Memorandum submitted by Wessex Water Services
Limited
SUMMARY
A.1 Wessex Water is consistently considered
to be one of the most efficient of the water and sewerage companies.
Despite this our draft business plan suggests that customers bills
need to increase by 12% over the next five years. In coming to
this view we have sought to balance the interests and aspirations
of consumers and investors along with the need to improve water
and environmental quality.
A.2 Our plan shows that it should be possible
to maintain existing standards, and provide a return to investors
which reflects the cost of capital without the need to increase
bills. This is despite having to spend additional sums to maintain
an increasing and ageing asset stock. We are able to achieve this
because of efficiencies we have made over recent years.
A.3 However, because of changes to Inland
Revenue tax rules, customers are going to be asked to pay 2.75%
more for the same level of service in the next five years.
A.4 Whilst it may seem attractive to squeeze
maintenance expenditure or returns to investors in order to reduce
bills, neither option is sustainable.
— The water industry is an integral
part of the economy and society. Undue risk should not be taken
with asset maintenance as this is bound to prejudice service.
— Returns to investors have been somewhat
below the cost of capital in recent years. This has already resulted
in the exit of significant amounts of equity. Continuation of
these returns in AMP4 will lead to difficulties in accessing all
capital markets.
A.5 Against the background of these constraints
Wessex has endeavoured to prioritise investment in customer, quality
and environmental improvements such that bills increase by no
more than consumers willingness to pay.
A.6 Joint national customer research indicates
that the typical family is content for bills to rise by around
2% pa—broadly equal to increases in household disposable
income. The research also indicates that investment in areas such
as sewage flooding is regarded as important.
A.7 Faced with this information Wessex believes
it is right to challenge environmental improvements to ensure
those included have clear and significant environmental benefit.
We are not yet convinced that all those obligations in Packages
A or B can be justified on cost benefit grounds and, as such,
some could be deferred to AMP5.
A.8 The Plan is however draft. If it transpires
that there is a willingness to pay for improvements which goes
beyond RPI+2% pa, and provided returns to investors reflect the
cost of capital, then Wessex believes the quality and environmental
improvement programme could and should be increased to include
items in Package B.
BACKGROUND AND
APPROACH TO
THE PRICE
REVIEW
A.9 Wessex Water set out its strategic objectives
in its 1999 Business Plan. Our 2004 Business Plan will confirm
these as:
— safeguard public health and provide
the highest possible quality of water and sewerage services;
— maintain the operating capability
of our assets;
— balance supply and demand;
— meet enhanced customer expectations;
— meet enhanced environmental requirements,
within the constraints imposed by customers' willingness to pay;
— deliver returns to investors commensurate
with the cost of capital;
— be the leading company in efficiency
and service standards; and
— meet all the above objectives in
a sustainable way.
A.10 Wessex Water has achieved these objectives
in AMP3. Our record is of continuously being one of the most efficient
and profitable of the water and sewerage companies, producing
some of the highest levels of service.
| Wessex Water's performance
| 1997-98 | 1998-99
| 1999-2000 | 2000-01
| 2001-02 | 2002-03
|
| | |
| | | |
| Ofwat operating efficiency band* | Band A
| Band A | Band A | Band A
| Band A | Band A |
| Ofwat capital efficiency band | Band B
| Band A | Band A | Band A
| Band B | Band A |
| Ofwat overall service ranking | 1st
| 2nd | 3rd | 3rd
| 8th | 2nd |
* Bands range from A (top) to E (bottom)
A.11 These achievements provide a solid foundation on
which to build a sustainable strategy for 2005-10 and the longer-term.
A.12 Our approach to the 2004 price review is based upon
the principle of sustainability. The definition of sustainability
used by groups such as Forum for the Future is "the capacity
to continue". This definition is applied to the "five
capitals":
A.13 Our focus in developing our plan has been on the
first three. Specifically we have tried to ensure continued:
— ability and willingness to pay for services;
— access to the capital markets so to allow the
company to meet customer and regulatory requirements;
— maintaining existing standards; and
— improvement in service levels and environmental
performance.
Inevitably this has meant the need for compromise between
the often-competing needs of each.
FORMING THE
PLAN
A.14 In formulating our plan, we have sought to establish:
— what our customers are prepared to pay;
— the costs of meeting our existing core obligations,
allowing for past and future efficiency, including the returns
that are commensurate with the cost of capital; and
— which customer and environmental improvements
provide best value for money.
A.15 This plan seeks to balance all stakeholder interests
and allow us to meet our statutory obligations as we see them
today. A number of issues have yet to be fully resolved, including:
— the full implications of the water framework directive;
— the implications of future pension shortfalls;
— the extent of future electricity price increases;
and
A.16 Our views on these issues, and the balance between
each stakeholder group, will evolve in light of new information
and the feedback we receive. Next April we will update our plan
and put forward final proposals for the next five years.
WILLINGNESS TO
PAY
A.17 Unlike the last price review the industry has jointly
commissioned customer research along with Regulators, DEFRA and
Consumer groups. The first phase of this research established
broad willingness to pay for improvements.
A.18 The results show that the great majority of customers
(87%) want to see bill rises kept within the range of 0% to 2%
above inflation per annum.
A.19 Increases around this level broadly reflect the
long-term growth in the economy real disposable household income.
A.20 It is however clear from the national research,
and previous work, that willingness to pay does differ between
elements within society. Broadly speaking those who are willing
to pay more for environmental improvements are those who either
understand the benefits of the improvements and/or, have higher
levels of disposable income.
A.21 Wessex does recognise that by assuming willingness
to pay is restricted to increases of 2% pa above inflation, we
are not reflecting the divergence of views within society. Indeed
we also recognise that it may be possible to find additional resources
to pay for environmental improvements were it possible to charge
different consumers differing amounts. However, there is a reluctance
by Government and Regulatory authorities to allow companies to
differentiate prices on the basis of willingness and ability to
pay despite the fact that this may produce desirable social and
environmental outcomes.
THE SCOPE
FOR FUTURE
EFFICIENCIES
A.22 The current regulatory regime has been very successful
at driving out the inefficiencies inherent in the water industry
at privatisation. Despite the fact that the privatisation effect
itself has long been exhausted, the Board considers that there
is always scope for further efficiency gains, but that three important
precautionary principles should be applied when setting future
targets:
— first the law of diminishing returns applies to
the water industry in general, and Wessex Water in particular;
— second, because of the strategic and social importance
of the industry, targets should be based only on sound evidence—where
the evidence is weak caution should be applied; and
— third, the industry works under an RPI-X based
system, where the RPI already has "baked-in" to it the
productivity gains of the economy as a whole.
A.23 Additionally the scope for savings must be viewed
against a background where:
— the industry cannot change its product, uncontrollable
costs are increasing and its mix of inputs are largely immovable;
— there is limited scope for technological advance;
— the regulatory system discourages savings made
through medium term capital investments;
— it is unlikely under the current regulatory regime
to be able to reduce costs by way of merger;
— there is upward pressure on a number of costs
driven by in large part by legislative changes;
— there are shortfalls in pension funds; and
— water industry input prices rise faster than RPI
resulting in a "real price effect".
A.24 The last point is of particular significance. The
cost structure of the water industry does not reflect the make
up of the RPI. For example:
— labour is acknowledged as having at least a 2%
RPE;
— non-controllable costs, such as business taxes
and EA charges, have been rising at 5% faster than RPI in recent
years; and
— there is a widespread anticipation that power
prices will rise steeply as over-capacity in generation and supply
is eliminated and transmission and distribution charges begin
to rise faster than inflation.
A.25 Together these changes mean that the water industry
faces real price increases of nearly 1% pa before any savings
can be made.
MAINTAINING ASSETS
A.26 Recent experience in the transport and energy sectors
clearly shows the negative effects that utility asset failure
can have on the rest of the economy. Be it concern about security
of supply, public health or specific asset failure, the consequences
of things going wrong in utilities is far greater than the consequences
of things going right. This suggests a precautionary approach
to the Price Review in general, and to capital maintenance in
particular.
A.27 We believe that there are three key reasons why
maintenance expenditure must rise if we are to meet this objective.
— Assets are ageing and their condition is deteriorating.
— The post-privatisation investment in new quality
obligations is moving out of its maintenance holiday period.
— There are a number of extraordinary lumpy investments
to be undertaken.
A.28 Taking all factors together we consider that there
is a need to increase capital maintenance expenditure by 17% in
AMP4. However we estimate this increase in investment will only
add 2.5% pa to customer's bills.
THE COST
OF CAPITAL
A.29 Wessex Water has outperformed the AMP3 capital and
operating expenditure targets by around 10%. This outperformance
has produced financial returns that are in excess of Ofwat's 1999
view of the cost of capital. But Water companies have been trading,
and have been sold, at values well below their Regulated Capital
Values for the whole of the AMP3 period. This clearly suggests
that returns have been set below the cost of capital.
A.30 It is unclear exactly what this discount has been
but the broad consensus is that it is in the region of 5-10%.
This range is consistent with the discount Wessex Water was sold
for in 2002. Together this evidence suggests that the allowed
rate of return in 1999 was up to 1% below the cost of capital.
A.31 Setting returns at least equal to the cost of capital
is vital if the industry is able to continue to attract the finance
that is necessary to undertake its investment programmes.
A.32 Over the last few years the reduction in equity
in the UK water industry has been as a direct result of returns
being below the cost of capital. Equity players have taken advantage
of the availability of relatively cheap debt market to improve
their returns. However, it is by no means clear that this trend
can continue in the medium term. The cost of debt is already moving
back up towards its long term level, and the tax advantages of
additional gearing are being passed on to consumers, so making
"securitisation" less attractive.
A.33 It is also unclear whether the bank and capital
markets will be able to finance the industry on their own. Like
equity markets, debt markets also require sufficient returns before
they are willing to invest and, by definition, also have limited
capacity.
A.34 Wessex Water's owners, YTL, do not wish to increase
the indebtedness of WWSL, and hence their return on capital employed,
by moving to a highly geared, securitised, financial structure.
They are comfortable with the fundamentals of the UK regulatory
system and would, in principle, be prepared to consider a further
investment. However the action they take post 2005 will depend
upon whether the allowed rates of return reflect the cost of capital.
THE COST
OF RUNNING
THE BASE
BUSINESS
A.35 Because of our out-performance to date, and the
scope for further efficiencies in the future, we should be able
to continue to meet existing standards within existing charges.
This is despite having to invest significantly more to maintain
our assets and make good shortfalls in our pension fund.
A.36 However, there are changes in Inland Revenue tax
rules that we are unable to control. The imposition of these changes
mean customer bills for the same level of service need to increase
by 2.75% over five years.
A.37 In addition, the continued need to invest to meet
growth demands from new customers adds a further 1.25% over five
years.
MEETING NEW
QUALITY AND
ENVIRONMENTAL STANDARDS
A.38 With this unavoidable upward pressure on costs,
and customers' desires for bills to go up by no more than 10%
over five years, we have looked critically at the quality and
environmental and service improvement programme. We have concluded
that certain improvements represent better value for money than
others, and that customers are more likely to support certain
outputs than others.
A.39 In particular we consider that an investment in
eliminating the risk of internal sewage flooding at a cost of
around £5 per customer represents a better use of funds than
a number of the environmental requirements contained within Reference
Plan A or Reference Plan B.
A.40 Consequently, and in order to strike a balance between
all our stakeholder interests, our preferred plan defers certain
statutory outputs where the benefits do not exceed the costs,
specific examples of this include:
— Phosphorus removal is required on the Hampshire
Avon but, despite a major investment the river would remain eutrophic
unless diffuse pollution is also dealt with, and
— Dry-weather-flow exceedence at a number of our
sewage treatment works where there is a technical breach of consent
which has no negative consequence on river water quality.
A.41 The Board are however clear that if environmental
outputs are put forward that have customer support, provided the
returns to investors is adequate, it will support and carry out
the necessary investment.
BILLS AND
PRICE LIMITS
A.42 Our approach to the draft business plan allows Wessex
to constrain price increases below the level required by Reference
Plans A or B. The detailed impact on bills in AMP4 for each of
the three Plans is given in the table below. Because of the interaction
of many of the influences on bills it is often difficult to be
precise as to the exact influence of each. Nonetheless, in the
interests of transparency we have attempted to break out each
component part—at least to an accuracy of plus or minus
0.5%.
| Drivers of changes to bills | Company Plan
| Reference Plan A | Reference Plan B
|
| | |
|
| Passing back past outperformance | -1.50%
| -1.50% | -1.50% |
| Future efficiency | -1.50% |
-1.75% | -1.75% |
| Maintaining assets | +2.50%
| +2.50% | +2.50% |
| Taxation | +3.25% | +3.25%
| +3.25% |
| Running the existing business | +2.75%
| 2.50% | 2.50% |
| Balancing demand and supply | +1.25%
| +1.25% | +1.25% |
| Sewage flooding | +1.75% |
+1.75% | +2.00% |
| Quality and environmental improvements |
+6.25% | +7.25% | +11.50%
|
| Total bill impact by 2010 | +12.00%
| +12.75% | +17.25% |
| Average annual bill rise | +2.3%
| +2.4% | +3.2% |
| | |
|
Although our preferred plan seeks an increase in customers'
bills by an average of 12% over five years, price limits are set
to ensure the company has enough revenue to fulfil its obligations.
All else being equal, revenue goes down each year, primarily as
a consequence of meter options and a decline in sewerage requisition
revenue. To cover these two items price limits must rise by an
additional 0.6% p.a.
SUMMARY
Ensuring a sustainable outcome requires companies to balance
the interests of all the stakeholder groups. Inevitably that means
compromise and it is not sustainable to favour one group at the
expense of another.
Wessex Water believes there is natural pace of improvements
which is driven by consumer's willingness and ability to pay and
the legitimate and necessary requirements of the financial markets.
Current evidence suggests that willingness to pay is limited
by increases in household income and that returns to the provider
of capital are inadequate. However, it may be that more can be
done to explain the value of quality and environmental improvement
to consumers and hence alter the existing balance.
17 October 2003
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