24 July 1998

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. The application concerns the implications for your company of the requirements to introduce secondary treatment, by 31 December 2000, at a number of estuarial and coastal sewage treatment works. You considered that these requirements, which differed from the assumptions made in the 1994 periodic review, are relevant changes in circumstances (RCC) as set down in the licence. You cited RCC1 - change in legal requirement.

You submitted a report with your application. You estimated the additional capital costs of meeting the changed requirements would be £247m spread over the next three years. Your estimates are set down in Table 1. I have placed a copy of your application in the OFWAT library.

My staff sought some additional information on your application and raised a number of queries and points where clarification was sought. Over the past few weeks you have provided answers to all these requests.

I asked David Arnell (Binnie Black & Veatch), the independent reporter for your company, to review the application and provide me with his considered assessment. He submitted his report to my office on 14 July 1998. I have annexed to this letter Mr Arnell's conclusions.

Table 1 - Company estimated net additional costs Arising from the changes in requirements
Estimated additional capital costs £m (1997-98 prices)
Projects	1997-98	1998-99	1999-00	2000-01	Total
Hendon STW - provision of secondary treatment	-	2.4	10.7	10.7	23.8
Howdon STW - provision of secondary treatment	0.5	7.5	50.0	26.0	84.0
Bran Sands STW - provision of secondary treatment	-	3.8	15.9	7.6	27.3
Coastal STWs - provision of secondary treatment at Horden, Marske & Seaton Carew	-	1.5	21.8	21.8	45.1
Extensions to the regional sludge treatment centre (RSTC) at Bran Sands	-	8.6	37.5	21.0	67.1
TOTAL ADDITIONAL CAPITAL COSTS	0.5	23.8	135.9	87.1	247.3

My assessment of your application has been in accordance with the terms of your licence. There have been four stages

1. Seeking confirmation of the changed requirements from the relevant authorities.
2. Assessing the reasonable net additional costs of the confirmed obligations that should properly be taken account of in price limits.
3. Checking that the total net additional costs pass the Condition B materiality threshold.
4. Determining the appropriate increase in your price limit for 1999-2000 to reflect the net additional costs in the years up to and including 1999-2000.

Stage 1 - Confirmation of the changed requirements

Following your application I sought confirmation from officials at the Department of the Environment, Transport and the Regions (DETR) that your assessment of the requirements under the Urban Waste Water Treatment Directive (UWWTD) at the major sites were appropriate and necessary. It was particularly important to establish the position of DETR Ministers on your earlier applications for derogations under the terms of the Directive.

I have received satisfactory assurances from DETR officials that the levels of treatment and the latest commissioning dates required at each major site are as you set down in the application (Bran Sands, Hendon and Howdon). There remains the possibility of you securing derogations under article 8.1 of the UWWTD at some future date if you experience technical difficulties.

My staff sought similar confirmation 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 you submitted to them last year.

The EA has confirmed its assessment of the comprehensive study reports you had submitted to them. The comprehensive study 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 EA announced its decision on the comprehensive study reports and the UWWTD treatment requirements at Horden, Marske and Seaton Carew on Wednesday 22 July 1998.

I am content 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. I have 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

I set down my approach to reviewing company costs in my recent papers Setting price limits ……(February 1998) and Assessing the scope for future efficiency (April 1998). I have adopted these approaches in assessing the reasonable net additional costs arising from the changed requirements. I have also considered to what extent costs could have been avoided by prudent management action.

Broadly my 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 capital efficiency improvement factor of 1% p.a. to reflect continuing technical progress year by year, and
d. making final adjustments to take account of offsetting savings (re-phasing of some projects within the statutory dates), unnecessary work you have already carried out at some of these sites and my previous determination assumptions.

My office has completed sufficient of their analysis of the Cost Base submissions to enable me to take a view on robustness of your company's capital costs. The analysis has identified a significant gap between your company's sewerage service (non-infrastructure) cost base and the best in the industry. My staff have calculated that to move your cost base half way to the best in the industry requires a further17% reduction in capital costs.

As indicated above I shall apply the same general efficiency assumption of a further 1% p.a. as was used in the last periodic review to reflect sharing the continuing progress you will be making.

You have identified the scope for re-phasing some other projects so that they will now be completed later than planned but still within the statutory dates. This provides some short term relief in the next two years (£10m) but with these monies adding to your programme in 2000-01. I welcome this flexibility and have taken it into account.

My staff have reviewed what I allowed in 1994 for the original obligations and also question some of the work that you have carried out that has subsequently been shown to be unnecessary. I have adjusted the final figures downwards by around £15m for these two factors.

My overall assessment of the reasonable net additional costs arising from the changed requirements is summarised in Table 2.

Table 2 - 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. Slightly above 10% reduction	Small	-2.5	-13.8	-8.9	-25.2
(b) Cost Base Adjustment Factor. 17% reduction	Small	-3.6	-20.7	-13.3	-37.8
(c) General efficiency improvement adjustment. 1% p.a. year on year reduction starting in 1998-99	Nil	-0.2	-2.0	-1.9	-4.2
d. Other adjustments (see text)	-7.5	-8.0	-9.0	10.0	-14.5
TOTAL ASSESSMENT OF THE REASONABLE NET ADDITIONAL COSTS	-7.1	9.6	90.3	73.0	165.7
Note columns and rows have been rounded so totals may not tally

Mr Arnell has identified in his conclusions a number of areas in which he believes the company may have taken a conservative approach to estimating the costs. My staff have carried out a parallel analysis as a sense check of the overall adjustments arising from the main approach. Their findings support my conclusions as to the reasonable net additional costs set down in Table 2.

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 Limited's turnover for 1997-98 was £322.5m. The materiality threshold is just over £32m. The total reasonable net additional costs for the three years 1997-98, 1998-99 and 1999-00 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 1999-00, 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 1999-00, 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 as part of the current periodic review.

Condition B states that the investment allowed for in the interim determination should be remunerated using a current rate of return on borrowing. The appropriate 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 Table 3.

Table 3 - 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	0.2%
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	0.2%
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	2.3%
Note total does not tally due to rounding

Therefore, my draft determination of your application is that the current price limit of -2.1% for the charging year 1999-00 shall be increased by +2.3% to +0.2% as a result of the changes in sewage treatment requirements set out above.

I shall make my final determination of your application by 14 September, consistent with the timetable set down in Condition B. I understand that you will want to consider this draft determination in some detail over next few weeks. I will schedule a formal meeting to enable you make any representations you have on the draft determination face to face. Please let me know if you wish to take up this opportunity.

I am placing this draft determination in the Ofwat library at the same time as I announce my decision on the London Stock Exchange.

Interested parties may wish to make their views on the draft determination known to me. If so please could I receive them by Tuesday 1 September 1998. This will enable me to give them proper consideration before I make my final determination.

I am copying this draft determination to Alan Davis (DETR), Roger Hyde (EA(NE)), 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

Extract from the Independent Reporter's Report to the Director on Northumbrian Water Ltd's Interim Determination Application of 15 June 1998

GENERAL CONCLUSIONS

We believe that the Company has made a substantial effort to assess and cost the new obligation considered in the Interim Determination Application within the timescale available to it. The Company has made its assessment in a transparent way and has provided open access to its calculations and base data for the purpose of this audit. Where possible the Company has made significant use of current contracts which reflect its current cost base. Through sample audit in a limited timescale we have identified some areas of concern in the assessment of the scope of work costed and in the preparation of the cost estimates. This leads us to the conclusions that the estimates are conservative. In some areas the Company accepts this to be the case and will address the issues raised as it develops its estimates for the 1999 Periodic Review submissions.

Key points which contribute to this general conclusion are summarised below:

1. The Company appears to have based the scope of work underlying the estimates on design parameters which we consider to be robust but not unduly conservative for this level of estimate. In the report we have drawn attention to key points which might allow the Company to reduce the scope of work included and the associated costs. These include:
a. The Company has based its assessment on the use of technology with which it has confidence based on current experience. The development of the designs may allow the Company to adopt alternative technologies at lower costs but we accept that time constraints may preclude some detailed evaluations.
b. The Company has not developed the scope of work costed to a level which allows the application of scheme specific value engineering to reduce costs. However, the Company has based much of its costs on current schemes in which process development and value engineering have already been applied.
2. The Company has generally based the scope of work costed on its understanding of the UWWTD supported by discussions with the EA and local planners. Based on these discussions the Company has incorporated design requirements which we consider to be reasonable. Particular points have been brought to the attention of Ofwat in the main text.
3. In general we have concluded that in some areas the cost estimates prepared by the Company for the Interim Determination Application are conservative. We have identified the following areas where we believe that cost estimates should be reviewed:
a. The Company has applied project on-costs at a rate which is higher than that determined from a general analysis of a range of Company projects. We believe that the general analysis was based on a set of projects with a smaller project value than the seven projects now being considered. In principle we would have expected some economies of scale to reduce any percentage applied as a result of the general analysis although we accept that any reductions are likely to be smaller than the difference between the applied on-costs and the general analysis, which remains our main concern. We believe that the Company has further work to do to review and justify the appropriate level of project on-costs.
b. The Company has developed an estimate for Bran Sands using current tender costs and applied additional percentages for working on a live plant, for design development and for an EBA. We believe that the Company has further work to do to justify the level of percentages applied to tender costs in addition to the EBA. These percentages are also included in elements of the Bran Sands "look-a-like" estimates for other works.
c. The TR61 estimates prepared by the Company for the three coastal works have been estimated at the upper confidence limit (90%-ile) for each element of the various works. The main use of these estimates is to provide confidence in the alternative Bran Sands "look-a-like" estimates. Following on from point (b) above, we believe that both sets of estimates may be over-estimated and their comparability may engender an unreasonable degree of confidence in the estimates for the three coastal works.
d. The Company has developed an estimate for the RSTC extensions from tender and outturn costs. However, it has used average as opposed to lower tender costs and applied an addition to part of the costs for working on a live site. An EBA has also been applied. We believe that the Company has further work to do to justify the level of percentages applied to tender costs in addition to the EBA. The Company has explained that its choice of average tender costs was to offset some of the risks which it believes to be associated with Phase 2. We accept that because the Company cannot gain operating experience on the Phase 1 plant it faces a higher level of risk than it might otherwise have.