Memorandum submitted by Northumbrian Water
Ltd
SUMMARY
1. The Committee's decision to conduct a
second inquiry into water pricing is appropriate, since Ofwat's
2004 Periodic Review of water company price caps (PR04) has now
reached a crucial stage. Ofwat published its Draft Determination
(DD) for each company on 5 August. The companies had until 15
September to respond. Ofwat will issue its Final Determination
(FD) for each company on 2 December, and then it is for companies
to decide whether to accept the FD or to make an appeal to the
Competition Commission. The deadline for making an appeal is 2
February 2005.
2. The committee has stated that the issues
it wishes to focus on in this second inquiry are:
— Stakeholder reactions to the DD.
— The extent to which the review takes
into account long term planning for climate change and environmental
improvements.
We have therefore structured this evidence around
these major topics.
3. Inevitably, our views on the DD reflect
our particular situation. However, we have tried to present a
balanced and objective view, incorporating the views of other
stakeholders where known. In doing so, we do not elaborate on
the technical details. These are for Ofwat, and, if necessary,
the Competition Commission, to consider.
4. Our reaction to the DD can be summarised
as follows. We are surprised by Ofwat's reduced allowances for
operating costs, both in terms of its assumptions for future efficiency
gains and in its treatment of known prospective increases in base
operating costs. We are less surprised by, but strongly disagree
with, Ofwat's approach to the Cost of Capital and a number of
other critical financing issues.
5. To surprise and disagreement can be added
disappointment that Ofwat has removed from our capital expenditure
proposals, or substantially reduced in scope, important projects
that are at the top of customer priorities for improvements in
service—projects that also have the full support of our
regional WaterVoice representatives. These projects deal with
discolouration of water supplies and relief from sewer flooding.
We understand that other companies have also had their capital
investment proposals in these areas reduced by Ofwat.
6. Ofwat's conduct of PR04 has, thus far,
been much more transparent than either of the two previous reviews
in 1994 and 1999. We wish to record our appreciation of the level
of detail provided by Ofwat in its confidential DD Supplementary
Report, and in the Aquarius financial model that Ofwat has supplied,
which together have enabled us to reconstruct with some accuracy
the changes made to our Final Business Plan (FBP).
7. Nevertheless, as indicated above, some
aspects of the DD come as a complete surprise. We were led by
Ofwat's previous statements on the subject[1]
to expect a much lower average efficiency assumption than has
been applied to operating costs (average 3% per year across the
industry). The DD efficiency assumptions are not supported by
the evidence and cannot be reconciled even with studies published
by Ofwat itself. We have made it clear to Ofwat that we consider
the DD efficiency assumption we are now faced with is totally
unachievable if compliance and customer service standards are
to be maintained. We are also concerned that Ofwat has failed
to take account of recommendations by the Competition Commission[2],
which would entail a less aggressive application of its efficiency
models with greater recognition given to their limited accuracy.
8. In contrast to the last two price reviews,
Ofwat now appears to accept that allowance for increased maintenance
expenditure is needed in PR04. To this extent, Ofwat is acting
in a much less short-termist way than hitherto. Failure to make
proper allowance for the maintenance of water assets increases
the risk of service deterioration for current customers and increases
costs for future customers. Unfortunately, the change in Ofwat's
stance appears less than whole-hearted. The uplift in our maintenance
investment, proposed in our FBP, has been significantly reduced
in the DD.
9. Climate change is probably responsible—at
least in part—for the increases in the frequency and severity
of sewer flooding problems. In the North East region there is
a rising trend in the number of properties flooded each year,
and each year brings additional properties onto the "at risk"
register. Uplift in investment is needed to simultaneously cope
with these new properties while dealing with those already identified.
It is therefore regrettable that Ofwat has chosen to reduce the
investment we assumed in the FBP so that not all known problems
are addressed by 2010.
10. Whilst we recognise that the cost of
dealing with sewer flooding of some properties is relatively high,
we do not consider Ofwat's ceiling cost of £120k per property
to be appropriate. We believe all customers have a right to expect
investment to alleviate sewer flooding. We also consider it unacceptable
that the company is asked to take the risk of new problems arising
faster than historic trends. This is dependent upon changing weather
patterns, over which the company has no control.
11. In our previous evidence to the Committee's
first inquiry into water pricing we concluded:
"Water prices are artificially low. Price
cuts imposed at the 1999 price review were focused on the short
term and it was always clear they were not sustainable."
The issue of sustainable prices links to another
conclusion from that previous evidence:
"The water industry is a long-term industry.
Its assets are long-lived, it invests for future generations as
well as the current generation, and competent stewardship by a
water company requires it to focus on maintaining those assets
properly."
The evidence from the DD is that Ofwat has not
yet elevated longer-term priorities sufficiently above the short-term
pressures to hold prices as low as possible.
STAKEHOLDER REACTIONS
TO THE
DRAFT DETERMINATION
12. As indicated in the Summary, we were
surprised by Ofwat's DD treatment of our projected operating costs
for the next five years. These are built up from "base opex"
(essentially the company's current operating costs) and "additions
to base" (forecast increases in opex above inflation due
either to externally imposed costs, over which the company has
no control, or to the costs of running new assets constructed
to meet imposed quality standards). Ofwat applies efficiency targets
to both base opex and additions to base.
13. Ofwat has excluded from additions to
base, in part or in whole, several well-researched cost increases
that the company is certain to face. These relate to abstraction
charges levied by the Environment Agency and necessary increases
in pension fund contributions. In addition, we also face increases
in bad debt, which is on a rising trend.
14. Some of these additional costs can be
made the subject of an "Interim Determination", after
they have materialised and provided they both satisfy the threshold
requirements and qualify as increases resulting from industry-specific
legislation.[3]
We made a successful IDoK (Interim Determination of K) claim last
year, a major part of which related to increased bad debt. However,
the company has to bear the increased costs until the threshold
is reached and this threshold is set very high.
15. Since these additional costs not recognised
by Ofwat are not covered by prices charged to customers, or else
in some cases the price-effect is delayed, the company can only
cover the costs by outperforming Ofwat's efficiency targets. We
therefore regard these disallowed costs as "hidden efficiency
targets".
16. Ofwat claims to have heeded industry
complaints that its PR99 approach to setting efficiency targets
left no incentive for outperformance. To meet these criticisms
it has assumed around half of its 3% pa assumed scope for further
efficiency within the price limit (the "stick" element),
and the remaining half is assumed to be the "carrot",
available for outperformance.[4]
However, we do not believe Ofwat's assessment of the total scope
for efficiency gains to be realistic, and we have challenged them
to justify it. Even the studies commissioned by Ofwat do not appear
to support such an aggressive assumption. In reality the "carrot"
efficiency is not attainable and therefore does not provide a
meaningful incentive. The scale of the hidden efficiencies referred
to above only compounds this problem.
17. The opex issue would be less critical
if there was headroom elsewhere in our finances to enable us to
temporarily absorb the extra costs, but Ofwat has left no headroom
in the DD. In common with most water companies, Ofwat has adjusted
our price determination to produce absolute minimum values for
the financial ratios it regards as critical to enable companies
to finance their functions. Hence, it will only require a relatively
minor adverse effect to place the whole industry in financial
difficulty. In the light of this we are surprised by what we consider
to be a short term positive reaction to the DD from the financial
markets, as evidenced by share price movements.
18. WaterVoice, nationally, welcomed the
DD as "better than expected" (meaning, of course, that
the prospective increase in bills is not as great as WaterVoice
had feared). However, Northumbria Region WaterVoice is less content.
Its Chairman has written to Ofwat expressing concern that two
projects, that were included in our FBP with their full support,
have been cut. One of these, dealing with water discolouration,
has been removed in its entirety. The Drinking Water Inspectorate
has also expressed concern at the removal of this project, which
it identified as a high priority water quality scheme. The other
affected project, to address outstanding sewer flooding problems
and deal with new ones as they arise, has been substantially reduced
in scope. These projects are at the top of the customer priorities
emerging from the most recent comprehensive customer research.
This gives cause to reflect on what Ofwat may have sacrificed
in order to produce the "better than expected" DD result.
THE CONDUCT
OF PR04
19. We have already noted the transparency
of the review thus far. As a consequence of this we find we have
more detail with which to take issue than at previous price reviews.
But, we do at least know how Ofwat has adjusted our FBP to arrive
at the DD. In the two previous reviews we were given little or
no detail, and our requests for further information were to no
avail.
20. Ofwat consulted extensively on the price
review process, and, by and large, has conducted the review in
line with the conclusions it drew from the consultation. There
are some exceptions, and this partly explains why the DD contains
some surprises for us. We discussed earlier the unexpected scale
of the efficiency targets, but we also did not expect that Ofwat
would deviate from Ministerial guidance in adjusting our capital
investment programme. We hope we are successful in persuading
Ofwat to correct these aspects in the FD.
21. Although Ofwat is the key player in
Periodic Reviews, there are other players who influence its conduct.
Apart from the water companies themselves, the Environment Agency,
Drinking Water Inspectorate, English Nature, Defra and, not least,
Ministers, all play important roles. From next year, WaterVoice
will assume a separate statutory role as the Consumer Council
for Water.
22. This interplay between key players makes
the Periodic Review a complex task for all concerned. Work must
start about three years before the Final Determination is made,
with tightly timetabled review activities taking place throughout
the price review process, and a very extensive data collection
exercise to inform the myriad decisions.
23. Some of the complexity of the review
process arises from its "batch" nature. After each review
is completed and the inevitable post mortems are conducted, it
is time to start all over again, preparing for the next review.
Some observers have remarked that the scale of Periodic Reviews
is such that they should be conducted only every 10 years, rather
than every five. But this would be impractical unless the interim
adjustment mechanisms were significantly strengthened.
24. The concept of the Periodic Review is
something that grew out of ideas about price cap regulation for
utility privatisations in the 1980s. The basic principle is that
the regulator should reset the price cap periodically and not
intervene until the next scheduled review, thereby giving the
regulated utility an incentive to cut costs and increase profits
between reviews. The revealed efficiencies can then be captured
by the regulator and transferred to customers at the next price
review. This process has proved very effective, but it is not
perfect. It was realised at an early stage that the incentive
to make efficiencies reduces as the next price review approaches.
Ofwat has addressed this by introducing rolling efficiency adjustments
for both capex and opex, so that the incentive to make efficiencies
is the same irrespective of when they are made.[5]
25. It has also become obvious that Periodic
Reviews are very disruptive to company capital investment programmes.
After each of the two previous reviews, water industry investment
dropped sharply—principally because company programmes depend
on the outcome of the price review, and Final Determinations come
too late to allow the next year's programme to be planned properly.
Ofwat has tried to address this problem by introducing an "Early
Start" programme, for which Ofwat can give early sanction
to projects with feasibility and design stages spanning between
two review periods. It remains to be seen how effective this is.
26. These shifts in the regulatory review
process are all in the direction of a rolling, or semi-continuous,
review process, as opposed to the current "batch" process.
The idea of a rolling review is also attractive from a number
of other perspectives. Prices charged to customers would become
less volatile[6],
and stakeholders would be less inclined to treat Periodic Reviews
as once-in-five-years opportunities to secure investment in favoured
projects. This would help to reduce the adversarial nature of
the regulatory process.
LONGER-TERM
SUSTAINABILITY ISSUES
27. The Committee will be pleased to note
that Ofwat has made increased allowance for capital maintenance
across the industry, compared to that allowed at PR99. However,
the overall allowance at national level is still considerably
less than companies have indicated they need in their FBPs, and
on a company-specific basis the extent of the uplift varies considerably.
28. The debate on the appropriate level
of capital maintenance is not about company profits. Ofwat assumes
no allowance in price caps for investment returns on capital maintenance,
which is treated as a cost-recovery item. Companies are concerned,
instead, to protect services to customers and avoid additional
operating costs arising from service deterioration. Ofwat has
resisted calls by companies for it to increase allowances for
capital maintenance at previous reviews mainly because it is such
a significant cost element. Significant increases in maintenance
expenditure result in material price increases in the short term.
29. Whilst Ofwat has partially recognised
the need for long-term planning of capital maintenance for a sustainable
future water industry, there is less evidence that the financial
arrangements it has in mind are sustainable. The Weighted Average
Cost of Capital assumed by Ofwat in the DD is little higher, at
5.1% post tax, than the 4.75% Ofwat assumed in 1999, which prompted
a wave of financial restructuring in the industry. The WACC is
a weighted average of the cost of debt and the cost of equity.
The cost of debt is relatively easy to establish, but the cost
of equity is subject to wide margins of error. We believe Ofwat
has again seriously under-estimated the cost of equity and hence
the WACC.
30. In our view, if Ofwat in the DD had
allowed returns on regulatory capital values that equalled or
exceeded the true WACC for the sector, it would not have found
it necessary to increase price caps in some years to produce "bankable"
financial ratios. We understand Ofwat has found this necessary
in a number of companies' DDs, not just a few. If Ofwat is seriously
concerned to preserve the equity model for financing the future
water industry in England and Wales, it needs to rethink its approach
to the WACC.
31. Our final comment on the issue of sustainability
is to remind the Committee that, as stated earlier, there are
significant real cost increases, faced with some certainty by
companies in the next five years, which have been excluded from
consideration in the DD. By not making any allowance for these,
Ofwat has both increased the financial risks faced by companies
and made IDoK applications more likely. So, even once PR04 is
complete, this does not mean prices are then fixed for the next
five years.
CONCLUSIONS
32. In our previous evidence we warned that
prices needed to increase sharply at this review, not because
of exceptional investment requirements[7],
but mainly because prices have been held unsustainably low—especially
in the last five years. Companies have been forced to gear up
their balance sheets by borrowing heavily to make up the shortfall
in cashflow, but their capacity to increase debt is approaching
its limit and prices must increase.
33. Stakeholder reactions to the price increases
indicated in the DD are mixed. Ofwat itself had warned customers
to expect price rises, so some customer representatives have welcomed
the fact that they are less than those indicated by companies
in their FBPs. Others have noted the fact that Ofwat has achieved
this partly by excluding projects at the top of customer priorities,
and are less content.
34. Companies are reflecting on the enormity
of the efficiency targets assumed in the DD, to which are added
the "hidden efficiency targets", or excluded costs they
will be expected to absorb. In addition to these industry-wide
issues, each company will have concerns over the detail of its
own DD. They will have the opportunity to discuss these with Ofwat
in October, and Ofwat will also seek further Ministerial guidance
before issuing FDs in December.
35. Ofwat's transparency in managing PR04
has been exemplary. This has made the important task of understanding
the assumed changes to our FBP much easier for the company. Nevertheless,
we believe the process is still overshadowed by short-termism,
and we consider some fundamental changes to the regulatory regime
are essential to make it more efficient in facilitating a sustainable
water industry. We strongly recommend that Defra commences a review
with these aims, in partnership with Ofwat, water companies and
other stakeholders, as soon as PR04 is completed.
22 September 2004
1 Water and sewerage service unit costs and relative
efficiency 2002-03 report (page 41): Ofwat, January 2004. Back
2
Reports on Mid Kent Water plc and Sutton and East Surrey Water
plc references under sections 12 and 14 of the Water Industry
Act 1991: Competition Commission, August 2000. Back
3
It will be noted that rises in pensions costs are not a consequence
of industry-specific legislation, so would be excluded. Changes
in taxation are also excluded, which is a major concern since
these are totally outside of company control could have a material
impact on finances. So far, Ofwat has accepted that increases
in bad debt are due to the ban on disconnection of domestic properties
for non-payment, introduced in the Water Industry Act 1999. Back
4
Companies are allowed to retain any outperformance for five years,
after which it is all transferred to customers, who benefit every
year thereafter. Back
5
In practice only a very small number of companies appear to have
received any incentive allowance in the DD. Back
6
It was clear long beforehand that prices could be reduced significantly
at PR99, but it has also been obvious for some time that prices
would need to increase significantly again at PR04. A rolling
review process would allow these adjustments to take place gradually,
rather than in sudden steps. Back
7
The water industry is capital intensive and can be expected to
require similar levels of investment to those in the last decade
for the foreseeable future. The next major cost driver will be
the Water Framework Directive. Back
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