Memorandum submitted by Anglian Water
Services Ltd
SUMMARY
Pressure for price increases comes from a number
of sources including:
— Components of operating costs;
— Current prices suppressed below sustainable
levels by the previous price review;
— The reducing scope for further efficiency
gains;
— The large scale of the investment
programme.
Anglian Water's aggregate investment proposals
are the third highest in the industry. This is due to our relatively
high investment needs across all four of Ofwat's cost categories
and is the prime reason why the price increases arising from our
proposals are the second highest within the industry.
It is timely to review refinements of the price
control methodology, especially with a view to alleviating cost
pressures. The context in which regulation is applied has changed
markedly since privatisation: the scope for further efficiencies
has declined, whilst the capital to be remunerated continues to
grow. In our view, the continued application of aggressive efficiency
targets would carry a number of potential concerns:
— Companies cutting spending with consequent
impacts on performance;
— Companies encountering financial
difficulties with possible knock-on effects such as disruption
during business takeover;
— A rise in risk feeding through to
the cost of capital and, hence, prices given the capital intensive
nature of the industry and the need for ongoing new finance.
At the same time, companies should continue
to be incentivised to outperform. And customers must continue
to participate quickly in efficiencies achieved during the price
control period.
Our business plan proposals deliver these potentially
competing regulatory objectives by:
— Adopting a cautious approach to the
forecast efficiencies built in to price control targets;
— Sharing achieved outperformance with
customers on a year-by-year basis rather than with a five year
lag.
We believe this innovative approach will better
serve the interests of customers by combining a reduction in regulatory
risk with more frequent return of efficiencies to customers.
INTRODUCTION
1. The EFRA select committee has announced
that it is conducting a review of water pricing. The focus of
its review is on:
— The level of investment required;
— The price increases necessary to
deliver that investment;
— Whether the current approach to water
pricing is in the best interests of customers.
2. Water UK is making a submission on behalf
of the industry as a whole. We understand that Water UK's submission
will describe the periodic review process and some of the generic
issues facing the industry. The purpose of this submission is:
— To apprise the committee of issues
which are of particular importance to Anglian Water Services Ltd
(AWS);
— To recommend a refinement of the
price control process which we believe is better suited to current
circumstances and designed to deliver a more favourable outcome
for customers.
3. We have restricted our comments to our
company preferred strategy.
PRICE INCREASES
AND THE
LEVEL OF
INVESTMENT REQUIRED
4. Like most companies, we have substantial
confirmed and potential upward pressures on operating costs from
a number of sources including:
5. The level of the price increases required
can be explained by three further key factors:
— The unrealistically tough settlement
at the last review (PR99) with the consequence that prices are
currently suppressed at unsustainable levels;
— The scale of companies' investment
plans;
— The declining scope which companies
have to offset these cost pressures through further efficiencies.
6. We acknowledge that our price increases
(averaging 8.6% pa) are the second highest proposed by the industry.
This is primarily due to our total investment plans being the
third highest in the industry. We estimate that, in absolute terms,
the size of our investment proposals range between second and
fourth in each of Ofwat's four categories for the reasons set
out below.
BASE (MAINTAINING
EXISTING ASSETS
AND SERVICE
LEVELS)
7. We have a wide range of statutory obligations,
principally regarding the quality of our drinking water and discharges
from our sewage works. Maintenance investment has been persistently
underfunded at past reviews. This is reflected in the implied
asset lives shown in the table below. At AMP3, we were allocated
the third lowest capital maintenance allowance in terms of £/property.
8. In the past, we have been able to maintain
service performance through smarter operational methods. However,
these techniques are now being used to their fullest extent. Applying
new forward-looking risked based techniques endorsed by Ofwat,
all other regulators and the water industry, our business plan
demonstrates that, if standards are not to deteriorate, substantially
more expenditure will be required than allowed at PR99, reflecting
a degree of catch up.
Table
INVESTMENT LEVELS AND IMPLIED ASSET LIVES
| PR04 GMEAV (£million)
| Av. Yearly Capital Maintenance Investment Proposed for AMP4 (£million)
| Implied Asset Life (Years) |
Water
Infrastructure | 4,924
| 51 | 96 |
| Non Infrastructure | 1,347 |
30 | 45 |
Wastewater
Infrastructure | 11,308
| 28 | 403 |
| Non Infrastructure | 4,219 |
71 | 59 |
| Total | 21,798 | 180
| 121 |
| | |
|
9. AWS has submitted a request for capital maintenance
(CM) expenditure of £1,134 million. This is driven by a number
of circumstances specific to our region:
— AWS has the largest geographic area and a dispersed
rural population. Consequently, we have one of the longest water
mains networks in England and Wales.
— The disproportionate proportion of PVC mains which
have shown themselves to have relatively short lives. Unless we
start replacing these mains at a faster rate, problems of bursts
including flooding, supply interruptions and level of leakage
will rise unacceptably.
— AWS also has an extensive sewerage network infrastructure.
We believe that there is a need to substantially increase the
current rehabilitation rate from 6 km/annum to, at least, 40 km/annum
given our current marginal assessment of the serviceability of
this network.
— AWS has more than 50% of its customers on a water
meter (the highest number of metered customers in the industry).
In our dry and environmentally sensitive region, this is a key
part of our water resource conservation strategy. We are now at
the point where many of our meters are at the end of their lives
and need replacing.
— Our region has a high proportion of raw water
abstracted from surface sources in catchments dominated by arable
production. These tend to have high concentrations of nitrates
and phosphates and, as such, require more extensive treatment.
Much of the complex plant installed in the 1990's now requires
extensive refurbishment or replacement.
MAINTAINING THE
SUPPLY/DEMAND
BALANCE AND
SECURITY OF
SUPPLY
10. Demand from industry is projected to decline, offset
by increased demand from new households. Our region has been identified
by the ODPM to absorb a significant proportion of the housing
growth required in the south of England. At the same time, we
are required to curtail abstractions in some parts of our region
for environmental protection reasons. (We have the highest concentration
of SSSIs of any water and sewerage company (WASC).)
11. To accommodate the combination of these factors and
to achieve Ofwat's target for supply security, we will need to
invest both in large scale mains to transfer water from zones
of surplus to deficit zones as well as additional treatment capacity
where we already have adequate abstraction licence quantities.
This is illustrated in Appendix 1.
12. On sewerage, we are following Ofwat's new approach
which aims to project and provide for emerging issues rather than
react after the event. Inevitably, this will result in greater
expenditure for AMP4. In particular, we aim to ensure growth does
not exacerbate foul flooding by providing adequate sewerage capacity.
However, we believe this is entirely consistent with the growing
public attitude to sewerage issues.
13. Consequently, we assess a need for £524 million
of capital expenditure to meet the supply/demand driver for AMP4.
QUALITY INCLUDING
NEW LEGAL
REQUIREMENTS
14. Our company preferred strategy reflects the minimum
legal requirements we think will apply, similar to Ofwat's reference
plan A. Even so, there are some legal obligations which we have
recorded which are not accounted for under plan A. We are disproportionately
affected by the obligation to provide first time rural sewerage
services under section 101A of the Water Act 1991.
15. We estimate the total cost of quality enhancements
to be in the region of £863 million—(the second highest
WASC expenditure after United Utilities).
SERVICE ENHANCEMENTS
16. In our business plan for the period 2000-05 (AMP3),
we proposed to make substantial progress at reducing sewer flooding.
At the time, Ofwat rejected our initiative, but has since supported
a revised set of proposals to make substantial progress during
the current period. We have made further proposals to substantially
eradicate internal flooding during AMP4 and to address the worst
cases of external flooding. These proposals are strongly endorsed
by WaterVoice Eastern. However, the cost of resolving problems
increases markedly as we approach the rump of more intractable
cases.
17. In addition, we have proposals to tackle known sewerage
odour problems and where we anticipate issues could arise from
new housing which is programmed for our region and from greater
public sensitivity to this issue.
18. As a result of these two initiatives, our capital
expenditure proposals under this driver show a 200% increase from
the amount allowed by Ofwat at AMP3 to £206 million.
A NEW APPROACH
TO PRICE
CONTROL
19. In view of the pressures noted above, we believe
it is timely to consider what can be done to mitigate them. Ofwat's
proposed approach for AMP4 (published March 2003) closely follows
the RPI-X approach applied at the previous reviews. Key features
of the approach are:
— Aggressive prospective cost reduction targets
(crudely the X in RPI-X).
— Allowing companies to retain the benefits of outperformance
for five years.
20. This approach was appropriate to the circumstances
which prevailed in the early years of privatisation. Aggressive
targets ensured customers benefited immediately from the substantial
efficiencies available. At the same time, allowing companies to
keep the benefits of achieved outperformance for five years encouraged
companies to seek even greater efficiencies from which customers
also ultimately benefited.
21. The drawback to the approach is that it exposes companies
to relatively high regulatory risk, namely that they will not
be able to achieve the aggressive targets. The risk is magnified
if, as is now the case, the scope for efficiency gains declines
markedly. Regulatory risk is inevitably reflected in the cost
of capital. This will have a relatively severe impact on costs
if, as is the case in the water industry, there is a high capital
value to be remunerated and a high investment programme to finance.
22. We believe that the time has come to update regulatory
techniques. Unfortunately, as noted above, there is little evidence
that this is in prospect. And, despite evidence that the rate
of efficiency improvements is slowing down, Ofwat's consultants
have factored in a continuing "privatisation" effect
in their initial assessments of prospective efficiencies. In our
view, the outcome would be counterproductive because the adverse
effect on the cost of capital would outweigh the benefits. Other
risks arising from overly aggressive efficiency targets might
include:
— Companies cutting back on spending with consequent
impacts on service performance.
— Financial difficulties with consequent impacts
on cost and performance and possibly dislocations whilst businesses
are transferred.
23. Ofwat itself has recognized these sorts of risk at
paragraph 89 of its consultation on incentives (MD187). Although
these concerns clearly apply to water companies, most other regulated
industries are also capital intensive and also, increasingly,
now have large investment requirements.
RECOMMENDATION
24. Our business plan proposals reconcile the competing
regulatory objectives by complementing a cautious approach to
prospective efficiencies with more frequent sharing of actual
outperformance. We advocate sharing of achieved operating cost
outperformance on an annual basis in addition to the five yearly
recalibration of the baseline.
25. Companies are still incentivised to outperform. Customers
receive a share of achieved outperformance more quickly. And the
reduced regulatory risk translates into a lower cost of capital.
We believe this approach is in the best interests of customers.
17 October 2003
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