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Letters to Managing Directors
MD186 1 May 2003 Dear Managing Director INTERIM DETERMINATIONS 2003 This letter sets out our intended approach to any interim determinations which we are requested to make in 2003, in terms of principles, methods and process. These reflect the requirements of part IV of Condition B of the licence and build on our experience of earlier interim determinations. This letter provides guidance on how we will approach the key issues of optional metering, bad debt, vulnerable groups, changes in the construction price index (where applicable), new quality obligations and counter-notices. We believe that all parties will benefit from early discussions to consider the issues and processes to be followed. If your company is contemplating an application please contact Kieran Duffy (0121 625 1446), who is our Project Manager for interim determination applications. Your Ofwat Board lead contact will also be involved in overseeing the IDoK process and issues for your company. Applications for interim determinations must be comprehensive and accurate to enable us to review each case fully and set soundly-based price limits. The timetable does not allow for significant changes in information presented as part of an interim determination application. We, like you, will also be busy with periodic review issues so we would like to make this as streamlined as possible. A. Process There are two important, general points. 1. Interim determinations can only deal with the impact of relevant 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 minimum timetable for interim determinations is set out in Condition B of the licence as follows:
For several years now we have issued and consulted on draft interim determinations. This enables us to consider stakeholders' views and take representations from the relevant WaterVoice Committees. To achieve this tight timetable during a key stage of the 2004 review process it would be helpful if you could give an early indication of whether you are likely to make an application. We will do the same. In recent years some companies have involved their Reporters from the start of the process. Their scrutiny and opinion is very useful to you and to us. Consequently we encourage you to invite your Reporter to attend any early discussions. We would like any application for an interim determination to be submitted by Thursday 11 September 2003. Your supporting documentation and Reporter's report should be submitted on the same date. If this deadline is met we will announce determinations no later than Thursday 11 December 2003. If we decide to trigger an interim determination we will announce this on 11 September and announce determinations by 11 December. If you apply between 11 September and the deadline (1 October) we may be unable to announce our determination of that application by 11 December. I attach at annex A the timetable we intend to follow this year. Please tell us of any difficulties you foresee with this programme. In 2002, we made the electronic spreadsheet that underpins our interim determination calculations available to all companies. The version that we will use for 2003 is now available to download from the Ofwat 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. If a company believes that there has been a change in the obligations placed on it 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 may consider submitting such changes in a logging-up/down claim so that these changes to costs can be reflected in the price limits at the periodic review. We set out our approach to logging up and down for the 2004 price review in annex 4 to 'Setting water and sewerage price limits for 2005-10 Framework and approach', March 2003.' We do not propose to amend the logging up/down process before 2004. The main submission on logging up should be included in your draft business plan in August 2003 and updated in your final business plan in April 2004. B. Method of calculation set out in Condition B We will issue any counter-notices no later than 14 days after receipt of 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(*). 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 change 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 which, at a price setting, we have recorded specifically as having not been allowed for (either in part or at all). There are currently three. A difference from the assumptions made when price limits were last set in:- the take-up of the free meter option; - the effects of the prohibition of disconnection of household supplies for non-payment of charges; and - the cost of administering the statutory scheme for abatement of metered charges to domestic customers in vulnerable groups. (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 include additional provision in price limits for non-trivial changes. If the net present value (NPV) of the specific change is less than 1% of the company's turnover for the last reporting year, then it would not normally be carried forward to the materiality test included in any reassessment of price limits. 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. In the meantime, you should assume the discount rate will be the same as the value used at the last price setting. (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 revenue losses 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 which will be set out in the spreadsheet. (6) Licence matters In its conclusions on the references by Mid Kent Water and Sutton and East Surrey Water, the Competition Commission decided that it was inappropriate to limit the scope of the notified item for the impact of optional metering and associated licence modifications to cover only revenue losses incurred by the companies, not gains. The Commission proposed symmetrical notified items and associated licence changes. In re-determining price limits for Dŵr Cymru, Tendring Hundred Water, Dee Valley Water and South West Water we made an agreed licence modification and issued a revised symmetrical notified item for optional metering. Similar changes should be anticipated by companies seeking an interim determination that includes a claim for the effect of optional meter take up this year. Copies of the revised notified item and licence modifications are attached at annex B. Bournemouth & West Hampshire Water's, Severn Trent Water's and Yorkshire Water's applications for an interim determination did not relate to optional meters. We agreed that in these instances the licence modification was inappropriate, as it would be for other applications not including a claim for the effect of optional meters. C. Optional meters (1) Optant numbers To project revenue impacts of optional metering, we will use out-turn figures for numbers of switchers in the years from 1998-99 to 2002-03, in place of the figures assumed for these years in the latest price determinations. To arrive at assumptions about the number of meter optants expected by 2004-05, we will consider a number of company-specific factors:
The forecasts for optional metering will be based on the past trends of annual rates of switching in each company, adjusted for the factors outlined above. We shall also adjust assumed annual switching rates to take account of evidence of the company's past "in-year" switching profile (that is, the proportion of annual meter optants who switch to measured charging in the period April to September, compared to those opting in the period October to March). Experience shows that the in-year switching profile is important in assessing trends in optional metering. (2) Meter location In the absence of evidence to the contrary we will assume that, of those optional meters not installed in existing boundary boxes, 25% of optional meters will be installed inside the customer's property and 75% in new external boundary boxes. This is consistent with the Competition Commission's determinations for Mid Kent Water and Sutton and East Surrey Water in 2000 and our decisions at the last periodic review. (3) Optant characteristics For the 1999 final determination, we judged that available evidence for most companies supported the following assumptions about the characteristics of meter optants:
We will accept an alternative set of company-specific assumptions on optant characteristics if you produce compelling evidence. In the 2000 and 2001 interim determinations we made alternative, company-specific assumptions about the average optant's pre-switching consumption. But we continued to assume that optants, on average, reduced their consumption by 5%. In assessing assumptions about optant characteristics we will take into account:
We shall take account of the likelihood that the average characteristics of optants will change for later 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. D. Bad debt The determinations made in 1999 included a notified item for the impact of the ban on disconnection of household customers on bad debt and debt recovery costs. We have now collected data on levels of debt and recovery costs for the years 1998-99, to 2001-02. We issued the results of our high level analysis of debt levels in RD12/01 – 'Notified Item for bad debt (August 2001)' and RD26/02 – "Industry Information on Debt and Debt Recovery" (September 2002). RD12/01 also contained a pro-forma which companies seeking an interim determination were asked to complete. This pro-forma has been updated for 2002-03, and is available on request for companies considering making an application which includes bad debt. The form now contains five columns to be filled in – one for each year since 1998-99. This is so that the pattern of debt over the five years can be easily identified as part of our preliminary analysis. The table should be completed in the same price bases as used for each relevant June return reporting year (ie out-turn prices). Please contact Sally Inett of the Service and Performance team on 0121 625 1308 for a copy. When we calculate the amount allowable, we will use a similar process to the one we used in 2001 and 2002. We will take account of changes actually experienced in the current period compared with 1998-99. Where any allowance was made for this issue in the existing price limits we will take account of that when we assess the change. Given the proximity of the next price review and the level of uncertainty around subsequent changes in costs and recovery rates, we will assume, that for the purpose of calculating cashflows, in future these continue at 2002-03 levels. RD12/01 also included general guidance to companies, Reporters and auditors in respect of the information that should be included in interim determination applications. We do not anticipate making any significant changes to this guidance. However, if changes are made a further letter will be issued informing companies of any revisions to the guidance. As in previous years, this guidance may be supplemented with company specific queries in the case of an application. As already noted, early discussions will help to identify the key issues and ensure clarity of our requirements. RD12/01 and RD26/02 are both available on our website, www.ofwat.gov.uk, or from our library, telephone 0121 625 1373. E. Vulnerable groups We shall continue to collect data on the administrative costs associated with the introduction by the Water Industry Act 1999 of protection for vulnerable customers. The information available to date shows that uptake of these tariffs has so far been low and that any associated administrative costs are unlikely to be significant. F. The quality programmes (1) New or revised quality obligations New or revised quality obligations or new requirements associated with abstraction licences can qualify as relevant changes of circumstance. 'Future water and sewerage charges 2000-05', pp161-164, Appendix E – protocol for changes in companies' obligations and consents after the final determination summarises the relevant processes you will need to follow. For environmental improvements - the baseline positions for the work included in price limits are the programmes of work signed-off by Ministers in April 2000 and included in the annex to the EA document 'Achieving the quality – The Environment Agency's view of the benefits to the environment of water company investment over the next five years', published in June 2000, modified by interim determinations. Agreed environmental obligations affecting the sewerage service are set out in spreadsheets held by the Environment Agency (EA) and approved by Ministers (or in the case of Wales by the Welsh Assembly Government). Stuart Hoggan's (DETR) letter of 13 March 2001 to Martin Griffiths (EA) headed 'Periodic review 2000-2005: Procedure for changes in companies' agreed environmental obligations affecting the sewerage service', (available from Ofwat Library, telephone 0121 625 1373) sets out the process for changes to these spreadsheets in England. The Assembly has also issued similar guidance. Philip Bishop's letter of 3 August 2001 to Roger Thomas of the EA Wales sets this out. For drinking water quality improvements - since the final determination the DWI has reviewed programmes and in some cases reassessed the priority of work. This re-balancing was accepted by companies as having no significant impact on the overall costs of the drinking water quality programme and so can be carried out within the price limit package. There are some areas where there have been other changes.
You may be required to carry out an additional programme of work specified in an undertaking to regain compliance with current quality standards. We will assume that you will absorb any costs incurred in carrying out such programmes as price limits have assumed compliance with all current obligations. (2) Failure to deliver expected quality outputs on time The DWI and the EA will report to us in June 2003 on your progress with delivering the quality outputs included at the last price setting. 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).
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 value any change using the assumptions made when we last set price limits. G. Construction price index 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 periodic 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:
For the purpose of A, a charging year is one in which Ofwat assumed (when last setting price limits) that the company would incur capital expenditure (ie for the last periodic review this covers the period commencing 2000-01). 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 2003, this means the assumed capital expenditure in 2000-01, 2001-02 and 2002-03. 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 periodic review for 2000-01, 2001-02 and 2002-03. 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 review, we set out the notified index for the financial years 1997-98 to 2004-05. 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 2002-03. 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 change of circumstance. H. Other Issues Our approach to dealing with other issues as part of an interim determination application is set out in our Final Determinations for Severn Trent Water Ltd and Yorkshire Water Services in December 2002. These are available on our website. In MD180 we confirmed that for the purposes of any interim determination, additional outputs to alleviate sewer flooding problems will be specified by Ofwat as a new obligation. Given the constrained timetable within which the IDoKs are conducted, both the outputs and expenditure to alleviate sewer flooding problems must be agreed with us, after consultation with the relevant WaterVoice Committee and before any application for an IDoK is submitted. I. Licence terms The following expressions set out in this letter are terms as defined in the licence (Condition B):
PHILIP FLETCHER (*) Where a number appears such as 13/14, the first one is the paragraph in the water companies' licences and the second is the number in the water and sewerage companies' licences. ANNEX A INTERIM DETERMINATIONS 2003 – INDICATIVE TIMETABLE13 June June returns submitted for report year 2002-03 June/July/August Company/Ofwat/Reporter dialogue about scope and context of potential interim determinations/supporting information. August Company involves Reporter in preparation for submission/supporting information. 11 September Company/Ofwat triggers an interim determination. Supporting information provided. 11 September Reporter's report submitted. 25 September Ofwat/company issues any counter-notices. Sept/Oct Queries raised with companies and Reporters and quality regulators Working level meetings with companies. 5 November Draft interim determination issued to company and published. 5-26 November Public consultation on draft determination. 19 November Company written response to interim determinations. 24-28 November Representation meeting with Director and Ofwat senior staff. Nov/Dec Confirmation by quality regulators of changes to quality outputs. No later than Final interim determination issued to company and 11 December published. ANNEX B WATER INDUSTRY ACT 1991 S.13(1) MODIFICATION OF CONDITION B OF THE CONDITIONS OF APPOINTMENT OF [ ] Made on [ ] Coming into effect on [ ] 1. In Condition B, in place or paragraph 13/14.2(6)* there shall be inserted –
(a) where any Base Cash Flows under (5) consist of items which (b) below does not apply, what is the Net Present Value of those Base Cash Flows calculated up to the start of the first of the Charging Years for which the next Periodic Review falls to be carried out; (b) where any Base Cash Flows under (5) consist of revenue and/or Operating Expenditure, what is the Net Present Value of those Base Cash Flows calculated over 15 years - and what is the aggregate of those Net Present Values calculated under (a) and (b) ("the Materiality Amount"); 2. Paragraph 12/13.3 (Definitions of Costs and Receipts in paragraph 13/14 and in the definition of a 'Relevant Change of Circumstance') shall be amended as follows – (i) after the semicolon at the end of (1), delete "and"; and (ii) at the end of (2), delete the full stop and insert – "; and
Philip Fletcher * NOTE: where a number appears such as 13/14, the first one is the paragraph number in the water companies' licences and the second is the number in the water and sewerage companies' licences. ANNEX B NOTIFIED ITEM - WOC(for IDoK in 2003) For the purpose of this determination Ofwat has assumed that the cumulative increase in the numbers of measured household customers arising from the exercise of the free meter entitlement under s.144A(1) of the Water Industry Act 1991 will be as specified for each year in the following table.
The costs attributable to the Notified Item shall be interpreted to comprise: i) the difference in capital expenditure to be attributed to the provision and installation of a different number of meters; ii) the difference in annual operating expenditure to be attributed to the provision of measured charging for a different number of customers; iii) the extent to which annual revenues accruing to the company from standard charges are different as a result of the cumulative number of household optants varying from the numbers specified above. [date] ANNEX B NOTIFIED ITEM - WASC(for IDoK in 2003) For the purpose of this determination Ofwat has assumed that the cumulative increase in the numbers of measured household customers arising from the exercise of the free meter entitlement under s.144A(1) of the Water Industry Act 1991 are as specified for each year in the following table.
The costs and revenues associated with any difference between either or both of the assumed cumulative numbers and the actual, cumulative number(s) at 30 September in the year in question is a Notified Item. The costs attributable to the Notified Item shall be interpreted to comprise: i) the difference in capital expenditure to be attributed to the provision and installation of a different number of meters; ii) the difference in annual operating expenditure to be attributed to the provision of measured charging for a different number of customers; iii) the extent to which annual revenues accruing to the company from standard charges are different as a result of the cumulative number of household optants varying from the numbers specified above. [date]  |
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