TO ALL REGULATORY DIRECTORS OF
WATER AND SEWERAGE COMPANIES
AND WATER ONLY COMPANIES

15 October 1999

NOTIFIED ITEM FOR HOUSEHOLD OPTIONAL METERING AND PROPOSED MODIFICATION TO LICENCE CONDITION B

In MD149 the Director set out details of the Notified Item for household optional metering and a proposed modification relating to the materiality calculation in Licence Condition B.

He asked companies to respond to the proposals in MD149 by 6 September 1999.

The purpose of this letter is twofold. First, to address issues raised in the company responses and secondly, to set out in an Appendix to this letter details of the Notified Item and Licence Amendment the Director is minded to present as part of the final price limit determinations.

MD149 Objectives

In their responses, companies broadly supported the objectives set out in MD149 for the Notified Item for household optional metering. Companies agreed that the proposed amendment to the Licence Condition B materiality calculation would help to meet this objective.

Companies did, however, raise some concerns. These were principally about the assumptions underlying the calculation of base cash flows associated with the Notified Item and timing issues around Interim Determinations. These concerns and other issues raised by companies are addressed below.

In addition to these specific concerns, companies stated in their responses that the proposed Licence Amendment should be extended to all Relevant Items that may require an Interim Determination of price limits. This would in effect reduce the general materiality threshold for all Interim Determinations.

The proposed Licence Amendment set out in MD149 is intended to provide effective protection against the uncertainty associated with household optional metering and it is on this that companies' views were sought. The Director has noted views expressed about general application of the proposed amendment. This issue will be addressed with the Final Determinations.

Refinements to the MD149 Proposals

In light of company responses, the MD149 proposals have been refined in two ways.

First, it is acknowledged that sewerage undertakers face a particular exposure to risk that is outside their ability to influence directly. Under s.144A(1) of the Water Industry Act 1999, household customers, from 1 April 2000, will have the entitlement to serve a Measured Charges Notice on the water supply company and s.144A(9) obliges sewerage undertakers to fix charges for foul drainage for such customers with reference to the volume of water supplied following such a notice.

To take account of this, as set in the Appendix to this letter, we propose to revise the definition of the Notified Item. This revision would provide for sewerage undertakers being able to make a reference for an Interim Determination in the circumstance where only the price limit assumptions for sewerage service household optants are exceeded.

Secondly, we have considered carefully the concern raised by all companies that the calculation of the base cash flows associated with outturn optional household metering should reflect the outturn position for meter optant characteristics, and actual metering costs incurred.

The proposals in MD149 sought to ensure that the correction mechanism was based on information that was straightforward to identify and feasible to verify. They should also ensure that the proposed Notified Item is consistent with the Director's primary duties to promote efficiency and economy.

It is relevant, therefore, to distinguish between factors that are subject to direct influence by companies and those which are not. Those that are not could include the characteristics of those households who will choose to opt for measured charging.

The Director is minded to accept, therefore, that the calculation of attributable revenue losses could reflect the actual characteristics of meter optants. This would require companies to make timely provision of reliable and verifiable billing information on actual metered volumes used by households opting for a meter in the period between 1 April 2000 and the timing of any Reference Notice. Where such information cannot be provided, the price determination assumptions would continue to apply.

The costs of installing optional meters are subject to a greater degree of control by companies. The Director is not persuaded that the calculation of the base cash flows associated with metering costs should necessarily reflect actual costs. To do so would harm incentives to companies to minimise their meter installation costs and it is right that the Director should adopt an approach that assumes the costs expected of an efficient company. Comparative analysis of company costs, as at this price review, will therefore continue to provide the basis for calculating attributable meter capex and metering opex. Where, however, the location mix of actual meter installations is different to the assumptions in the Final Determination, the Director is minded to take account of this actual mix where this materially changes the unit costs assumed in price limits. Companies would need to substantiate any such material differences with evidence on why they had needed to deviate from the mix of meter locations assumed in price limits and the consequences for actual costs.

Clarification on issues relating to Implementation and Interim Determinations

Timing Issues

There is an industry wide presumption that the earliest date for any Interim Determination associated with optional metering would be for the charging year 2002-03. This is on the assumption of companies serving a Reference Notice to the Director no later than 1 October 2001. MD149 neither implied nor imposed any such restriction on timing. Companies would be within their rights to serve a Notice by 1 October 2000 if evidence indicated that the price limit assumptions had been, or were likely to be, exceeded in the charging year 2000-01. Paragraph 14.2(1) of Licence Condition B is clear on allowing provision for costs that are, or are likely to be, reasonably attributable to the Notified Item. Reference Notices for an Interim Determination can therefore be forward looking. The onus is on companies to submit to the Director compelling evidence, particularly where Notices are served on the basis of extrapolations rather than confirmed outturns.

Related to this timing issue, some companies suggested the starting point for the Notified Item should be 1999-00. It would be inappropriate to do this for two reasons. First, the Notified Item is part of the Determination of price limits for the period 1 April 2000 to 31 March 2005 and hence, relates to optional household metering in this period.

Secondly, the legal entitlement conferred on households through the Measured Charges Notice will not come into force until 1 April 2000 and this is explicitly referred to in the wording of the Director's proposed Notified Item.

Re-Notification

There was a mixed appreciation of the MD149 proposal (Section 6 of Appendix) to re-specify the Notified Item at Interim Determinations. Some companies welcomed this as a way of avoiding repeated Interim Determinations, while a number of companies advanced the same idea as way of alleviating their concerns about such possibilities. The Director reiterates his intention therefore, to update in light of actual experience at any Interim Determination, the optional metering projections constituting the Notified Item for the remainder of the relevant period.

The Director is not persuaded, however, by the argument that to reduce uncertainty he should specify the precise basis for determining the projections for meter optants to apply for the remainder of the relevant period. Some companies have suggested that such projections could be simple extrapolations of the actual average annual rate of optional metering observed since 1 April 2000. There is no compelling basis for doing so and the observable pattern of optional metering for companies with existing free meter options in the last few years does not bear out this view.

Meter Capex

A number of companies were uncertain as to whether the additional meter capex assumed for the purposes of any Interim Determination would be added to the regulatory capital value. It is the Director's interpretation of 14.2(8) and 14.2(9) in Condition B, Part IV, that the regulatory capital value would be adjusted to include the allowed net capital expenditure associated with any additional optional meter installations.

Prudent Metering Policies

In their responses, a number of companies queried the meaning of the reference to prudent metering policies in Future Water and Sewerage Charges 2000-05 (page 76). The Director has recently set out in MD152 (and the attached paper) his conclusions to the consultation on the criteria for the Approval of Charges Schemes. These conclusions include criteria relating to companies' policies on optional metering schemes and the Director considers these would provide the benchmarks by which the implementation of company policies would be assessed as prudent. In addition the Director will have regard to companies' tariff policies, in particular the balance between unmeasured and measured charges.

Clarification is also provided in Section 3 of the Appendix to this letter on a number of technical details relating to the materiality calculation in Condition B.

Next Steps

I invite your further response to the matters set out in this letter and the Appendix by Friday 5 November 1999. We will then finalise the details of the Notified Item and the proposed amendment to Licence Condition B which will be published with the Final Determinations.

The Director remains of the view that any modification to Condition B should only proceed where a company has indicated acceptance of the Final Determinations of price limits for the years 2000-01 to 2004-05.

Yours sincerely

Dr A J Ballance
Chief Economist 

Top of page

APPENDIX 1
Back to text

Licence Condition B Part IV 13.1 and 13.3 respectively define what is meant by "Notified Item" and the interpretation of costs to be attributed to the Notified Item.

In the context of optional household metering "Notified Item" shall be defined as:

The difference in costs in any Charging Year, which is attributable to the fact that:

1.1 the number of customers who have (or are to be treated as having) served a measured charges notice under s.144A(1) of the Water Industry Act 1999 is greater than the cumulative numbers specified in the table below:

And in the case of water and sewerage undertakers:

1.2 the number of customers for whom the sewerage undertaker is obliged to, under s.144A(9) of the Water Industry Act 1999, fix charges in respect of foul drainage provided by the sewerage undertaker by reference to the volume of water supplied to those premises is greater than the cumulative numbers specified in the table below:

2. THE AMENDMENT TO LICENCE CONDITION B

"14.2(6)

1. Subject to subparagraph (2) below, what is the Net Present Value of the amounts determined under (5) and calculated up to the start of the first of the charging years for which the next Periodic Review falls to be carried out (…….)

2.    In the case of Relevant Items for which it is deemed applicable by the Director, what is the Net Present Value of that part of each of the amounts determined under (5) as represents loss of revenue and annual operating costs calculated over 15 years.

and what is the aggregate of those Net Present Values ("the Materiality Amount")?"

3.1 Pre vs. Post tax discount rates

In their responses some companies sought clarification on whether the discount rates applied in the NPV materiality calculations would be pre- or post tax. Ofwat confirms that the pre-tax discount rate would be applied since no adjustment is proposed for tax payments in the calculation of the base cash flows. Where appropriate, the small company premium would also apply.

3.2 Start point for NPV calculations

Many responses suggested that the amendment to 14.2(6) should note that the NPV calculations should start from the notice of an IDOK. This is unnecessary as the term "Net Present Value" is already clearly defined in Part 13.1. It is clear from this that "Net Present Value" means the net present value calculated as at 30 September in the year in which the relevant Reference Notice is given.

3.3 MD149 worked examples and workings of the tariff basket

A number of responses interpreted Ofwat's simplified worked example, in particular the assumptions on revenue losses, to represent the approach Ofwat would adopt at the time of any reference for an interim determination. The principal purpose of the worked examples was to contrast the current and modified materiality calculations on the basis of standardised assumptions. The simplified examples did not, and were not intended to, replicate the actual workings of the tariff basket. The calculations at any future IDOK will reflect the actual workings of the existing tariff basket.

Top of page