MD181

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

In MD174 we reviewed the differences between companies' current licence conditions and made a number of proposals for increasing consistency. We also sought views on whether some conditions, recently introduced for Dwr Cymru, were appropriate for all companies.

We received 26 responses to MD174. Copies of all responses, except those marked confidential, are available from the Ofwat library. A list of respondents is attached at Annex 1 and a summary of their responses is attached at Annex 2.

In general, companies were not persuaded that there was a good case for the modification of licence conditions to bring all companies' licences into alignment. Other respondents were more supportive. In order to implement the changes without a referral to the Competition Commission, the consent of companies is required. In the light of the responses from companies, we do not propose at this stage to seek to implement any of the proposed changes.

We will review, at the 2004 Periodic Review whether it would be appropriate to include some of the proposed changes to Part IV of Condition B, which covers the mechanism for interim determinations of price limits between reviews.

We will continue to seek modifications on ring-fencing of the regulated business and corporate governance when companies restructure or are involved in mergers.

At this stage, we do not propose to seek for all companies licence conditions on procurement or on restricting the activities of the Appointed Business. Nearly all respondents felt that these were either unnecessary or undesirable except where companies choose to outsource most operations or adopt unconventional ownership structures.

Many of the companies in their responses expressed concern about Ofwat's desire to be able to make licence modifications by majority consent rather than by individual agreement. Though we continue to believe that this would be a valuable tool in enabling us to ensure that in future significant differences between companies' licence conditions did not arise we do not, at this stage, intend to pursue the issue, which would require a change to the current legislation.

A number of companies took the opportunity to raise other areas where they believed there was a case for reviewing the current licence conditions. Those raised by more than one company were:

(i) The ten-year notice period for terminating water companies' licences.
(ii) Codifying the procedures for 'logging up' within the licence conditions.
(iii) Introducing an appeals procedure for individual parts of Ofwat's price setting methodology, rather than just for the price limits.
(iv) The removal of Condition H (Code of Practice and Procedure on Disconnections) now that disconnections of household premises are not permitted.
(v) The revision of Condition L (Underground Asset Management Plans) to bring it into line with the economic approach to maintaining serviceability set out in MD161.

On (i) we recently announced proposals to increase the notice period to 25 years. We agree with respondents that extending the notice period is likely to reassure investors and ensure that companies are able to raise the finance required to deliver their current and future capital investment programmes. Consultation on this proposal closed on 24 September 2002 and we will announce the results shortly.

On (ii) we issued a consultation document on the process for logging up and down on 28 June 2002. The consultation has now closed and we will consider carefully any views expressed on this issue. However, our preliminary view, expressed in the consultation paper, is that codification of the processes in the licence would not allow sufficient flexibility to deal with evolving issues and that it would not be consistent to codify one particular part of the price setting methodology within the licence but not others.

On (iii) we do not agree that giving companies the ability to appeal against individual aspects of the price setting methodology in isolation from the whole would be desirable. We can not see how this would work in practice, particularly if companies were allowed to appeal before the review is finalised. Such a provision could make the whole review process unworkable.

The Competition Commission is already able to focus on particular areas during the course of an appeal, particularly where there are key differences between the company's view and ours. But the Commission must set a price limit taking into account the full range of outputs and expenditure and the interactions between them. We consider this to be the right approach.

We will however discuss with the industry representatives and their consultants, the proposals in their recent report 'Appeals against regulatory decisions: improving the mechanisms'.

On (iv), we consulted on new guidelines on debt recovery in January 2002, along with proposed changes to Condition H. We will issue the finalised guidelines shortly, and will modify Condition H in due course.

On (v) we will review the need to revise Condition L as we further develop our approach to capital maintenance and serviceability for the next periodic review.

We believe consistency has a role to play in minimising unnecessary regulatory uncertainty, which is in the interests of all stakeholders in the industry and therefore regret that companies were not more supportive of our proposals for greater consistency. However, we will continue in the future to seek consistency between companies' licence conditions where we can.

PHILIP FLETCHER

Encl.

ANNEX 1

List of respondents to MD174

Water and sewerage companies

Dwr Cymru Welsh Water

Northumbrian Water

Southern Water

South West Water

Thames Water*

United Utilities

Wessex Water

Yorkshire Water

Water only companies

Bristol Water

Folkestone & Dover Water

Mid Kent Water

Portsmouth Water

South Staffordshire Water*

Tendring Hundred Water

Three Valleys Water

Regional WaterVoice Committees (previously Customer Service Committees)

WaterVoice Central

WaterVoice Eastern

WaterVoice Northumbria

WaterVoice South West

WaterVoice Thames

WaterVoice Wales

WaterVoice Wessex

WaterVoice Yorkshire

Others

Mr Barry Walton

Water UK

* These responses were marked as confidential.

ANNEX 2

Below is a summary of the responses to each of the issues raised in MD174. The proposals / questions in MD174 are shown in bold type.

CONDITION B

All companies will be offered the reciprocal version of RCC(4) (the defined Relevant Change of Circumstance which relates to changes in the Construction Output Price Index) at the next Periodic Review. Currently only four companies have this condition. (Paragraph 2.11);

All but two companies broadly supported the proposal. The WaterVoice Committees all supported the proposal. Two respondents did not comment.

We invite views on whether the cost of capital for Interim Determinations of K (IDoKs) should be the same for all companies (for twelve companies it is currently the cost of debt only and for all others it is the weighted average cost of capital (WACC)), and if so which. We are not expressing a preference for one or the other but believe a standard form would improve transparency. (Paragraph 2.22);

Eight companies supported consistency. Two were opposed or thought it unimportant. Of the eight, three backed the cost of debt and four the WACC. Four answered only from a company specific perspective, with two wanting to keep cost of debt and two the WACC. The WaterVoice Committees all supported the proposal.

We invite views on whether Condition B should be changed for all companies, to allow increases in revenues to be taken into account when calculating the materiality of an IDoK, or whether this change should only be made for companies that apply for an IDoK on the basis of the Notified Item for metering. (Paragraph 2.26);

Most companies see one-way notified items as a key part of the 1999 periodic review 'package' (which set prices until 2005) but would not object at the next periodic review or following an IDoK on the basis of the Notified Item for metering. Only one company, which already has the two-way version of the condition, supported a change now. All of the WaterVoice Committees supported the change.

CONDITION F

A number of elements of the higher financial ring-fence (parts (i) to (v) in section 3.6), should be included in all companies' licences. (Paragraph 3.11);

Broadly speaking, those companies that already have these conditions felt that they were appropriate for all. None of those companies without the conditions accepted that they were necessary. One company thought they were excessive and duplicated existing provisions. Another particularly objected to any reference to dividends. All of the WaterVoice Committees were supportive.

All companies should be prohibited from entering into any agreements incorporating cross-default obligations. (Paragraph 3.13);

Respondents generally answered as for the previous question. One company noted that some existing cross-default clauses may be expensive to unwind and two others argued it would be prohibitively expensive and was not necessary for all companies.

We invite views on whether it would be appropriate to formalise in the licence the requirement for all companies to comply with the Code of Best Practice of the Financial Services Authority. (Paragraph 3.15);

Only one company said it would accept the condition but others, without the condition, did not believe that the condition was appropriate for companies whose parents are listed.

The WaterVoice Committees were supportive of the proposals on the grounds of greater transparency.

We invite views on whether all companies should be required to publish results for the Appointee as if it were a separate listed company, or whether this requirement should be limited to those companies where the regulated water business represents only a minority of the group's activities. (Paragraph 3.17);

Reponses followed the pattern for the other ring-fencing questions. Companies commented that they already publish a lot of information about their financial performance.

All companies except the small water only companies should be required to maintain an investment-grade credit rating. (Paragraph 3.21);

A number of smaller companies (some of whom would be exempt from the requirement) felt that the condition would impose additional costs for no clear benefit. Two companies believed that Ofwat was the biggest influence on their credit rating.

We invite views on whether it would be appropriate for all companies to have a condition which restricts the activities of the water company. (Paragraph 3.31);

All companies except Bristol Water were opposed to this modification, most highlighting the benefits diversification could bring for customers. Bristol was prepared to accept the licence condition subject to a de minimis exception for closely related activities. Similarly all the WaterVoice Committees were opposed but emphasised the need for clear relationship between regulated and non-regulated activities. Watervoice Wales suggested a compromise whereby diversification above a certain level would require regulatory approval.

It was not clear from the responses that all respondents appreciated that only the Appointee would have to be a single purpose entity, not the group as a whole.

CONDITION P

Condition P (The Role of the Appointee's Owners) should be introduced into all companies' licences with a requirement for there to be at least three independent non-executive directors on the Appointee's board. (Paragraph 4.11);

Broadly speaking, those companies that already have this condition felt it was appropriate for all. Those that do not currently have the condition were mostly opposed, principally on the grounds of additional cost for what they perceived as a limited benefit. Yorkshire Water and United Utilities Water, which both have a requirement for two rather than three non-executive directors, rejected the idea of having another.

WaterVoice Committees broadly welcomed the proposal, but there was some scepticism over the effectiveness of non-executive directors of representing customers' interests.

CONDITION R

We invite views on whether Condition R (dealing with internal controls and the procurement of services), which currently applies only to Dwr Cymru (Welsh Water) should apply to all companies, but activated only when a significant proportion of operational activities is outsourced. (Paragraph 5.6);

None of the companies supported this proposal. The main reasons given were that it was perceived as an unnecessary regulatory burden and constituted the regulator straying into management decisions.

Five WaterVoice Committees supported the proposal for a dormant condition. One supported the condition "when a significant proportion of activities is outsourced", but another had reservations and did not think a licence condition was the best way of protecting customers.

We also invite views on the appropriate threshold for activation of Condition R, and how this threshold should be defined. (Paragraph 5.7);

Of the five companies that commented, three suggested that a simple numerical threshold might be difficult to set and highlighted that the issue was one of the strategic importance of particular activities rather than just their value.

One company suggested a threshold of 50% of operating expenditure with capital expenditure not taken into account. Another company noted that any threshold should relate to functions rather than a particular proportion of costs.

WaterVoice South West agreed that a proportion of operating expenditure would be more appropriate than turnover. WaterVoice Wales considered that the threshold should not be set too high.