of Tables 1 and 2 (see annex)
therefore, it seems that, in broad terms, the water company revenues
are established by price determinations based on estimated capital
and operating expenditure budgets but are accounted for under
the main headings of "Operating costs" and "Operating
profit". This then leaves the bulk of any capital expenditure,
as is now being publicly admitted, to be financed by debt. This
so contradicts the previous story, that the capital programme
has been the cause of high water and sewerage charges, that consumer
groups should be demanding explanations from Ofwat and the companies
as a matter of urgency.
Not the least ridiculous aspect of this peculiarly
lax regulatory arrangement is that it is the capital expenditure
budgets that determine the potential profitability of the companies.
A company with a high proportion of revenue from capital expenditure
allowances will obviously be better able to declare a higher "Operating
profit" after the deduction of "Operating costs".
See column 4 of Table 3 (see annex).
Further insights into the flaws in "arm's
length regulation" can be gained from an examination of the
regulatory financial reports of individual companies. As an example,
the 2001-02 and 2002-03 "profit and loss" and "operating
costs" as reported by South West Water are given in Tables
4 and 5 (see annex) respectively. The "profit and loss"
account sub-headings are similar to those given in Table 2, an
obvious difference being that in South West Water accounts depreciation
is included in the operating costs in Table 5. As can also be
seen in Table 5, there is very little detailed accounting for
the operating expenditure. The aggregate items "Other external
charges" and "Other operating charges" amount to
£61.6 million and with the depreciation charges of £60.9
million, for which no detailed account of expenditure is given,
there remains only £37 million of expenditure to be detailed
and this includes the single item of £26.8 million for "Manpower
costs". Also in 2002-03 there was further borrowing of £100.2
million for which there are again no detailed accounts of expenditure.
From the South West Water accounts presented
in Tables 4 and 5 it is clear that, as stated, the Ofwat policy
of "arm's length regulation" really is not concerned
with expenditure and it is equally clear that this laxity is grossly
unfair, not to say costly, for customers. The cost is particularly
evident in the 2002-03 dividend taken by the South West Water
parent company, Pennon Group Plc. The £72.7 million dividend
represents 27% of the total revenue—in effect, 27 pence
of every £1 paid by South West Water customers was skimmed
off by Pennon. This means that from a typical 2002-03 household
bill of (say) £380, no less than £100 was taken to pay
by Pennon as dividend. A further interesting perspective on the
£72.7 dividend is that, with a total of 1,339 employees (including
Directors) the dividend per employee is an amazing £54,294.
Presumably this is seen as "securing a reasonable return
on capital" for shareholders and is not listed as reason
for price increase. As previously indicated, the peculiar Ofwat
regulatory arrangements provide a higher profit potential where
the quality investment charges are high and South West Water charges
are the highest in England and Wales due, it is said, to the long
South West peninsular coastline. As can be seen from column 4
of Table 3, 68% of South West Water prices can be attributed to
the Ofwat allowances for capital expenditure and is the basis
for the total of £171.7 million—68% of revenue—that
was charged as "Depreciation" and "Operating profit"
after the deduction of "Operating costs" in the 2002-03
"profit and loss" account shown in Table 4.
CONCLUSIONS
It is to be expected that there will be flaws
in a financial regulatory system where the Director himself declares
a policy of "arm's length regulation" which is not much
concerned about expenditure. The lack of financial coherence is
also evident from the discrepancies between the budgetary projections
in Table 1 and the regulatory accounts as represented in Tables
2 and 4. The lack of financial restraint is obvious from the huge
dividends taken by the parent companies (see columns 2 and 3 of
Table 6) which are outrageous for operations with assured revenues
and such low risk. For several companies the dividends amount
to a charge of £100 or more on the average household bill
which may come as a surprise to customers who have been led to
believe that high water and sewerage bills were entirely due to
the cost of the quality improvement programme. This lax regulation
must prompt questions as to the statutory duties of the Ofwat
Director and the extent to which this casual policy of "arm's
length regulation" can be regarded as permissible. The key
duties in this respect, as defined in the Water Industry Act 1991—and
now carried forward into the new Water Bill—are as follows:
— to promote economy and efficiency
on the part of companies in the carrying out of the functions
of a relevant undertaker;
— to ensure that consumers are also
protected as respects any activities of such a company which are
not attributable to the exercise of functions of a relevant undertaker
and in particular by ensuring;
— that the company, in relation to
the exercise of its functions as a relevant undertaker, maintains
and presents accounts in a suitable form and manner.
The fact that these statutory duties are being
blatantly and outrageously flouted is clear and obvious with no
need for further elaboration. Ofwat and the water companies must
be well pleased with their success in keeping levels of debt and
the dividends taken by parent companies out of the public debate
about the proposed 30% price increases. In this they have the
apparent support of the nominal "consumer watchdogs"
such as WaterVoice, the National Consumer Council and the Parliamentary
representatives of water and sewerage customers in England and
Wales.
These "watchdogs" must have been aware
of the fact that there are serious financial flaws in the Ofwat
regulatory process since 1997 when Gordon Brown declared the companies
to be "awash with cash" and imposed a special tax on
the excessive profits which yielded £1.69 billion. Since
1997, the net debt has increased by more than £12 billion,
which includes the additional borrowing for the payment of Mr
Brown's tax. The total dividends taken by parent companies since
1997 also, no doubt by sheer coincidence, amount to more than
£12 billion. In customer terms, these figures represent a
debt increase of about £75 per property per year plus an
average £75 a year from every customer in England and Wales
taken as dividend. It is to be hoped that the regulatory authority
to be appointed under the new Water Bill will not only be aware
of the statutory duties of customer protection as defined in the
Bill but will take them seriously.
February 2004
Annex
Table 1
PROJECTIONS OF EXPENDITURE 2000-05 (£
MILLION)
The following table sets out the average annual
capital and operating expendituresallowed in the Ofwat price limits
by type of investment.
CAPITAL EXPENDITURE
| Base services: |
|
| infrastructure renewals expenditure
| 430 |
| non-infrastructure capital maintenance
| 852 |
| Enhanced service levels | 28
|
| Supply/demand balance | 337
|
| Quality enhancements | 1,476
|
Total capital expenditure | 3,123
|
OPERATING EXPENDITURE
|
|
Base service | 2,312
|
| Enhanced service levels | 0
|
| Supply/demand balance | 47 |
| Quality enhancements | 189
|
Total operating expenditure |
2,548 |
Total projected average annual expenditure
| 5,671 |
| |
Table 2
AGGREGATE PROFIT AND LOSS ACCOUNT 2002-03 (£ MILLION)
Turnover | 6,631
|
| Operating expenditure | (2,699)
|
| Capital maintenance charges: |
|
| current cost depreciation | (1,596)
|
| infrastructure renewals charge |
(470) |
| Working capital adjustment | 10
|
| Operating profit | 1,876 |
| Other income | 23 |
| Net interest | (992) |
| Financing adjustment | 527
|
| Profit before tax | 1,434
|
| Tax | (53) |
| Deferred tax | (355) |
| Dividend payable to group | (1,464)
|
| Deficit | (438) |
| |
Table 3
PROJECTED AVERAGE ANNUAL CAPITAL EXPENDITURE 2000-05 BY
COMPANY
Columns 1 and 2 are taken from Table 8 in the Ofwat report
Future water and sewerage charges 2000-0 which "sets out
for each company, the annual average capital expenditure allowed
in its price limits, absolute terms and on a £ per property
basis". Column 3 gives the estimated average household bill
for 2000-05 taken from figures set out in the same report. Column
4 is then derived from columns 3 and 4 to show, by company, the
approximate percentage of the household bill that is attributable,
as reported by Ofwat, to the financing of the capital investment
programme.
| £M
| £/property | h'hold bill
| %/property |
| Water and sewerage companies |
| | | |
| Anglian | 280 | 126
| 245 | 51 |
| Welsh | 222 | 167
| 264 | 63 |
| North West | 603 | 194
| 225 | 86 |
| Northumbrian | 146 | 125
| 196 | 64 |
| Severn Trent | 391 | 112
| 195 | 57 |
| South West | 145 | 213
| 312 | 68 |
| Southern | 217 | 140
| 238 | 59 |
| Thames | 435 | 99
| 181 | 55 |
| Wessex | 153 | 182
| 240 | 76 |
| Yorkshire | 291 | 139
| 209 | 67 |
| Water companies | |
| | |
| B'm'th and W Hants | 10 |
52 | 97 | 54 |
| Bristol | 25 | 52
| 102 | 51 |
| Cambridge | 4 | 31
| 84 | 37 |
| Dee Valley | 5 | 46
| 122 | 38 |
| Essex and Suffolk | 34 |
45 | 109 | 41 |
| F'stone and Dover | 6 | 80
| 120 | 67 |
| Mid Kent | 17 | 73
| 117 | 62 |
| North Surrey | 8 | 40
| 105 | 38 |
| Portsmout | 10 | 33
| 76 | 43 |
| South East | 36 | 60
| 111 | 54 |
| South Staffs | 22 | 40
| 83 | 48 |
| Sutton and E Surrey | 13 |
49 | 101 | 49 |
| Tendring Hundred | 3 | 46
| 130 | 35 |
| Three Valleys | 44 | 43
| 104 | 41 |
| York | 3 | 34
| 85 | 40 |
| |
| | |
Table 4
SOUTH WEST WATER PROFIT AND LOSS ACCOUNT FOR THE YEAR
ENDED 31 MARCH 2003 (£ MILLION)
| 2002-03
| 2001-02 |
Turnover | 270.3
| 260.4 |
| Operating costs* | (159.5) |
(153.4) |
| Operating profit | 110.8 |
107.0 |
| Net interest payable | (44.4)
| (40.2) |
| Profit before tax | 66.4 |
66.8 |
| Tax | (15.0) | (4.1)
|
| Profit after tax | 51.4 |
62.7 |
| Dividends | (72.7) | (66.7)
|
| Deficit | (21.3) | (4.0)
|
| |
|
* includes depreciation (see Table 5)
Table 5
SOUTH WEST WATER OPERATING COSTS FOR THE YEAR ENDED 31
MARCH 2003 (£ MILLION)
| 2002-03
| 2001-02 |
Manpower costs | 26.8
| 28.8 |
| Raw materials and consumables | 9.4
| 9.7 |
| Rentals and operating leases: |
| |
| Hire of plant and machinery | 0.7
| 0.9 |
| Other operating leases | 1.3
| 1.2 |
| Research and development expenditure | 0.1
| 0.1 |
| Auditors' remuneration | 0.1
| 0.1 |
| Other external charges | 51.7
| 47.9 |
| Depreciation: | |
|
| On owned non-infrastructure assets | 31.6
| 30.2 |
| On owned infrastructure assets | 12.1
| 11.4 |
| On assets held under finance leases | 17.2
| 16.2 |
| Provision for impairment of fixed asset investments
| 0.3 | 0.1 |
| Profit on disposal of fixed assets | (0.5)
| (0.8) |
| Deferred income released to profits | (1.2)
| (1.2) |
| Other operating charges | 9.9
| 8.7 |
| Totals | 159.5 | 153.4
|
| |
|
Table 6
WATER AND SEWERAGE COMPANY REVENUES including dividends
paid to parent companies and net debt
| Revenue
| Dividend | Debt
| | |
| (£M) | (£M)
| (%) | (£M)
| Yrs |
| Water and sewerage companies |
| | | |
|
| Anglian | 719.3 | 273.1
| 38% | 3,307.5 | 4.6
|
| Welsh | 457.6 | 14.0
| 3% | 2,006.1 | 4.4
|
| Northumbrian | 421.7 | 74.9
| 18% | 1,358.5 | 3.2
|
| Severn Trent | 905.0 | 141.9
| 16% | 2,174.7 | 2.3
|
| South West | 262.2 | 72.7
| 28% | 869.3 | 0.3
|
| Southern | 431.1 | 68.0
| 16% | 1,257.3 | 2.9
|
| Thames | 1,073.7 | 127.1
| 12% | 2,260.5 | 2.1
|
| North West | 965.1 | 202.2
| 21% | 2,487.4 | 2.6
|
| Wessex | 261.3 | 275.4
| 105% | 1,028.4 | 3.9
|
| Yorkshire | 567.8 | 100.8
| 18% | 1,170.5 | 2.0
|
Water companies |
| | | |
|
| B'm'th and W Hants | 27.2 |
3.5 | 13% | 22.3 |
0.8 |
| Bristol | 67.9 | 16.9
| 25% | 74.8 | 1.1
|
| Cambridge | 14.5 | 2.3
| 16% | 12.7 | 0.9
|
| Dee Valley | 16.2 | 1.2
| 7% | 21.8 | 1.3
|
| F'stone and Dover | 13.1 |
2.3 | 18% | 15.7 |
1.2 |
| Mid Kent | 36.8 | 29.7
| 81% | 127.6 | 3.5
|
| Portsmouth | 29.5 | 7.0
| 24% | 69.1 | 2.3
|
| South East | 88.6 | 12.1
| 14% | 141.8 | 1.6
|
| South Staffs | 58.8 | 4.8
| 8% | 96.3 | 1.6
|
| Sutton and E Surrey | 38.8 |
5.0 | 13% | 53.3 |
1.4 |
| Tendring Hundred | 12.1 | 3.0
| 25% | 10.5 | 0.9
|
| Three Valleys | 162.2 | 25.9
| 16% | 185.6 | 1.1
|
Industry totals | 6,630.5
| 1,463.8 | 22% |
18,751.7 | 2.8 |
| |
| | |
|
Details extracted from the Ofwat 2002-03 Report—Financial
performance and expenditure of the water companies in England
and Wales.
|
