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Price review 2009
PR09/14 26 June 2008 Dear Regulatory Director PR09 Treatment of renewable energy Introduction Mitigating the impact of climate change is an increasingly prominent challenge. Emissions associated with energy generation form the largest and most visible proportion of greenhouse gas emissions resulting from human activity. Consequently, there is increasing pressure on the water and sewerage sectors to reduce energy-related emissions, and we expect each company to play its part in the national effort to mitigate climate change. We understand the importance and potential of renewable energy. There is a real opportunity for the water and sewerage sectors to innovate and show leadership on the journey to a low carbon economy. The water and sewerage sectors are directly responsible for approximately 1% of the UK's total emissions. Power costs resulting from energy intensive distribution and treatment processes form a significant percentage of operating expenditure. Some of the sectors' core assets and processes can be harnessed to allow the generation of electricity. These include the use of hydroelectric schemes at reservoirs, combined heat and power and methane from sewage sludge. This letter clarifies our position on the treatment of renewable energy generation. We aim to ensure that consumers will benefit from the appropriate use of renewable energy generation and are not subject to undue costs or risks. Customers should benefit from investment which they have paid for or will be paying for in the future. We will guide and monitor this by providing clear guidance, supported by transfer pricing investigations. Equally, companies should gain appropriate rewards for developing innovative approaches to renewable energy. PR09 investment We set out our position in 'Setting price limits for 2010-15: Framework and approach' (March 2008). There is a competitive market for energy generation and our starting presumption is therefore that companies' renewable energy activities should not be part of the appointed business subject to price controls, unless there are compelling reasons for this. For us to consider proposals for investment in renewable energy as part of the appointed business, a company would need to demonstrate that:
Summary of current company activity We wrote to all companies in February this year to ask how they were accounting for income, costs and assets relating to energy generation. As a result of this exercise it is clear that we need to clarify our guidance on accounting treatment. Many companies were not following the existing guidance in the Regulatory Accounting Guidelines (RAGs). While there are differences in the types of generation between companies, with water and sewerage companies having much greater scope to generate energy than water only companies, there are clear inconsistencies in accounting treatment, particularly for Renewables Obligation Certificates (ROCs), levy exemption certificates and the national grid reserve service (NGRS). Some companies treat such income as non-appointed activity, others as appointed 'other' income, and some as negative appointed operating expenditure. The situation is further complicated where companies lease land to third parties for generation by wind or hydro-power. These differences in treatment have implications for our assessments of relative efficiency and when we set prices. In some instances it appears that appointed assets may have been used to generate income for the non-appointed business. Where this has happened it is not always clear that there has been an appropriate charge from the appointed to non-appointed business for the use of appointed assets or that the non-appointed business has borne an appropriate share of the costs. As you will be aware, licence condition F.6.1 (which is common to all appointees) requires appointees to ensure that there is no cross-subsidy between the appointed and non-appointed businesses. Guidance We set out below guidance which should help companies correctly allocate costs and incomes and ensure consistency. Definition of appointed activities We define appointed activities as those which are integral to the business of a water company. Examples include combined heat and power (CHP) plants which are installed as an integral part of a sewage treatment works. A wind turbine, however, is not an integral part of the works and so would be classified as a non-appointed activity. We are aware of instances where sites are leased out to third party operators. Where this involves the use of appointed land or assets, for example hydro-power at a reservoir, we would regard this as an appointed activity – land that is integral to the appointed business activities is being utilised, therefore the rental income should be similarly recorded in the appointed business. We would also expect the appointed business to receive rental income where a small portion of land at, say a water treatment works, was leased out to a wind farm operator. Where CHP activities are undertaken outside the appointed business, we would expect transactions to include a value for the 'fuel' transferred out of the business as part of the generation process (for example biogas). This might include consideration of benefits accrued, for example avoided disposal costs. Wherever possible, the price paid to the appointed business for fuel-related by-products should be market tested. As the renewable energy market and technology develops, some by-products may increase in economic value. In the future, more innovative schemes such as co-digestion may become more widely integrated as part of national waste or CO2 reduction measures. Such activities may be carried out by an associate. Again, Ofwat would wish to be satisfied that any such agreement was fair to customers and complied with transfer pricing guidance. Where assets are transferred out of the appointed business we will reduce the regulatory capital value (RCV) of the appointee by the value of assets transferred. Any electricity then purchased from the outside operator should then be shown as an operating cost in the normal way. Where generation is within the appointed business, we will require all income received from those electricity sales, including income from ROCs, levy exemption certificates and the NGRS, to be recorded as negative operating expenditure. Relative efficiency For us to assess companies' relative efficiency it is important that companies are accounting for costs consistently. We have stated in the section above that companies should treat income from energy generation as negative operating expenditure. This will benefit companies when we assess their relative efficiency as their costs will be reduced. This offers a specific incentive as part of the relative efficiency process for companies to sell any surplus energy to the grid. We will follow up companies' treatment of costs and income as part of the JR08 process, and make adjustments to ensure consistent accounting treatment when we carry out the 2007-08 relative efficiency assessments. We will also take account of any transfer pricing adjustments as discussed below. Transfer pricing We examine the allocation of costs between the appointed and non-appointed businesses as part of our work on assessing compliance with RAG 5.04 and Condition F. Where we find that costs are not robustly allocated we will consider making a downward adjustment to base operating costs at the periodic review, to ensure that only costs correctly attributable to the appointed business are reflected in customers' bills. Our general principle is that where possible the assets, costs and income related to an activity should all be reported within the same part of the appointee (appointed or non-appointed). However we accept that this may not always be possible. Section 1.10 of RAG 5.04 provides guidelines to appointees on how costs should be allocated between the appointed and non-appointed parts of the appointee. As stated in RAG 5.04, "[t]he key principle is that costs should be allocated in relation to the way resources are consumed." Appendix 3 of RAG 3.06 sets out our approach to the use of appointed assets for non-appointed activities. The guideline states that "[w]here companies classify activities as non-appointed and these workstreams make use of appointed assets, then either a) these assets need to be removed from the RCV, if possible, or b) if not, there needs to be an appropriate charge from the appointed business to the non-appointed business for the use of these assets." Where it is not clear how assets should be classified, we encourage companies to discuss this with us. If an associated company (including a joint venture) or third party uses appointed land for the purpose of generating electricity, we expect that a rental payment is made to the appointee. As set out in section 219 of the Water Industry Act 1991, the creation of "any interest or right in or over land" constitutes a disposal of protected land. Any such rental payments should therefore be reported in table 39 of the June return, as set out in the June return reporting requirements. In line with our stated policy, 50% of the net proceeds from the disposal of any protected land (which includes rental payments) will be removed from a company's RCV. Timetable We have set out below the timetable for the changes arising from this guidance.
Other issues Carbon reduction commitment (CRC) The CRC will begin in 2010, and this mandatory cap and trade scheme may influence the water and sewerage sectors' operating costs. Defra has not finalised the scheme and will consult again in the summer. This means that neither we nor the sectors know the likely final costs. We will consider our position in the light of the summer consultation and the proposals in companies' business plans. However we believe it is important, as Defra has set out in their social and environmental guidance to Ofwat, that the water and sewerage sectors are not insulated from the scheme's financial incentives to reduce carbon. Renewable energy and planning Since 2003, many local authorities have been revising planning policy to include requirements that new non-residential developments must incorporate renewable energy production equipment to provide a certain percentage of the site's predicted energy requirements. We have set out previously in the AMP4 change protocol on how we expect water companies to deal with all planning requirements. It is for the water company, as applicant, and the local planning authority working within planning law and guidance, to seek to reach an appropriate solution to a particular requirement. Water customers should not be asked to finance the consequences of excessive and unreasonable requirements sought by planning authorities, whether in terms of location, design or planning gain requirements which go beyond Government planning guidance on such issues. We expect companies to challenge requirements for on-site renewable energy production where the additional costs involved are unreasonable and the technology is unable to deliver the required capacity. This letter has been prepared by a number of Ofwat teams. If you have any questions please contact Helen Twelves by telephone on 0121 625 1307 or by e-mail helen.twelves@ofwat.gsi.gov.uk. She will ensure that your question is dealt with by the appropriate Ofwat team. Yours sincerely George Day Director of Network Regulation  |
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