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MD 228


To Managing Directors of all
water and sewerage companies
and water only companies

There are two important, overarching principles.

1. Interim determinations can only deal with the impact of relevant items (Relevant Changes of Circumstance and Notified Items). An interim determination is not a mini-periodic review.

2. The procedure is also available to us – that is, we can decide, regardless of whether you have applied for an interim determination, that we ought to take action.

The timetable for interim determinations is set out in Condition B of the licence as follows.


• To change prices in the 2009-10 charging year either you or we must trigger an interim determination process by no later than 15 September 2008.
• Where this happens the other party may issue a counter-notice within 14 days.
• We must make an interim determination decision within three months of a request.

The scrutiny and opinion of your Reporter and Auditor is an important element of the interim determination process. Consequently, we expect you to invite them to attend any early discussions with us and involve them in the subsequent development of your application.

Any application for an interim determination must be submitted by Monday 15 September 2008. Your supporting documentation and Reporter's report and Auditor's report (if appropriate) should be submitted on the same date. If this deadline is met we will announce determinations no later than Monday 15 December 2008. If we decide to trigger an interim determination we will inform the company no later than 15 September and announce determinations no later than 15 December.

We expect that historic data contained within an interim determination application will be consistent with data previously submitted to us.

Where there are any differences in data we expect companies to provide strong evidence to support the difference, including a review by the Reporter or Auditor of the reasons for the difference. Given the timetable, we will not be in a position to provide companies with repeated opportunities to resubmit or improve their explanation. Therefore, the onus is on companies to submit a complete and full justification. Where a justification is inadequate or incomplete, we will use the data set that produces the lowest price limits for customers.

Where we ask for data to be revised or resubmitted during the interim determination process the Reporter or Auditor should also review the new data.

We believe that customers' interests are best served by operating an open and transparent approach to regulation. We are committed to issuing draft interim determinations for consultation with stakeholders. We also believe it would be beneficial for a company that requests an interim determination of price limits to inform its customers when it makes an application. This should include details of the application. We will publicly announce any interim determination we decide to initiate. We would also expect you to share details of your application, and any subsequent submissions, with CCWater.

When you submit your application you should:


• set out why you believe it is necessary and appropriate for you to increase customers' bills, within the context of your overall performance as achieved against the financial assumptions in your 2004 final determination; and
• detail the efforts you have made to contain the upward pressures on customers' bills and how you have accounted for any allowable, counteracting downward pressures.

I attach at annex A the timetable we intend to follow this year. Please tell us of any difficulties you foresee with this.

The electronic spreadsheet that underpins our interim determination calculations for 2008 is now available to download from our website (www.ofwat.gov.uk). It includes table formats that we use to summarise our interim determination. The spreadsheet automates the assessments of triviality and materiality, and calculates the annual allowable amount and the K adjustment required. The completed spreadsheet should be submitted with your supporting documentation.

If a company believes that there has been a change in the functions covered by relevant items since price limits were last set, but its valuation of the changes does not exceed the materiality threshold of 10%, these will not be dealt with by the process set down in this letter. Companies have the opportunity to use the procedures set down in MD197, the AMP4 change protocol. Where companies use these procedures we will indicate the items to be logged up or down at the next price review. We aim to respond to a request for approval/confirmation of a change protocol submission within six working weeks of receipt of all the relevant material from the company.

We will issue any counter-notices no later than 14 days after receiving a company's application. Where possible, we will indicate our intention to do so during any early discussions that we have with individual companies.

We will examine each application against the list of questions set out in Condition B paragraph 13/14.2(1) . The determination will either be a revision to price limits, or no revision to price limits because the materiality threshold has not been met.

1) Relevant Changes of Circumstance and Notified Items

Interim determinations may be available, provided that each of the matters at issue is a relevant item; that is, either a Relevant Change of Circumstance (RCC) or a Notified Item.

The Relevant Changes of Circumstance are defined in Condition B. The standard ones are:


• RCC(1): a new or changed legal requirement (each of these is also defined);
• RCC(2): differences in the proceeds of land disposals from that assumed when price limits were last set; and
• RCC(3): failure to achieve some output, funding for which was provided at the last price setting.

A few companies have a fourth – RCC(4) – changes in the construction price index (COPI) from what was assumed at the last price setting.

Notified Items are anything that, at a price setting, we have recorded specifically as having not been allowed for (either in part or at all). There are currently five. They cover:


• changes up or down in the number of meter optants;
• increases in household bad debt and the costs of managing household debt;
• increases in charges for abstractions and discharges to controlled waters;
• charges for lane rental/traffic management; and
• increases in the taxation of infrastructure expenditure arising from the introduction of International Financial Reporting Standards (IFRS).

2) Materiality

The materiality threshold and its arithmetic are set out in Condition B. This is calculated using the appropriate discount rate (see below). The costs, savings and changes in revenue used in the arithmetic will reflect our judgements of what is reasonably attributable to the relevant item(s) in question.

3) Triviality

We will only take non-trivial changes into account in price limits. Following our proposal in 'Setting water and sewerage price limits for 2005-10: Framework and approach' (March 2003) to amend the definition of triviality (at para 9.12) we will use the following approach.

If the net present value (NPV) of the change is less than 1% of the relevant service turnover (water or sewerage) to which it, in our view, relates exclusively, then it would not normally be carried forward to the materiality test included in any reassessment of price limits. Where it appears to us that a change does not relate exclusively to either the water service or the sewerage service, triviality will be assessed with reference to 1% of the combined water and sewerage turnover.

When assessing triviality, we group together all schemes in response to a single Relevant Change of Circumstance. For example, all the work necessary to comply with a cryptosporidium notice will be considered together (both monitoring and additional treatment costs).

4) Discount rate

For the majority of companies, Condition B states that the investment allowed for in the interim determination should be remunerated using the current rate of borrowing. In these cases the value used will be pre-tax cost of debt. For all other companies the discount rate will be the pre-tax rate of return reflecting the weighted average cost of capital.

The actual value will be assessed during the interim determination period. We will confirm the value we are using for each company.

5) Annual allowable amount and revised price limits

Condition B requires the determination of an annual allowable amount and prescribes the method of calculating the revised price limits.

These items will be calculated in accordance with Condition B using the discount rate (see above) and our judgements on the costs and revenues as used in the materiality calculation. We will provide details of our calculation of these items in the format and at the level of detail set out in the spreadsheet.

1) Optant numbers

The revenue forecasts for 2005-10 in the 2004 price review (PR04) used assumptions about optant numbers in 2004-05. In assessing the impact of changes in the uptake of optional metering on 2005-10 revenues, we will use out-turn figures for numbers of optants in 2004-05, in place of the assumed figures used for the final determination for 2004-05.

To arrive at assumptions about the number of meter optants expected by 2009-10, we will consider company-specific evidence and trends.

2) Meter location

Companies' assumptions on meter location, as presented in their final business plans, were generally accepted at PR04. We would expect you to continue to adopt the final business plan assumptions on meter location unless you provide compelling evidence to support changed assumptions.

3) Optant characteristics

For PR04, company-specific assumptions were applied based on final business plan information and other available evidence. We will continue to adopt this approach.

We will expect all companies to present updated evidence on optant characteristics. This should be based on out-turn evidence, for example from billing data. Companies should set out evidence for successive cohorts of optants showing:


• post-switching demand (in the first year after opting and subsequent years);
• the rateable value of optants' homes; and
• the change in water consumption associated with the move to metered charging (to date we have normally assumed a figure of 5%).

We will assess the robustness of evidence that companies provide in reaching judgements about the likely characteristics of future optants.

4) Other

In assessing incremental investment requirements relating to the supply/demand balance, we will take account of any impact on demand expectations arising from out-turn trends in optional metering. This could reduce growth expenditure needs or operating costs.

At PR04, we retained the operation of a one-way Notified Item for increases in bad debt and debt management costs where these relate to private dwellings or to premises where any part constitutes a private dwelling.

When assessing an application that includes bad debt we will consider evidence gathered from:


• the June return;
• debt and disconnection returns;
• previous interim determinations;
• our wider review of bad debt measures in 2005; and
• any other information we have available which will help to support our analysis.

The basic methodology for calculating the annual allowable amount will, however, follow the same principles as used in previous years' interim determinations.

Companies will be required to demonstrate that costs have increased above those reported in 2003-04 (the base year). The net change between 2003-04 and each full year of the 2005-10 period will be determined for the total of four components.


• Financing costs associated with increases in revenue outstanding.
• Outstanding revenue written-off.
• Operating costs involved in managing outstanding revenue.
• Capital expenditure due to investment in debt management systems.

In addition companies must show that:
1) they undertake their debt management activities in an efficient and cost-effective manner using good practices established by other service providers; and
2) any increase experienced is in general terms due to the disadvantageous conditions under which water and sewerage undertakers are required to operate as compared with other service providers.

We believe this methodology continues to be the most appropriate and see no reason to alter our approach. Consequently, if a company chooses to propose an alternative methodology to calculate the annual allowable amount it must still submit data compatible with our methodology.

As explained in section A, where any data is inconsistent with June return submissions, companies must justify the change and provide supporting evidence to demonstrate why the change was required and how it has been calculated. Auditors must also confirm the revised data and supporting evidence. Given the timetable, companies will not be able to resubmit and improve their justification. Therefore, the onus is on the company to ensure that its justification is complete and comprehensive. If the company cannot justify the revised data we will use the data set that produces the lowest price limits for customers.

For additional information on the bad debt element please contact Sally Inett in the Service and Performance Team on 0121 625 1308.

At PR04, we assumed there would be no real increase in unit rates of charging for abstractions and discharges to controlled waters above those reported in 2003-04.

The costs associated with any net increase in the total charges payable for existing abstractions or discharges, arising from real changes in unit rates above the charges reported for 2003-04, is a Notified Item.

We would expect companies to demonstrate the real change in unit rates above the 2003-04 level with actual expenditure, supported by invoices and reviewed by Auditors.

In addition, we expect companies to demonstrate that the amount payable has been determined in line with the relevant approved charging schemes and that the final amount paid by the company represents best value.

At PR04, we set price limits assuming that there will be no change in the charges that water companies pay to highway authorities for occupying the highway. While companies may have begun to incur some additional costs, we do not anticipate that these will be significant enough for inclusion in interim determinations.

We do not believe this Notified Item will be relevant for interim determination applications in 2008. The convergence of UK GAAP to International Financial Reporting Standards (IFRS), which would impact on this Notified Item, has not occurred. We would only consider applications from companies when they are compelled to follow IFRS, not if they chose to adopt IFRS for other reasons. We are unaware that this applies to any water company.

Currently, Condition B of the licence does not specifically address the treatment of tax for the purposes of calculating materiality. For materiality purposes we intend to regard tax in a similar way to changes in operating costs and revenue (i.e. over 15 years).

A few companies have clause RCC(4) in Condition B of the licence. This allows for an interim determination arising from changes to the Notified Index if different from that assumed at the last price review. The Notified Index is the index of national construction costs (COPI) relative to the retail price index.

Condition B defines the way in which the adjustment arising from any variation in the Notified Index should be calculated. This is called the indexed capital cost amount and is defined as A x B where:


• A is the aggregate amount of capital expenditure which when setting price limits, we assumed the company would occur in the relevant charging year; and
• B is the percentage difference between the level of the Notified Index for that charging year and the level which we assumed for that year.

For the purpose of A, a charging year is one in which we assumed (when last setting price limits) that the company would incur capital expenditure (i.e. for the last price review this covers the period commencing 2005-06). RCC4(b) goes on to state that the capital expenditure assumed in A must correspond to the charging years for which there has been a change in the level of the Notified Index. For an interim determination in 2008, this means the assumed capital expenditure in 2005-06, 2006-07 and 2007-08.

Consequently, for interim determinations this year, we would apply the difference in the Notified Index to the capital expenditure that we assumed at the last price review for 2005-06, 2006-07 and 2007-08. This would be the indexed capital costs amount.

The method of calculating B is described in RCC4(b). This states that, when calculating the percentage difference in the Notified Index for the relevant charging year we must take account of the actual level of the Notified Index for "any charging year ended before the making of the relevant reference".

In our notification to you of adjustment factors and standard infrastructure charges, following the last price review, we set out the assumed Notified Index for the financial years 2004-05 to 2009-10 (although the difference in the Notified Index and capital costs amount cannot be claimed for 2004-05; this year is an assumption and the difference contributes to the cumulative difference in 2007-08). Therefore, for any interim determination application made this year for the purpose of calculating the indexed capital costs amount, we will use the cumulative difference in the Notified Index based on actual COPI and RPI to 2007-08.

Once the indexed capital costs amount has been derived, the calculation of its impact on the revenues needed by the company and hence its impact on bills is the same as for any other Notified Item or Relevant Change of Circumstance.

1) New enhancement expenditure

We expect companies and others to have used the AMP4 change protocol (MD197) during the year. Any changes to enhancements included in the formal application for an interim determination must already have been confirmed using the principles and, where appropriate, the procedures set down. If this process has not been completed by 15 September the enhancement will not be considered at an interim determination this year. We will only consider changes that meet the triviality test set out in section B of this letter.

2) Failure to deliver expected quality outputs on time

The Drinking Water Inspectorate (DWI) and the Environment Agency will report to us by June 2008 on your progress with delivering the quality outputs included at the 1999 and 2004 price reviews, as amended by any subsequent interim determination for the AMP3 period, or formally agreed via the AMP4 change protocol.

In each of the cases below where changes are non-trivial we will consider whether to issue a counter-notice or trigger an interim determination under RCC(3).


• The Environment Agency reports each year on progress on the five-year National Environment Programme (NEP). If you have failed to deliver the expected outputs set down in the NEP and have not agreed changed priorities with the Environment Agency, we will take account of any shortfalls.
  
  
• The DWI will report on progress with improvements to treatment works to comply with regulations. We will take into account shortfalls in delivery from the programmes of work assumed when we last set price limits.
  
  
• The DWI will also report on progress with delivering the programme of mains renovation started in 1989 to improve quality at the tap. If the milestones for the lengths of mains to be renovated have not been delivered to the DWI's satisfaction, we will quantify the renovation not carried out. We will treat this as a shortfall.

We will assess the change in revenue needed to deliver the outputs to the delivery dates now expected, compared with that assumed when we last set prices. We will quantify any change using the assumptions made when we last set price limits.

The following expressions set out in this letter are terms as defined in the licence (Condition B):


• relevant item;
• charging year;
• Relevant Change of Circumstance;
• Notified Item;
• appropriate discount rate;
• net present value; and
• annual allowable amount.