Supplementary memorandum submitted by
Ofwat
At the hearing of the Environment, Food and
Rural Affairs Committee on Wednesday 20 October I promised to
supply some additional information to the Committee.
I was asked about how water and sewerage bills
in England and Wales compare with those in Europe. I said that
the costs of water and sewerage services are broadly in line with
those countries where water and sewerage bills are not subsidised.
There is very limited published information available on this
subject. In March 2004 we published "International comparison
of water and sewerage service—2001-02 report" which
brings together the latest information available on the relative
performance of international companies that are directly comparable
to those operating in England and Wales. A copy of this report
is enclosed. The section on bills (page 49-51) of this report
compares domestic and commercial charges.
The Aqualibrium report "Europe Water Management
between regulation and competition" (page 330) compares water
charges across a range of European companies. The European countries
that are most directly comparable include Denmark, Germany, Finland
and Sweden, as they base charges on full financial cost recovery.
Bills in most other European countries have some element of subsidy.
On the basis of the figures included in the Aqualibrium report
water charges in Denmark (4.31 euros per cubic metre of water);
Germany (3.6 euros) and Finland (2.75 euros) are higher than in
England and Wales (1.57 euros). Sweden's are lower at 1.15 euros
per cubic metre.
We are not aware of any data that identifies
the extent to which charges in different European countries are
driven by European legislation. Environmental taxes, ranging from
discharge and extraction charges to specific taxes are levied
in most countries, and in some are used to help fund the sewerage
network.
You sought a commentary on the post tax cost
of capital and the yield. The expenditure associated with large
capital programmes means that companies have negative net cash
flows each year. Consequently the companies have to raise funds
via the capital markets. Our headline weighted average cost of
capital (WACC) of 5.1% is calculated on a fully post-tax basis.
This is equivalent to a return of 5.81% which is based on a cost
of equity of 7.7% and a cost of debt of 4.3% for the water and
sewerage companies. This is the return allowed on the companies'
capital base (the regulatory capital value) after allowing sufficient
revenue to cover their actual tax bill. The fully post-tax WACC
of 5.1% could be presented as a fully pre-tax WACC of 7.3% assuming
a marginal tax rate of 30%.
Mr Taylor noted that if the water authorities
had remained publicly owned corporations the cost of capital to
them would be significantly less than the cost to private sector
companies. He questioned whether the difference is justified by
the additional efficiencies the companies have made since privatisation.
Meaningful comparisons between the relative financial benefits
and costs of public and private ownership are not straightforward.
The nearest thing to such a comparator is Scottish Water, a public
sector nationalised industry. The analogy is not exact. Scottish
Water has only recently been formed from the three previous regional
water authorities. However, my opposite number the Water Industry
Commissioner for Scotland published comparisons in February 2003
indicating that Scottish water and sewerage bills in 2001-02 were
60% higher than would have been the case if they had been operating
as efficiently as their English and Welsh counterparts. As a result
the average household bill paid in Scotland was about £80
more than should have been necessary.
In terms of the cost of raising finance, the
difference between the credit of a public corporation and that
of a significant utility company with a credit rating comfortably
within the investment grade is around one percent per annum. However,
a number of other factors come into this part of the equation.
Thus, had the water authorities remained in public ownership the
evidence of public funding in the 1970s and 1980s suggests that
Governments would have been unwilling to sanction the increase
in the Public Sector Borrowing Requirement necessary to deliver
the enhanced drinking water and environmental quality programmes
required. (The overall level of investment, some £50 billion
since privatisation in 1989, is at least double the level of investment
over the equivalent previous period.)
The form which privatisation took in 1989 was
intended to put pressure on the companies both to deliver better
services and to do so more efficiently. Regulation of monopoly
utilities was to be combined with the pressure of shareholders
and other financial stakeholders, as well as from customers, on
the companies to out-perform the regulatory assumptions.
Our regulatory assumptions include challenging
requirements for year by year improvements in efficiency that
must be met or exceeded for a company to develop.
Outperformance of the regulatory challenge would
initially be to the benefit of the shareholders but such benefits
are returned to customers at the next review of price limits in
the form of lower bills.
At each price review, Ofwat has made efficiency
assumptions which require the companies to outperform significantly
the level of efficiency achieved by the economy as a whole. The
figure in paragraph 24 of our evidence shows the reductions in
operating costs the companies have made. At each price review
companies have also made capital efficiency savings over and above
those assumed in price limits. Overall, the effect of efficiency
improvements from 1990-91 to 2004-05 has held the average household
bill around £90 below the level it would otherwise have been.
This letter offers only a broad commentary.
The five reports which Ofwat publishes each year on aspects of
company performance offer much more detailed assessments of levels
of efficiency in terms not just of expenditure but of improved
service to customers and to the environment at large.
Philip Fletcher
1 November 2004
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