The Director welcomes your views on all of the issues that are addressed in this consultation paper. Please send them to:

If you wish to clarify any points in this paper, please contact Dilys Plant, Head of External Relations (0121 625 1450) in the first instance and she will ensure that your query is dealt with.

Unless otherwise requested, responses will be placed in the Ofwat library and made available to the public.

1. FOREWORD

In the 1999 Periodic Review I shall determine new price limits to come into effect from 1 April 2000 for the water (and sewerage companies) of England and Wales. This paper sets out my proposals for the framework and approach I intend to adopt. It is one of a series of public consultation papers. I shall shortly be publishing a further paper which seeks views on my information requirements for the review and on the business planning process I am minded to adopt.

I intend to conduct an open and transparent process for the review and shall be consulting widely. I wish to give all interested parties ample opportunity to make their views known to me so that I may take them into account when I set price limits in late 1999.

In setting out my proposals and the issues on which I am consulting, I have been mindful of events since 1994 when I last set price limits. I have taken account of the recommendations of the Monopolies and Mergers Commission (MMC) in its reports on South West Water and Portsmouth Water. I have also seen how companies have managed their affairs under the price limits, particularly in regard to their capital programmes.

Following the period of consultation, I shall be publishing early in 1998 my conclusions on the framework and approach I will use.

My letter to the companies in February (MD124) outlined my objectives for the review and the key principles which I intend will guide the process. I am grateful to those who responded and, in writing this paper, have been mindful of the views expressed. A summary of the responses is on page 45.

I am particularly interested in the views of customers and their representative bodies, shareholders, environmental groups, and those of the companies themselves. I shall be holding a number of meetings with these parties to explain my proposals and reasoning and to seek views.

I believe that some matters will be more directly of interest than others to customers. In particular, I would expect customers to wish to comment on the following proposals and questions:

• That price limits should be determined at least every five years and set only for five year periods rather than ten years as at present.
• That in the first year of new price limits there should be an initial downward adjustment of prices to pass on to customers the benefits of out-performance.
• That, thereafter, companies should meet their obligations without prices rising in real terms.
• Should there be financial rebates to customers of companies which fail to meet their legal obligations?
• Should customers only pay for new quality enhancements once companies have delivered the planned improvements?
• Should price limits be adjusted up or down for those companies offering a good or poor service to their customers? What differential between the better and poorer performing companies would provide an appropriate incentive to improve services?
• Should customers whose demand is increasing pay for any necessary resources needed to meet that demand?
• Should legislation be clarified to allow differential hosepipe bans?

Once I have received their guidance, I intend to publish a position paper in the autumn of 1998. I intend that to be a seminal document for the Periodic Review. In it I shall draw together all the various strands of consultation, both my own and those of the companies with their customers, as well as the guidance and advice I have received. Within that framework, the paper will set out choices for customers and the environment. This will take account of regional as well as national issues. It will be an important forerunner for the draft determinations which I am proposing to publish in July 1999.

I C R BYATT

Director General of Water Services

2. SUMMARY

On 15 October 1996, the Director General of Water Services (the Director) announced that in 1999 he would be determining price limits for the water (and sewerage) companies from

1 April 2000. On 11 February 1997, he set out his proposed timetable in (MD124) , a letter to the Managing Directors of those companies.

The Director intends to conduct an open and transparent process during the Periodic Review. This consultation paper is one of a series which invites the views of interested parties on aspects of the review. It describes the approach the Director is minded to adopt in setting prices and raises a number of issues on which he welcomes comment. After the consultation period, the Director will publish in early 1998 his conclusions on the framework and approach he proposes to adopt.

2.1 The Director's proposals

In summary, the Director's proposals contain the following principal elements.

• The Director believes that the existing RPI ± K regime contains significant incentives for companies to increase efficiency, the majority of the benefits of which are transferred to customers at Periodic Reviews. Between reviews, voluntary benefit sharing has an important role to play.
• Price limits should be determined at least every five years and licences should be changed to require this.
• In the first year of new price limits, 2000-01, there should be an initial downward adjustment of prices (P_o) to pass on out-performance - arising both from operating and capital efficiencies - to customers.
• Voluntary benefit sharing schemes implemented by some companies should be taken into account in arriving at the Po adjustment.
• Prices for water and sewerage services have risen very substantially since 1989. The Director believes that customers now wish to see the greater efficiency achieved by water companies reflected in a reduction in bills. He also believes that they expect companies to meet their investment and service obligations without prices needing to rise in real terms, financed through expected efficiency gains. Customers should be consulted about their views on the trade-offs and priorities within this framework of falling prices.
• Differential incentives on companies to increase both operating and capital efficiency, taking into account past achievements, should be dealt with through the continuing X factor. Comparative analysis will be used to inform the Director's assessments of the company-specific X factors and their profile over the period of price limits.
• As at the last Periodic Review, the Director considers that the most appropriate way to assess the level of expenditure required for the maintenance of assets is by examining serviceability to customers. He will consider across the industry the past relationship between such expenditure and the levels of service provided. Where serviceability has been maintained, comparative analysis will be used to determine the extent to which greater efficiency in carrying out maintenance work can be allowed for in price limits.
• Capital expenditure on quality programmes will be monitored to ensure that companies carry out their environmental and quality obligations. Where companies have failed to deliver such outputs, adjustments should be made to regulatory capital values to ensure that companies do not gain financially.
• Allowance should only be made in price limits for quality and environmental enhancements, whether statutory or supplementary, which have measurable outputs and defined times for delivery. The Director intends to ask the Secretaries of State to provide guidance on the implementation of legislation to improve the quality of drinking water and the environment.
• The Director proposes a new approach for the future remuneration of quality programmes. Companies would only be able to raise revenue from customers for quality obligations after they had delivered the planned outputs. This would provide them with stronger incentives to deliver schemes on time and customers would only pay for the service they receive. This approach would require licences to be amended.
• Investment required to balance supply and demand should be broadly self-financing. Companies will need to develop tariff structures incorporating the long-run marginal costs of supplying water and will need to demonstrate proper comparisons between the costs of demand management schemes, reducing leakage, bulk supplies and new resource development. In analysing the costs of these options, total system costs should be considered which bring together both their operating and capital costs.
• Companies will be asked to provide and publish an assessment of their economic level of leakage for 2002-03. This will then be used to derive annual targets for total leakage for each year of the five year period. Where leakage remains above its economic level, no allowance will be made in price limits for new resources until this gap is closed. Failure to meet a target will result in enforcement action.
• Where reliable water yields are reassessed downwards, it may be necessary for the generality of customers to bear the cost of increased security of supply.
• Companies should continue to achieve improvements in levels of service to customers without specific allowance for this in price limits.
• Regulatory capital values should be adjusted to reflect outputs not achieved and capital efficiencies up to 1997-98. Supplementary investment within the limit of allowed investment totals will not be removed from regulatory capital values, provided there are demonstrable benefits for customers.
• The industry remains relatively low risk; the cost of capital is not expected to deviate substantially from its level in 1994. It should also reflect companies' increased gearing levels since then.
• The Director should assume that companies have access to a broad range of financing options, including equity through ordinary share issues.

Further details of the proposals are set out in the remaining sections of the paper. The Director invites views on the following key issues.

Section 3: The framework for setting price limits

•  How should benefits be passed to customers? The Director considers that the use of a P_o adjustment within the RPI ± K regime would produce earlier and greater benefits for customers, without materially reducing incentives, than the system adopted at the 1994 Periodic Review. A formal profit sharing scheme could be incompatible with a P_o adjustment. It would undermine incentives for greater efficiency and could delay the passing of benefits to customers. In the longer term, it would only add marginally to the customers' share of benefits. Accordingly, the Director is minded to pass benefits to customers via a P_o adjustment. 
• He also proposes to seek licence amendments to require Periodic Reviews to take place at least every five years. He has received a large measure of agreement, in responses to MD124, that the current requirements of the licence should be tightened. The Director seeks confirmation that his proposal is appropriate.

•  Does a company-specific package of P_o and X factors provide appropriate incentives for efficiency or would a uniform P_o adjustment across the industry provide a better balance of incentives between the more and less efficient companies? 
• How far do the proposals to consider operating and capital efficiency separately provide an adequate treatment of efficiency? 
• Is there more or less scope for efficiency savings (both operating and capital) in the water industry than in other utilities or other industries? 
• How quickly might companies be expected to make such efficiency savings to catch up with, or overtake, their most efficient peers? 
• How should cost savings be phased over the price review period? 
• What operating costs might be considered atypical in any one year?

•  How should the interaction between capital maintenance and quality enhancement programmes be assessed? 
• Should the Director adopt a materiality threshold for claims from companies for an adjustment of price levels to meet additional obligations? Should this or a similar threshold also be applied to the valuation of any shortcomings in company performance in delivering the expected quality enhancements? 
• Should the Director consider implementing financial rebates to customers if companies do not continue to comply with existing quality standards and obligations required by law?
• Would it be in the public interest for the Director to introduce a new approach to making allowance for quality improvements in price limits only after the expected completion date? This approach is based on the principle that customers should not be expected to pay for an improvement until it has been completed.

•  Should those customers whose demand is increasing pay for any resource development necessary to meet that demand, and how can this be achieved? 
• Should the water (and sewerage) companies have a statutory duty to use their charging powers to promote economy in the use of water resources? This could require the development of more sophisticated tariff structures. 
• Should legislation be clarified to allow water (and sewerage) companies to differentiate between measured and unmeasured customers when imposing hosepipe bans? 

• Should price limits be adjusted up or down for those companies offering a good or poor service to their customers? What differential between the better and poorer performing companies would provide an appropriate incentive to improve services? 
• If performance falls materially short of expectations should there be a financial penalty in addition to enforcing the required levels of service? 
• Is it unreasonable to expect companies to pay for improved service levels out of efficiency savings rather than charges to customers? 
• Is it reasonable that supplementary investment on improving levels of service, which has been endorsed by the Customer Service Committees (CSCs), should be included in the regulatory capital value and earn a rate of return, provided total capital expenditure does not exceed that allowed for in existing price limits?
• Under what circumstances, if any, might the Director allow the remuneration of supplementary investment which takes capital expenditure beyond that already allowed for in existing price limits? 

•  Does the proposed approach to adjusting regulatory capital values retain adequate incentives for companies? 
• Are the risks faced by the water industry materially different from those in 1994 and do they warrant a different cost of capital? 
• Should the cost of capital be considered on a pre-tax basis? 
• What are appropriate levels of financial indicators and over what period, taking into account the availability of equity capital? 
• Is an approach to non-infrastructure assets valid which, for the purposes of price setting, reduces the CCA depreciation charge by reference to actual expenditure and, if so, over what period should equivalence be determined? 

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