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Letters to Managing Directors
MD 216 10 May 2006 INTERIM DETERMINATIONS 2006 This letter sets out our intended approach to any interim determinations which we are requested to make or we initiate in 2006, in terms of principles, methods and process. These reflect the requirements of part IV of Condition B of the licence and in some cases build on our experience of earlier interim determinations. This letter does not cover applications under the 'substantial effect clause'. This letter provides guidance on how we will approach the following key issues in 2006: i) changes up or down in the number of meter optants; ii) increases in bad debt and the costs of managing debt; iii) increases in charges for abstractions and discharges to controlled waters; iv) charges for lane rental/traffic management; v) increases in the taxation of infrastructure expenditure arising from the introduction of International Financial Reporting Standards (IFRS); vi) changes in the construction price index (where applicable); vii) new enhancement expenditure and the change protocol; viii) other relevant changes of circumstance; and ix) counter-notices. Price limits for 2005-10 were set in December 2004, 17 months ago. It is possible that some relevant cost elements have deviated from the 2004 Periodic Review assumptions, or relevant new costs have crystallised in this period. However, we do not expect to receive many, if any, interim determination applications this year. We will, of course, apply the provisions of the licence as set out. To ensure smooth operation of the interim determination mechanism, 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 Board Lead Contact and Company Adviser at Ofwat will also be involved in overseeing the IDoK process and issues for your company. A. PROCESS There are two important, general points. 1. Interim determinations can only deal with the impact of relevant items (relevant changes of circumstance and notified 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 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 Consumer Council for Water and the relevant local Committee (CCWater). Early discussion of a potential application with us will assist this also. We encourage companies to inform CCWater about any potential interim determination application. In recent years most 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 with us and involve them in the subsequent development of the proposed application. We also encourage involving the Auditor where some aspects of the application will require audited financial information to support the company's case. Any application for an interim determination must be submitted by Friday 15 September 2006. 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 Friday 15 December 2006. If we decide to trigger an interim determination we will inform the company by 15 September and announce determinations by 15 December. We believe that customers' interests are best served by operating an open and transparent approach to regulation. Therefore, we believe it would be beneficial for a company that requests an interim determination of price limits to inform its customers when it makes an application. We will publicly announce any interim determination we decide to initiate. I attach at annex A the timetable we intend to follow this year. Please tell us of any difficulties you foresee with this. In previous years we made the electronic spreadsheet that underpins our interim determination calculations available to all companies. The version that we will use for 2006 is now available to download from our 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 functions covered by relevant items 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 have the opportunity to use the procedures set down in MD197, the AMP4 change protocol. Where companies use these procedures we will indicate the items to be logged up or down at the next price review. We aim to respond to a request for approval/confirmation within six working weeks of receipt of all the relevant material from the company. 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(1). 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:
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 five. A difference from the assumptions made when price limits were last set in: i) changes up or down in the number of meter optants; ii) increases in bad debt and the costs of managing debt; iii) increases in charges for abstractions and discharges to controlled waters; iv) charges for lane rental/traffic management; and v) increases in the taxation of infrastructure expenditure arising from the introduction of International Financial Reporting Standards (IFRS). 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 take non-trivial changes into account in price limits. Following our proposal in 'Setting water and sewerage price limits for 2005-10: Framework and approach' (March 2003) to amend the definition of triviality (at para 9.12) we will use the following approach. If the net present value (NPV) of the change is less than 1% of the relevant service turnover (water or sewerage) to which it, in our view, relates exclusively, then it would not normally be carried forward to the materiality test included in any reassessment of price limits. Where it appears to us that a change does not relate exclusively to either the water service or the sewerage service, triviality will be assessed with reference to 1% of the combined water and sewerage turnover. 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 revenues 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. C. OPTIONAL METERS 1) Optant numbers The revenue forecasts for 2005-10 in the 2004 Periodic Review used assumptions about optant numbers in 2004-05. In assessing the impact of changes in the uptake of optional metering on 2005-10 revenues, we will use out-turn figures for numbers of optants in 2004-05, in place of the assumed figures used for the final determination for 2004-05. To arrive at assumptions about the number of meter optants expected by 2009-10, we will consider company-specific evidence and trends. However, we will be cautious in drawing conclusions from the level of metering observed during the first months following significant increases in bills in April 2005. 2) Meter location Companies' assumptions on meter location, as presented in the Final Business Plans, were generally accepted in the 2004 Periodic Review. We would expect you to continue to adopt the Final Business Plan assumptions on meter location unless you provide compelling evidence supporting changed assumptions. 3) Optant characteristics For the 2004 Periodic Review, company-specific assumptions were applied based on Final Business Plan information and other available evidence. We will continue to adopt this approach. We will expect all companies to present updated evidence on optant characteristics. This should be based on out-turn evidence, for example from billing data. Companies should set out evidence for successive cohorts of optants showing:
We will assess the robustness of evidence provided by companies in reaching judgements about the likely characteristics of future optants. We will assume that optants have average characteristics in terms of supply leakage (both when unmeasured and subsequently when measured), unless compelling evidence is presented to the contrary. 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 or operating costs. D. BAD DEBT At the 2004 Periodic Review, we retained the operation of a one-way notified item for increases in bad debt and debt management costs where these relate to private dwellings or to premises where any part constitutes a private dwelling. In December 2005 we requested information from all companies on a number of bad debt measures in order to understand better the interaction between them. We also asked for details on accounting policies and procedures, and the way in which data is taken from billing and accounting systems. This information will be used alongside reported June Return numbers when assessing applications for interim determinations involving bad debt. The basic methodology for calculating the annual allowable amount will, however, follow the same principles as used in previous years' interim determinations. Companies will be required to demonstrate that costs have increased above those reported in 2003-04. The net change between the base year (2003-04) and each full year of the 2005-10 period will be determined for the total of four components:
In addition companies must show that: 1) their debt management activities are undertaken in an efficient and cost-effective manner using good practices established by other service providers; and 2) any increase experienced is in general terms due to the disadvantageous conditions under which water and sewerage undertakers are required to operate as compared with other service providers. E. ABSTRACTIONS AND DISCHARGES TO CONTROLLED WATERS At the 2004 Periodic Review, we assumed there would be no real increase in unit rates of charging for abstractions and discharges to controlled waters above those reported in 2003-04. The costs associated with any net increase in the total charges payable for existing abstractions or discharges, arising from real changes in unit rates above the charges reported for 2003-04 is a notified item. We would expect companies to demonstrate the real change in unit rates above the 2003-04 level with actual expenditure, supported by invoices. In addition, we expect companies to demonstrate that the amount payable has been determined in line with the relevant approved charging schemes and that the final amount paid by the company represents best value. F. LANE RENTAL AND TRAFFIC MANAGEMENT At the 2004 Periodic Review, we set price limits assuming that there will be no change in the charges payable by water companies to highway authorities for occupying the highway. The Secretary of State for Transport has not approved any proposals to introduce charges payable to highway authorities for occupying the highway. As a result, this notified item would not be relevant for any interim determination applications in 2006. G. INCREASES IN THE TAXATION OF INFRASTRUCTURE EXPENDITURE ARISING FROM THE INTRODUCTION OF IFRS We do not believe this notified item will be relevant for interim determination applications in 2006. The rate of convergence of UK GAAP to International Financial Reporting Standards (IFRS) has slowed considerably compared to what was anticipated at the 2004 Periodic Review. We would only consider applications from companies when they are compelled to follow IFRS, not if they chose to adopt IFRS for other reasons. We are unaware that this applies to any water company. Currently Condition B of the licence does not specifically address the treatment of tax for the purposes of calculating materiality. For materiality purposes we intend to regard tax in a similar way to changes in operating costs and revenue (i.e. over 15 years). We will ensure that the necessary licence amendments are in place before processing any applications concerning this notified item. H. 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 we assumed (when last setting price limits) that the company would incur capital expenditure (ie for the last Periodic Review this covers the period commencing 2005-06). 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 2006, this means the assumed capital expenditure in 2005-06. 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 2005-06. 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 assumed notified index for the financial years 2004-05 to 2009-10 (although the difference in the notified index and capital costs amount cannot be claimed for 2004-05, this year is an assumption and the difference contributes to the cumulative in 2005-06). 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 2005-06. 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. I. ENHANCEMENT EXPENDITURE AND THE CHANGE PROTOCOL 1) New enhancement expenditure We expect companies and others to have used the AMP4 change protocol (MD197) during the year. Any changes to enhancements included in the formal application for an IDoK must already have been confirmed using the principles and where appropriate the procedures set down. If this process has not been completed by 15 September the enhancement will not be considered at an IDoK this year. 2) Failure to deliver expected quality outputs on time The Drinking Water Inspectorate (DWI) and the Environment Agency will report to us in June 2006 on your progress with delivering the quality outputs included at the 1999 and 2004 Periodic Reviews, as amended by any subsequent interim determination for the AMP3 period. 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 quantify any change using the assumptions made when we last set price limits. J. LICENCE TERMS The following expressions set out in this letter are terms as defined in the licence (Condition B):
KEITH MASON DIRECTOR OF REGULATORY FINANCE & COMPETITION (1) 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 2006 – INDICATIVE TIMETABLE
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