MD124

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

 11 February 1997

1999 PERIODIC REVIEW
Introduction 

I announced in MD120 (15 October 1996) my intention to review in 1999 the price limits for the 29 water and sewerage companies in England and Wales. I also intend to review the infrastructure charge limits. The new price limits for K factors and infrastructure charges will take effect from 1 April 2000.

This letter sets out my objectives for the next Review and the key principles which I intend to use to guide the process.

In MD120 I said I would publish a schedule early this year for the Periodic Review. This letter, appendices and the draft timetable attached set out my current thinking on key stages of work and milestones leading up to final determinations. This is intended to give both the companies and my Office time to implement an effective business planning process, including proper involvement of all interested parties, especially customers, through to 1999.

Objectives and principles for the next Review

At the next Review I will expect companies to demonstrate improving standards for their customers and efficiency gains which allow prices to come down in real terms, despite continuing capital investment requirements. From my discussion with the Chairmen of the Ofwat Customer Service Committees (CSCs), I believe that this is what customers want. In creating this dynamic pressure on prices, I act as proxy for a competitive market.

Incentive regulation is working. Although no system is perfect, RPI-X regulation enables companies and the regulator to achieve a proper balance between the interests of customers and shareholders. Crucially it creates incentives for efficiency, the benefits of which are transferred to customers. Other systems that have been suggested, including various forms of profit sharing or sliding scale regulation, risk corrupting such incentives and hence could result in lower benefits for customers in the medium term.  

As to the period between reviews, I have already stated that I consider ten years is too long. I believe there is a case that an interval of four years would still be consistent with the preservation of adequate incentives whilst allowing swifter distribution of benefits to customers. This is so, for example, with the regulation of the telecommunications industry and the National Grid Company. 

I would welcome views on both the current system of regulation and the period between reviews. 

Companies have reported significant efficiency savings since the last Review of price limits. I propose to transfer the future benefit of these savings to customers at the next Review through an initial downward adjustment of real prices. Following the initial downward adjustment of prices, I will establish a framework which seeks to accommodate any new quality obligations and any investment required to maintain a balance between supply and demand within the constraints set by likely future improvements in efficiency. I will also need to take account of the outcome of the review of the tariff basket. 

In taking these decisions, I will respect incentives for companies to continue to improve economy and efficiency. In this respect, I am minded to appoint senior industrialists, who could offer me strategic advice on my decisions in this area. 

During the Review I shall be working closely with the Environment Agency and Drinking Water Inspectorate to clarify the nature and timing of quality obligations within price limits which customers will accept. I will advise the Secretaries of State on costs and seek their guidance on timing and scale. 

I intend to appraise supply/demand balance issues by the methods set out in Annex 2 of Paying for Growth (1993), but taking account of the part which companies' plans for promoting efficient use of water by their customers should play in that consideration. Where possible, expenditure to meet imbalances in supply and demand should be met by changes in bills (and revenue) rather than overall price limits. I will work closely with the Environment Agency in assessing companies' plans for balancing supply and demand. 

I intend to treat supplementary improvements in levels of service according to broadly similar principles as used in the last Review, set out at page 40 of Future Charges for Water and Sewerage Services (1994). 

I intend to conduct an open process. One of my objectives in proposing the timetable outlined in this letter is to provide every opportunity for resolving issues before the companies' business plans are finalised in 1999, especially the scale and nature of the outputs to be financed in future price limits. All who have an interest in the result will be able to put their point of view. I will then balance these different interests in setting price limits.  

As I mentioned in MD121, in the early stages of the Review I would like to meet the Board of each company, including its non-executive directors, possibly together with the CSC Chairman, in order to discuss my general strategy and, in particular, the processes of public consultation which can best ensure that all the interested parties are fully involved.  

The process which I am minded to follow is set out below.

Final and draft determinations 

In drawing up a proposed timetable for the next Review, I have considered a number of options, in particular learning from the experience of the last Review and from other regulators. As you will see, I am suggesting a number of changes to the timetable compared to that adopted for the 1994 Periodic Review. In the light of experience and wider concerns expressed to me, I am minded that my draft determinations should be placed in the public domain for comment from interested parties rather than kept confidential as in 1994. This approach has implications for the timetable and process. 

I intend to announce my final determinations in December 1999. This would allow for a reasonable period of consultation following the publication of draft determinations at the end of July 1999 and a formal meeting with each company. I believe it should then be possible for companies to submit Principal Statements by 31 January 2000, but would welcome views on this proposal.  

Publishing draft determinations requires a longer period than previously between the receipt of the companies' business plans (around the end of March 1999) and final determinations in order to allow for external consultation and comment. Companies would be submitting their July Returns for 1998-9 while my Office is undertaking analysis of business plans in order to inform my decisions. July Returns will, of course, be relevant to the analysis and hence I see advantage in having that data before publishing the draft determinations. I suggest that: 

• each company's business plan submitted around the end of March 1999 includes its best estimates of 1998-9 outturn figures; and
• the date for submitting 1998-9 July Returns (including regulatory accounts) is brought forward to 1 June 1999. Those returns should include an explanation of any material changes to specified key numbers submitted with business plans.  

Business planning process 

The business planning process will involve successive data submissions from the companies and discussions, taking account of public responses before the final plan is submitted. The planning process will provide an opportunity for each company to set out:

• what it considers constitutes the proper carrying out of its functions over the ten year period 2000-10;
• the price limits for the ten year period 2000-10 which it considers are necessary for it to be able to finance the proper carrying out of functions;
• the state of its assets in 1997-8, especially the state of the infrastructure assets;
• the investment needs and priorities to maintain long-term serviceability to customers, to improve service where considered necessary, to meet new legal obligations and to ensure an adequate balance between supply and demand in the provision of water and sewerage services for customers; and
• risks and uncertainties involved in all elements of this work, perhaps in the form of scenarios, and to justify the robustness of the plan to changing circumstances.

• the reporting structure for the final plan and the linkages with data submissions earlier in the planning process;
• the arrangements for appointing Reporters and their role in validating the companies' data submissions;
• the scope and content of a summary version for publication at the same time as the final plan is submitted to me, taking into account the need to balance the need for openness and transparency with any requirements of commercial confidentiality; and
• requirements for establishing a monitoring base for the price limit period following my determination.  

In light of these and other issues, it is likely that there will be some adjustment to the timing and/or content of Ofwat's annual reports on company returns in 1999. 

Consultation with customers and companies

Companies have the prime responsibility for establishing customers' priorities. I expect them to work closely with the CSCs. By customers' priorities, I mean particularly those between quality, resource development and levels of service. 

I currently envisage that companies, with the involvement of CSCs, will establish customers' views at a regional level throughout the period to 1999. This would include consultation on environmental outputs as well as on levels of service against the background of company progress - actual and prospective - in improving efficiency. I also envisage the quality regulators will ascertain the views of customers and environmental interests about environmental priorities, setting out costed options with measurable environmental benefits, both at a regional and national level. I will want to discuss with the companies and the quality regulators mechanisms for ensuring that there is a co-ordinated approach to establishing customers' views.

I would expect each company's business plan to reflect its work with customers, and will be asking CSCs to report to me on that aspect in particular.

I am committed to ensuring that companies have the opportunity to understand and contribute to my thinking on major areas of work. They will be involved in discussions on the way the next Review is conducted and contribute to a progressive refinement of the information I receive during the business planning process.

To enable companies to plan their involvement, I have identified five milestones: 

• A paper on key methodological issues, to be published this Summer. The purpose of this paper will be to invite views from interested parties on the principles and policies I propose to adopt in my approach to setting price limits in 1999.
• A first draft of Periodic Review information requirements, also to be issued this Summer. This will cover various submissions of information leading up to the company's business plan including, for example, requirements for information to supplement the July Return in 1998 and expectations of the Reporters' and Auditors' involvement in examining company submissions.
• A methodology paper to be published in early 1998, outlining my anticipated approach to the Review in light of the views of interested parties.
• A detailed specification of Periodic Review information requirements to support the business planning process, to be issued in early 1998.
• Later in 1998, a position paper focusing in particular on the outcomes of the various activities undertaken by my Office, the companies, the Drinking Water Inspectorate, the Environment Agency, Department of the Environment and the Welsh Office. This paper will draw together quality, environmental and supply/demand issues with thinking on efficiency and customers' priorities.

There will be a series of formal and working level meetings with individual companies at key points in the business planning process, including: 

• formal review meetings with certain companies, in the last quarter of this year, where their performance may be giving rise to concern;
• working level meetings with all companies in the last quarter of 1998, which will focus on the key issues for companies to address in advance of preparing their business plans;
• a formal meeting with me in early 1999 prior to each company finalising its business plan; and
• a formal meeting with me following the publication of draft determinations in order to give each company the opportunity to make representations before I make my final determination. 

I will expect each company to be able to provide as part of its business plan a capital investment programme, including the maintenance of existing assets, setting out needs and priorities, taking account of local factors, new demands, contingency, and evaluating the revenue and capital consequences.

At the last Review, I gathered cost estimates and refined these as the nature of new quality obligations became clear. The uncertain legislative timetable and extent of the current proposed changes in programmes indicate that the process will need to be able to accommodate changes in planned investment and be flexible. 

Companies should clearly define the improvements that customers will have to fund through their bills, so that I can monitor annually progress against programmes both in terms of scheme progression, (interim and final) outputs, activity and how much is being spent. 

There remains a need to ensure that there is clarity on the nature and timing of quality obligations. I propose, together with the Secretaries of State and the quality regulators, to engage the companies in a business planning process which takes into account the likely costs of these obligations and the priorities of customers. The key milestones in this process, as currently envisaged, are detailed below: 

• I propose to collect summary data from most companies on likely future costs of quality programmes, based on initial guidelines to be issued shortly. The data will be required in May 1997 and will be used to assess the current best estimate of the scope of the quality issue.
• In November 1997, in association with the Secretaries of State, the Drinking Water Inspectorate and the Environment Agency, I will issue specifications on costing/quality programmes to each company.
• In February 1998, I will ask companies to submit their forecast cost data in relation to quality programmes based on the specifications agreed in November 1997. This data will be requested at the level of detail used in the MD91/99 submissions and the Paying for Quality exercise in the last Review, amended to be compatible with the current format of July Returns information.
• I will use the data to advise the Secretaries of State, in an open letter in April 1998, on the indicative costs of the possible quality programmes, and seek policy guidance from them on the timing and scale of obligations consistent with price limits acceptable to customers.
• I will seek a response from the Secretaries of State before the 1998 Summer recess. This will enable the Drinking Water Inspectorate and the Environment Agency to prepare formal guidelines for the industry in September 1998.
• I will then ask companies to update their capital and operating expenditure forecasts in the February 1998 summary format, by the end of November 1998. 

It will also be necessary to consider how to respond, particularly for some companies, to any imbalance between the supply of and demand for water. Consideration should begin with the matters discussed in Water resources and supply: Agenda for Action (October 1996), DoE, and, in particular, take account of the fresh estimates of reliable yields to be made this year by the Environment Agency.  

Methodology and views of interested parties 

Discussion with interested parties will follow publication this Summer of my paper on key methodology issues. Although some of these issues will be of a technical nature, others will cover matters on which customers or their representatives may have views. Issues covered may include: 

• the regulation of capital investment programmes, as outlined above;
• how quickly efficiency gains in capital and operating expenditure are passed on to customers;
• the balance between leakage and demand control measures and new resources, including the use of bulk supplies, in maintaining a balance between supply and demand or enhancing security of supply (as set out in the Government paper Water resources and supply: Agenda for Action (October 1996));
• the treatment of supplementary investment, over and above that needed to comply with quality obligations;
• the approach to capital maintenance;
• financial issues, including the use of regulatory capital values, the treatment of customer rebates and reductions in K during the period 1995 to 1999;
• the role of Reporters.

A methodology paper will then be published in early 1998 setting out the policy and methodological framework for the Review.  

1998 position paper  

In 1998 I will develop my understanding of regional issues and priorities, within the overall framework and objectives for the Review. I intend to ask CSCs to report back to me on companies' consultation exercises together with their comments on the conclusions drawn by the companies. This would provide me with further material for a position paper which would bring together the results and views of the interested parties thus far on the issues to be settled at the Review, namely the position reached on: 

• The work of the companies, with their customers, including CSCs, on customers' priorities, having taken account of the guidance of the Secretaries of State. Ideally, this should be about priorities within the objectives and framework for the Review.
• The work of the Environment Agency, with companies and other environmental bodies, at local level, involving CSCs. I envisage that this consultation would produce a clear specification of quality obligations and scope for national policies to improve the environment together with a priority list of possible work, including benefits and appropriate costings.
• The work of my Office, the Department of the Environment and Welsh Office on the analysis of indicative costs of quality improvement programmes, including company and Environment Agency involvement. Ideally this should produce costings of what is known must be carried out, especially for the period 2000-05 at the company level. Issues not settled would be left to interim determinations, or a subsequent price review. It could be useful to set out blocks of expenditure likely to be required to meet new quality obligations.
• My Office's work on efficiency gains across the spectrum of outputs and costs, and on cost of capital and financial with implications for the size of the initial downward adjustment of prices and expectations for future efficiency, unwinding of any advancement of price limits and of infrastructure renewals accruals.

Comments on this letter would be welcomed by 4 April. 

I am sending copies of this letter to the organisations/individuals listed in Appendix 2.

 I C R BYATT

APPENDIX 1

THE APPROACH TO THE 1999 PERIODIC REVIEW:
ISSUES FOR FUTURE CONSULTATION

As indicated in my letter, I plan to publish, this Summer, a consultation paper on key methodological issues. I shall also at that time be initiating consultation with the industry on Periodic Review information requirements. 

This Appendix sets out my preliminary thinking on the nature and scope of certain issues likely to be raised this Summer.  

The proposed overall approach for this review of price limits will be broadly similar to that adopted in 1994. I have sought to learn from the last Review, however, and to respond as new issues have developed. As a result, the approach may be modified in certain areas following discussion with interested parties. 

Overall framework 

In the last Review, for the purposes of establishing an overall framework for price-setting, I adopted the concept of K as equivalent to -X + Q. In the interests of transparency, I believe it is helpful now to think of K as being made up of a number of components, as follows: 

P_o : efficiency gains delivered

X : expected efficiency in the future

Q : expenditure on quality enhancements

S : enhanced service levels expenditure

V : supply/demand balance expenditure 

The final determinations in 1999 will explain the material influences on price limits at an industry and company level. Not all the components will be independent. 

Efficiency gains and leakage 

I have a duty to promote economy and efficiency and I will continue to use comparative competition to further this end. The assessment of comparative efficiency is dependent on reliable measures of inputs and outputs. The current regulatory regime places strong incentives on companies to minimise their costs within the price cap.

At the last Review, the return on capital was reduced over the ten year period of the Review in part to reflect efficiency gains in the first quinquennium. Since then the concept of an initial adjustment to price limits to pass on accumulated efficiency gains has emerged and been applied by the electricity and gas regulators. I believe that this approach has merit for the setting of prices for water and sewerage. 

This initial adjustment is represented by the P_o element of K in the first year of the new price limits. Future efficiency gains, on the other hand, would be reflected within price limits for subsequent years in the X element of K. 

In determining the scope of future efficiencies, account will be taken of other utilities and the wider economy. Econometric analysis will be applied in order to examine variations in costs across companies. 

High leakage may be regarded as a measure of inefficiency. Companies will be expected to demonstrate that they understand their economic level of leakage and are working towards it. New leakage targets should be based on an assessment of companies' progress on reaching economic levels.  

Supplementary investment 

I need to be assured not only that supplementary investment is in the interests of customers, but that it is not at the expense of other programmes nor making up for existing shortfalls. 

Supplementary investment claimed by companies will not be automatically rewarded. Companies may need to demonstrate to me, for example, that investment has been material, has a higher customer valuation and priority and has created an exemplary comparator in the area.  

I will be consulting on the precise criteria against which supplementary investment will be tested. 

Supply/demand balance 

At the last Review I concluded that expenditure to maintain a balance between supply and demand should as far as practicable be paid for by changes in bills (and revenue) rather than overall price limits. Given that demand as measured by distribution input at the last Review was forecast by the companies to be fairly stable over the following 20 years, expenditure to meet supply/demand imbalances was not significant in terms of the impact on price limits. Where there was growth in water delivered, companies forecast that this would largely be offset by leakage control and metering. Growth in demand from new customers was financed by contributions from infrastructure charges, requisition charges and an appropriate proportion of the extra revenues from new connections.

Following the hot and dry summer of 1995 there has been considerable discussion on the potential need to widen the margin between supply and demand and increase security of supply. Some companies which had allowed increased leakage to erode this margin have already incurred additional expenditure to restore or increase the security of supply of water. Given the significance of this issue for some companies, an additional "V" component of K is under consideration to reflect any price increase needed for increases in the security of supply, ie less resort to residual river flows. This "V" element could be negative where companies can sell surplus water resources to neighbouring companies. 

The general approach to this issue adopted at the last Review (ie that expenditure to meet supply/demand imbalances should, as far as is practicable, be paid for by changes in bills (and revenue) rather than overall price limits) remains valid. This may require greater sophistication in tariffs and tariff structures. Companies will need to consider, therefore, the role that price mechanisms may have in addressing supply/demand imbalances. 

Infrastructure Charges 

Companies report administrative difficulties in levying infrastructure charges. I intend to review the infrastructure charge limits and explore whether there is a need to simplify the policy in this area still further. 

Tariff Basket 

I have already announced that I will be conducting a review of the tariff basket and expect to publish a consultation paper on this subject soon. Any changes in the structure of the tariff basket will need to be accommodated in price limits. 

Capital maintenance 

I expect to adopt a broadly similar approach with regard to capital maintenance as in the last Review. 

The approach in this area begins with the companies' duty to maintain their assets to ensure that serviceability to customers is sustained in the long term. Price limits will, therefore, be sufficient to allow companies to fulfill this duty. 

I expect companies to link their understanding of how their asset stock is maintained with serviceability to customers, and to respond on both conditions of assets and serviceability in their business plans. I intend to seek information on assets in advance of business plans. 

I will expect companies to advise me on the relationship between serviceability to customers and expenditure, and the interaction between quality enhancements and capital maintenance. I expect broad equivalence between capital maintenance expenditure and accounting charges over an appropriate period. It would be appropriate to deal at the next Review with the Infrastructure Renewals Accrual where this is significant. 

Financial issues 

The price limits set in 1994 assumed that customers should meet operating and capital maintenance costs on a year-by-year basis and provide a return on capital to remunerate net new investment. 

The return on capital is dependent on both the cost of capital and the capital base. The cost of capital for utilities in general has achieved a consensus around a narrow band of between 6-8% before tax in real terms. Water companies are of generally lower risk on average and hence the cost of capital is likely to be around the lower end of this range. Allowance will need to be made for the likely tax paying position of companies, particularly in the light of the recent changes to tax relief on capital expenditure and a possible utility tax. 

The principles underlying the capital base, ie the regulatory capital value, will also remain broadly consistent with those used in the last Review and, indeed, have been adopted by other regulators. The regulatory capital value will represent the market value of the companies around the time of privatisation rolled forward to take account of net new capital investment that has achieved the required outputs.

The regulatory capital value at 1999 may also be adjusted to take account of any capital efficiencies together with adjustments either to take account of outputs not met or the delivery of new quality obligations imposed on companies. Supplementary investment that has resulted in significant improvements in service performance may also be considered for inclusion in the regulatory capital value, as indicated earlier in this Appendix. 

I have stated that, to be fair, I will be ready to take account of benefit sharing - or lack of it - at the next Review. The onus should, however, be on companies to demonstrate that customer rebates or deferrals of K are a result of accelerated transfer to customers of benefits in the current quinquennium rather than resulting from before the last Review. 

I will also make adjustments to price limits where cross-subsidy is found in the course of transfer pricing investigations. 

Financial indicators will be considered, but, as at the last Review, will be of secondary importance compared with providing a return on capital.  

Role of Reporters 

As indicated in my letter, I envisage a requirement for various submissions of information, as well as July Returns, leading up to companies' business plans. Reporters will play a valuable role in providing an independent evaluation of these submissions. 

I believe there is scope to build on the current process of expert scrutiny and independent reporting on company submissions. I am, therefore, looking at the possibility of taking responsibility for decisions on Reporters' appointment in future. Companies would continue to meet the costs of rigorous performance-based contracts. Presently companies appoint their own Reporters and I have power of veto over their nominations. I shall consult on possible changes to the independent reporting regime prior to publication of the methodology paper this Summer 

APPENDIX 2 

COPY ADDRESSEES

Age Concern England

All Party Water Group

Association of Metropolitan Authorities

Association of County Councils

Association of District Councils

Confederation of British Industry

Consumers' Association

Council for the Protection of Rural England

County Landowners Association

Department of the Environment

Drinking Water Inspectorate

English Nature

Environment Agency

Federation of Master Builders

Friends of the Earth

House Builders Federation

Institute of Directors

Liberal Democrat Spokesman on the Environment

Local Government Association

Major Energy Users' Council

National Farmers Union

National Consumer Council

National Federation of Consumer Groups

National Association of Citizens Advice Bureaux

Office of Gas Supply

Office of Electricity Regulation

Office of Telecommunications

Office of the Rail Regulator

Ofwat Thames CSC

Ofwat Wessex CSC

Ofwat CSC for the South West

Ofwat CSC for Wales

Ofwat Southern CSC

Ofwat Central CSC

Ofwat Eastern CSC

Ofwat North West CSC

Ofwat Northumbria CSC

Ofwat Yorkshire CSC

Public Utilities Access Forum

Royal Society for the Protection of Birds

Shadow Environment Secretary

Surfers Against Sewage

UNISON

Utility Buyers Forum

Water Companies Association

Water Services Association

Welsh Office

1999 PERIODIC REVIEW - DRAFT TIMETABLE 

Consultation paper on methodologies	Summer 1997
First draft of information requirements	Summer 1997
Consultation period on Ofwat methodologies	July to October 1997
Consultation on information requirements	September to October 1997
Publish methodology paper	Early 1998
Publish specification of information requirements	Early 1998
Customer consultation - by companies and Quality Regulators	March to September 1998
Ofwat position paper	Late 1998
Customer consultation on position paper	October to November 1998
Meetings with companies - focused on key issues	October to December 1998
DG formal meetings with companies, prior to strategic business plans	January to February 1999
Strategic business plans	[9 April 1999]
1999 July Returns	[1 June 1999]
Publish draft determinations	July 1999
DG formal meetings with companies, in light of draft determinations	September to November 1999
Public consultation period	September to November 1999
Publish final determinations	December 1999
New price limits take effect	1 April 2000