Memorandum submitted by Ofwat
SUMMARY
In July 2004 we will set draft price limits
for the water and sewerage companies in England and Wales, for
consultation, followed by our final decisions in November 2004.
These will be based on companies' final business plans, which
they will submit in April 2004. We must by law set price limits
that are high enough to enable well managed companies to run their
businesses. But, to protect the interests of customers of these
monopoly companies, prices should be no higher than they have
to be.
Price increases for many companies' customers
are needed simply to maintain the huge improvements made over
the last 15 years. There are also upward pressures on bills at
this review. These include new requirements to improve drinking
water and environmental quality, and changes in taxation, capital
maintenance and financing. Other potential upward pressures on
bills, for example the new Bathing Water Directive and
adoption of private sewers have not been included in companies'
business plans.
In August, the water and sewerage companies
published their draft proposals for price limits for the period
2005-10. This paper concentrates on the issues coming out of the
draft plans that impact most on price limits. Average industry
price limits could rise in real terms by 6% each year, more than
30% over the period 2005-10, based on the companies' proposals.
At the extreme, United Utilities has made proposals that could,
if accepted, lead to an increase of £173 in the average bill
for its customers.
We are scrutinising the draft plans carefully.
We will question each company and, where we do not consider its
proposals are fully justified, challenge them. The submission
of the draft plans early in the process is proving invaluable
as a basis for working with other regulators and water companies
to ensure we have good quality final plans next year.
In January 2004, Ministers will issue their
principal guidance on the quality and environmental obligations
they expect the companies to cost in their final plans and deliver
in 2005-10. This will follow advice from us which we will provide
in December and from the Environment Agency, English Nature and
the Drinking Water Inspectorate on the outputs to include in their
guidance. We expect outputs to be properly costed by companies
and deliver clear enhancements, in line with sustainable development
principles.
In making our decisions on price limits we must
consider customers' interests. WaterVoice, which represents customers'
views, will provide us with its views on future price limits.
With others we are conducting joint customer research into customers'
opinions and priorities for investment. This research will be
published in December. However, we know from our postbag and press
coverage that customers are concerned about the future level of
bills and the affordability of those bills. Earlier research found
that customers are satisfied with tap water supply, sewerage services
and value for money and they see little need to improve the current
service they receive.
We will all need to test the priority and value
of the proposed improvements and the outputs that we expect to
be delivered by each company. Our early analysis shows that there
will be hard choices to make if we are to limit the cost pressures
faced by companies to those that can be appropriately financed,
and to set price limits that are affordable. Unless the scale
and pace of the proposed outputs are changed, customers will face
very significant increases in bills in order to pay for them.
PRICE SETTING
1. Our primary duty is to enable efficient
companies to carry out and finance their functions under the Water
Industry Act 1991. Our role is to set price limits that allow
each company to do this while protecting the interests of customers.
The approach we intend to take at this review is published in
"Setting water and sewerage price limits for 2005-10:
Framework and approach" (March 2003).
2. In the New Year, Ministers will publish
their principal guidance on the outputs they expect companies
to deliver in 2005-10. Their guidance will be developed on the
basis of advice from the quality regulators; the results of the
customer research setting out customers' priorities and what they
are prepared to pay; and advice we will provide on the costs and
implications for customers' bills.
DRAFT BUSINESS
PLANS
3. In August 2003 each company submitted
its draft business plan to Ofwat. The plan allows each company
to set down and explain its application for price limits. We expected
the plans to include all the challenges facing the company in
the price limit period 2005-10.
4. Three companies Anglian, United Utilities
and Northumbrian have also sought agreement to increases in bills
for 2004-05 under the "interim determination" procedure.
If granted this would reduce the increases sought from 2005 onwards.
PREFERRED STRATEGIES
5. The price limits proposed by each company
based on its preferred strategy are set out in annex 1. Annex
2 includes each company's projections of its annual average household
bills from 2004-10. The industry average increase in price limits
would be 6% each year, over 30% in the period 2005-10. On average,
companies project an increase of £72 in the average water
and sewerage bill, taking the average bill in 2004-05 from £234
to £306 in 2009-10. Companies' proposals cover a range of
increases. United Utilities is seeking the largest with an average
annual increase to its price limits of 12%, which would increase
its average bills from £243 in 2004-05 to £416 in 2009-10.
6. Most companies' profile of price limits
includes a large increase in 2005-06 and smaller changes thereafter.
Some companies including United Utilities and Yorkshire are seeking
a more even profile of similar price limits in all five years.
REFERENCE PLANS
7. As well as setting out their preferred
strategies in their plans, each company produced reference plans
including a defined package of quality and environmental improvements.
These were based on assumptions, set by us, about the cost of
capital, the scope for future efficiencies, the level of meter
optants and RPI. Companies have generally indicated that they
believe our assumptions to be too severe. These assumptions are
not predictions of the assumptions we will use to set price limits.
All the data set out in this paper is based on the projections
of costs and revenues provided by the companies.
8. The purpose of the reference plans is
to give us an indication of the prospects for price limits of
a range of quality and environmental outputs. Plan A, which all
companies completed, resulted in similar average price limits
to the companies' preferred strategies. A more extensive quality
and environmental programme was included in plan B. For the purposes
of this paper our focus is on the companies' preferred strategies.
9. Our work going forward will focus on
each company's preferred strategy. We will meet each company to
discuss issues in its draft plan, so the final business plan in
April 2004 provides us with the information we need to set price
limits. The areas we want to explore for each company are set
out in annex 1 of "Setting water and sewerage price limits
for 2005-10: Overview of companies' draft business plans"
(October 2003).
ISSUES ARISING
FROM THE
DRAFT BUSINESS
PLANS
10. Ministers will give guidance to Ofwat
on the scale and scope of the quality and environmental obligations
they want delivered. We will work with the quality regulators
to test the cost effectiveness of the programmes proposed.
11. The table below sets out the areas of
expenditure that are driving the proposed changes in the average
bill coming out of the companies' preferred strategies. This identifies
the items that will have a major impact on customers' bills and
guides the issues we will be following up with companies. Proposed
increases to the costs of base service levels and new quality
and environmental obligations would have the biggest impact on
customers' bills.
WHAT IS
DRIVING THE
COMPANIES' PROPOSED
CHANGES IN
BILLS IN
ENGLAND AND
WALES (£S)?
| Average household bill in 2004-05
| | 234 |
| Less | (1) past efficiency savings and outperformance
| (8) |
| (2) scope for reduction through future efficiency improvements
| (10) |
| Plus | (3) maintaining base services of which
| 37 |
| (a) changes in revenue
| 3 |
| (b) changes in operating costs
| 6 |
| (c) changes in capital maintenance
| 19 |
| (d) impact of taxation
| 9 |
| (4) improving services of which
| 41 |
| (a) drinking water quality
| 10 |
| (b) environmental improvements
| 26 |
| (c) service performance (mostly sewer flooding)
| 5 |
| (5) maintaining security of supply to all customers
| 12 |
| Average household bill in 2009-10 |
| 306 |
OPERATING COSTS
12. The industry is proposing net increases of nearly
8%, after taking account of efficiency improvements it is proposing
to make to its operating expenditure. Pension costs are the most
significant element. Many companies have also expressed concerns
about the effect on future costs and revenues of bad debt as a
result of the ban on disconnections. Some include additional costs
in their proposals. The section on incentives and efficiency (paragraph
32) sets out the efficiency improvements companies propose making
in more detail.
13. Companies' proposals span a wide range of increases
and, where appropriate, we are challenging individual companies'
justifications. However, we expect companies to be able to make
some efficiency savings in the period 2005-10, above the general
improvements in the economy at large.
TAXATION
14. Tax changes will lead to a step increase in the level
of tax the companies pay in 2005-06 and beyond. Until now, corporation
tax has not been a significant driver of the changes in customers'
bills year-on-year. However, from 1 April 2005, the Inland Revenue
is changing the way it will treat certain types of expenditure.
In general, the impact is larger for water and sewerage companies
(equivalent to a 3% increase in price limits in 2005-06). Where
the water only companies have quantified the impact, it leads
to a 0% to 4.5% increase in price limits in 2005-06.
15. Another possible change is in accounting standards,
which would have a knock-on effect on the timing of tax deductions
for some underground assets. This has not been included in companies'
plans.
ENVIRONMENTAL AND
DRINKING WATER
QUALITY IMPROVEMENTS
16. Although the scope of work included by companies'
in their preferred strategies was based on reference plan A, there
were some differences in the quality enhancements companies chose
to include. In total, companies' preferred strategies include
expenditure of £6.9 billion for water quality and environmental
improvements. For reference plan B, which assumes a larger quality
and environmental programme, companies' proposals are £12.7
billion. The key water service and environmental improvements
included in companies' plans are set out in annex 3.
17. For comparison the determination in 1999 assumed
investment of £7.9 billion (in 2002-03 prices) for quality
and environmental improvements for 2000-05, the largest quality
programme ever. The Environment Agency responded warmly at that
time, its then Chairman Lord De Ramsey said "By 2005 we will
have reached a position where the significant environmental damage
created over the past 200 years will have been repaired."
18. There are other pressures on prices that companies
have identified, but not incorporated into their plans. These
include estimates, for example to protect the quality of the Thames
Tideway during heavy rain. Companies also suggest that planning
for the implementation of the Water Framework Directive could
add to their costs. Most of the costs arising from the Directive
will only be incurred from 2010 onwards. The Environment Agency
will be consulting on the draft River Basin Management Plans in
2007-08. Companies will need to provide information on practical
measures they may need to take to implement them.
CAPITAL MAINTENANCE
19. At an industry level companies are seeking increases
in prices to fund significant extra capital expenditure. In total,
companies are seeking to spend £1.7 billion more than their
current plans for 2000-05, an increase of 23% over their current
base service. The main reasons given for this increase are the
need to maintain serviceability (the ability of assets to maintain
services to customers now and in the future); and sustain levels
of services for customers.
20. Companies are funded through price limits to maintain
their assets to a stable condition. Our current assessment is
that companies' asset systems are stable, with the exception of
above ground sewerage assets (mostly sewage treatment works) which
we assess as marginal. (Our judgements range from improving, stable,
marginal to deteriorating and individual company performance spans
this range.)
21. There are wide variations. Some companies seek increases
of almost 80%. Two, Bournemouth and West Hampshire and Portsmouth,
(both water only companies), foresee reductions. Some companies
have presented well-argued justifications for their proposals
based on sound asset performance information, but in other cases
the justifications are weaker.
MAINTAINING SECURITY
OF SUPPLIES
22. Overall, companies' plans suggest almost a three-fold
increase, from £1.1 billion (2000-05) to £2.8 billion
(2005-10), in investment to maintain the balance between supply
and demand for both the water and sewerage services. Thames Water's
plans to invest to resolve leakage and supply issues in London
contribute significantly to this. Although companies expect demand
for water to be broadly flat up to 2010, many argue that their
revenue base is likely to be adversely affected by metering and
reduced commercial and industrial demands.
SERVICE PERFORMANCE
23. The sewerage companies have proposed investing £1.6
billion to address most of the worst known cases of properties
at risk of sewer flooding and some of the worst cases of external
sewer flooding.
ACCOUNTING FOR
CAPITAL PROGRAMMES
24. Capital expenditure is not directly reflected in
price limits, and hence in customers' bills, in the year in which
it is incurred. Instead, the cost is recognised over the period
the assets are used, through either current cost depreciation
(CCD) or the infrastructure renewals charge (IRC), together with
a return on the capital invested.
25. We expect depreciation on base service assets to
remain stable over a five-year price setting period with a broadly
neutral effect on customers' bills, although this is not reflected
in all companies' plans. Investment in new assets results in additional
depreciation and hence an increase in customers' bills year-on-year.
At an industry level, companies are projecting CCD of £8.5
billion for the five years 2005-10, compared to £6.6 billion
allowed in price limits for 2000-05. This contributes, on average,
an increase of 4% to price limits in 2005-06 and a further increase
of up to 1% per annum for the period 2006-10.
26. Infrastructure assets are not depreciated, instead
infrastructure renewals accounting is used. The infrastructure
network is treated as a single asset system to be maintained in
perpetuity. An annual charge, the IRC, is made against profits
for the annualised costs of maintaining the system. Expenditure
to maintain and replace the network is infrastructure renewals
expenditure (IRE). We expect the level of IRC to be broadly constant,
in real terms, over the medium term, assuming networks are in
a steady state.
27. At an industry level, companies are projecting IRC
of £3.1 billion for the five years 2005-10 compared to £2.1
billion allowed in price limits for 2000-05; and stepped increases
in levels of IRE. At an industry level this contributes an increase
of 3% in price limits in 2005-06.
COST OF
CAPITAL
28. We must act in a way that allows companies to finance
their functions, in particular by securing reasonable returns
on their capital. The cost of capital is the minimum return investors
will accept for investing in a particular company. Because it
is applied to the entire capital base of each company it is a
highly significant element within the determination of price limits.
If it is set too low companies may experience difficulties in
financing their investment programmes; too high and shareholders
earn windfall returns.
29. The range of company estimates for the weighted
average cost of capital (WACC), equity and debt, including all
premiums for water and sewerage companies is 5.2% to 5.8% on a
post tax basis. For the water only companies this range is 5.7%
to 6.9%. This compares with the average of 5.0% used for water
and sewerage companies at the periodic review in 1999. All of
the companies argue in their draft business plans that the WACC
used at the last review was too low.
FINANCEABILITY
30. There are two strands to our duty to allow companies
to finance their functions. One is to ensure that if a company
is efficiently managed and financed it earns a return equal to
the cost of capital. The second is do its revenues, profits and
cash flows allow it to raise finance on reasonable terms in the
capital markets: "Financeability". For some companies
a significant element of the price increase sought in 2005-06
is required in order to achieve what, in their view, is an acceptable
financial profile. This is in order to allow them to maintain
their view of the necessary level of financial indicators to provide
assurance to investors, and allow them to secure finance to fund
new capital expenditure projects.
EFFICIENCY AND
OUTPERFORMANCE
31. We operate an incentive-based regulatory regime.
Mechanisms are in place to encourage companies to innovate and
become more efficient. Companies that beat our assumptions benefit
financially. Where companies fail to meet our expectations they
bear the costs. We recently consulted on proposals to provide
enhanced rewards for outperformance.
32. At an industry level the assumptions on operating
cost efficiency in the companies' preferred strategies would result
in base operating costs reducing by around 2% each year, equivalent
to an annual reduction in the average bill of about 1%. This is
about half the level that we included in the assumptions we provided
to companies for inclusion in the reference plans. For capital
efficiency companies have, in aggregate, assumed savings of about
4% on the total capital programme for 2005-10 in their preferred
strategies. The easiest gains following privatisation have now
been made and companies have outperformed efficiency targets since
2000 by much less than in the 1990's.
PUBLIC DEBATE
33. Since companies published their draft business plan
proposals our postbag has included concerns from customers and
elected members about the prospects for customers' bills. The
main focus has been on the affordability of bills, particularly
for customers that are in receipt of benefits, pensions or are
on low incomes. The impact of more customers facing debt as a
result of increasing water bills and the cost to other customers
of managing that debt is also causing concern.
NEXT STEPS
34. Further research is being conducted based on the
proposals included in the draft plans. The results will be published
in early December and will provide us with an understanding of
customers' priorities for further investment and what they are
willing to pay.
35. We will be advising Ministers on the prospects for
price limits and will publish a broad summary of our advice later
in December. In January 2004, Ministers will issue their principal
guidance on drinking water quality, environmental improvements
and social issues. Based on this companies will submit their business
plans in April 2004.
36. In July 2004, we will publish, for consultation,
our draft determinations of what price limits should be for the
five years beginning 1 April 2005. This will be followed by publication
of the final price limits in November 2004. Companies can ask
us to refer our determinations to the Competition Commission if
they do not accept our decisions. The new price limits will be
reflected in customers' bills for the year beginning 1 April 2005.
15 October 2003
Annex 1
PRICE LIMITS INCLUDED IN EACH COMPANY'S PREFERRED STRATEGY*
(%)
| 2005-06 | 2006-07
| 2007-08 | 2008-09
| 2009-10 | Annual
Average
|
| Water and sewerage companies |
| | | |
| |
| Anglian | 20.8 | 5.7
| 5.2 | 5.8 | 5.8
| 8.5 |
| Dwr Cymru | 9.4 | 4.8
| 4.3 | 4.1 | 3.1
| 5.1 |
| Northumbrian** | 20.7 | 6.8
| 3.7 | 2.6 | 1.3
| 6.8 |
| Severn Trent | 13.3 | 3.7
| 1.6 | 0.7 | -0.4
| 3.7 |
| South West | 9.5 | 6.6
| 5.5 | 4.0 | 3.5
| 5.8 |
| Southern | 10.7 | 5.3
| 6.2 | 6.2 | 1.9
| 6.0 |
| Thames | 16.6 | 1.1
| 0.5 | -0.3 | -0.1
| 3.4 |
| United Utilities | 11.9 | 11.9
| 12.0 | 12.1 | 12.3
| 12.0 |
| Wessex | 6.3 | 2.8
| 2.3 | 2.0 | 1.5
| 2.9 |
| Yorkshire | 3.6 | 3.6
| 3.6 | 3.6 | 3.6
| 3.6 |
| WaSC average*** | 13.1 | 5.3
| 4.6 | 4.2 | 3.6
| 6.1 |
| Water only companies |
| | | |
| |
| Bournemouth & W Hampshire | 9.5
| 4.4 | 4.4 | 4.4
| 4.4 | 5.4 |
| Bristol | 11.0 | 1.0
| 1.0 | 0.0 | 0.0
| 2.5 |
| Cambridge | 23.4 | 5.4
| 2.6 | 1.7 | 1.5
| 6.6 |
| Dee Valley | 15.0 | 1.6
| 1.6 | 1.6 | 1.6
| 4.1 |
| Folkestone & Dover | 5.8 |
5.8 | 5.8 | 5.8 |
5.8 | 5.8 |
| Mid Kent | 6.9 | 6.9
| 3.3 | 3.3 | 3.3
| 4.7 |
| Portsmouth | 6.7 | 3.6
| 2.7 | 1.8 | -0.3
| 2.9 |
| South East | 22.7 | 2.2
| 1.6 | 0.1 | -0.4
| 4.9 |
| South Staffordshire | 6.9 |
2.2 | 1.8 | 0.2 |
1.7 | 2.5 |
| Sutton & East Surrey | 17.0
| 2.0 | 2.0 | 2.0
| 2.0 | 4.8 |
| Tendring Hundred | 6.3 | -0.3
| 0.6 | 0.9 | -1.2
| 1.2 |
| Three Valleys | 16.5 | 5.0
| 5.0 | 5.0 | 5.0
| 7.2 |
| WoC average*** | 14.0 | 3.5
| 3.0 | 2.4 | 2.3
| 4.9 |
| Industry Average*** | 13.2 |
5.1 | 4.5 | 4.1 |
3.5 | 6.0 |
| | |
| | | |
*The price limits are annual price limits for each company
and are taken from the company's preferred strategy for their
draft business plans. The percentage increase does not reflect
inflation.
**The price limit for Northumbrian Water incorporates the
limits for the Northumbrian Water area and the Essex & Suffolk
Water area.
***Each average has been weighted according to the size of
each company's turnover.
Annex 2
COMPANY PROJECTIONS OF AVERAGE ANNUAL HOUSEHOLD BILLS
FROM 2004 TO 2010 (£s)
| Company preferred strategy
| | | |
| |
| 2004-05
| 2005-06 | 2009-10
|
| Water and sewerage companies |
| | | |
| |
| water | sewerage
| water | sewerage | water
| sewerage |
| Anglian | 115 | 162
| 129 | 198 | 145
| 234 |
| Dwr Cymru | 119 | 156
| 134 | 173 | 155
| 195 |
| Northumbrian | 87 | 115
| 104 | 141 | 118
| 161 |
| Essex and Suffolk | 111 |
| 131 | | 149 |
|
| Severn Trent | 110 | 100
| 123 | 114 | 128
| 120 |
| South West | 121 | 213
| 131 | 228 | 151
| 256 |
| Southern | 91 | 160
| 101 | 177 | 123
| 216 |
| Thames | 104 | 92
| 141 | 94 | 146
| 93 |
| United Utilities | 119 | 124
| 128 | 143 | 167
| 249 |
| Wessex | 120 | 144
| 127 | 152 | 135
| 161 |
| Yorkshire | 114 | 123
| 119 | 126 | 140
| 138 |
| WaSC average* | 110 | 124
| 126 | 138 | 143
| 164 |
| Water only companies |
| | | |
| |
Bournemouth &
W Hampshire | 101
| | 109 | |
125 | |
| Bristol | 103 |
| 114 | | 116 |
|
| Cambridge | 86 |
| 105 | | 115 |
|
| Dee Valley | 102 |
| 116 | | 120 |
|
| Folkestone & Dover | 140 |
| 48 | | 186
| |
| Mid Kent | 123 |
| 131 | | 152 |
|
| Portsmouth | 73 |
| 78 | | 84 |
|
| South East | 123 |
| 151 | | 156 |
|
| South Staffordshire | 87 |
| 93 | | 99
| |
| Sutton & East Surrey | 122
| | 142 | |
154 | |
| Tendring Hundred | 152 |
| 160 | | 157 |
|
| Three Valleys | 114 |
| 132 | | 155 |
|
| WoC average* | 108 |
| 123 | | 136 |
|
| Industry Average* | 110 |
| 126 | | 142
| |
| | |
| | | |
*Each average has been weighted according to the size of
each company's turnover.
Annex 3
THE KEY WATER QUALITY AND ENVIRONMENTAL IMPROVEMENTS INCLUDED
IN COMPANIES' PLANS
WATER
— Upgrades to water treatment works to comply with
quality standards for nitrates (£0.75 billion).
— Completion of work to replace rusty water distribution
mains (£0.85 billion).
— Replacement of companies' lead pipework which
supplies individual properties, with an estimated cost of between
£0.3 to £1.2 billion depending on the extent of replacement.
— Improving the acceptability of drinking water
to customers (taste, odour, appearance and hardness) at a cost
of £0.3 billion.
SEWERAGE
The main environmental improvements include:
— Dealing with environmentally unsatisfactory overflows
from the sewerage system (£1.9 billion).
— Improving rivers to be more favourable to fish
populations (£1.4 billion).
— Improving the microbiological quality of coastal
and estuarial waters used for shellfish harvesting (up to £2
billion).
— Removal, from sewage effluents, of chemicals classified
as dangerous (£0.3 billion).
— Removing nutrients from sewage treatment works'
effluents in order to protect nature conservation sites (£0.8
billion).
— Finding alternative sources of water to replace
those causing damage to nature conservation sites. The cost of
this could range between £0.1 to £0.6 billion.
| 
