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Letters to Managing Directors
MD214 21 March 2006 OFWAT RESPONSE TO INDEPENDENT STEERING GROUP REPORT INTO THE CONDUCT OF THE 2004 OFWAT PERIODIC REVIEW Last August the Independent Steering Group (led by John Baker) published its conclusions and recommendations following its review. We have considered the views of the Steering Group with care and taken forward work in a number of areas. However many of the recommendations are about how we conduct the next price review in 2009 (PR09) and it would be premature to take decisions on all these matters now. We will be beginning our PR09 preparations shortly and will look to engage the industry and key stakeholders in our planning from the outset. Meanwhile our response to each of the Steering Group recommendations is attached at Annex A. Philip Fletcher Annex A RECOMMENDATIONS Powers and Roles 1. Defra should revive the Regulators' Group sooner rather than later with a view to making a more determined attempt than last time to clarify respective roles and responsibilities ahead of the 2009 periodic review. Better project management arrangements between the parties to the Regulators' Group for 2009 need to be established. The Regulators' Group should establish and agree formal terms of reference. The Defra chaired Regulators' Group comprised representatives of Defra, Welsh Assembly Government, Ofwat, Drinking Water Inspectorate, Environment Agency and English Nature. This group met a few times in the run up to the price review and then approximately monthly from July 2002 to March 2004. On some occasions Water UK joined the meeting to discuss particular issues, at its request. After the principal ministerial guidance was complete, This group was replaced by an Ofwat-led regulators' briefing meeting in March 2004. We held briefing meetings attended by all the key parties including Treasury (but not the Prime Minister's office or Water UK). When the group met following the issue of our decisions on price limits in January 2005 we agreed to continue these meetings and have met quarterly since then. This group allows us to update each other on progress on a wide range of issues of mutual interest including for example scenario modelling, the Water Framework Directive and the frequency of price reviews. Before deciding on the future role of the Regulators' Group as proposed in this recommendation it is important to consider its role in relation to two interacting programmes of work:
We consider that it is appropriate for a Defra-led group to focus on the second. We have discussed these issues with Defra and the other regulators and conclude that the overall planning of the PR09 timetable and exploration of the issues are properly led by Ofwat over the next eighteen months. The need for a Defra-led group for considering the policy and associated changes to standards affecting PR09 and beyond will be reconsidered in 2008, before price limits are set again in 2009. 2. Government departments outside Defra – notably Treasury and the Prime Minister's Policy Unit - have a direct interest in the policy decisions made as part of the review process. Consequently, there is a case for extending the membership of the Regulators' Group to include representation of these interests from the outset, both to help resolve questions of process and methodology as well as to keep them informed on progress. This should help to minimise the delays resulting from Ministers having to consult their colleagues in other departments in the latter stages of the process. We agree with this and the Treasury has been represented at the Ofwat-led regulators' briefing meetings since May 2004. The Prime Minister's Policy Unit rightly take an interest but do not expect to get involved in such issues at a working level. It is helpful to have this broader input from Government. The independence of the Regulator is a key requirement for maintaining the confidence of all the parties to the regulatory process and, in particular, of investors in the industry needed to secure the future funding of large-scale investment programmes. Thus it is important that any strengthening of the co-ordination arrangements for the next review should be seen not to prejudice the integrity and independence of the future Water Services Regulation Authority. We are required to establish MoUs with each of the following: Consumer Council for Water (CCW), Defra, Welsh Assembly Government, Drinking Water Inspectorate and the Environment Agency. Each of these MoUs will reflect the relationships and issues of common interest at a price review. We also consider that agreeing final terms of reference for the regulators' group would ensure that the integrity and independence of the WSRA is protected. 3. The publication of a high level strategy document Periodic Review – Directing the Flow – Priorities for Future Water Policy (November 2002) was a major development in the context of PR04 - representing a first attempt by Defra to set out a long-term framework for water policy. We should like to see this approach further developed well in advance of the 2009 review - and used to set out a long-term vision for the industry together with some planning guidelines and assumptions for the review, on issues such as climate change. Defra is committed to update Directing the Flow. We have begun to discuss with Defra the content and timing of the guidance it can issue under the Water Act 2003 to Ofwat on environmental and social issues. We understand that Defra intend to address sustainable development matters in this guidance following the outcome of our current consultation on our sustainable development duty "Contributing to sustainable development – a consultation on Ofwat's approach". 4. At the same time, we suggest that the Regulators' Group give early consideration on a high level scenario basis not just to the issues around the quality programme but to the aggregate spending context in which they are likely to sit. Any assessment of this kind should look beyond the immediate five years ahead, at the implications for customer bills, both on average and, given the differential impact of the way the programme costs fall on different companies, region by region, and at the implications for funding the water companies. This scenario analysis could then provide useful guidance to the parties from the outset of the likely outer boundaries within which a suitable, realistic and affordable set of programmes could be placed, enabling a more mature view to be taken of trade-offs between conflicting aspirations. Ofwat has conducted some preliminary scenario modelling around the potential issues that could affect the industry over the period 2010 to 2030. We expect to share the modelling tool we have used with companies and others who have access to our financial model. An outline of the initial assumptions and results has been published alongside this response on our website. The Environmental Programme The process of decision making on the environment programme appears to be the most complex and time-consuming in the periodic review process and is the area where the principal tensions emerged. A number of different elements need to be reviewed. These include the approach to negotiating new EU Directives, identification of priorities, the use of regulatory impact assessments and economic criteria to assist decision making and also the presentation of the impact on bills. 5. We see benefit in early discussion between the Regulators' Group and companies to identify and cost projects with a high probability of being needed post 2010, so as to constitute as large an "early start programme" as possible. This should help provide some certainty for companies as well as giving all the parties a long-term view as to how these programmes can be expected to be phased over the longer term. We agree. We will want to review with companies, at the end of 2006-07, the delivery of the early start programme, which companies proposed and we agreed at PR04. We will review how the process can be improved for PR09. This will need to consider the uncertainty surrounding all elements of the capital investment programme and the practicalities of confirming specific projects in advance of price setting. 6. We agree with some stakeholders that there appears to be the need for greater emphasis on prospective costs and benefits of Commission proposals in the negotiation process for EU Directives. This process should involve other relevant Government departments as well as Defra, and include consultation with UK business and consumers. Once agreed there also needs to be a clearer understanding of what constitutes statutory requirements arising from these Directives – particularly in the case of Framework Directives where more discretion is allowed to Member States on how particular outcomes are to be achieved. In our view, it must be for Defra to take a first view on those elements of the programme required to meet statutory requirements, also having regard to the risk of infraction proceedings. We share the steering group's concerns about these issues. We agree that the use of economic criteria and regulatory impact assessments that take account of costs and benefits of proposed new standards would aid decision making. At a national level we have recently helped Defra to understand the potential impact on customers' bills of a number of initiatives including the adoption of private sewers and compensation payments for loss of abstraction rights. We have also assessed the potential impact of the designation of further stretches of rivers under the Freshwater Fish Directive. However, we believe that at European level there should be much sounder information on the potential costs of new Directives – alongside the benefits –before adoption. We would be willing to work with Defra/Welsh Assembly Government as well as CCWater and Water UK to contribute at a European level to debates about future directives. As economic regulator, we welcome the adoption of the Water Framework Directive as this does include economic analysis and tests as an integral part of its requirements. 7. Ofwat should set the cost of the quality programmes in the context of water companies' plans for other operating and capital expenditure on their existing assets and provision of water services, and ensure it is even-handed in the way it presents information on the costs that go to determine customers' bills. We accept that there were criticisms of the way we produced the table showing the components of the average bill. We addressed this in "Final Determinations – Future water and sewerage charges 2005-10" (pages 129 and 130). We will need to work with companies to ensure the presentation of costs and drivers for bill increases are set out consistently. In particular we will improve the presentation of efficiency savings. But we do believe there is merit in explaining to customers how their bills would change if service was maintained at the current level as distinct from the effect on bills of improvements. Where the cost of improvements puts financial pressure on the company such that they need additional revenue to maintain financial ratios then we believe this should be allocated to the appropriate enhancements in a bill impact table. 8. In advance of the start of PR09, the Government should establish how to build sound cost benefit analysis into the process. This should allow collective decisions to be taken by Ministers on which environmental capital programmes should proceed, taking account of the cost and benefits of the environmental improvements, affordability for consumers and any risks of infraction proceedings. All members of the Regulators' Group will then understand the common criteria which need to be used for assessing costs and benefits and to assist decision making on all capital programmes including the environmental programme. There are various tools that could be used for this including regulatory impact assessment, cost effectiveness analysis, cost benefit analysis and Ofwat's five detailed criteria. While we do not consider it is our role to suggest precisely how these tools are best used in combination, we do emphasise the need for the Regulators' Group to work to common agreed criteria in future. We also see merit in extending the scope of cost benefit analysis to improve the value for money of the environmental programme and so protect the interests of water customers against a background of rising concerns about affordability. Agreed. We see this as an area where Ofwat, Government quality regulators, companies and CCWater should be working together between price reviews. We also note the work being undertaken by UKWIR to develop guidance on cost benefit analysis for the water industry. We think this is a useful initiative and should support improved use of cost benefit tools to inform decision making for long-term planning more generally, as well as for specific environmental improvements. 9. We recommend a review of the ways of improving the usefulness of the Ministerial Guidance within the review process so that it has more operational value to companies and other stakeholders and is used to narrow the range of options at each of the main stages of the review. The process of consultation required around environmental and social guidance should ensure the process is necessarily iterative. Ministers should have sufficient robust information on potential costs before taking decisions about policies. Cost information is in turn dependent on the specification of the potential policy changes. This process could be improved if Ministers gave preliminary indications well in advance of the scope of any policy changes. This would allow regulators and companies to work together to provide Ministers with more focused cost information. Format of cost information 10. Early dialogue between Ofwat, the companies and the Regulators' Group should consider what improvements can be made to the provision and format of cost information to provide a sound basis for Ministers' decisions on policy choices, including the impact on customers' bills. This should assist in the process of making policy decisions, so improving the usefulness of Ministerial Guidance. There is a dilemma here – Ministers deal in policies, while companies can only cost the impact they will have on their assets. However these are not mutually exclusive, we expect companies to put forward efficient and integrated proposals for improvements. It is would not be practical or feasible to gather information to set out the costs of each policy independently of other policies. It would then be necessary for companies to cost, and us to assess the bill implications for each permutation and combination of policies. The information burden on companies would be unreasonable. The marginal cost of introducing a second improvement in addition to a first improvement can be very different from the cost of introducing both independently. At PR04 companies provided cost estimates for delivering new policies in a strict hierarchy set out by the Environment Agency after consultation with Defra and Welsh Assembly Government officials. Many projects had more than one policy driver, with the costs allocated to the incremental costs of delivering additional policy requirements. When analysing information, we had the costs of delivering specific sets of improvements in the reference plans. And also the incremental costs of specific policies, if implemented. We appreciate that Ministers and officials did not have full information on every combination of policies. However, within an envelope of keeping the information burden to reasonable levels, it may not be practical to provide this level of detail. We will work with colleagues in Defra and Welsh Assembly Government and the quality regulators to ascertain the policy areas where Ministers wish to see the separate costs, and work with companies to provide sufficient information for policy making. This may well be at a more general level than that needed for price setting. Long term planning 11. We fully support the need for early planning and preparatory work on issues such as the Water Framework Directive and water resource plans. We believe that a revived Regulators' Group should address this issue as fully and as early as possible, including constructive dialogue with companies in its approach. Particular emphasis should be given to identifying and costing projects with a high probability of being needed post 2009. Consideration should also be given, by Ofwat and others where necessary, to alternative mechanisms of funding particularly costly projects recognising the distinctive risk profile of large capital projects and their longer planning and construction periods. This will provide some certainty for companies, as well as giving all the parties a long-term view as to how these inevitably large expenditure programmes can be expected to be phased over the longer term of the next 15-20 years, both to provide cost-effective procurement of projects and to smooth the impacts on consumer prices. Early planning and preparatory work for all aspects of PR09 will be essential. We are working with Water UK and companies to understand the potential impact of the Water Framework Directive on water company activities. We are also playing our part in the Defra and EA led Water Framework Directive consultations and working groups. By 2010 the water companies will have managed a programme of investment totalling around £70 billion in England and Wales. However difficult and complex this has consisted largely of projects that are relatively small in proportion to the overall scale of the programme. There have been few major long-term projects. This may change in the future. A number of current workstreams are relevant to this possibility. We have already pointed, in our January 2006 consultation paper 'Setting water and sewerage price limits: Is five years right?', to the fact that price limits, however long the period, must be able to take account of projects which cover two or more periods. We have also recognised that there may be a need to provide clearer assurances to companies and investors for very long term major projects and that such projects may carry a level of risk which differs from the construction, financial and regulatory risks associated with capital programmes to date. We will continue to develop internal thinking with regard to large capital projects that may span regulatory review periods. We would expect those companies who maybe faced with large capital projects to act similarly. We will work with companies and other stakeholders as necessary should such schemes emerge ahead of PR09. We have recently published jointly with Ofgem the 'Financing Networks' discussion paper (February 2006) which amongst other things discusses ideas around the concept of 'regulatory commitment', ie how regulators might seek to minimise any unnecessary risk and uncertainty associated with the regulatory treatment of capital investment. The responses to this paper will be highly relevant to the issue of how investors and companies may get more comfortable around the financing of longer term projects. 12. We support Ofwat's plans to consult on the length of the periodic review cycle towards the end of this year but note the uncertainties that extending the periodic review cycle could add. One option which would benefit from further consideration would be for companies to set out their forecasts for the forthcoming five-year period based on current standards alone and also in the context of a long-term scenario. We suggest that Ofwat's review should include consideration of how long-term planning for water resources, and infrastructure renewal could be better accommodated within the current five-year cycle. Our consultation on the frequency of future price reviews is now underway. In it we ask respondents for their views on mechanisms to increase certainty beyond the end of the next review period. The WSRA will want to make a decision on the length of PR09, and consider any other changes to our approach, when we have the responses. Collection and use of information 13. The Group is aware that some stakeholders cannot see the value that reference plans added to the process. There is a clear need to consider the role and scope of the reference plans for the 2009 periodic review and review whether more effective and less demanding alternatives are available. We found the companies' reference plans valuable. They facilitated the early sharing and publication of cost information across companies and with all stakeholders. The reference plans also enabled us to present packages of benefits and associated bill impacts in the customer survey, which in turn informed the Ministerial guidance. However, we recognise the information burden these placed on companies and would like to explore with all stakeholders the best way forward for PR09. Indeed the reference plans approach could well deliver many of the recommendations here, such as high level scenarios placing the potential quality expenditure within the total capital and operating costs context. They may also allow Ministers to have a view of the aggregate impact of a few well-specified packages of new policies. 14. We suggest that Ofwat undertake some investigative work to see whether similar price limits for the periodic review 2004 would have been produced with reduced data requirements. As part of this, they should examine the scope for reducing the information burden for water only companies. This could then be used to inform Ofwat's consultation process on the data to be collected for the periodic review 2009. We also suggest Ofwat considers producing and consulting on a regulatory impact assessment, as part of this process. For their part, stakeholders would need to consider whether they would be willing to accept the inevitably increased element of "rough justice" which would result from the use of a reduced information requirement. We recognise the information burden we place on companies. We consulted on the information needed for price setting alongside our methodology consultation. We took account of stakeholder's views. Last summer we consulted on the June return information we intend to collect from 2006. However, we are concerned that had we set price limits on the basis of less than complete information we could find companies that felt the "rough justice" had worked against them. We will consider the need to produce an RIA for PR09. Communication and relationships 15. Ofwat should consider in advance of the next periodic review how changes in policy in areas such as capital maintenance and sewer flooding could have been better flagged or explained to interested parties. While both of these areas were subject to extensive consultation in the run-up to PR04, we agree that we should consider how to improve transparency in our policy development processes. We will need to develop agreed processes with CCWater, companies and other key stakeholders to ensure they feel better informed at key stages through PR09. We also need to review the way out documentation flags up issues of relevant to particular stakeholders. Some issues, however, only become clear when industry-level information is available (for example, following submission of draft business plans). 16. We believe it should be possible, through consultation with companies, WaterVoice and other stakeholders, for Ofwat to establish before works starts on the next review what information will be made available during the price review and to which stakeholders, recognising that different stakeholders have differing needs. Ofwat should also consider the format (eg price base) in which it presents price information to customers. Ofwat, consumer bodies and the water companies need to work together to improve the way companies present information to their customers on the outcome of the periodic review. We agree with this aim. We will endeavour to work with our stakeholders to understand their needs. We will develop processes with the new CCWater to involve customer representatives in the presentation of information to customers. However not all the issues at stake may be clear at the outset of the review and we need to have freedom to respond to new information and representations on draft determinations. 17. Ofwat needs to ensure it carefully explains the status of the Draft Determinations focusing on the possibilities of change for the Final Determinations. The aim should be that Draft Determinations are substantially the figures to be finally determined, where possible. This will minimise the risk of stakeholders being taken by surprise following publication of Ofwat's Final Determinations. We agree. The draft determinations were the figures we would have finally determined had we reached final decisions in August. However the process of draft and final determinations enabled us to:
Length of the review process 18. We suggest the length of the review is considered by Ofwat in the context of the other issues already discussed: namely relations between stakeholders, clarification of roles, early strategic planning and a review of the overall information burden. There may be a debate to be had around whether the resolution of some of these other key topics might reduce the amount of time needed to complete a price review. We agree. These issues will need to be addressed when we prepare the timetable for PR09. Internal management 19. The results of the independent audit carried out by KPMG, as Ofwat's internal auditors, covering Ofwat processes supports the way Ofwat carried out the price review and validates the integrity and consistency with which decisions were taken and policy applied. The recommendations of that report relate to Ofwat's administrative procedures, and Ofwat should take account of these when preparing for the 2009 price review to improve further the consistency of recording of the process. We agree. On the whole the KPMG report endorsed our approach however we will take note of the need to improve consistency in internal documentation and to consider issuing a formal closure letter to the companies at the end of the review. This could respond to issues companies raise in responding to their final determinations. 20. We recommend that Ofwat management take forward the findings of the internal projects within our review. The principal issues among these are internal communications, awareness of pressures and workload on staff, and internal planning. We have taken steps to improve internal communication mechanisms since the end of PR04. We hope these improvements will help to address those issues but it will also be important for Ofwat management to review these issues at the outset and throughout PR09 to ensure we have the resources we need and everybody understands their role. We will review our process as we go along so that we are aware of the impacts of any changes/additional burdens that arise. Methodologies 21. We propose that Ofwat should review the methodologies relating to efficiency, capital maintenance banding adjustments, the cost base and financeability adjustments in the run up to the next price review with a view to improving transparency, confidence in the outcomes and also minimising the scope for gaming. This recommendation identifies some of the key price limit methodologies and in each case we will review these as we build up to setting new price limits in 2009. In some cases these reviews have begun already – we are consulting on our approach to financeability, and we have started to work with the industry on a joint review of our approach to efficiency (see recommendation 23). On capital maintenance a joint review of the application of the common framework has already been completed through UKWIR, as well as an independent assessment of our processes by our consultants (Mott Macdonald). These have raised a number of issues, and we will consult with the industry this spring on developing our process for assessing capital maintenance needs. 22. It is essential that issues such as financeability adjustments and the cost of capital are fully considered and based on sound advice and expertise. Ofwat needs to ensure it receives the highest quality external financial advice available. The report highlights financeability adjustments as "late"; "unexpected" and "could have been problematic". Allowing a real rate of return (equal to the assumed real WACC) on an inflating capital base, together with a large capital programme, can leave companies in a cash flow negative position, resulting in financial indicators incompatible with an investment grade credit rating. Allowing additional revenue which feeds directly through to cash flows, addresses the problem. Financeability was a feature of PR99 and PR04 and generally we applied the same methodology at both reviews. Our approach was explained in our methodology papers and we addressed the City directly at a number of City Briefings in both London and Edinburgh. We, along with other regulators, are considering the issue of financeability generally as an extension to the recommendations made by HMT/DTI in its report entitled "The drivers and public policy consequences of increased gearing". Our work will involve representatives of the investment community and the water companies. This work will be concluded in good time for the findings to inform our approach at the next periodic review, which will of course be fully explained to all stakeholders. We issued the joint Ofwat/Ofgem discussion paper, 'Financing Networks', in February 2006. This includes a section setting out various options for addressing financing constraints. These options include both market mechanisms and alternative approaches that could be adopted by regulators. We intend to hold a seminar during the response period to stimulate discussion with stakeholders on the issues raised in the paper. In the light of the views of respondents and discussion at the seminar, Ofgem and Ofwat will set out how they intend to take this work forward. We have asked for responses to the discussion paper by 5th May 2006. Any change to future price setting approaches would be subject to further consultation by individual regulators. 23. In view of the widespread concerns that have been expressed by companies about Ofwat's approach to assessing efficiency and the perceived lack of transparency about the basis for judgements in this area, we believe there would be value in instituting a joint industry review of efficiency studies and econometric approaches with the aim of developing a common industry approach for the 2009 review. Since receiving the report we have worked with the industry to identify its concerns and crystallise them into a project reviewing our approach. The project management team includes representatives from Ofwat, UKWIR and the industry. The team has agreed a project specification and will be inviting tenders for the work. It is hoped that the consultants will start the project as early as possible in the next financial year reporting back at the end of the year.  |
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