MD148

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

31 March 1999

PUBLICATION OF LONG RUN MARGINAL COST DATA

LRMC information

In MD 123 (February 1997) I set out the importance I attach to the use of long run marginal cost (LRMC) i.e. the continuing costs of augmenting supply (including incremental capital costs) in water pricing (and in the allocation of water resources). Since then companies have been asked to provide Ofwat with estimates of LRMC and the supporting investment appraisal analysis on a number of occasions. As part of the Supply/Demand Balance Submissions in June 1998, companies were asked to provide Ofwat with estimates of LRMC for average and peak use. Although most companies put their LRMC numbers in the public domain, a significant number (including eight of the water and sewerage companies) did not, on grounds of commercial confidentiality. Companies are now being asked to provide an update to their LRMC work in their Business Plans, to be submitted to Ofwat by 9 April 1999.

The importance of LRMC information

I have set out previously on a number of occasions that tariffs for large users should be set with reference to robust estimates of LRMC (i.e. the LRMC for resources, treatment and bulk transmission). This is in order for such tariffs to avoid undue discrimination/undue preference in charging.

The Water Industry Bill currently before Parliament will also give me additional powers to approve companies' Charges Schemes, in effect formalising the Director's role with respect to charging. This will include the approval of large user tariffs and given I have set out the need for such tariffs to be set with reference to LRMC the need for robust estimates of LRMC becomes more important.

LRMC information is also important in establishing correct pricing levels for competition. Ofwat has published a number of letters to regulatory directors (RD letters) setting out the importance of LRMC for establishing the terms of inset appointments, particularly for determining bulk supply agreements. I have powers under the Water Industry Act 1991 to determine terms and conditions for bulk transfers between undertakers and for non-domestic water supplies. I intend to produce guidelines in the near future on the application of the Competition Act to the water industry, which will cover pricing aspects (including the application of LRMC to tariffs for large users).

While I recognise the practical and methodological problems in estimating LRMC, I am concerned that the wide variation in LRMC estimates submitted by water companies in June 1998 is not readily explicable. Even more important, I am concerned in respect of some companies that the approach to water resource investment, large user tariffs, bulk supplies and demand management is not consistent with LRMC estimates.

On the other hand, some companies have adopted apparently logical and informative approaches to the determination of LRMC. Where LRMC information is soundly based, it is, as set out above, important in setting the framework for tariff setting, terms for bulk supplies and the competitive framework. I believe that the quality of this work will be improved by wider access both to the methodologies adopted and to the results.

All this points to the need to publish companies' LRMC information, much of which is not currently in the public domain. I believe it makes sense, therefore, to begin that process. I propose to do this, initially, by publishing companies' LRMC numbers in the 1999-2000 Report on tariff structure and charges, to be published in May 1999. I propose to use the LRMC numbers submitted in the Business Plans for this purpose. I also believe that companies should also make public their LRMC work, which they submit as part of the Business Plans, and believe they should do this on 1 April 2000, as indicated in Setting price limits for water and sewerage services.

After price limits have been set, Ofwat intends to publish a report on companies' LRMC numbers, covering the numbers themselves and a critique of the methodologies used. This will be identified in the Ofwat Forward Programme, to be published on 31 March 1999.

Confidentiality of company information

You will remember our general presumption of non-confidentiality for all the information submissions for the 1999 Periodic Review in The business planning process, customer consultation and information requirements for the 1999 Periodic Review. In Setting price limits for water and sewerage services (February 1998), I confirmed that view.

In MD135 (Confidentiality for July Returns and PR99 Information submissions) I set out the following process for companies (and Ofwat) to follow:

• Whoever proposes that any information be treated as confidential must provide a written statement of reasons in support.
• If Ofwat is satisfied that those reasons demonstrate that disclosure would (or might) seriously and prejudicially affect the interests of anyone to whose affairs the information relates, we will normally respect the confidentiality and excise the relevant material from submissions, or ask for an excised version including the applicant's written statement of reasons for omitting the confidential information.
• If no written justification is received, then Ofwat will release the submission unamended.
• Even if Ofwat accepts that a case exists for preserving confidentiality, as above, I may, nevertheless, decide that publication is necessary in order to fulfil my regulatory duties. In that case Ofwat will tell the company seeking confidentiality and give an opportunity for further representations to be made, before finally deciding what to publish. We are using this procedure in the case of LRMC information.

Next Steps

I look to companies to inform me of:

• Any particular objections to the plans for exposing LRMC information to greater public scrutiny in the way set out above.
• And therefore how publishing this information would seriously and prejudicially affect the company's interests.

I C R Byatt