This paper sets out the consequences for cost reduction of three efficiency target scenarios which, broadly speaking, cover the range of targets that my office believes are plausible.

In setting efficiency targets or 'X factors' for individual companies, I shall be mindful of the need to maintain incentives. The X factors will be higher for the relatively inefficient companies than for the efficient ones.

The companies are, generally speaking, outperforming the efficiency assumptions made at the 1994 Periodic Review. Although price limits tightened significantly then, water companies have not experienced the rigors of competitive markets nor the difficulty of securing finance in a non-regulated environment. These points suggest scope exists for further improvement, perhaps at a faster rate than in the past.

Customers want to see continuing investment to improve services and the environment without seeing bills rise. The range of efficiency savings documented in this report would be sufficient to finance substantial capital enhancement investment without any need for prices to increase.

The range of possible savings is inevitably very wide at this stage of the price review. To enable me to consider company responses in preparation for the publication of Prospects for prices in October 1998, companies are invited to respond to this paper by the end of June. I hope companies, and others, will comment on — and challenge — the results.

I hope companies will tell us, and their customers, how they are judging their current levels of efficiency and the scope they see for further progress. In particular, I should be interested in whether they have carried out the benchmarking studies which so many firms in competitive markets have found so helpful — and, indeed, necessary for survival. Indeed some of them may be able to make international comparisons from their own experience in the world market. I should be interested to learn what companies have done to raise awareness of what is possible through benchmarking and the extent to which they have set objective performance standards for key activities to match or surpass the best in the world.

If the work emanating from companies is incomplete Ofwat may commission its own work in this area.

I C R BYATT

Director General of Water Services

2.THE EFFICIENCY FRAMEWORK FOR THE 1999 PERIODIC REVIEW

2.1 Estimating the scope for future efficiency to assume in price limits — X factors

The Director General of Water Services (the Director) identified the key constituents of K in the recent paper Setting price limits for water and sewerage services — the framework and business planning process for the 1999 Periodic Review (February 1998). The price limit year by year was seen as a function of past outperformance (P_o), future efficiency gains (X), quality standards (Q), and enhancements to the security of supply (V) and service levels (S). The Director's conclusions on the framework and approach to estimating future efficiency — or X factors — were set down in the paper.

This paper builds on these foundations by describing the work carried out by Ofwat to date to assess the scope for future efficiency savings at both industry and company level. The paper includes the early results from the analysis. The work is set in the context of the approach taken to similar issues during the 1994 Periodic Review.

Past outperformance (P_o) will be dealt with in Prospects for prices, which is due to be published in October 1998.

2.2 General approach to assessing the scope of the X factor

The assessment of the X factor has two key elements:

This paper outlines the Director's approach to both elements (see 2.4 and 2.5). The approach is tailored to the three main components, operating expenditure, capital maintenance expenditure and capital enhancement expenditure. It is usual to add together the latter two components under the term capital expenditure (capex) but, for the purposes of price setting, they are considered separately.

As in the 1994 Review, the Director intends to consider separately the scope for efficiency improvements in operating expenditure, capital maintenance expenditure and capital enhancement expenditure. He will test his conclusions by looking closely at the interactions between the expenditure areas. An alternative approach to efficiency assessments, based on total costs, has been rejected following a detailed study.

The approach to opex will be similar to that used in 1994, updated in the light of the recent performance of companies. As set down in Setting price limits, variations in service performance between companies will be dealt with separately (see A proposed approach to assessing overall service to customers — a technical paper (March 1998)). In 1994, levels of service performance was one of the non-econometric factors taken into account in deriving the relative opex efficiency of companies.

The approach to capital maintenance has evolved since the first Periodic Review. In 1994, capital maintenance expenditure on underground assets was reviewed using a historical serviceability approach. Capital maintenance expenditure on water and sewerage surface assets was subject to an upper limit of £20 per property per annum. Company specific efficiency improvements were set for both capital maintenance expenditure and capital enhancement expenditure by an examination of comparative capital works' unit costs (using the cost base (see 2.6) and a separate comparative analysis of the costs of meeting the Urban Waste Water Treatment Directive). In addition, a general capital productivity assumption was applied to all companies.

For the 1999 Periodic Review, the historical serviceability analysis has been extended to cover surface assets. Statistical models similar to those for opex have also been developed for the comparative analysis of historic capital maintenance expenditure. These models will help identify high and low cost companies and so guide judgements on the scope for improvements in efficiency. The cost base exercise will be repeated to inform judgements on the scope for efficiency gains in both capital maintenance and capital enhancement expenditure (see Chapter 5).

The approach to capital enhancement expenditure will be similar to that used in 1994. Companies will submit their estimates for the cost of achieving enhanced performance required by new legislation. These projections will be largely based on companies' current data on capital unit costs. The cost base will then be used to test whether there is scope for improvements in capital unit costs in individual companies when compared to their peers. A general capital productivity assumption will also be applied to all capital enhancement expenditure.

2.3 The components of total expenditure and trends since privatisation

The total expenditure by the industry, in 1997–98 prices, since 1989–90 for both the water and sewerage services is shown in Table 1.

Table 1: Total expenditure by water companies in the period 1989–90 to 1996–97

(£ billion at 1997–98 prices)
Service area	Operating expenditure		Capital maintenance		Capital enhancement
	£bn	% of total	£bn	% of total	£bn	% of total
Total water service	13.0	60	5.0	51	7.3	50
Total sewerage service	8.6	40	4.8	49	7.3	50
Total both services	21.6	100%	9.9	100%	14.6	100%

Note: Numbers may not add up because of rounding.

Figure 1 shows the composition of operating costs and capital maintenance costs. The large slice relating to 'other operating expenditure' expenditure includes costs associated with customer services, associated companies and doubtful debts.

Figure 1: Proportions of operating and capital maintenance expenditure by purpose — 1996–97

The total actual expenditure shown in Table 1 is generally less than was assumed in the price limits set in 1989 by the Secretaries of State and in 1994 by the Director. For example, in 1989, operating expenditure, including quality improvements, was expected to increase by 20% by 1994, whereas it only increased by 2.5%. In 1994, an efficiency improvement of 10% by 1999 was assumed. Companies have reported operating expenditure reductions, including new expenditure on water quality and other improvements, of around 12% since the 1994 price review. These reductions may, on latest estimates, reach between 15% and 20% by 1999. The reduction is, however, less — 6% since the price review — when new expenditure to meet quality obligations is added. It is not yet clear whether the performance of the water companies on operating expenditure is as good as that achieved by the other utilities that were privatised in the 1980s. For example, the regional electricity companies have cut their distribution operating expenditure by around 20% between 1992–93 and 1996–97. Further work is planned to compare the performance of the water companies with other sectors of industry. 2.4 The overall scope for efficiency savings In 1994, Ofwat concluded that the overall scope for improvements in opex that should be included in price limits was 2% per annum for the period 1995–96 to 1999–2000 and 1% per annum thereafter. For the period 1995–96 to 1999–2000 the improvement was split into two elements; a general assumption (1% per annum) and company specific improvements depending on their relative efficiency. For both capital maintenance and capital enhancements expenditure, Ofwat assumed capital productivity improvements at a rate of 1% a year, in addition to company specific adjustments derived from the Cost Base as described in MD 127 (Capital unit costs in the water industry — the 1994 Periodic Review cost base) (March 1997). In total, these adjustments corresponded to a 2–2.5% per annum reduction in capital unit costs. For the 1999 Periodic Review, Ofwat will be commissioning consultants to review the scope for overall improvements in both opex and capex. The trends in other utilities, particularly those that have been subject to growing direct competition, would suggest that continuing scope for improvements should be expected in the water industry. Indeed, some companies that were assessed as below average efficiency in 1994 had reduced total operating expenditure by more than 20% by 1996–97. Companies also cite improvements in capital efficiency of the order of 15%. This suggests that, particularly for inefficient companies, the scope for improvements during the next price limit period could be much larger than those assumed for the period 1995–96 to 1999–2000. This implies that the combined effect of the general efficiency assumptions and the catch-up arising from the comparative efficiency analyses within the industry for both opex and capex could be well in excess of 2.5% and possibly up to 4% or 5% a year for the next five years. The scope for improvements will not be uniform across companies. Those companies with historically high levels of opex and capital maintenance might be expected to account for a larger proportion of the cost reductions expected of the industry as a whole. Therefore, comparative assessments of companies' operating and capital maintenance costs will be a vital tool for use in the 1999 Periodic Review. The work to date in assessing comparative levels of expenditure is summarised in the next section. 2.5 The comparative expenditure of the companies Rankings of company comparative opex were set down in the 1996–97 Report on water and sewerage service operating costs and efficiency (December 1997). Further work on the econometric models has changed the bandings for some companies. Since the 1994 Review, considerable effort has been devoted to the development of comparative capital maintenance models, similar to the approach developed for comparative operating expenditure efficiency in the early 1990s. The comparative capital maintenance work has built on these foundations, taking on board the learning points. The analysis has been reviewed by Professor Mark Stewart (University of Warwick) but has yet to be subject to public challenge. Ofwat follows a step by step approach to the statistical assessment of company performance (see Appendix 1). As part of this process, econometric equations are derived that describe the relationships between expenditure, outputs, company size and a very limited number of statistically significant explanatory factors. These relationships are called econometric models. The current econometric models for both opex and capital maintenance expenditure are summarised in Appendices 2 and 3. Ofwat has decided to publish these now to ensure that all interested parties have an opportunity to understand and contribute to challenging and refining the work. It is for higher cost companies to explain, justify and quantify why they should not be classed as less efficient than their peers. Only at the end of the process of challenge and after assessments of company specific factors, will a final relative efficiency ranking be derived for use at the Periodic Review. The results of the models for the water and sewerage services are set down in Chapter 4. Some companies have a much better cost performance than suggested by the models — these are banded as 'A' companies. Other companies' cost performance is not as good as the models suggest it should be and their actual expenditure is well above that which is predicted by the models — they are banded as 'E' companies. Table 2 maps out a matrix pattern showing clearly that some companies have lower than expected expenditure in both areas — the A/A companies, while others have higher than expected expenditure in both areas — the E/E companies. It also draws attention to those companies with low expenditure in one area but high expenditure in the other. The relative efficiency targets for such companies are considered further in Chapter 5. Table 2: Matrix pattern for opex and capital maintenance analysis   Table 2: Matrix pattern for opex and capital maintenance analysis Operating expenditure analysis A High/low High/low Low Low Low B High/low As expected As expected Low Low C High As expected As expected As expected Low D High High As expected As expected High/low E High High High High/low High/low   E D C B A Capital maintenance expenditure analysis Tables 3 and 4 show for the water and sewerage services the relative cost positions of the water and sewerage companies. Table 3: Preliminary results from the econometric models — water service Table 4: Preliminary results from the econometric models — sewerage service 2.6 The cost base In the 1994 Review, comparative capital unit costs were used to assess the relative procurement efficiency for both capital maintenance and capital enhancement expenditure in an exercise known as the cost base. The cost base exercise will be repeated for the 1999 Review with an initial submission from companies due in June 1998. The cost base will contain standard costs that are relevant to both capital maintenance and capital enhancement expenditure. The standard costs have been selected to reflect probable capital expenditure programmes in the period 2000–05 and specified so that improvements in capital efficiency since 1992–93 can be identified. In addition to the cost base, for capital maintenance expenditure there will be a related assessment of comparative efficiency arising from the econometric models. The cost base will assess the relative efficiency in procurement and implementation of capital projects. The econometric models will provide an overall indication of comparative capital maintenance efficiency in carrying out the right capital maintenance activity at the right cost on the right assets at the right time. 2.7 Implications of comparative efficiency rankings for company specific elements of X factors In 1994, company specific assumptions of opex efficiency improvements were such that 25–35% of the identified difference between the least efficient company and the leading representative company's performance were removed over the first five years (ie by 1999–2000). The efficiency improvements for capital maintenance and capital enhancement expenditure, derived from the cost base, represented the immediate elimination of about a quarter of the gap between company reported costs and the lower quartile yardsticks. The size of the company specific catch-up that will be assumed in 1999 will depend on judgements on a number of factors. These include: the relative ranking in the final efficiency tables; the robustness of efficiency analysis; the chosen benchmark performance; how much of the gap should be removed; whether this should be reduced because of opex/capex performance relationships; and how the catch-up should be phased over the price limit period. These decisions are crucial to maintaining the correct balance of incentives. In particular, too lax assumptions will not challenge the companies to innovate. Successful innovation by the companies is in the long-term interests of customers. The final efficiency ranking will be influenced by the companies' performance in 1997–98 and 1998–99, reported in the July Return for 1998 and 1999. This ranking will also reflect the Director's judgements on any company specific factors that affect the outcome of the models. Judgements on the robustness of the ranking will vary from service to service and between opex and capex. Decisions on the most appropriate benchmarks have yet to be taken. In 1994 the leading comparator, ie the representative company with the best performance, was used for opex and the lower quartile of the industry was used for the cost base. The current preferred approach is to use the leading comparator as the benchmark, provided that this represents a reasonable proportion of the industry, and then phase the catch-up towards this performance over the price limit period. Conventional practice for yardstick competition would imply using the average performance as the benchmark, with the catch-up to this performance being assumed in year one. The Director consulted on these issues in The business planning process, customer consultation and information requirements for the 1999 Periodic Review (July 1997). There was a mixed response, some respondents suggesting the catch-up in two years, others proposing five years (as in the 1994 Review) with tougher targets in the early years. In Setting price limits (February 1998) Ofwat inclined towards a phasing of the catch-up over the five years, but with greater progress achieved in the early years. 2.8 Possible expenditure savings through improving efficiency Cost savings through projections of improved efficiency are built into current price limits. Chapter 3 sets out the assumptions made at the 1994 Periodic Review. Broadly, price limits assumed 2% per year improvements in operating efficiency, comprising 1% per year overall improvement and the remainder achieved by less efficient companies catching up. For the most efficient companies, the 1% per year overall improvement was reduced to 0.5% per year. On capital expenditure, the efficiency improvements were set at a level equivalent to an average of 1.5% per year for improvements in procurement efficiency and an additional 1% per year target for technological improvement. These assumptions reduced expenditure requirements by around £0.8 billion for opex and £0.4 billion for capital maintenance over the period 1995–2000, compared with static levels of efficiency. In the event, companies are likely to achieve more, possibly of the order of £2 billion for opex. Expenditure on capital maintenance is likely to be less than was assumed at the last review by as much as £0.5 billion. The extra savings will be passed on to customers through the Po adjustment. At the 1999 Periodic Review, the combination of overall targets and company specific catching-up could generate significant further savings in expenditure requirements. As indicated above, the size of the savings are dependent on a number of judgements yet to be made. These judgements will be influenced by developments since 1994. In particular, a number of companies have reported large reductions in opex — some have achieved more than 20% reductions in total opex in four years. On capex, some companies report that they are achieving efficiencies of 15% or more. Indeed, a joint government/industry review of procurement and contractual arrangements in the UK construction industry — Constructing the team (Sir Michael Latham, 1995) — identified the potential for reductions of up to 30% in construction costs. These developments point to targets that are tougher than those assumed in 1994, particularly for the less efficient companies. In Table 6, three efficiency scenarios have been developed to illustrate the possible scale of expenditure reductions over the next price limit period. In Chapter 5, there is a year by year breakdown of these scenarios. At this stage of the Periodic Review it is desirable to look at a wide variety of options. These have been grouped together in three scenarios. These are still subject to considerable uncertainty. For example the correct balance between industry target and catch-up is uncertain. The scenarios can be described as follows: All three scenarios are at least as tough as those targets set at the 1994 price review. Scenario 1 — Steady pressure. Scope for efficiency improvements similar to that assumed in 1994 for the period 1995–96 to 1999–2000. This assumes that studies will show that the water industry has moved forward at a similar pace to improvements in the economy as a whole and that there remains potential for further savings. This implies about 2–2½% per year overall improvement for opex and capital maintenance split broadly equally between a general efficiency assessment and the company specific efficiency catch-ups. It is anticipated that for the most efficient companies a slightly lower general efficiency assessment might be applied. Scenario 2 — Challenging. Scope for efficiency improvements greater than assumed in 1994. This assumes that studies will show that the water industry has lagged behind productivity improvements elsewhere in the economy. This scenario is supported by the gains made in the other utilities that have been exposed to more direct market competition and the claims made by some companies about savings promised during the current price limits. It implies overall improvement of around 3–3½% per year for opex and capital maintenance. Scenario 3 — Aggressive. Assumes companies are far from exhausting the scope for efficiency improvements. This assumes that studies will show that the water industry has lagged far behind productivity improvements elsewhere in the economy. Benchmarking studies supporting this scenario would be expected to show the continued presence of old practices that have not been subject to the rigours of direct market competition. Overall the judgement would be that there is an accelerating efficiency gap between a cosseted monopoly service and external comparator industries. This gap would need to be addressed by a more aggressive approach to the X factor for the period 2000–05. It would imply improvements of 4–5% per year for opex and capital maintenance. To carry out this analysis at this stage of the Review, a number of very broad assumptions have had to be made. In particular, the scale of expenditure reductions resulting from less efficient companies catching up depends on both the size of the gap between the most and least efficient, and on how many companies are in each efficiency band. The results of the scenario analysis are set down in Chapter 5. The three scenarios for each of the expenditure areas are summarised in Table 6 (on page 18). These numbers need to be treated as illustrative and with extreme caution. They indicate the possible range of efficiency savings which might be achieved by the 1999 Periodic Review. However there is still a lot of work to be done by Ofwat and the companies to refine this analysis. These efficiency scenarios have been developed on a set of assumptions in each of the three expenditure areas, operating costs, capital maintenance and capital enhancement. The assumptions for each area are: The scope for general efficiency, that is for all companies steady pressure 1% challenging 1½% aggressive 2% These assumptions may be softened for leading companies. The additional scope for company specific adjustments dependent on assessment of each company's efficiency compared with that of the most efficient companies. Each scenario assumes different amounts of catch-up as shown in Table 5: Table 5: Catch-up assumptions for the three scenarios (%)   Opex Capital maintenance Capital enhancement Steady pressure 50 30 50 Challenging 60 40 60 Aggressive 70 50 70 The timing of the delivery of company specific improvements can be either flat over the five year period or concentrated in the early years (front loaded). In the steady pressure scenario, the improvements are assumed to be flat, while in the challenging and aggressive scenarios they are front loaded. In 1994, company specific targets to lessen the efficiency gap were equivalent to 1% per year reduction in opex, for the industry as a whole. The corresponding annual reductions in the three scenarios are around 1½%, 2% and 2½% respectively, although these figures might be different if the distribution of large companies is more towards one end of the efficiency range than the other. In scenarios 2 and 3, the targets would close the efficiency gap faster than in scenario 1 – they are front loaded rather than flat. In 1994 flat targets were set for opex. For capital maintenance, the £400 million reduction illustrated in scenario 1 in Table 6 is a similar level of efficiency to that assumed in current price limits. As with opex, scenarios 2 and 3 for capital maintenance assume that a greater portion of the efficiency gap between companies can be caught up and that this catch-up occurs earlier in the quinquennium. This leads to combined targets for both general and company catch-up equivalent to 3% per annum and 4% per annum respectively. For capital enhancement, scenario 1 also contains similar assumptions to those in current price limits which would result in a 7% saving over the period 2000–05. Scenarios 2 and 3 assume 60% and 70% catch-up respectively, leading to 11% and 13% savings. Table 6: Illustrative impact of different efficiency scenarios on reductions in expenditure requirements 2.9 Using X to finance Q, S and V   Illustrative description of the efficiency scenarios Illustrative impact on expenditure requirements Expenditure category Scenario General Efficiency improvement Elimination of gap to leading comparators % Profile Total reductions over the period 2000–05 £m or % Reduction in 2004–05 £m or % Operating expenditure Scenario 1 – Steady pressure 1% 50% Flat £900 £300 Scenario 2 – Challenging 1.5% 60% Front loaded £1,300 £400 Scenario 3 – Aggressive 2% 70% Front loaded £1,700 £500 Capital maintenance expenditure Scenario 1 – Steady pressure 1% 30% Flat £400 £150 Scenario 2 — Challenging 1.5% 40% Front loaded £700 £200 Scenario 3 — Aggressive 2% 50% Front loaded £900 £250 Capital enhancement expenditure Scenario 1 – Steady pressure 1% 50% Flat 7% saving 12% saving Scenario 2 — Challenging 1.5% 60% Front loaded 11% saving 16% saving Scenario 3 — Aggressive 2% 70% Front loaded 13% saving 20% saving The Director has indicated that improvements in water company efficiency following the Po adjustment would be used to mitigate the upward pressures on customers' bills arising from further quality improvements (Q), other service improvements (S) and ensuring continuing security of supplies (V). Ofwat will be addressing these trade-offs, at both an industry and company level, in Prospects for prices (October 1998). 2.10 Key dates in taking forward efficiency issues This paper sets down the Director's proposed approach to efficiency issues. For the Prospects for prices paper (October 1998) the Director will make assumptions on appropriate ranges for efficiency savings at the next review. These assumptions will take account of: responses to this paper; the outcome of research into the scope for general efficiency; and company results for the year 1997–98. Following publication of Prospects for prices, companies will have an opportunity to discuss their relative efficiency with Ofwat before submitting their views on the scope for general efficiency and future savings within their own companies as part of the Draft Business Plan. Finally, the Director will take judgements based on company submissions and 1998–99 results to product his draft determinations. Companies and other interested parties will have an opportunity to comment on these before they are finalised in November 1999. A more detailed timetable is set out in Appendix 7.

3. APPROACH TO EFFICIENCY AT THE 1994 PERIODIC REVIEW 3.1 Overview In 1994 the Director considered separately the issues of operating and capital efficiencies. For each he made an assessment of the general scope for savings across the industry and an assessment of the different relative efficiencies of companies within the industry. This section contains an outline of the key elements of the approach the Director took, showing how it achieved a balance of incentives. The strategy was subject to detailed scrutiny by the Monopolies and Mergers Commission (MMC) in the South West Water and Portsmouth Water referrals on the Director's determinations. The MMC endorsed the strategy used by Ofwat. The current framework has evolved from this base. 3.2 How the overall scope for efficiency savings was assessed The Director's assessments of the overall scope for savings across the companies formed the basis for annual efficiency targets that were built into price limits. This gave companies incentives to outperform targets, but companies could not raise prices through failure to meet these targets. 3.2.1 Operating expenditure efficiency The Director assessed the overall scope for efficiency savings on operating expenditure in the water industry as 2% per annum for 1995–2000 and 1% per annum for the subsequent five years. The Director commissioned a report on general efficiency trends from Bosworth, Stoneman & Roe. They calculated that the reduction in real unit operating cost in productive and manufacturing industries over the period 1979 to 1989 was around 1–1.25% a year. Quantification was difficult, but the evidence was consistent with a judgement that real reductions in unit operating costs in the wider economy were 1% a year greater than measured, after taking into account known biases in the data and unaccounted for quality improvements. This would lead to a central estimate for manufacturing industry over the period 1980–90 of 2–2.25% per annum. The Director noted that quality enhancements in the water industry were accounted for separately. Companies reported to the Director the extra spending they considered necessary to meet new quality obligations and this was scrutinised by the Director separately (see 3.2.2 and 3.3). Other industries would not make the same distinction. The limited evidence available suggested that this distinction between the water industry and others might be significant. It was therefore assumed that the overall scope for efficiency savings in opex would be 2% and that all companies would be able to achieve at least a 1% efficiency saving. Appendix 5 provides a summary of the Bosworth, Stoneman & Roe report. A full copy of this report has been placed in the Ofwat Library. 3.2.2 Capital efficiencies across the industry An assessment was made of an industry-wide target for continuing capital productivity efficiency arising from technological progress, following two separate studies of the scope for widescale introduction of new innovations. A conservative judgement was made, owing to uncertainties in the timing and take up of newer and emerging technologies, and it was assumed, when price limits were set, that there would be scope for continuing reductions of 1% per year in capital expenditure. As a result, companies had incentives for early adoption of lower cost technologies and practices. The 1% per annum target was applied to both capital maintenance and capital enhancement expenditure, in addition to the reduction implied by comparative analysis of capital unit costs in the cost base exercise. The additional adjustments arising from the cost base ranged between 0-7.5% in total over the five year period. This resulted in the expectation that there would be an average reduction in total capital costs across the industry of 2-2.5% per annum. 3.3 Assessing relative efficiency between companies Within the overall framework of incentives to improve efficiency, Ofwat recognised that the scope for improvement was not the same for all companies, because of differences in starting levels of efficiency. To take this into account in price limits, Ofwat assessed relative efficiency for each company, for operating expenditure and for capital expenditure. 3.3.1 Assessing relative operating expenditure efficiency Companies' relative operating expenditure efficiency was assessed using a combination of econometric techniques, as described in Appendix 1, and adjustments for non-econometric effects, such as significant differences in levels of service or particular circumstances of single companies. Econometric models were developed for the water service as a whole, resources and treatment, distribution and business activities. Each company was given an efficiency ranking for each activity and an overall assessment was reached. For the sewerage service, econometric models were developed for operation of the sewer network and for large sewage treatment works. Assessments of the comparative costs of small sewage treatment works and sludge treatment used unit costs but took into account works size, load and treatment levels. For sludge disposal, unit costs were used, taking into account the various disposal methods. Business activity performance was assessed using costs per property billed. The operating expenditures predicted by each sub-service model were summed for each company. The average of these sums with the results of the overall service models was calculated — it was considered that both approaches had equal validity. These averaged predicted expenditures were compared with actual reported expenditures, less local authority rates, third party costs and National Rivers Authority charges, none of which were modelled. Companies were ranked on percentage differences. The ranked companies were each allocated a provisional expenditure band. The bands were determined so that companies with similar reported expenditure relative to predicted expenditure were allocated to the same band. Converting from provisional expenditure bands to final efficiency bands required individual company circumstances to be taken into account, either quantitatively, to accommodate a specific cost, or qualitatively, based on an assessment of quality of service, trends in expenditure or other specific factors. It was recognised that the differences between predicted and actual expenditure, even after adjustment for specific factors, did not translate directly to differences in efficiency. Some of the differences were the result of errors in the data used to model expenditure and especially in the models themselves, as simple models could not take all factors into account. The approach adopted was to set company specific efficiency targets that would move individual company expenditure towards those of the best performers, over a five year period. The amount of movement was taken to be around 25% – 35% of the difference in predicted cost. In addition to the company specific targets, all companies had a target of 1% per year for reducing costs, resulting from the overall scope for efficiency as discussed earlier. For the best performers, only the 1% overall target was set but, for those with the highest expenditure, the combined target was a 3.5% expenditure reduction per year. 3.3.2 Assessing relative capital maintenance efficiency During the Review Ofwat developed a range of analytical tools to interpret the information submitted by companies in their Strategic Business Plans. These were used to form a view of the levels of capital maintenance expenditure that would need to be required by companies over the ten year period 1995–2005. The main tool used to assess comparative efficiency for both capital maintenance expenditure and enhancements was the comparative capital unit cost approach — the cost base. This was developed so that the Director could compare capital expenditure across the industry and identify those companies that appeared to be more efficient at procuring capital assets than others. Companies with higher capital unit costs were considered to have more scope for savings in their expenditure projections than companies with lower capital unit costs.   4.RECENT RESULTS IN COMPARATIVE EXPENDITURE 4.1 Expenditure trends since the 1994 Periodic Review The majority of companies have, so far, been successful in reducing operating expenditure by a significant amount. Total opex decreased by 6% between 1992–93 and 1996–97, in spite of the new costs of operating additional water and sewage treatment plants to meet European Union directives. Without these new costs, companies report that expenditure would have decreased by 12% in the same period. Ofwat published comparisons of 1992–93 and 1996–97 operating expenditure in the 1996–97 Report on water and sewerage company operating costs and efficiency (December 1997). The trends in capital maintenance expenditure are less clear. Large variations in capital maintenance expenditure can occur on an annual basis, as it becomes necessary to renovate or replace major assets. In recent years, reported capital maintenance expenditure has generally been in line with the amounts assumed in price limits. However, a number of companies are reporting savings in unit costs of up to 10%. This would suggest that the reductions in capital unit costs that have been claimed have been offset by higher overall levels of capital maintenance activity. For capital enhancement expenditure, comparisons can be made between the actual expenditure of the companies and the amount assumed in price limits. The main component of the capital enhancement programme for both water and sewerage services is expenditure to meet new quality standards. Companies are currently reporting that they have made considerable savings in capital enhancement expenditure compared with the amounts that were assumed in price limits. At the end of 1996–97, there was a considerable cumulative difference between the expenditure that was assumed in price limits and actual expenditure by the companies. However, companies are reporting that a substantial part of this difference will be spent later in the quinquennium and that the overall difference on the quality programme by the end of the five years to 2000 is likely to be of the order of 15%. The sources of these efficiency savings in capital expenditure vary between companies. A large proportion of the savings are reported by companies to be due to uptake of new construction techniques. Examples of this have been: more sophisticated measurement of flows at sewage treatment works, use of Granular Activated Carbon sandwich techniques for water treatment, greater use of no-dig techniques for mains and sewer renewal and general better management of contracts and resources. In addition, companies with relatively high capital unit costs, as measured by the cost base, may have approached the 1994 yardsticks at a faster rate than was assumed when price limits were set. The industry cost base submission in June 1998 will enable Ofwat to measure the progress made by individual companies in reducing their capital unit costs during the current price review period. 4.2 Results of the econometric analysis 4.2.1 Water and sewerage services There are important differences between the water and sewerage services that affect how comparative performance is assessed. For the water service, it is generally possible to derive robust econometric models for explaining expenditure, because there are 28 separate companies, a sufficient number of comparators. In contrast, there are only ten separate sewerage companies. For these, Ofwat uses disaggregated data, for example for several sub-areas of each company or for individual large treatment works. With disaggregated data it is not usually possible to assess the role of economies of scale. However, the range of sizes of the sewerage companies is much less than that of the water companies. It is important that expenditure is allocated reliably between the water and sewerage services because misallocations can affect assessments of economies of scale which, in turn, could affect how efficiency is assessed for the smaller water only companies. 4.2.2 Operating expenditure econometric models The econometric models used at the 1994 Periodic Review were published in the 1993–94 Report on the cost of water delivered and sewage collected (December 1994). The models resulted from extensive research and consultation with the industry. Some of the early research was published as research papers in 1993 and 1994 (copies available in the Ofwat Library). For the water service, the econometric models have been re-estimated each year since the 1994 Review. The form of the resources and treatment and business activities models have not changed, only the coefficients have altered. The water distribution model has been reformulated (see Appendix 2). An econometric model for power expenditure has replaced the previous unit cost approach. This was found necessary because of apparent economies of scale on power expenditure. The combined sub-service models are now judged to be more robust than the overall water service models. This is mainly because expenditure is now allocated more reliably than in 1992–93. It is intended to use an overall model only as a check on the results of the sub-service models. Data was collected for sewerage areas and individual large sewage treatment works for 1996–97, the first such data collection since 1992–93. The sewer network model and large treatment works model have been revised and improved. For other parts of the sewerage service a unit cost approach is retained, using similar calculations to those used in the 1994 Periodic Review. Ofwat is aware of the potential for new explanatory factors to become material, for example with the increase in domestic metering and new requirements for water treatment, and will be examining 1997–98 data for evidence of this. Some factors are suspected but prove difficult or impossible to measure consistently, for example the split between urban and rural areas within companies. Where companies can demonstrate that a particular explanatory factor is a material cost driver across the industry and can be measured consistently, Ofwat will consider its use, if its inclusion leads to a better model on engineering and statistical grounds. 4.2.3 Capital maintenance expenditure econometric models Companies must renew their assets to ensure continuity of services for current and future customers. Ideally, an asset should only be renewed when the present value of additional operating expenditure required to maintain serviceability becomes greater than the capital cost of renewal. To achieve the optimum level of capital maintenance, companies must carry out the right capital maintenance activity at the right cost on the right assets at the right time. The approach to capital maintenance at the 1999 Periodic Review starts with serviceability to customers. Before making any assessment of comparative efficiency based on historic expenditure, Ofwat will assess whether the trend in serviceability to customers has deteriorated. Declining serviceability may be indicative that the company has failed to carry out sufficient capital maintenance — its activity may be too low, ineffective, or a combination of both. The company will be challenged to explain its position. Stable trends in serviceability will be indicative that recent capital maintenance activity has been adequate. Companies will also be submitting an update of their asset inventory in August 1998. This will enable the changes in the condition and operational performance of their assets from 1992–93 to 1997–98 to be identified. Account of capital enhancement expenditure during this period will need to be taken so that the state of the underlying asset base can be assessed. Where there is evidence that assets have deteriorated companies will be challenged to explain why this is so. This may indicate that recent levels of capital maintenance expenditure have not been sufficient. Unless serviceability is deteriorating, current levels of capital maintenance expenditure can be taken to be a reasonable reflection of the requirement for capital maintenance activity over the period of the next price limits. There is a wide range of unit capital maintenance costs across the industry, suggesting that some companies are more effective at maintaining serviceability to customers than others. This range of unit costs may be attributable to variations in the effectiveness with which companies target their capital maintenance expenditure leading to inappropriately high levels of activity. Companies' capital maintenance strategy and unit costs have been assessed using the same statistical techniques as those used in the approach to operating expenditure. In common with the opex models, the capital maintenance econometric models inform judgements about how far individual companies are from the best in the industry. An important difference between the capital maintenance and opex econometrics is that opex models take annual data for both expenditure and explanatory factors. The capital maintenance models currently take an average of the capital maintenance expenditure over the four year period 1993–94 to 1996–97, and explanatory factors that relate to 1992–93. This is in order to take account of annual variations in capital maintenance expenditure and ensures that the explanatory factors are not affected by modelled expenditure. The capital maintenance econometric models developed from company data are set down in Appendix 3. This data has been derived from the Capital maintenance return (November 1997). A copy of the datasets used to develop the econometric models presented in this report is available from the Ofwat library. In common with the opex models, the capital maintenance models have also been developed using the principles outlined in Appendix 1. 4.2.4 Robustness of the econometric models The econometric models for both opex and capital maintenance predict a level of cost for a particular company based on the performance of the other companies in the industry. These predicted costs can be compared with companies' actual costs and companies can then be grouped into cost variation bands according to the size of the difference between actual and predicted costs. Some of the difference may be the result of shortcomings in the models as well as comparative cost performance. Whilst accepting this limitation, the econometric modelling of reported company expenditure, their outputs and statistically significant explanatory factors, reveals wide ranges of cost performance. High cost companies will need to be able to demonstrate why their costs are higher than other companies in similar situations. Table 7 summarises the results of the econometrics using a consistent banding convention linked to the gap between reported expenditure and the central estimate of predicted expenditure from the relevant model. Bandings for both operating expenditure and capital maintenance expenditure are shown in the table. The banding convention is: Band A: well below predicted expenditure (less than 85% of C) Band B: below predicted expenditure (85–95% of C) Band C: around predicted expenditure (within 5% of modelled expenditure) Band D: above predicted expenditure (105–115% of C) Band E: well above predicted expenditure (more than 115% of C) The results presented compare predicted expenditure with reported expenditure. They do not take account of legitimate, company specific factors that may affect expenditure. The bands, therefore, are not definitive statements of the relative efficiency of individual companies. It should be noted that opex accounts for between 50% and 80% of the combined total of opex and capital maintenance. Appendix 4 sets out the results for each of the econometric models developed for the water and sewerage services. These are presented in matrix form, showing comparisons between operating expenditure bandings and capital maintenance expenditure bandings. Table 7: Results of the econometric modelling summarised for the water and sewerage services   Water service Sewerage service Company Operating expenditure banding Capital maintenance expenditure banding Operating expenditure banding Capital maintenance expenditure banding Water and sewerage companies Anglian C E C A Dwr Cymru E D D A North West B C C D Northumbrian C D C C Severn Trent C E C E South West D C E E Southern D A E C Thames C E C E Wessex B E B E Yorkshire C E B A Water only companies Bournemouth & West Hampshire B E     Bristol E B     Cambridge B A     Chester C C     Essex & Suffolk E B     Folkestone & Dover D D     Hartlepool D E     Mid Kent C D     Mid Southern B B     North Surrey D A     Portsmouth A E     South East E E     South Staffordshire C C     Sutton & East Surrey C E     Tendring Hundred E B     Three Valleys C C     Wrexham A B     York A A     4.3 Limitations of the analysis The analysis and results in this report are preliminary. Much more analysis remains to be done, to take into account, for example: suggestions from companies; additional data, for 1997–98, which companies will report in July 1998; and company specific factors not covered by the models. 4.4 Total efficiency and interactions between operating expenditure and capital maintenance expenditure As shown in the matrices in Chapter 2 and Appendix 4, there are a number of cases where companies appear efficient on opex and inefficient on capital maintenance, or vice versa. This raises the wider question of whether it is appropriate to consider different categories of expenditure separately and whether the system of analysis sets up perverse incentives to companies. For example, companies may have the scope to make investments that reduce operating costs. Such investments may be classified as capital maintenance. Some companies might adopt strategies where they spend extra on capital maintenance in order to reduce operating expenditure. An active policy of leakage detection and repair is an example of this. Overlap also occurs because of accounting practices which affect how costs, such as leakage control, are allocated between operating expenditure and capital maintenance. It is essential that the overall framework for judging comparative efficiency maintains the incentive to undertake cost saving investments as these become viable in net present value terms. It is also important that different practices in allocation do not affect the overall adjustments resulting from the structure proposed above. It is, therefore, considered appropriate to assess efficiency on operating expenditure and capital maintenance together. This approach helps to ensure that companies are not unduly penalised, or rewarded, because of the way they choose to minimise expenditure, or the way in which they allocate expenditure. In practice, it means that a company's band for operating efficiency could be adjusted if it is an outlier on capital maintenance efficiency and vice versa. Such adjustments would take into account the actual expenditure involved. An alternative to this framework would be an aggregate approach to efficiency involving total efficiency measures. Companies and others commented to the Director in response to his paper The proposed framework and approach to the 1999 Periodic Review (June 1997) that total efficiency, or at least the interaction between operating and capital efficiencies, needed to be examined. There were concerns about the incentives provided to companies by treating them separately. The Director considered the issue of total efficiency in 1996 to see if the difficulties with this method could be overcome. Bosworth, Stoneman & Thanassoulis conducted a study into the feasibility of assessing total efficiency through production functions. This concluded that capital expenditure should be considered in assessing efficiency, but that defining appropriate inputs and outputs for the industry was problematic and that defining data requirements and collecting such data was very difficult. There are a considerable number of factors beyond management control, for example geographic areas and the inherited capital stock, that would need to be adjusted for. Although the research concluded that some data envelopment analysis might be possible, there are practical difficulties in collecting sufficient data of good quality to an appropriate degree of detail. This leads the Director to conclude that separate efficiency comparisons using operating expenditure and capital maintenance expenditure are likely to lead to more robust conclusions than analysis undermined by patchy and unreliable data. He will, therefore, assess these separately but base his judgements on the total of opex and capital maintenance analyses. Furthermore, having considered these comments and the research, the Director considers that the best way to identify any interaction of capital maintenance and operating efficiencies is to assess comparative efficiency in both areas using similar econometric techniques. The relationship between the two assessments will then be reviewed and an allowance for any significant interaction, where it can be identified, would be made when future efficiency targets are set. A summary of the study is given in Appendix 6. A copy of the full report is available in the Ofwat Library.

5. IMPLICATIONS OF RELATIVE EFFICIENCY RANKINGS AND THE SCOPE FOR EFFICIENCY IMPROVEMENTS 5.1 Implications of the work for the X factor Ofwat has looked at the possible implications for expenditure of different judgements on the robustness of the relative efficiency rankings and the overall scope for efficiency improvements by the industry as a guide to understanding the impact of the X factor. This section describes these simulations. 5.2 Assessing the scope for future savings in operating expenditure and capital maintenance expenditure together As the Director stated in Setting price limits (February 1998), he intends to treat efficiency savings in operating expenditure and capital maintenance expenditure cumulatively. For those companies who are equally efficient or inefficient in both areas their operating expenditure and capital maintenance can be treated independently. Section 2.8 set down three scenarios which varied in terms of general improvement and company specific efficiency assumptions. The general improvement assumptions vary between 1% (steady pressure scenario) and 2% (aggressive scenario) while the company specific assumptions vary in both the degree and timing of the catch-up to the leading comparators. 5.2.1 Relationship between company specific efficiency targets for operating costs and capital maintenance This section considers the interaction between company specific factors for operating expenditure and capital maintenance and how the Director intends to take account of this at the Periodic Review. Where companies are efficient in one area and inefficient in the other it is presumed that this is a result of a conscious decision to increase spending in their inefficient area in order to be efficient in the other. In other words Ofwat recognises that the separate measures of efficiency in the two areas may be too harsh. For this reason it is proposed to give such companies less tough efficiency targets for their inefficient area than would otherwise be the case. That is, they are not to be penalised for decisions which make them leading comparators in one area at the expense of apparent inefficiency elsewhere. Taking scenario 2 as an illustration, companies would be expected to move 60% towards the benchmark company in operating expenditure and 40% towards the benchmark company in capital maintenance. Table 8 illustrates the percentage changes over the five year period which might be expected. Similar tables can be derived for other scenarios. Note that for those companies falling in the top left or bottom right hand corners, the targets for their inefficient areas are relatively softer than for companies falling elsewhere in the matrix. This has not made a significant difference to the industry wide figures presented in this report. In addition to the percentage changes in Table 8, all companies will also be set a general efficiency target for both opex and capex as set out in Table 6. 5.2.2 Timing of catch-up to leading companies The degree of catch-up to the leading comparators for opex ranges between 50% (steady pressure scenario) and 70% (aggressive scenario) and between 30% (steady pressure scenario) and 50% (aggressive scenario) for capital maintenance. The timing of the catch-up for the company specific assumptions can affect the total savings expected. Two timing options have been adopted, one assumes the improvements to be achieved evenly over the period while the more challenging option is for the improvements to occur early in the period. Table 9 below sets out the timing assumptions for the more challenging front loaded scenario. Table 9: The front loaded option Illustrative apportionment of catch-up through price limit period Year 2000–01 2001–02 2002–03 2003–04 2004–05 Proportion of catch-up 30% 30% 20% 10% 10% The potential for savings range from £430 million for capital maintenance and £920 million for opex under scenario 1 (steady pressure) to £850 million for capital maintenance and £1,660 million under the aggressive assumptions in scenario 3. 5.2.3 Detailed profiles of efficiency savings in operating costs and capital maintenance Tables 10, 11 and 12 illustrate the break down of the efficiency savings that would be available using the steady pressure, challenging and aggressive efficiency assumptions as set out in Table 6. It should be remembered that these scenarios are only illustrative at this stage. The Director will consider a wide range of options before setting efficiency targets. He may decide to go further in some areas than others. Table 10: Illustrative impact of 'X' factors on industry expenditure for the price limit period Scenario 1 – Steady pressure (Assuming a normal distribution of companies across the relative efficiency scale (by turnover)) Water service savings year by year 2000–01 £m 2001–02 £m 2002–03 £m 2003–04 £m 2004–05 £m Five year total £m 1 Opex savings — company specific assumptions 20 50 70 90 110 340 2 Opex savings — general improvement assumption (1% / year) 10 30 40 60 70 210 Opex savings 40 70 110 150 180 550 3 Capex (maintenance) savings — company specific assumptions 10 10 20 30 30 100 4 Capex (maintenance) savings — general improvement assumption (1% / year) 10 10 20 30 40 110 Capex (maintenance) savings 10 30 40 60 70 210 Total water service savings 50 100 150 200 250 760 Sewerage service savings year by year 2000–01 £m 2001–02 £m 2002–03 £m 2003–04 £m 2004–05 £m Five year total £m 1 Opex savings — company specific assumptions 20 30 50 60 80 230 2 Opex savings — general improvement assumptions (1% / year) 10 20 30 40 50 140 Opex savings 30 50 70 100 120 370 3 Capex (maintenance) savings — company specific assumptions 10 10 20 30 40 110 4 Capex (maintenance) savings — general improvement assumptions (1% / year) 10 20 20 30 40 110 Capex (maintenance) savings 10 30 40 60 70 220 Total sewerage service savings 40 80 120 160 200 590 Total savings — both services 90 180 270 360 450 1,360 Note: numbers may not add exactly because of rounding. Table 11: Illustrative impact of 'X' factors on industry expenditure for the price limit period Scenario 2 – Challenging (Assuming a normal distribution of companies across the relative efficiency scale (by turnover)) Water service savings year by year 2000–01 £m 2001–02 £m 2002–03 £m 2003–04 £m 2004–05 £m Five year total £m 1 Opex savings — company specific assumptions 40 80 110 120 140 490 2 Opex savings — general improvement assumption (1½% / year) 20