Memorandum submitted by Anglian Water
INTRODUCTION
1. We understand the aim is to gauge the
reaction of stakeholders to the draft price limits, and to an
extent also to assess how the Periodic Review has been conducted,
particularly looking at how it has taken—or should take—into
account long-term planning for climate change and environmental
improvements.
2. This evidence provides a summary of Anglian
Water's reaction to the draft price limits and discusses the issues
raised by the Committee.
SUMMARY
3. Our overall view of the draft price limits
is that the company faces a high probability that it will fail
to maintain services to customers and will not be able to finance
the business at a reasonable cost. The result will be higher bills
for customers in the long term.
4. Although the Periodic Review 2004 process
has been conducted in a more transparent manner than was the case
in 1999, there are still a significant number of instances where
Ofwat has not applied its methodologies in a transparent or consistent
way or where decisions have been made that are not supported by
the evidence. There are also significant examples of Ofwat having
taken a short-term view of investment requirements, in particular
in respect of capital maintenance investment requirements and
in addressing sewer-flooding problems.
5. The areas where Ofwat has either departed
from due process or where its determination is not supported by
the evidence include:
— Financeability and risk.
— Efficiency.
— Capital maintenance investment.
— Metering.
— Sewer flooding.
6. As a growth region, Anglian Water has
an imperative to reinforce its network and upgrade its water resources.
We believe Ofwat is far too optimistic in its assessment of the
potential to recover these costs from new customers.
7. Adequate consideration has been given
to the impact of climate change on water resources, during AMP4,
given current knowledge. The position on wastewater is less satisfactory.
All parties need to work together to build our understanding in
order to inform AMP5 plans.
8. These issues are discussed below.
FINANCEABILITY AND
RISK
9. Ofwat assesses the ability of companies
to raise finance at a reasonable cost by checking that their determinations
should result in minimum financial ratios that are consistent
with an investment grade credit rating. In carrying out this test
Ofwat has used financial ratios that are at the very minimum of
what is acceptable. No allowance is made for normal business variability
in cash flows.
10. Ofwat does not appear to have carried
out any risk or sensitivity analysis to assess whether companies
have a reasonable prospect of meeting minimum financial ratios.
Anglian Water's risk analysis indicates a 99% probability of ratios
being breached based on the draft determination and Ofwat's assessment
of a "normal" level of gearing.
EFFICIENCY
11. Ofwat has proposed an overall scope
for efficiency in the water sector of circa 3% per annum This
assessment is either above, or at the top end of, the scope identified
by economic consultants, carrying out studies commissioned by
Ofwat. In making its assessment Ofwat appears to be assuming that
water companies will continue to improve productivity at a faster
rate than the economy as a whole because of the effects of privatisation,
even though by 2010 it will be 20 years after privatisation.
12. When taking account of other likely
costs that Ofwat has not allowed in setting prices (eg redundancy
costs, landfill tax, bad debts) the effective efficiency rate
required is double Ofwat's headline rate.
13. A reasonable central estimate of the
overall scope for efficiency is 1.4% p.a. based on evidence of
the scope for efficiency in manufacturing.
14. Ofwat has not reflected previous Competition
Commission decisions in respect of:
(a) The weight to be placed on the two alternative
methods for assessing comparative efficiency.
(b) The speed with which companies can improve
efficiency in enhancement investment.
15. In respect of (a) the Competition Commission
placed a weighting of 75:25 on the most favourable assessment
to take account of uncertainties in the robustness of any methodology
whereas Ofwat has assumed an equal weighting. In respect of (b)
Ofwat has assumed that companies can become more efficient and
move to within 75% of the benchmark company from day 1 of the
new period whereas the Competition Commission phased the improvement
required over three years.
CAPITAL MAINTENANCE
INVESTMENT
16. Ofwat has reduced proposed capital maintenance
investment, based on a banding adjustment introduced subsequent
to submitting final business plans and without consultation. Ofwat
has also been inconsistent in its assessment of the quality of
a company's capital maintenance proposals between draft and final
business plans.
METERING
17. Ofwat has reduced the forecast number
of meter optants for Anglian Water, the driest region in the country,
below the current level of optants being experienced. The alternative
model used by Ofwat to forecast the number of meter optants is
not robust. As Europe Economics, the author of Ofwat's models,
concludes the models ". . . have undesirably large unexplained
variation in them".
18. The potential consequences of reducing
the metering forecasts include:
— The company discouraging customers
opting for a meter (thereby missing an opportunity for demand
management);
— Price instability as a result of
an Interim Determination of price limits being triggered part
way through the period;
— Financial instability, with companies
breaching key financial ratios.
SEWER FLOODING
19. Ofwat has applied a simple cost cap
in assessing the eligibility of companies' sewer flooding proposals.
The draft determination takes no account of evidence on the severity
and frequency of sewer flooding in assessing the level of investment
to be allowed to alleviate flooding incidents. The imposition
of an arbitrary cost cap does not take account of the benefits
of solving individual problems. Customers are left with severe
and frequent sewer flooding that will not be resolved for many
years. In the case of Anglian Water the funding of a further £23
million investment in sewer flooding alleviation schemes, to address
the most severe and urgent cases, would increase the average bill
by only 27 pence by 2009-10.
IMPLICATIONS FOR
THE LONG
RUN
20. We believe Ofwat's approach to the above
issues will lead to adverse consequences in the long run, namely
higher investment or higher cost of capital or both. Ultimately,
these effects will be reflected in higher prices for customers.
ENVIRONMENTAL IMPROVEMENTS
AND CLIMATE
CHANGE
21. We turn now to your specific questions
regarding environmental improvements and long term planning for
climate change.
WATER RESOURCES
PLANNING
22. We submitted details of our proposals
in our Water Resources Plan (WRP04) to the Environment Agency
(EA) that has subsequently been reported to ministers. We were
disappointed at the response from the EA that concentrated on
technical detail rather than strategic planning, but hope to work
with them as they produce their strategies for 2006. Our supply-demand
balance investment for the Periodic Review is based on the full
utilisation of existing assets eg by the extension of treatment
works at Rutland Water to use the full potential of the reservoir
and the transfer of limited surpluses to meet forecast deficits.
We anticipate the need for larger scale investment to meet planned
economic growth and the reduction in the availability of water
arising from climate change and environmental concerns. As discussed
in more detail below, we believe Ofwat is far too optimistic regarding
the extent to which these system reinforcement costs can be recovered
from new customers.
ENVIRONMENTAL IMPROVEMENTS—WATER
SERVICE
23. The draft determination limited the
Water Resources Environment Programme to investigations only.
In the longer term the Habitats Directive and the Water Framework
Directive (WFD) will require environmental improvements during
AMP4 which are unfunded. Indeed there appears to be a lack of
long-term consideration of the implications of the WFD, which
is being deferred to AMP5.
24. The issues above were addressed in the
Water Resources Plan submitted to the EA in parallel with the
final business plan to Ofwat. We were disappointed at the lack
of co-ordination between the information requirements from the
two regulators and the outcomes, particularly with the Water Resources
Environment Programme referred to above.
CLIMATE CHANGE
25. The water industry is one of the leading
industries in including the impact of climate change in their
future plans and has invested in a number of joint research studies
with experts and through Ukcip (UK Climate Change Impacts Programme).
On balance we have taken the impact as far as we can based on
the current knowledge base but there needs to be a concerted effort
during AMP4 for Defra, regulators and researchers to make this
a more definitive exercise in preparation for AMP5. The impact
of climate change on water companies carrying out their functions
could be substantial both in terms of its impact on assets and
activities.
26. The current situation is set out below.
27. In terms of activities the major impact
considered is the impact on water supplies and demands. Water
companies were advised both by the EA and Ofwat guidelines to
take this into account utilising previous studies. Where there
was a degree of uncertainty then companies could allow for climate
change in headroom ie the margin of additional supply capacity
above demand. Ofwat would not allow specific investment on the
back of climate change unless rigorous analysis had been undertaken.
Overall the approach was reasonable and an element of allowance
has been made in future plans. This needs to be firmed up during
AMP4 and an allowance has been made in future Water Resource investigations.
28. However, on the wastewater side, where
climate change can impact on wastewater volumes and in particular
flood events, climate change has not been adequately taken into
account. It is believed that this is a result of some uncertainty
as to the impact of climate change on flood events (surface and
groundwater flooding) which has given rise to the regulators not
being in a position to support funding for enhancement of assets.
It is considered that Defra should give a lead in clarifying which
of the various flood impact analyses should be taken as standard
(eg Flood Estimation Hand Book vs. Flood Studies Hand Book) for
planning purposes through the Centre of Ecology and Hydrology
(CEH) and the British Geological Survey (BGS) during AMP4.
29. As regards the impact of climate change
on assets and their performance, no account has been taken of
climate change. Again this is due primarily to the uncertainty
of the impact eg the structural impact of increased intensity
of rainfall on the overloading of sewers and groundwater flooding
on the water mains network and leakage.
30. Although the impact of climate change
on biodiversity has been explored by a number of Ukcip supported
studies, the impact of climate change on the preservation of wetlands
and other water dependent environments has not been considered.
Here the concern is that we may be attempting to conserve now
what, in the future due to climate change, could be impossible
to conserve.
FUNDING AND
LONG TERM
INVESTMENT
31. The two examples above illustrate that
there is a need also to review how these are funded and the necessity
for long term planning.
32. The current rounds of five yearly AMPs
do not facilitate long term planning and encourage a "shortermism"
approach. As such the long term consequences of climate change
and environmental enhancement, in particular those that need to
be addressed by the Water Framework Directive, are not being adequately
addressed and continue to be deferred, building up funding problems
for the future.
33. This also raises the issue of who should
pay for these longer-term issues and their consequences. In the
case of the Anglian region we have significant growth proposed,
as a consequence of the ODPM's Sustainable Housing Initiative,
but also a significant number of wetlands that need to be protected.
In addition the impact of climate change will progressively reduce
our water resources in the future. As a consequence of this we
need to transfer water over large distances from areas of surplus
to areas of potential development. This has been accepted by Ofwat
and the EA for AMP4. Except where the costs can be directly attributed
to new development the costs need to be funded by the generality
of customers.
27 September 2004
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