The main factor driving prices up is the companies' spending programme. Around £50 billion in the fifteen years to 2004-05. From 2000-2005 £15 billion will be spent on the capital programme. At least half of this is to improve the quality of drinking water and to improve methods of sewage treatment and disposal.

We the Office of Water Services (Ofwat) set price limits (K factors) in 1999. The decisions on major environmental improvements are made by Ministers. They have confirmed the need for costs and benefits to be fully weighed when deciding how, or where, new environmental obligations should be placed on the companies.

We work closely with the Department for Environment, Food and Rural Affairs, the National Assembly for Wales, the Environment Agency (EA) and the Drinking Water Inspectorate (DWI) to clarify the nature and timing of current and future quality obligations and the scope for other environmental improvements.

At price reviews the companies provide costs for work to meet any tighter standards that are confirmed as necessary by the quality regulators, the EA and DWI. Companies also establish their customers' priorities.

Do the companies have to carry out this programme?

Yes, for the most part. Companies have to meet legally enforceable Government and European Union requirements for better water quality and a cleaner water environment. Water should also be used efficiently and dirty water disposed of in the most effective way, in accordance with the principle of sustainable development.

Who pays for quality and environmental improvements?

The companies meet an element of the costs from their own resources. They also borrow from lenders to finance their obligations. The 'Financial performance and expenditure report', published each year, sets out the level of borrowing.

Customers contribute to the cost of raising the capital to finance investment which will bring them better quality water and environmental improvements. Grants are available from the European Development Fund for certain projects in assisted areas.

Between 1995-2000 some companies undertook discretionary capital investment to improve their services. They funded this through efficiency savings which were in excess of the assumptions included in price limits set in 1994.

Shouldn't the shareholders finance a company's investment programme?

We do not tell the companies how to raise money. The decisions made by the companies will depend on the relative costs of sources of finance. Interest rates in recent years have been at historically low levels and companies have taken advantage of cheap borrowing.

In addition, on privatisation, the Government wrote off some company debt and injected cash of £1.5 billion into the companies.

Water companies raise funds from shareholders and financial markets to fund their capital expenditure programmes. They also use retained profits to fund the capital programme.

Customers do not pay the whole cost of the companies' operating and investment programmes. The companies need to raise sufficient capital to cover the interest on the money they borrow to finance the programmes. Customers meet those interest costs.

In order to attract funds, companies pay interest at rates which reflect market expectations. Companies decide the level of dividends they pay to their shareholders. Our price limits do not assume any increase to the level of dividends. In setting price limits we assume that companies will raise finance in the cheapest way. Price limits we set in 1999 assume that the companies can finance their functions at a lower rate of return on capital than they have in the past. This reflects the lower risks which companies now face, compared with the situation at privatisation.

Who sets price limits and when?

Price reviews take place every five years. The Secretaries of State for the Environment and Wales set the initial price limits in 1989 for ten years. We took the earliest opportunity to review price limits again in July 1994 and again in November 1999. Prices set in November 1999 took effect from April 2000.

Reviews of individual company charging limits may take place between price reviews in some circumstances. These are known as interim determinations of price limits. These take account of specified unanticipated requirements which may be imposed on companies. The interests of companies and customers are best served if most changes in price limits are made at five yearly periodic reviews.

• Average annual price limits for the first five years of privatisation were 5% above the rate of inflation.
• For the second five years average annual price limits were 1.3% above inflation.
• Price limits for 2000-2005 are 2% on average, each year, below the rate of inflation.

What is the charging limit?

Each company has its individual price limit this is called its K factor. At the five yearly review we assess, for each year, what each company needs to charge in order to finance the provision of its services and meet its obligations.

The price limit is then applied according to a formula laid down in the water companies' licences. Ofwat checks that the increases do not on average exceed inflation plus the K factor (K can be negative). The move of inflation used is the annual increase in the all items Retail Price Index (RPI) in the November prior to the beginning of the charging year (April).

Do companies have to charge the maximum allowed under this formula?

No, not necessarily. Price limits are set on the basis of companies' information about their capital investment plans. If investment programmes fall behind, we expect companies to consider voluntarily charging below the maximum permitted until the programme is back on schedule. Then in the next charging year companies would be able to recoup the unused K, keeping charges within their original limits.

We monitor companies' achievement of environmental and quality obligations and their performance in delivering service to customers. It is the outputs achieved that are most important.

Why do some customers' bills go up by more than a company's allowed charging limit plus RPI?

The charging limits apply to a company's average charges. The formula is applied to a "tariff basket" of charges, that is:

• charges for unmeasured water supply;
• charges for measured water supply;
• charges for unmeasured sewerage services;
• charges for measured sewerage services;
• charges for reception, treatment and disposal of trade effluent.

Charges should reflect the costs of providing a service. Unless there are special costs involved, each company should charge all customers similar amounts for similar services to avoid undue discrimination or preference, no matter what the basis of the charge. In approving companies' charges we seek to achieve a fair balance between water and sewerage charges.

Further information

We produce a wide range of information about its work and the water and sewerage industry.
Contact the Ofwat Library telephone: 0121 625 1361
E-mail address: enquiries@ofwat.gsi.gov.uk

July 1995
(Revised September 2001)