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Letters to Managing Directors
MD189 2 March 2004 PROPOSED LICENCE MODIFICATIONS CONSULTATION In 'Setting water and sewerage price limits for 2005-10: Overview of companies' draft business plans' (October 2003) we signalled our intention to consult on a number of licence modifications we intend making. A number of these proposed modifications were also consulted on in MD174 (1), MD181 (2), and 'Setting water price limits for 2005-10: Framework and approach' (October 2002). We are now consulting formally on these modifications. This letter briefly summarises what we are trying to achieve with each of our proposed modifications. The annexes set out in more detail the issues on which we are consulting, what we are proposing, where we have consulted on items previously, and the actual modifications we are proposing to make. Most of the modifications relate to Licence Condition B and are in annex 1. Another relates to Licence Condition H and is in annex 2. We intend to set out with our draft determination the account we have taken of comments on these modifications and the final text of the Licence modifications we will expect companies to adopt where they accept our final determination of price limits for the period 2005-10. In particular, the proposed modifications to RCC(4), and the 'standard IDoK' and 'substantial effect IDoK' calculations of materiality discussed below will bear on our assessment of the risk borne by companies at the coming periodic review. They should be considered as one overall package of modifications. We do not for example think it would be appropriate for companies to seek the modification to RCC(4) without the other modifications in the package. With the exception of the proposed modifications to Licence Condition H discussed below (which we think should be made to Cholderton Water's Licence), we are not intending to make any modifications to the Licences of Albion Water or Cholderton Water. In MD174 we consulted on changes to Licence Condition F (ring-fencing) and P (role of Appointee's owners). In MD181 we summarised responses. Broadly speaking, those companies that already had the changes felt that they were appropriate for all. But none of the companies without the changes in their Licences accepted that they were necessary. In MD181 we stated that we would continue to seek modifications on ring-fencing and corporate governance when companies restructured or were involved in mergers. We will still do so. We continue to believe that the modifications are necessary. But they are not directly relevant to the outcome of the current periodic review, and so we intend to consult separately on these modifications after the review has been completed. Other modifications to Licence Conditions will be necessary as a result of the Water Act 2003, including for example, the new licensing arrangements. We have consulted on these separately in WSL1/04. Defra plans to establish the Consumer Council for Water (CCW) during 2005-06. To meet this timetable expenses will be incurred during 2004-05, for example advertisement, recruitment and salary costs of the CCW. Our draft Forward Programme (para 6.2) referred to Defra's regulatory impact assessment relating to the establishment of the CCW (July 2003). The regulatory impact assessment indicated possible set-up costs of £1 million. It is estimated the initial part of the set-up costs will fall in 2004-05 and will be £550,000. We expect this will be recovered from companies during the summer of 2004, under a separate licence fee invoice. Licence Condition N will be modified, subject to separate consultation, to reflect the new fee recovery arrangements. Consultation on this cannot occur until Section 37 of the Water Act 2003 comes into force. We anticipate this will have a commencement date of 1 April 2004. However this will be confirmed by Defra. Proposed modifications to Licence Condition B Tariff basket headroom effect We consulted on this previously in RD 25/03 (3). Licence Condition B operates in such a way that companies are able to increase charges to other customers when they introduce new, below average charges that add to the number of chargeable supplies. This is because price increases in the unmeasured basket are assessed according to changes in the 'average charge per chargeable supply'. We have referred to this as the 'tariff basket headroom effect'. We propose modifying Licence Condition B to remove the headroom effect under these circumstances. Our proposal would not impact on the headroom effect that, for example, allows companies to increase charges when unmeasured customers with above average bills opt for a meter. These issues are set out in more detail in section 1 of annex 1. Definition of large users We consulted on linking more closely the definition of large users in Licence Condition B with the corresponding definition in the Water Industry Act 1991 in RD 25/03. The proposed modification will achieve this. Further detail is set out in section 2 of annex 1. Changes in the Notified Index (RCC(4)) We consulted on this issue in MD174, MD181 and referred to our intention to propose modification in 'Setting water and sewerage price limits for 2005-10: Framework and approach' (March 2003). RCC(4) allows for price limits to be reviewed, either at the initiative of Ofwat or companies, if the 'Notified Index' has risen at a different rate than was assumed at the last periodic review. The 'Notified Index' reflects the difference between the construction output price index (COPI) and the retail prices index (RPI). At privatisation, all companies had RCC(4), then known as RCC(6). But now only four (4) companies have it. We believe that this difference in companies' Licences is unsatisfactory and means that the risks faced by different companies between price reviews may differ. We recognise that those companies that retained the clause are unlikely to be willing to give it up. In the interests of providing a level playing field, we therefore believe that there is a good case for offering RCC(4) to all companies to further reduce regulatory uncertainty. For those companies which accept RCC(4) (or already have it) we are minded to assume that COPI will rise in line with RPI for the purposes of the 'Notified Index' for this price review. These issues are discussed further in section 3 of annex 1. Standard IDoK materiality calculation We consulted on modifications to the calculation of materiality which applies to a 'standard IDoK' application (under sub-paragraph 14.2 of Licence Condition B) in our October 2002 methodology paper. The materiality threshold for a 'standard IDoK' application is 10% of the appointed business' turnover. The net present value (NPV) of cash flows arising from the items eligible for a standard IDoK must, in aggregate, exceed this threshold. As part of the last periodic review in 1999 the calculation mechanism was modified to extend the period for assessing changes to operating costs and revenue losses to fifteen years, to recognise the significance of operating costs (and revenue losses) on companies' cashflows. However, this modification has caused difficulties. First, the reference to the fifteen year period means that changes in the early part of a five-year price review period can have a disproportionate effect, when extrapolated forwards over the fifteen year period. We are therefore proposing to modify the standard IDoK materiality calculation to base it on twice the present value of changes in revenue or operating expenditure over the five-year periodic review period. Under the proposed modification, a revenue or operating cost change averaging around 1% of turnover for each year of the periodic review period would satisfy the materiality calculation. Second, the calculation mechanism for most companies only allows for consideration of 'loss of' revenues over fifteen years. It does not allow us to take into account increases in revenue. When dealing with price limit appeals from Mid Kent Water and Sutton & East Surrey following the last review, the Competition Commission concluded that it should be made clear in the Licences that increases in revenue should apply in the same way as losses of revenue. As a result, we have modified the Licences of Mid Kent Water and Sutton and East Surrey, and the Licences of the four companies (5) which applied for standard IDoKs involving meter optancy since the last review. We propose to make the same modification to other companies' Licences. These issues are discussed further in section 4 of annex 1. Section 5 of annex 1 also looks at the relationship between materiality and the resulting change in price limits. The recent interim determination for United Utilities Water highlighted an issue that would, under certain circumstances, produce an inappropriate outcome. However, no Licence modifications are proposed to deal with this at this stage.
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