Memorandum submitted by Northumbrian Water
Limited
1. EXECUTIVE
SUMMARY
1.0 Northumbrian Water Ltd (NWL) is pleased
to have the opportunity to comment on the subject of water prices
at a time when the whole of the water industry in England and
Wales is working towards Ofwat's 2004 Periodic Review of prices.
Each company submitted its Draft Business Plan in August, and
Final Business Plans will be issued in April next year, following
feedback from Ofwat and stakeholders on the draft versions.
1.1 Since privatisation investment has substantially
increased compared to the prior period under public sector ownership,
services have improved greatly, and major advances in companies'
operational efficiency have paid for a significant part of the
service improvements and increased investment. As a result customers
in England and Wales benefit from generally lower prices and better
water services than their neighbours in Scotland, where services
have not been privatised.
1.2 However, the water industry in England
and Wales will not be able to sustain investment at the current
high levels beyond 2005 without significant increases in water
prices. Most of the possible efficiency gains have already been
made, as Ofwat now acknowledges. Companies have already borrowed
heavily to finance investment and they cannot increase borrowing
indefinitely. It will be possible to introduce new equity only
if the allowed returns are adequate. The forthcoming price review
in 2004 (PR04) is therefore crucially important to the future
of the industry.
1.3 This response is in two parts. First
we consider the pressure on the level of prices. Second we consider
some issues relating to the incidence of water charges
2. UPWARD PRESSURE
ON PRICES
Water prices and financing investment
2.0 Commentators often overlook the fact
that all the water company profits—and more besides—are
ploughed back into the industry in the form of capital investment.
It is important to consider the industry's cash flows (which include
capital investment) as well as profits (which do not). In only
one year since privatisation has the industry's cash flow been
positive. In every other year, the industry has been forced to
spend more than it was receiving in revenues. Increased borrowing
has made up the difference.
2.1 The amount of debt carried by a company
as a percentage of its total of debt and equity investment is
called its gearing. As a company's gearing increases, its credit
rating deteriorates and the cost of further borrowing increases.
Eventually, it will not be possible to raise additional finance
at economic interest rates.
2.2 In recent years companies have benefited
from historically low interest rates and have financed investment
through borrowing since debt was cheaper than equity. Gearing
is now approaching maximum sustainable levels. It is possible
to reduce gearing by raising new equity (ie issuing new shares).
But this can only be done if the returns available are sufficient
to attract equity investors. This requires the regulator to allow
companies to remunerate equity, as well as debt finance, appropriately.
2.3 Strongly negative cash flows cannot
continue indefinitely, either costs must be reduced, or income
increased. If a continuing high level of capital investment cannot
be avoided, then the prices paid by customers must increase if
the necessary finance is to be raised.
Decisions on future investment affect customers'
bills
2.4 The water industry is very capital intensive.
Most of the industry's costs are associated with providing, maintaining
and operating the extensive networks and treatment facilities
needed to deliver water services. However, for the last decade
and a half the industry has additionally been required to invest
heavily to satisfy the requirements of European Directives. Many
of the required improvements have been desirable, but they do
not come free. It is unlikely that those in Brussels legislating
for the improvements considered very deeply the impact they would
have on customers' bills.
2.5 Unfortunately customers, who sooner
or later must pay for environmental improvements, are not allowed
any choice over which improvements they would prefer to pay for.
This is partly a consequence of the way in which the industry
is regulated. When prices are reset every five years at periodic
reviews, the economic regulator, Ofwat, consults the Environment
Agency, English Nature and Drinking Water Inspectorate over the
content of the industry's investment programme for the next AMP
(Asset Management Plan) period. The environmental regulators have
a tendency to see this as a once in five years window of opportunity
to maximise environmental gains. By contrast Ofwat tends to view
the environmental aspirations as obstacles to the lowest possible
prices for customers. Ministers are left to decide the correct
balance. The companies face a real risk that they will be expected
to deliver more environmental improvements than have received
adequate funding.
2.6 These regulatory tensions could be reduced
if a more collaborative and less adversarial framework were to
be adopted. We consider that a legal requirement for the regulators
to collaborate in the long-term interests of the industry and
its customers would be beneficial.
2.7 It is essential that preparations for
compliance with the Water Framework Directive are undertaken on
a true catchment management basis with improvements required from
polluting industries and agriculture rather than focusing simply
on end of pipe solutions from the water industry.
2.8 Many commentators have noted the deficiency
in the regulatory regime with regard to capital maintenance. If
too little investment in maintenance is made, assets will deteriorate
and a backlog of maintenance investment will be created. Present
customers will then be benefiting at the expense of future customers.
However, it is not easy to calculate the level of capital maintenance
that will hold overall asset condition constant, and it takes
a long time before it becomes obvious that deterioration has occurred.
2.9 An opportunist economic regulator may
be tempted to cut the allowance in the price cap for capital maintenance,
leaving the problem for his successors. Environmental regulators
may in the past have preferred to see direct investment in quality
improvements and viewed capital maintenance as a competing investment
area.
2.10 We are pleased to note that the EA
has started to recognise that asset maintenance is vital to securing
the environmental improvements achieved to date and the industry
and Ofwat have worked together to develop a more robust framework
for assessing capital maintenance requirements. What is clear
is that any service failing due to poor maintenance will be regarded
as the company's responsibility.
Areas where economic regulation must improve
2.11 Too often in the past economic regulation
of the industry has been characterised as short termist. Ofwat
cut prices to the bone at PR99 and it was clear at the time that
this was not sustainable. Significant price rises in PR04 now
look inevitable, but they need not have been so significant—and
in some cases may not have been needed at all—if price setting
in 1999 had been conducted with due consideration for the longer
term.
2.12 In its insistence on setting prices
in 1999 as low as possible, Ofwat adopted lowest rather than central
forecasts of many items and excluded some drivers, such the Cryptospridium
Regulations, which could have been foreseen. Consequently, this
AMP3 period has been characterised by interim determination applications.
Northumbrian Water is one of 10 companies having made such applications.
In our case we have not only had to fund obligations that were
not included in the price cap set in 1999, but in addition our
revenue is well below the level assumed by Ofwat. Ofwat's PR99
assumptions have proved far too optimistic. If our application
is successful, it will mean prices rising in 2004-05, but this
will simply bring forward part of the price rise otherwise necessary
in 2005-06.
2.13 The lessons of PR99 are clear. The
last review prompted an exodus of equity from the water sector
because Ofwat set the allowed rate of return to equity investors
too low. This needs to be rectified in PR04 if the industry is
to finance the required capital investment.
2.14 Ofwat's proposed methodology for the
review looks little different to that used in PR99 and we believe
this is a missed opportunity. But much depends upon the application
of the methodology. This must be applied in a more even-handed
fashion and with greater regard to the sustainability of the industry.
Ofwat is now operating in a much more transparent manner and the
Director General's statements to the effect that "prices
will be what they need to be" give cause for cautious optimism.
But the acid test will be the outcome of the periodic review.
The legacy of PR99 is that PR04 will be an exceptionally difficult
price review for the regulator and it is easy to see why Ofwat
has already concluded that "hard choices will need to be
made".
2.15 The right balance needs to be struck
at the review. This should then signal the start of an intensive
and inclusive dialogue on how the regulatory framework should
evolve to avoid the recurrence of such "make or break"
price reviews in future.
3. INCIDENCE
OF CHARGES
3.0 A long-term industry such as water must
adhere to the concept of sustainability. Sustainability has a
social as well as an economic dimension, and this is particularly
relevant for water pricing. From this perspective, it is not only
the level of water prices but also the incidence of water charges
that is significant.
Bad debt is a burden on customers who pay
3.1 In common with most other water companies,
Northumbrian Water has experienced an increasing problem with
bad debt ever since 1999, when the ban on disconnection of household
water supplies for non-payment came into effect. Despite an increased
focus on debt collection, and improved systems and procedures,
NWL's bad debt situation has become progressively worse, and we
have been forced to include this factor in our recent application
for an interim determination.
3.2 Whilst there is some debate over the
extent to which customers are generally aware of the ban (our
evidence suggests that the poor payers are), there is no dispute
that company collection procedures have been forced to change,
as they are no longer able to use the threat of disconnection.
Those customers who would previously have reacted to the threat,
either by settling their bill if they are able to pay, or making
partial payments by arrangement, are no longer faced with that
decision. Water company costs in pursuing those that can, but
won't, pay have unfortunately increased dramatically. The result
is that customers who do pay are increasingly subsidising those
who don't.
3.3 For those who can't pay there clearly
needs to be a support mechanism, but we believe this should be
a social security issue.
Some cross-subsidies are socially desirable
3.4 Whilst most cross-subsidies have been
eliminated from charges some social cross-subsidy persists. The
most significant remaining cross-subsidies in water industry charges
are 1) between urban and rural customers and 2) between high rateable
value and low rateable properties.
3.5 The costs of providing water services
to rural customers are significantly greater than the costs of
supplying urban customers, yet the tariff framework is the same
irrespective of location—charges are set on a regional average
basis. However, there are far more urban than rural customers,
so although urban customers would pay slightly less if the cross-subsidy
were to be removed, rural customers would pay considerably more
(in parts of our area more than double). It is generally accepted
that this particular cross-subsidy is socially desirable. One
of the problems associated with competition in water, especially
if domestic competition were to be introduced, is the potential
unwinding of such socially desirable cross-subsidies.
3.6 The other cross-subsidy, between high-RV
and low-RV customers, is currently being unwound by introduction
of the free meter option, introduced at the same time as the ban
on domestic disconnection. Part of NWL's loss of revenue in the
last five years stems from Ofwat's under-estimation of the potential
effects of the free meter option at PR99. Although there have
been fewer meter optants than Ofwat assumed, these have been high-RV/low
consumption customers, who have the most to gain from switching
to a metered supply. The revenue loss per meter optant has been
far more than Ofwat made allowance for. It is reasonable to assume
that high-RV/low consumption meter optants have a higher income
than low-RV/high consumption households, so the free meter option
is progressively unwinding the existing cross-subsidy that exists
between rich and poor in the unmetered customer grouping. The
impact off meter optancy on unmeasured bills needs to be considered,
particularly as the number of optants could increase with the
general increase in bills expected from 2005.
4. CONCLUSIONS
— 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 large gaps between companies'
revenues and their mandatory investment have been plugged by increased
debt, but this cannot continue forever. In fact, PR04 needs to
signal the end of the line for negative cash flows and the associated
heavy borrowing. It is clear that water prices need to increase
significantly in 2005 and that returns must be sufficient to attract
both debt and equity investment.
— How much prices will increase in
the future partly depends on how much longer the sustained period
of heavy capital investment, experienced by the industry since
privatisation, is expected to continue. Much of this requirement
emanates from Europe, but not all.
— 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. A similar long-term focus is also required on the part
of the industry's regulators who also need to work together and
with the industry more effectively to generate a more integrated
framework.
— It is essential that proper allowance
for maintenance is not squeezed between the demands for further
environmental investment and a desire to minimise price increases.
— Capital investment is not the only
factor driving prices. The bad debt resulting from 1999 legislation
to ban domestic disconnection is playing its part, as is the free
meter option. Other significant costs drivers include changes
in government taxation.
— Leaving some drivers of investment
out of PR04 and then bringing them in mid AMP4 to be dealt with
by interim price adjustments would be to continue a short-termist
approach creating damaging uncertainty and instability. A more
sustainable longer-term focus is required.
— As a result of the ban on disconnection
customers who choose not to pay are imposing an increasing burden
on those who do pay. This issue is likely to increase in significance
and may become politicised.
— Some existing cross-subsidies in
water charges are significant and socially important. They need
to be managed with care.
17 October 2003
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