Memorandum submitted by Water UK
Water UK is the representative body of the UK
statutory water and wastewater operators.
The main objective of the water industry for
the period 2005-10 is to secure the successes it has achieved
on behalf of customers and the environment in the past decade.
To do this it looks very likely from the draft business plans
prepared by companies that the price customers pay for water and
sewerage services will increase during the period 2005-10, on
average by 30%.
There are a number of drivers behind this likely
price increase. Companies must carry out further environmental
and quality improvements in order to comply with new European
standards to a timetable agreed by Government. More money needs
to be spent on asset maintenance. Many of our assets are over
150 years old and we need to ensure that the high level of service
that customers rightly expect from the industry is not compromised.
More money needs to be spent on expanding our networks to cope
with population shifts and changing patterns of demand.
Water UK's submission describes the draft business
plan process, the importance of customer consultation, the main
price drivers and the benefits that will be seen by customers
and the environment. The submission also looks at the problems
with the current process which we believe is not the best approach
for dealing with longer-term issues that require co-ordination
with other Government departments and sectors to deliver sustainable
solutions.
EVIDENCE
INTRODUCTION
1. On 15 August 2003 water companies in
England and Wales submitted draft business plans for the 2005-10
periodic review to Ofwat. This is the first critical step in Ofwat's
periodic review process leading to price limits for 2005-10, due
to be announced in November 2004. The industry wishes to secure
the successes it has achieved on behalf of customers and the environment
in the past decade. This paper describes:
— The draft business plan process.
— Customer consultation for the review.
— Investment requirements for 2005-10.
— The need for proper asset maintenance.
— What companies are saying about prices.
— The key factors driving prices up.
— Benefits for customers and the environment.
— Unresolved issues which will affect
prices.
— The weaknesses of the current process.
DRAFT BUSINESS
PLAN PROCESS
2. The draft business plans give a broad
picture to help government and the regulators to examine options
for future investment, future operating costs and the level of
customer bills. The plans reflect the government's requirements
for the industry set out in the initial Ministerial guidance issued
in January 2003 for environmental and water quality improvement
and guidance on social issues and in government's priorities for
the industry set out in "Directing the Flow" in November
2002.
3. The 2004 review process is different
from previous reviews. In the past Ofwat has led the process,
setting out costed options for Ministers in the form of an open
letter. Other stakeholders have then joined the debate, before
Ministers responded with detailed guidance. This time the companies
and their customers have a more prominent role. Companies prepared
three "draft business plans" to Ofwat, summaries of
which were published by companies and put on the Ofwat website
in early September.
4. The plans are draft and not final but
considerable work has gone into developing them. They are the
basis for further discussion and debate with stakeholders, both
at national and local level. The companies, regulators and government
are jointly researching the views of customers about the draft
plans and customers' priorities for action. The findings will
influence government's judgement about the environmental and drinking
water quality standards the country needs.
5. Each company has produced plans based
on different assumptions about how much should be invested during
2005 to 2010. Scenarios A and B were set by Ofwat, in consultation
with the EA and DWI. The third scenario is the company preferred
plan.
6. The draft plans will help government
and the regulators to examine a range of options for future investment,
future operating costs and the level of customer bills. Decisions
about environmental and quality requirements to be incorporated
in price limits set for 2005-10 will have to be taken early in
2004, and will be issued as Ministerial guidance. Companies will
send final business plans to Ofwat in April 2004.
7. All the plans were prepared within a
framework specified by Ofwat designed to:
— ensure that companies carry our their
statutory responsibilities; and
— enable companies to finance their
activities.
The differences between the plans come from
the different assumptions Ofwat and the other regulators have
required companies to make, partly on the basis of government
guidance.
8. In initial guidance issued in January
2003, Defra distinguished between three types of environmental
cost driver:
— Essential and clear—statutory
requirements that are clearly defined and where the timing of
delivery is also clear.
— Essential when clarified—an
expected obligation, but where timing and definition is not yet
established.
— Choices to be made—drivers
where the government has not yet taken a policy decision.
9. Two of the plans (A and B) are based
on assumptions set mostly by Ofwat. These assumptions relate primarily
to the size of the environmental and quality programme. Assumptions
have also been set for efficiency targets and allowed returns
on investment; these are standard assumptions to ensure comparability
and are the subject of discussion at the industry level.
10. Plan A assumes continuing service to
customers and a mostly essential and clear quality package.
11. Plan B also assumes continuing service,
but the quality package is more comprehensive. It contains most
of the cost drivers in the three categories set out by Defra in
January 2003, although some potentially costly items are excluded,
such as the possibility of prosecution by the EU for non-compliance
with discharge standards at coastal sites.
12. "Company preferred" scenarios
set out the company's view of what is realistic for 2005-10, what
the quality programme should be, what needs to be achieved for
customers; what is required to finance its activities; and what
is feasible in terms of efficiency improvements.
CUSTOMER CONSULTATION
13. Joint customer research (sponsored by
the industry, regulators, government and key NGOs) has been a
feature of the periodic review process for the first time. It
has been undertaken in two stages. In 2002 customers were asked
about their general attitudes to aspects of water and wastewater
services. The survey established at a high level some general
indicators of customers' willingness to pay for a range of different
impacts including security of supply, water quality improvements,
and environmental enhancement.
14. During September 2003 a second survey
was carried out, based on the draft business plans. The findings
will be published in December 2003 and will influence the government's
judgement about the environmental and drinking water quality standards
the country needs. Some companies are carrying out more detailed
company specific market research. WaterVoice, the EA and companies
are also holding public meetings to discuss the draft business
scenarios and priorities with customers and other stakeholders.
These processes will influence the preparation of final business
plans.
WHAT ARE
THE PLANS
SAYING ABOUT
INVESTMENT?
15. In the period 1990-2005, since privatisation,
investment by the water companies has been in total about £50
billion. This has gone into programmes to improve or maintain
drinking water quality, the water environment and customer service.
16. This level of spending is at a rate
of just over £3 billion per annum (£3.45 billion in
2002-03)—a high level for an industry with turnover of about
£6.5 billion. This reflects the capital-intensive nature
of the water industry, with assets valued at just over £200
billion in current values.
17. All the scenarios show capital investment
growing because:
— Government has to meet higher environmental
standards or risk prosecution under EU law.
— Companies have to step up the pace
at which they renew old water mains and sewers, or risk supply
problems, rising leakage and damage to the environment.
— Companies must respond to changes
in the level of demand resulting from shifts in population and
economic activity.
18. From the last price review in 1999,
planned investment for the five years from 2000-05 is around £17
billion at 2002-03 prices. The estimated figure for 2005-10 in
the Company Preferred Plans is around £20 billion, an increase
of about 20%. Actual company values vary from a fall of 15% to
an increase of 70%.
19. The components of this estimate show
other significant changes from the current (2000-05) plan:
— Capital maintenance expenditure at
just over £7 billion would increase by over 20% to over £9
billion. The proposed increases vary company by company from 1%
up to 50%.
— Investment in meeting higher quality
obligations would continue at current levels of about £7
billion in total. However company specific investment proposals
vary from minus 50% to plus 50% for the water and sewerage companies.
— Growth in assets to take account
of higher demand—including population shifts and service
improvements—would increase by over 80%, from about £2.5
billion to over £4.5 billion, that is from a much lower base
than investment in capital maintenance or higher quality standards.
Again there is a significant variation between company plans from
minus 50% up to plus 200%.
20. So whilst there are themes here there
is no one national position. There are clear differences between
the companies' plans and this is to be expected. The companies
themselves are different; they operate in different parts of the
country, with different regional priorities. For example, in the
north-west, improving the quality of the water environment will
be an investment driver whilst in the south-east, improving availability
of water resources whilst minimising impact of abstraction will
be key, particularly to the small water only companies. And importantly
the companies' customers will have different priorities that are
reflected in the company plans.
21. Plan A would invest £19.5 billion,
an increase across England and Wales of about 15%.
22. Plan B would invest £26.4 billion
an increase across England and Wales of about 55%.
GOVERNMENT REQUIREMENTS
AND AGEING
ASSETS
23. It used to be assumed that, after the
early years of high investment following full privatisation in
1990, expenditure growth would slow down, bringing a lower impact
on customers' bills. But with the government required to implement
a growing number of major directives aiming at higher quality,
and the realisation that after being squeezed in the last periodic
review, spending on replacing essential and ageing assets cannot
be delayed for ever; the price reductions of 2000 are beginning
to look like a temporary blip.
24. In London, for example one third of
the water mains and sewerage networks are more than 150 years
old. It is a similar story for other large, older cities. If companies
spend less than 1% of the total value of their assets on capital
maintenance then the average life of an asset would by inference
be over 100 years. During the current five year period spending
has been at around 3-4%, £1.8 billion per year, with assets
worth £200 billion.
25. During the current review period the
industry has agreed with Ofwat and the other regulators a new
forward-looking approach to capital maintenance, known as the
"common framework". This has shown a need for a marked
increase in spend if performance is not to drop off dramatically.
WHAT THE
PLANS SAY
ABOUT PRICES
26. To fund this investment, bills would
need to rise in the period 2005 to 2010.
27. Ofwat Director General, Philip Fletcher,
has said that the outcome of the price review should be bills
that are as high as they have to be (to enable efficient companies
to finance their functions) and yet no more than they have to
be (to protect customers of monopoly businesses).
28. In April 2000, as a result of the 1999
water price review, customer bills were reduced on average by
about £30. The increases in bills implied by the draft plans,
relative to 1999 bills, are therefore smaller than the increases
relative to current bills. The average annual increase is about
£5 per year and the range from lowest to highest is £0
to £15 per year.
29. Ofwat figures drawn from Company Preferred
Plans suggest that by 2010 the current average water and sewerage
bill across England and Wales would be around £306, an increase
of around £15 each year or £72 on the £234 average
bill expected in 2004. The range of average annual increases varies
from £6 to £35 though companies differ in the profile
of their increases over the five years—ie some scenarios
show higher increases in the first year than in later years.
30. Plan A would give an average bill of
about £305 in 2010, an increase of £70 on the 2004 average.
31. Plan B would give an average bill of
about £330 in 2010, an increase of £95 on the 2004 average.
32. Most, but not all, companies would expect
bills to rise by a larger amount in Year 1 (2005-06) than in succeeding
years.
33. So the average cost today for a family
for a 24-hour 365 days a year high quality water and sewerage
service works out at about 65p per day. In 2000 the average cost
was 73p. Based on these plans that would change to about 88p per
day in the year 2010.
WHAT IS
DRIVING THESE
PRICE INCREASES?
34. The most important factors are:
— Securing existing levels of service,
especially by higher investment in the renewal or repair of ageing
assets.
— Protecting security of supply in
the face of changing economic, demographic and climatic circumstances.
— Declining scope for efficiency improvements
as noted by Ofwat—"many of the easier gains have been
made already following privatisation in 1989".
— Continuing high investment to secure
the quality of drinking water and protect the environment.
— Need to secure extra finance from
investors. In their preferred plans some companies have used Ofwat's
reference assumptions—eg for cost of capital. Others have
used assumptions based on their view of company needs.
— The level of water company gearing
has increased from zero at privatisation to an industry average
of 59%, thus increasing the interest cost for the increased debt
and reducing the scope for further borrowing to fund the capital
programme without price increases to customers.
— Need to fulfil existing commitments
for which funding has not been available.
— Increasing levels of bad debt by
customers and the cost of pension provisions for employees.
— Declining business customer revenue
and inappropriate assumptions on meter switching at the last periodic
review.
— Other significant cost changes—eg
in taxation, which alone could lead to an impact on average bills
of around £10, energy costs, traffic management charges,
increasing the costs of infrastructure maintenance and renewal
and repair programmes. These costs are outside the control of
the industry.
BENEFITS FOR
CUSTOMERS AND
THE ENVIRONMENT
35. The benefits for customers will be:
— Continued reliability of existing
services, and compliance with quality and customer service standards.
— Improved security of supply in the
event of prolonged dry weather conditions, and scope for new development.
— Improved characteristics of drinking
water affecting taste, smell and appearance.
— Improved quality of drinking water
by reducing lead "pick-up" from customers' pipes and
meeting tighter standards for lead.
— Improvements to sewers reducing the
risk of sewer flooding.
— Better odour control at sewage treatment
works.
36. The benefits to the environment will
be:
— Sustainable approaches to the use
of water resources that protect the environment.
— In many river catchments wildlife
habitats will be protected or enhanced by new treatment standards
at sewage treatment works.
— Improved river quality by reducing
the frequency of operation of certain intermittent discharges.
UNRESOLVED ISSUES
37. In practice many other potentially costly
issues will be unresolved by the end of 2004, not least requirements
under the Water Framework Directive. The Water Framework Directive
formalises river basin management and catchment protection practices.
Work to implement the directive will have to start in 2009-10
to achieve good ecological status of water bodies by 2015. The
definitions of good ecological status, water bodies etc have not
yet been agreed in Brussels but it is likely that these definitions
will lead to an increase in standards for discharges and further
constraints on abstraction. If there are extra costs after the
end of 2004, but before 2010, companies may apply for interim
price determinations leading to revised (increased) price limits
for the remainder of the pricing review period. Revisions to the
Water Framework Directive will take place on a six-yearly cycle
which is a different cycle from the periodic review.
38. Another example is the Habitats Directive
which aims to protect specific nature sites. Certain water company
abstractions are considered to be causing damage to these sites
and English Nature and the Environment Agency are conducting a
"Review of consents for the Habitats Directive" that
has to be completed by 2012 with milestones for action at 2006,
2008 and 2010. The government is concerned about these sites and
has alleged that the water industry is causing "significant
environmental damage". These costs will not be included in
the November 2004 final determinations so any extra costs will
be dealt with by interim determinations or at the start of the
2009 review.
39. Since the last price review 10 companies
have asked the regulator for interim determinations to fund additional
work that could not be costed in 1999. With the increase in the
number of uncertainties facing the industry it seems inevitable
that interim determinations will be a significant feature of the
next review period. However, with the current process of price
setting, customers should have some certainty about the price
limits for 2005-10 when they are set in 2004, particularly in
a climate of rising prices.
THE PERIODIC
REVIEW PROCESS
40. When it was started the Periodic Review
was a reasonable tool to deliver what was needed: large-scale
investment in infrastructure over a relatively short time period
with well defined objectives. It provided reasonably predictable
prices over five-year periods. It delivered significant environmental
and quality improvements in an efficient manner, with efficiency
savings shared with customers. However, what is needed now is
an improved mechanism to deliver long-term stability and sustainable
solutions. The Periodic Review is not the tool to do this job.
41. It does not provide an effective mechanism
for dealing with issues that are either long-term or require co-ordination
with other agencies. There is a risk that it could degenerate
into a system where prices have to be reset frequently.
42. The UK needs to start considering the
whole catchment, including the impacts of farming, transport,
planning, flooding, groundwater protection and land use. New investment
proposals need to be tested against sustainability criteria to
find the best solution. The five-year Periodic Review as currently
structured cannot do these things.
43. At some point the UK needs to protect
water by changing land management practices. It is complicated
enough obtaining funding for a new water treatment works, where
there is a well-defined civil engineering project. The current
regulatory regime, and periodic review process is not set up to
cope with the idea of, for example, funding local stakeholder
groups to improve land-management techniques.
44. The structure is not in place to implement
holistic catchment management. And since this is the central element
of the Water Framework Directive, it illustrates the major gulf
that exists between the Periodic Review process and the urgent
requirements of current environment policy and legislation. This
gulf leads to higher prices for water customers who pick up the
bill for diffuse pollution. It is an inefficient way of managing
the water cycle, but not the fault of Ofwat.
45. Members of both chambers of the Houses
of Parliament, when considering the new Water Bill in committee,
have drawn attention to its lack of connection with the Water
Framework Directive.
46. The Periodic Review needs to be reformed
or replaced with something which can support long-term objectives.
The current review process cannot meet the needs of the holistic
approach as required by legislation such as the Water Framework
Directive.
47. In future, the plans and schemes needed
to deliver long-term sustainability, as required by the directives,
should be developed first to identify the investment required.
This needs to be carried out by multiple agencies, well in advance,
with a subsequently co-ordinated approach to providing funding
for the required programme. This requires a very different review
process.
CONCLUSION
48. Since 1989 the water industry and the
system of regulation set in place at privatisation has delivered
water improvements, 99.87% drinking water compliance, £50
billion in investment and low prices.
49. Government has made excellent progress
through Defra in bringing together some of the wider influences
on the water sector, and "Directing the Flow" encapsulates
the new agenda, setting long-term objectives for the water industry.
But the new thinking must spread out from Defra to ODPM, the Treasury,
DTI and beyond. We believe that a stakeholder forum could assist
with this and help to set priorities.
50. Now is the time for everyone—government,
industry, NGOs and the public—to begin valuing water more
and begin co-ordinating and collaborating to develop a new approach
to managing the whole water cycle.
FURTHER INFORMATION
51. Water UK has published many supporting
papers on its website to explain the PR04 process. These can be
accessed via http://www.water.org.uk/index.php?cat=2-256
17 October 2003
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