Restricted until 7.30am Monday 14 September 1998

A J Harding Esq
Managing Director
Northumbrian Water Limited
Abbey Road
Pity Me
Durham DH1 5FJ
11 September 1998

NOTIFICATION OF INTERIM DETERMINATION

On 15 June you made an application for an interim determination of your company's price limits under Part IV of Condition B of the licence. You also submitted a report in support of the application. This set out your estimate of the additional capital costs of the requirement to introduce secondary treatment at a number of estuarial and coastal sewage treatment works by 31 December 2000 rather than the post-2000 dates which were assumed when I last set price limits in 1994.

Following an initial assessment of your application, the accompanying report, and the review submitted by the independent reporter for your company, David Arnell (Binnie, Black and Veatch), I issued my draft determination of your application on 24 July 1998. This was that the current price limit of –2.1% for the charging year 1999-2000 should be increased by +2.3% to +0.2%.

I invited representations from interested parties on the draft determination. A full list of the representations received by 1 September 1998 is annexed to this letter. Your company was also afforded the opportunity to make a formal representation and did so at a meeting held on 8 September 1998.

My staff and I have carefully considered all the representations received. The evaluation of these and new information which has been made available since publication of the draft determination has led me to conclude that it is appropriate to modify certain of the assumptions on which the draft determination was based. In the light of these modifications I have determined that the price limit for the Charging year commencing April 1999 should be 0.7%. This is a 2.8% change from the current limit of –2.1%.

The assessment of your application is described in Annex B to this letter. The four stage process was described in the 24 July letter and further explained at the meeting with your company on 29 July 1998. Revised assumptions have been made with regard to:

i. the most appropriate cost base adjustment factor
ii. the adjustment made in respect of work carried out and subsequently deemed to be unnecessary

I am copying this determination to Alan Davis (DETR), Roger Hyde (Environment Agency, North East Region), Jim Gardner (Chairman of the Northumbria Customer Service Committee), and to all your local Members of Parliament and Members of the European Parliament.

I C R BYATT

ANNEX A

Representations received by 1 September 1998 on the Director General's draft determination of Northumbrian Water Ltd's price limit for the charging year 1999-2000 as published on 24 July 1998.

Northumbrian Water Limited
Durham County Council
Dwr Cymru Cyf / Welsh Water
Dr C D G Johnson, Berwick Upon Tweed
Mr E Scott, Sunderland
Wessex Water Services Ltd
Seaham Environmental Association

Copies of the above responses are being lodged in the Ofwat library except for those that have been submitted in confidence.

ANNEX B

Detail of four stage process employed in the assessment of Northumbrian Water Ltd's application for an interim determination of its price limit for the charging year 1999-2000.

Stage 1 - Confirmation of the changed requirements

Following receipt of the application, confirmation was sought from officials at the Department of the Environment, Transport and the Regions (DETR) that the company's assessment of the requirements under the Urban Waste Water Treatment Directive (UWWTD) at the major sites were appropriate and necessary. The Director wanted to establish the position of DETR Ministers on Northumbrian Water Ltd's earlier applications for derogations under the terms of the Directive.

Satisfactory assurances were received from DETR officials that the levels of treatment and the latest commissioning dates required at each major site are as set down in the company's application (Bran Sands, Hendon and Howdon). There remains the possibility of Northumbrian Water securing derogations under Article 8.1 of the UWWTD at some future date if it encounters technical difficulties.

Similar confirmation was sought from the North East region of the Environment Agency (EA) on the minor sites. This was to ascertain the position the EA had reached on assessing the comprehensive studies submitted by the company in June 1997.

The EA announced its assessment of the comprehensive study reports submitted in respect of the discharges from Horden, Marske and Seaton Carew on 22 July 1998. The EA had already made a similar announcement in the case of the Hendon comprehensive study on 16 October 1997. In all four cases the reports failed to convince the EA that primary treatment alone at the coastal sites would not have an adverse environmental impact. Therefore the full requirements of the UWWTD would be required at the relevant coastal sites – secondary treatment by 31 December 2000.

The Director therefore considered that the cases for provision of secondary treatment and its implications for the disposal of sewage sludge at the sites in question have been confirmed. These requirements are different from those assumed in 1994, which were based on advice from the then Government. The Director concluded that the changed requirements are a relevant change in circumstance under Condition B of the licence.

Stage 2 - Assessing the appropriate net additional costs

The Director's approach to reviewing company costs has been set out in Setting price limits for water and sewerage services (February 1998) and Assessing the scope for future improvements in water company efficiency (April 1998). These approaches have been adopted in assessing the reasonable net additional costs arising from the changed requirements.

Broadly the approach has involved:

a. reviewing, and where appropriate adjusting, the basis of the application costs to ensure reasonable consistency with the comparative capital costs work (Cost Base submission – information submission G),
b. applying the appropriate cost base adjustment factor to reflect the findings of our comparative analysis,
c. applying a general efficiency improvement factor of 1% p.a. to reflect continuing progress year by year, and
d. making final adjustments to take account of offsetting savings (re-phasing of some projects within the statutory dates) and my previous determination assumptions.

Sufficient analysis of the Cost Base submissions has been carried out to enable a view on the robustness of the company's estimated capital costs to be taken. The analysis has identified a significant gap between the company's sewerage service (non-infrastructure) cost base and the best in the industry. My staff have calculated that to move the company's cost base half way to the best in the industry requires a 13% reduction in capital costs. This reduction factor is now based on the full range of relevant specimen project costs. The earlier assessment had been based on a restricted range of specimen project costs.

As indicated above, the same general efficiency assumption of a further 1% p.a. as was used in the last periodic review has been applied in order to reflect sharing with customers the continuing progress the company is expected to be making.

Northumbrian Water Ltd has identified the scope for re-phasing some other projects so that they may be completed later than planned but still within the statutory dates. This provides some short-term relief in the next two years (£10m) but these projects will be added to the company's programme in 2000-01.

The North East Region of the EA would have preferred the company to meet the originally agreed dates. However, the Director still considers that it is sufficient for the company to meet the statutory dates for compliance. The determination has incorporated the impact of rephasing these works within the statutory dates.

The Director has reviewed what was allowed in the 1994 determination for the original obligations on estuarial discharges. This established that a capital allowance of £7million in 1999-2000 had been made in respect of work that was assumed would be completed beyond 2000. This allowance was not taken into account when the company submitted its cost estimates, and £7million has been deducted from the application in order to avoid double counting.

The Director has reconsidered his proposed retrospective adjustment of £7.5 million for work on sea outfalls that were thought to be longer than necessary. He has received strong representations that this would harm incentives for companies to act prudently, and may raise the cost of capital. The company provided evidence that demonstrated that the scale of the unnecessary work was much smaller than had been assumed. They also made a convincing case that they had acted prudently in making these investments. David Arnell has also reported that he can find no evidence that the company behaved imprudently in these investments. In the light of these representations the Director considers that the retrospective adjustment would not be appropriate.

The Director's overall assessment of the reasonable net additional costs arising from the changed requirements is summarised in the following table.

Summary of Director's assessment of reasonable net additional costs Arising from the changes in requirements
Adjustments	Net additional capital costs £m (1997-98 prices)
	1997-98	1998-99	1999-00	2000-01	Total
Total of Application	0.5	23.8	135.9	87.1	247.3
(a) To achieve consistency with the Cost Base. Approx. 10% reduction	Small	-2.4	-13.6	-8.7	-24.7
(b) Cost Base Adjustment Factor. 13% reduction	-0.1	-2.8	-15.9	-10.2	-28.9
(c) General efficiency improvement adjustment. 1% p.a. year on year reduction starting in 1998-99	Nil	-0.2	-2.1	-2.0	-4.3
d. Other adjustments (see text)	Nil	-8.0	-9.0	10.0	-7.0
TOTAL ASSESSMENT OF THE REASONABLE NET ADDITIONAL COSTS	0.4	10.5	95.2	76.2	182.3
Note columns and rows have been rounded so totals may not tally

Stage 3 – Materiality Test

Condition B of the licence sets a materiality threshold for consideration of interim determinations. If the net present value of the net additional costs up to the start of the next charging period (end of March 2000) arising from the changes is less than the materiality threshold then the application fails.

The materiality threshold is 10% of the turnover of the appointed business in the previous year. Northumbrian Water Ltd's turnover for 1997-98 was £322.5million. The materiality threshold is therefore just over £32million. The total reasonable net additional costs for the three years 1997-98, 1998-99 and 1999-2000 clears this threshold by a significant margin.

Stage 4 – Implications for price limits

The modelling of the interim determination has been carried out in accordance with the detailed methodology laid down in Condition B of Northumbrian Water's licence. This requires the Director to calculate an adjustment to the K factor for 1999-2000, being the sole remaining year following the application year of 1998-99 to the end of this quinquennium. A periodic review of price limits has already been called for the next quinquennium.

Costs from 1997-98 to 1999-2000, adjusted for amounts allowed at the last determination and as described above, have been included in the calculation of the adjustment to K. Costs for 2000-01 will be considered within the current periodic review and included within new price limits for the period 2000-05.

Condition B states that the investment allowed for in the interim determination should be remunerated using a current rate of return on borrowing. The company made strong representations for a higher margin on the risk free rate than had been assumed in the draft interim determination. The Director has given this matter careful consideration, reviewing the evidence the company presented. He has concluded that the draft interim determination assumptions remain appropriate, namely that the interest rate has been assessed using a margin of 75 basis points over the risk-free rate. The risk-free rate has been based on current gilt yields which together with the margin gives a nominal rate of interest of 6.55%.

The additional increments to your current price limit have been calculated on a scheme specific basis. These are set out in the following table.

Additional increments in Northumbrian Water Limited price limits For the charging year 1999-00 arising from the changes in requirements
Projects	Additional increments in "K"
Hendon STW – provision of secondary treatment	0.3%
Howdon STW – provision of secondary treatment	1.1%
Bran Sands STW – provision of secondary treatment	0.2%
Coastal STWs – provision of secondary treatment at Horden, Marske & Seaton Carew	0.4%
Extensions to the regional sludge treatment centre (RSTC) at Bran Sands	1.1%
Impact of re-phasing	-0.4%
TOTAL ADDITIONAL "K" TO REFLECT THE CHANGES IN SEWAGE TREATMENT REQUIREMENTS	2.8%
Current price limit for 1999-2000	-2.1%
NEW PRICE LIMIT FOR 1999-2000	0.7%

Note: Totals may not add up due to rounding