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Letters to Managing Directors
MD 194 5 August 2004
PROPOSED LICENCE MODIFICATIONS: CONCLUSIONS In MD189 we consulted on various proposals to modify companies' licences. We received responses from WaterVoice, Water UK and most of the water companies. We have reviewed these responses and we summarise our conclusions in this letter. The attached annex provides more detail, including the text of the modifications we will expect companies to adopt. In MD189 we said that we would expect companies to adopt the whole package of licence modifications where they accept our final determinations of price limits for the period 2005-10. This was on the basis that the proposed modifications to RCC(4), and to the 'standard interim determination (IDoK)' and 'substantial effect determination' materiality calculations, would bear on the assumptions about companies' exposure to risk that we make when setting price limits. As discussed below, we have decided not to pursue those proposals now. We will review them after the 2004 Periodic Review and we expect to make any licence modifications relating to these issues ahead of the Periodic Review in 2009. We have made our assumptions in the draft determinations about risk accordingly. We do, however, intend to pursue modifications to: We will not link these modifications to companies' decisions about whether to accept our final determinations. 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. Proposed modifications to licence Condition B Tariff basket headroom effect We intend to write separately on this issue. Definition of large users (paragraph 2) In MD189 we proposed to make the definition of 'Excluded charges' in paragraph 2 of Condition B more consistent with the Water Industry Act 1991 (WIA91). Responses to the consultation No respondents objected to the proposal to modify the definition of 'Excluded charges'. Some respondents took the opportunity to comment on a separate issue concerning the timing of changes to the tariff basket threshold. Our conclusion We will go ahead with the modification in exactly the same terms as described in MD189. This is set out again in the annex to this letter. We understand that DEFRA is considering making an order under Section 7(6) WIA91 to reduce the threshold for large user inset appointments to 50Ml/year in England, with effect from 1 April 2005. At this stage we do not know at what date the threshold is likely to change in Wales. Uncertainty over the timing of the change in the threshold will make no difference to the proposed licence modification, because this uncertainty would exist under the current definition of 'Excluded Charges' (which is also linked to changes introduced by order of the Secretary of State). Changes in the Notified Index (RCC(4)) (paragraphs 13.1 and 14.2) A Relevant Change of Circumstance (RCC) is a circumstance in which a company can apply for an interim determination of its price limits under sub-paragraph 14.2 of licence Condition B(1) (standard IDoK). RCC(4) allows for Ofwat to review price limits, either at its own initiative or that of a company, if differences between the Construction Output Price Index (COPI) and the Retail Price Index (RPI) diverge from the assumptions Ofwat made at the previous Periodic Review. In MD189 we noted that only four companies have RCC(4) in their licences. We said that this difference between companies' licences means that different companies will face different risks between price reviews. We proposed, therefore, to offer RCC(4) to all companies. Responses to the consultation Nearly all respondents who commented on this issue supported the inclusion of RCC(4) in all companies' licences. Our conclusions We said in MD189 that we saw the key proposals which related to IdoKs (ie the proposed modifications to RCC(4), and the standard IDoK and substantial effect determination materiality calculations) as being a package. Together we considered that these proposals would bring a more appropriate balance of risks borne by shareholders on the one hand and customers on the other hand. In view of companies' resistance to some of the other proposals in this package, and in the light of our decisions on those proposals described below, we will not offer RCC(4) to all companies at this stage. However, we may reconsider this position after the periodic review as part of our further work on this package (please see below). Standard IDoK materiality calculation When the Net Present Value (NPV) of cash flows arising from notified items or RCCs exceeds 10% of appointed business' turnover, a company or Ofwat can seek an interim review of the company's price limits. As part of the 1999 Periodic Review we extended the period for assessing changes to some of these cashflows (operating costs and revenue losses) to fifteen years. We argued in MD189 that changes to these cash flows in the early part of a five-year price review period could have a disproportionate effect on the materiality assessment when extrapolated forwards over the fifteen-year period. We proposed to modify the materiality calculation to base it on twice the present value of changes in revenue or operating expenditure over the five-year period. Responses to the consultation WaterVoice agreed with the proposal. Most companies accepted that cash flows should be assessed over a shorter period but considered that these cash flows should be multiplied by a number greater than two. The majority suggested a multiplier of three. Our conclusions Given companies' objections, we will not pursue this modification at present. Nevertheless, we intend to review this issue, as part of further work on the package of modifications to RCC(4), and to the standard IDoK and substantial effect determination materiality calculations. Following MD189 we have identified a possible drafting error in sub-paragraphs 14.2(5) and (6) of licence Condition B. Sub-paragraph 14.2(5) calculates the annual aggregate of one half of the Base Cash Flows relating to disposals of land and all of the remaining Base Cash Flows. Originally, the wording of sub-paragraph 14.2(6) made clear that it calculated the NPV of the amounts determined under 14.2(5). However, when we previously amended sub-paragraph 14.2(6) we referred to the NPVs of "any Base Cash Flows under 14.2(5)". At first sight, this might imply that referring to Base Cash Flows (which is a defined term), rather than expressly referring to the annual aggregate figure produced by 14.2(5), means that we should take account of all of the Base Cash Flows relating to land disposals, rather than just 50%. This is not the intention behind these sub-paragraphs, so we propose to modify the text to clarify this, as described in the annex. Symmetry in the notified items We noted in MD189 that the IDoK materiality calculation for most companies only allows us to consider 'loss of' revenues over fifteen years. It does not allow us to consider increases in revenue. In its decisions on the redetermination of price limits for Mid Kent Water and Sutton and East Surrey Water in 2000, the Competition Commission said that interim determinations should apply in the same way to increases in revenue. We proposed to remove the asymmetry. Responses to the consultation Most companies accepted that the notified item should treat revenue gains and losses symmetrically. Our conclusions We plan to modify companies' licences so that revenue gains and losses are treated symmetrically in the materiality assessment. We have set out the details of the modification in the attached annex. Deadbands In MD189 we noted companies' concerns about "deadbands", where a relevant item is increasing cash flows while another item is reducing them in equal amount, but the net effect on price limits is not neutral. We have agreed with Water UK to establish a working group to take this issue forward. Date of application for standard IDoKs We proposed in MD189 to change the closing date for IDoK applications from 1 October to 15 September. The period for Ofwat to respond would remain unchanged at three months. The earlier date would ensure that we could provide our final determinations in December. Responses to the consultation There were no objections to this proposal. Our conclusion We plan to go ahead with the modifications to sub-paragraphs 14.1, 14.4 and 15.1 of licence Condition B proposed in MD189, which we set out again in the annex. Substantial effect determination materiality calculation The changes we made in 2000 to the standard IDoK materiality calculation had a knock-on effect on the materiality calculation for determinations under sub-paragraph 14.3 of licence Condition B (substantial effect determinations). As a result, materiality for a substantial effect determination can now be triggered by progressive changes that would not amount to 'shipwreck events', which were the original purpose of the clause. We therefore proposed to modify the substantial effect clause to restore the materiality calculation to its original form. We also consulted in MD189 on corrections to some minor drafting errors in the substantial effect clause. Responses to the consultation Some companies said that they would resist the proposed modification because it would make it significantly more difficult to meet the materiality threshold and that this would affect the cost of capital. They thought that companies might have to rely instead on invoking the Director's section 2 WIA91 duty, which relates to financing companies' functions. Others pointed out that restoring the original wording would not restore the meaning of the original calculation because price review periods are now normally five years, rather than the ten originally envisaged when companies were privatised. WaterVoice also questioned whether the proposal would necessarily be in the long term best interests of customers, arguing that it would increase regulatory risk and thereby add to the cost of capital. WaterVoice suggested, however, that we should reassess the materiality calculation to achieve a more appropriate balance between companies' and customers' interests. Respondents did not object to our proposed corrections to the minor drafting errors in MD189. Our conclusions In view of the opposition to this proposal, we do not intend to pursue it at this stage. However, we agree with WaterVoice that we should reassess the materiality calculation to achieve a more appropriate balance between companies' and customers' interests. We will review this issue along with other further work discussed above. We intend to pursue the corrections to minor drafting errors, as detailed in the annex. Modifications to licence Condition H Licence Condition H requires companies to have a 'Code of practice and procedure on disconnection'. Currently, the code must describe the procedure that the company will follow before disconnecting a supply of water to any domestic premises. In MD189 we noted that the reference to disconnecting domestic premises was redundant because the Government has prohibited this practice. For the purpose of clarity, we proposed removing this reference from Condition H. Responses to the consultation All but one of the companies agreed to this proposal. The exception was a company whose view is that the whole of Condition H is unnecessary. Our conclusions We consider that Condition H remains necessary to protect customers. We think companies should have an approved document, which sets out the steps they will go through when recovering debt. We need to ensure that companies are doing enough to assist those having difficulty paying their bills. We plan to go ahead with this modification, as described in the annex. Next steps MD189 did not cover the modification to clarify the treatment of Base Cash flows. This modification should not be controversial. However, if companies do have any further comments, they should raise them by 30 September 2004, addressing them to: Paul Hope Head of Tariffs Office of Water Services Centre City Tower 7 Hill Street Birmingham B5 4UA e-mail: paul.hope@ofwat.gsi.gov.uk We will then write to companies individually to confirm the specific changes we intend to make to their licences, and to obtain their formal consent to those changes. We will then issue section 13 WIA91 notices, formally notifying companies of the changes. These modifications will take effect from 1 April 2005. PHILIP FLETCHER (1) Unless otherwise stated, all paragraph references are references to those paragraphs in the licences of water and sewerage undertakers. The equivalent sub-paragraph 14.2 for water only companies would be sub-paragraph 13.2  |
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