Memorandum submitted by Severn Trent Water
(Ofwat 14)
1. EXECUTIVE
SUMMARY
1.1 Ofwat's Price Review 2009 (PR09) is
taking place against a very different backdrop to previous Periodic
Reviews. The economic climate is much more challenging and water
companies must deal with new strategic and operational challenges,
such as managing the impacts of climate change.
1.2 We believe there are a number of key, unresolved
issues for PR09 which, if tackled as we outline below, could ensure
that customers benefit from lower bills, companies invest to provide
the services customers are willing to pay for and the UK as a
whole benefits from lower carbon emissions.
1.3 Affordability—We believe there
is a need to keep bills as low as possible for customers and we
aim to do this in our Final Business Plan (FBP) submission to
Ofwat. There are, however, a number of uncontrollable costs which
impact significantly on the water sector, including Traffic Management
Act costs, potential increases in abstraction licence charges,
increases in business rates, cumulo rates (business taxes levied
by central Government) and Ofwat's licence fees. These costs challenge
our ability to minimise any bill increases for customers and we
believe there should be scope for keeping these charges to a minimum
to help keep water bills affordable. This will require co-operation
across regulators and Government.
1.4 Climate change, environmental improvements
and carbon—There is a recognised need for Severn Trent
Water (STW) and other water companies to play our part in meeting
the Government's challenging carbon reduction targets. Our FBP
includes plans to generate more renewable electricity and reduce
our own energy use. Severn Trent currently generates 17% of its
own electricity and plans to increase this to 30% by 2013. Our
plans to reduce our own energy requirement will, however, be offset
by the major increase in energy use resulting from implementing
statutory quality programmes such as the Water Framework Directive
(WFD). Given the importance of reducing carbon emissions, we propose
there is a need to freeze the implementation of the WFD in its
current form while Government in the UK and the European Union
(EU) further consider the carbon impacts. In addition, this would
also help to keep bills affordable in the current economic climate
by reducing investment requirements and operating costs.
1.5 The conduct of the review—It
is essential, we believe, for Ofwat to consider our plan as a
package and for Ofwat not to simply accept some elements of the
plan and reject others, as has been a criticism in previous reviews.
STW has put together a holistic and balanced business plan, based
on our 25 year Strategic Direction Statement (SDS), published
in December 2007. Our plan assesses the investment required to
meet the challenges set out in that strategy in the most cost-effective
manner, along with the financing and efficiency projections associated
with that programme.
1.6 The RPI-X regulatory mechanism is now
more than 20 years old and is currently under review by the energy
regulator Ofgem. We believe that this review will also have relevance
for the water industry.
1.7 For these reasons, we believe that a
review of the regulatory framework for economic, quality and environmental
regulation is appropriate in the longer term, that is, after PR09
is concluded.
1.8 We believe it is essential to maintain
investor confidence and maintain a sustainable financial profile
for the industry over the short, medium and longer term. The major
investment programme since privatisation has in the main been
funded through debt. Our financial modelling suggests that further
investment required to meet statutory obligations could result,
for Severn Trent Water, in an amount of debt per customer of £2,600
by 2035 and we question whether this is financially sustainable.
A review of the framework should therefore address this critical
issue.
1.9 Further information on these key issues
is set out in the remainder of this response.
2. INTRODUCTION
AND CONTEXT
2.1 Severn Trent Water (STW) is the second
largest water company in the England and Wales, providing drinking
water to 7.4 million people and waste services to 8.5 million
people across the Midlands and mid-Wales. We welcome the opportunity
to provide written evidence to this short inquiry.
2.2 Ofwat's Price Review 2009 (PR09) is taking
place against a very different backdrop to previous reviews. The
economic climate is much more challenging, with the economy going
into recession and the spectre of deflation for which the regime
was not designed. This heightens the need to keep bills affordable
and increases to a minimum whilst still ensuring that the industry
continues to be able to gain access to the financial markets given
the dependency upon raising debt to make the investment required
inter alia to meet statutory obligations. In addition,
companies are facing a tougher environmental challenge, with recent
flooding events demonstrating the need to invest to cope with
the predicted impacts of climate change such as increased flooding
and evidence pointing to an imbalance and scarcity of water resources
going forwards. This is in addition to a continuing programme
of environmental improvements, such as the Water Framework Directive
(WFD).
2.3 There are a number of pressing key issues
which we believe need to be resolved as part of the PR09 process.
These issues align with the points set out in your terms of reference
and we set out our views on them below.
3. AFFORDABILITY
3.1 We aim to keep bills as low as possible
for customers. We are in the final stages of preparing our Final
Business Plan (FBP); our Draft Business Plan (DBP), submitted
to Ofwat in August 2008, delivered bills in 2014-15 which were
only around 1% higher, in real terms, than at the start of the
five year period for which prices are being determined, referred
to as AMP5.
3.2 We were able to deliver this by setting ourselves
challenging efficiency targets for both capital expenditure and
operating expenditure. Our DBP included efficiency targets of
7% on capital expenditure and 12% on operating expenditure over
the AMP5 period.
3.3 There are a number of uncontrollable
costs, however, which impact significantly on the water sector.
The chart below illustrates the impact of these costs on our operating
costs during the AMP5 period:
Figure 1
ANALYSIS OF OPERATING COST MOVEMENTS FOR
SEVERN TRENT WATER FOR 2010-15
As Figure 1 shows, these costs clearly challenge
our ability to keep our costs and therefore bills for customers
down. The impact of quality programmes and `quasi taxes' is around
£55m which adds around £7.00 onto a customer's bill
(of circa £300). We believe that, particularly in the current
economic climate, there should be scope for keeping these charges
to a minimum to help keep water bills affordable.
4. CLIMATE CHANGE,
ENVIRONMENTAL IMPROVEMENTS
AND CARBON
4.1 The Climate Change Bill incorporates
targets to reduce carbon dioxide emissions for the UK by 26-32%
by 2020, and by 60% by 2050. As the fifth biggest energy user
in the UK, the water industry will be expected to make a significant
contribution to these targets and Severn Trent is seeking to make
carbon reductions in line with Government targets.
4.2 STW is the biggest generator of renewable
energy in the UK water sector, largely due to our combined heat
and power operating on biogas from sludge digestion. Our current
annual electricity generation is 157 GWh per year (17% of annual
usage) and it is largely utilised to supply our own operational
sites. This self-supply of electricity reduces our carbon footprint
and lowers operating costs. To further this leadership position
we are seeking to pursue opportunities to expand our renewable
generation in 2010-15 (referred to as the AMP5 period).
4.3 Our FBP includes plans to generate more
renewable electricity and reduce our own energy use. We are also
investing, outside the regulated water services business, in wind
power and energy crops. Our target is to generate 30% of electricity
from renewable sources by 2013.
4.4 The work we will be doing to reduce
our carbon emissions over the next five years, however, will be
offset by the huge increase in energy use, and therefore emissions,
from implementing the statutory quality programmes such as the
WFD. This is set out in Figure 2 below:
Figure 2
DRIVERS OF GREENHOUSE GAS EMISSIONS CHANGES
IN AMP5 2010-15 FOR SEVERN TRENT WATER
4.5 Given the importance of reducing carbon
emissions, we believe there should be scope for reviewing these
statutory obligations and propose that there is a need to freeze
the implementation of the Water Framework Directive while Government
in the UK and EU consider the energy use required.
4.6 Freezing environmental standards at
their current levels will also help to keep bills affordable in
the current economic climate. In addition, in our Willingness
to Pay research, undertaken in 2007 and 2008 to research what
improvements, if any, customers are willing to pay for, customers
found the environmental quality spend the most difficult to understand
or justify, although they were willing to pay for the improvements
to river quality set out.
5. THE CONDUCT
OF THE
REVIEW
5.1 We believe there has been an improved
focus on strategic issues and longer term planning by Ofwat and
the companies for PR09. We have put together a holistic and balanced
business plan, based on our SDS, "Focus on Water", which
we published in December 2007.
5.2 Our business plan assesses the investment
required to meet the challenges set out in our SDS, including
the impact of climate change, continuing growth in demand and
the increasing importance of affordability in the most cost-effective
manner.
5.3 Some of the investment proposed in our
business plan will provide benefits in more than one area. For
example, some of the proposed expenditure to improve the resilience
of our assets will also have benefits for our supply/demand balance.
5.4 The plan also includes proposals for
ensuring investor confidence in order to finance the investment
programme and as mentioned above, a challenging capital and operating
efficiency programme. However, these elements of the plan must
be balanced together and accepted as a package to enable us to
deliver the best outcomes for customers and the environment.
5.5 In our discussions with Ofwat's Executive
team, it is clear that they understand and welcome the holistic
nature of our plan and our recognition of the customer burden.
There is, however, a risk that, at working level, Ofwat may still
consider elements of the plan in isolation, with little appreciation
of the bigger strategic picture. We have concerns that this could
lead to a price determination which will not provide the best
outcome for customers, the environment and investors. We believe
it is imperative that Ofwat recognises the holistic nature of
our plans and considers our proposals in their entirety in reaching
their price determination.
6. THE REGULATORY
FRAMEWORK
6.1 The RPI-X regulatory mechanism is now
more than 20 years old and regulators and commentators in the
energy sector are currently reviewing whether it is still the
most appropriate mechanism for regulating the sector to meet the
challenges of the twenty-first century (through the so-called
Ofgem RPI-X@20 review). We believe that this review will also
have relevance for the water industry; however, it is not due
to report until the end of 2010.
6.2 One central issue for the water sector, however,
will be the need to maintain investor confidence and to have a
sustainable financial profile for the industry over the short,
medium and longer term. The scale of the industry investment programme
since privatisation (around £70 billion), coupled with the
fact that customers pay for improvements typically over many years,
has led to the providers of debt, rather than customers, funding
the investment programme. From our financial modelling, based
on current debt profiles and the investment programme required
to meet statutory obligations and maintain service levels, we
estimate that industry debt could rise by some £90 billion
by 2035. For Severn Trent Water, the amount of debt equates to
around £1,000 of debt for each customer today, rising to
£2,600 by 2035. This suggests that bills will have to continue
to rise in future years to fund the repayment of this debt and
it is also a concern that such a situation is not financially
sustainable. We also do not believe that this is acceptable to
customers and suggest that Government consider this issue carefully
in its thinking about long-term environmental improvement programmes
and the regulatory framework.
6.3 For these reasons, we believe that a
review of the regulatory framework for economic, quality and environmental
regulation is appropriate in the longer term, that is, after PR09
is concluded.
7. CONCLUSION
7.1 We have limited our comments to those
issues where we believe the EFRA committee inquiry can impact
PR09.
7.2 We believe there are a number of key, unresolved
issues for PR09 which, if tackled as we have outlined, could ensure
that customers benefit from lower bills, companies invest to provide
the services customers are willing to pay for and the UK as a
whole benefits from lower carbon emissions.
Severn Trent Water
February 2009
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