MD144

TO MANAGING DIRECTORS OF ALL
WATER AND SEWERAGE COMPANIES
AND WATER ONLY COMPANIES

4 February 1999

PROPOSED CHANGES TO THE TREATMENT OF LARGE USERS AND TO THE UNMEASURED TARIFF BASKET– MODIFICATIONS OF LICENCE CONDITION B

In September 1998 I wrote to you (MD137) asking you to agree to my proposed modifications to Licence Condition B. These were to change two aspects of the workings of the existing tariff basket, as follows:

• to take large users (ie those using not less than 250Ml/year of water) out of the tariff basket; and
• to change the arithmetic of the unmeasured basket to bring it into line with the way the measured basket works.

Large users and the tariff basket

Twenty five companies including all the water and sewerage companies have agreed to my proposal to take large users out of the tariff basket and twenty three companies have accepted the appropriate amendments to their licences. I am also taking the opportunity to modify the licences of these companies to provide for five yearly Periodic Reviews. The remaining companies, Sutton & East Surrey Water and York Waterworks, have not yet agreed to my proposal in respect of large users.

There has been some confusion expressed as to what assumptions I will apply for revenues from large users at the Periodic Review. I have, I believe, made it clear that, in the first instance at least, I will assume (and believe that companies should also assume) that tariffs for large users should be set with reference to long run marginal cost (LRMC) ie the costs of resources, treatment and bulk transfer. If, however, the application of P₀ were to bring standard volumetric rates below the level of tariffs for large users then large users should benefit from tariffs at standard volumetric rates and not pay more for their water (and sewerage) than household customers. Large user tariffs should therefore be set in line with estimates of LRMC or with the standard volumetric rate if this is lower than LRMC.

Where companies have not agreed to modify their licences, however, I need to consider what action I will take to ensure that such companies are not afforded an advantage over those companies who have modified their licences. I am minded to use the powers to approve companies' charges schemes that I will be given under the Water Industry Bill, currently before Parliament, to prevent any tariff rebalancing arising from changes in large user tariffs from 1 April 2000 for the companies concerned.

Proposed changes to the unmeasured tariff basket

All companies have now indicated whether or not they wish to proceed with the proposed change in the unmeasured tariff basket. When I sent out MD137 four companies had already indicated their agreement to the change in the arithmetic of the unmeasured basket: Anglian Water, Cholderton Water, Essex and Suffolk Water and Northumbrian Water. In addition, Hartlepool Water, now part of Anglian Water, has also agreed.

All other companies have replied saying that they do not wish at this time to move to the revised tariff basket either while existing perceived uncertainties remain to be clarified or for the foreseeable future. In making this assessment companies have cited the following reasons:

1. The charging proposals of the Government in the Water Industry Bill.
2. Many of those companies unwilling to agree to the licence change consider that the effect of the proposed legislation on charging will be to increase significantly the rate of optional metering and, as a result, to increase the level of uncertainty in respect of future revenues.
3. Treatment of revenue forecasts at the Periodic Review.
• Several companies have indicated that they remain unsure as to how Ofwat will handle the revenue impacts of switching in the charging base at the 1999 Periodic Review. They asked for additional assurances as to how these impacts would be handled and what mechanisms would be in place subsequently to protect companies from significant income shortfalls as a result of high rates of optional metering before being willing to agree.

In MD 137 I said that I would not seek to implement a change to Licence Condition B unless there was a general move by all companies to agree to a revised tariff basket. It is clear to me from the responses received that the basis for such a change does not exist.

I have considered both the practicality of proceeding with two versions of the tariff basket at the Periodic Review and the lack of comparability in annual changes of customers' bills in relation to price limits if two different tariff baskets are in force. On balance, I have decided that customers' interests are best served by an approach which retains the existing unmeasured basket for the current review. I have, therefore, decided not to modify the licences in respect of those five companies that agreed to my proposal.

Before making my decision, I consulted the Northumbrian & Eastern CSCs. They both would have preferred the licences of the companies in their area to be changed as I had originally proposed.

I indicated in MD137 that the Government's policy conclusions on the Review of Charging could have an impact on assumptions I will make at the Periodic Review about tariff-switching effects. I will let companies know my conclusions on this issue in the "Dear MD" letter I am sending in March on methodology issues once my formal meetings with all companies have been completed.

I C R Byatt