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Price review 2009
PR09/06 27 November 2007 Dear Colleague setting price limits - logging down and shortfalling 1. Introduction Consumers expect each company to deliver all the outputs associated with price limits. Where an output included is not delivered because it is no longer required or for reasons outside a company's control, we will 'log down' associated capital expenditure. Where a company has no legitimate excuse for failing to deliver an output, we will shortfall that company (that is, make a financial adjustment to remove all benefit from the associated price limit allowance). This letter sets out how we will make logging down and shortfalling adjustments when we set price limits in November 2009. We will make these financial adjustments where companies have not delivered the regulatory output expectations we set down for the 2005-10 period. This letter builds on the approach set out in our PR09 methodology consultation paper and complements the guidance set out in:
Logging down and shortfalling will apply for outputs not delivered in respect of capital maintenance, supply/demand balance, quality enhancement or enhanced levels of service. Any financial adjustments are without prejudice to regulatory or legal action that we, or a quality regulator, may deem appropriate in particular cases of service failures. 1.1 Logging down We will log down outputs included and financed in 2005-10 price limits that have not been delivered because they are no longer required. When we log down we make a financial adjustment so that that bills going forwards reflect the outputs which companies have been required to deliver. Accordingly, we will adjustment the opening regulatory capital value (RCV) at 1 April 2010; we will also adjust the regulatory capital expenditure profile for the period 2004-05 to 2008-09 used in the calculation of the rolling incentive mechanism for capital expenditure. 1.2 Shortfalls We will make a shortfall adjustment where a company fails to deliver on time any outputs which are required and were included in price limit assumptions. Our adjustment will recover for customers the net present value of the benefit to the company from the delayed or failed delivery of the required outputs. The benefit to the company is the additional revenue reflected in its price limits for delivery of outputs. This includes revenues associated with the return on capital, relevant operating costs and infrastructure renewals expenditure. In addition to clawing back the additional revenue recovered by the company during 2005-10, we will also make an adjustment to the opening regulatory capital value at 1 April 2010 to ensure that customers' bills going forward reflect the outputs which companies have delivered. 2. Process We can envisage the need to make logging down or shortfalling adjustments, where the output that has not been delivered:
When we set price limits in 2009, we will need to make assumptions about likely performance during 2009-10, with material reconciliations carried forwards into future price reviews. Where the output is scheme based our adjustments will reflect scheme costs assumed in price limits in 2004. Our approach to specific types of outputs is set out below. 2.1 Serviceability outputs In MD212 'Asset management planning to maintain serviceability' (February 2006) we said that our starting presumption in the case of less than stable serviceability would be a shortfall in the delivery of regulatory outputs. Serviceability outputs are 'metric based' and not scheme specific, therefore we must judge the size of the shortfall adjustment based primarily on the 'degree of failure' to deliver expected output metrics. We will scale the adjustment based on a proportion (ranging up to a maximum of 50%) of the net present value of the 2004 expenditure assumption for the relevant sub-service. This maximum does not represent the top of a simple linear scale, but will be reserved for clear cut cases of deteriorating serviceability where the degree of failure is judged serious according to all of the factors set out below. The scaling of adjustments will take account of the factors set out below in relation to the specific performance of the company in question, with proportionately smaller adjustments where the degree of failure is judged to be less serious. This scale of adjustment is large enough to reflect the potential seriousness of serviceability failures, and is broadly in line with the risk companies are exposed to in our approach to handling exceptional underperformance in capital expenditure (as consulted on in MD187 and confirmed in MD191). We will adopt the following approach in implementing shortfall adjustments.
2.2 Supply / demand balance and security of supply Supply demand balance outputs were set out in detail in companies' supplementary reports (tables A.3.1.8a, 10w, A.3.2.7a and 10s). We will apply logging down for outputs that are not required because demand has been lower than assumed in 2005-10 price limits. Where companies have failed to deliver the outputs which are required, we will make a shortfall adjustment. Generally, for the water service we would expect to make scheme based shortfall adjustments. However, where this is not feasible, we will impose a shortfall adjustment that is scaled by the company's average incremental cost (AIC) and the size of the capacity gap that needs to be filled in order to deliver the target security of supply index. In determining such an adjustment, we will take account of any additional demand above that assumed in price limits at the 2004 review. We will apply similar principles for sewerage service outputs, in relation to the 2005-10 outputs set down at company level. We expect each company to maintain the water it has available for use in line with the assumptions underpinning its 2005-10 price limits. Companies may seek to achieve other operational objectives at the expense of water available for use (e.g. operating cost efficiencies), but should be aware that this will attract a shortfall adjustment. Where a company's latest view of water available for use in 2009-10 is less than that assumed in price limits, we will make a shortfall adjustment unless there is compelling evidence that this was beyond management control. Such an adjustment would reflect the value of the lost capacity and the company's AIC, or scheme specific cost(s) where available. We will log down meter costs by applying PR04 unit cost assumptions to the difference between PR04 meter number assumptions and actual meters installed. We will also apply logging down in relation to outputs required because of expected new development if the number of new connections has been materially less than expected. 2.3 Quality enhancement We will continue with the principles applied in 2004, and generally log down or shortfall quality enhancement outputs on a scheme basis. If there are material delays to the delivery of quality enhancement outputs we will apply a shortfall adjustment to ensure that shareholders do not benefit from delays. In some cases we may base adjustments on the unit costs of outputs assumed in setting 2004 price limits, such as the unit cost of mains renovation. 2.4 Flooding from sewers For sewer flooding companies are required to deliver both the net reduction in the DG5 register and the assumed numbers of problems to be solved or mitigated. We will make a shortfall adjustment in the event of any material failure to deliver the net reduction in the DG5 register, except where a company can demonstrate that no cost-beneficial schemes are available. Where this is the case logging down will apply. We will also make a logging down adjustment if companies do not need to deliver the assumed numbers of problems to be solved to achieve the net reduction in the risk register. Variations against the company's forecast of the numbers of newly emerging internal sewer flooding problems in the period up to 2010 are to be borne by the company, and are not eligible for logging up adjustments. Shortfall and logging down adjustments will be based on the relevant number of problems and the unit costs that were assumed in price limits of solving or mitigating problems. 2.5 Other enhanced service level outputs Enhanced service level outputs (ESL) may be scheme or metric based. Adjustments for scheme specific outputs will be handled on a scheme basis. For metric based outputs we will adopt similar principles to those for supply/demand or sewer flooding. We will base our adjustments on the unit costs implied in 2004 review expenditure assumptions that relate to ESL output metrics. An example could be the unit costs allowed for removing properties from the DG2 register, where expected reductions had not been delivered. In all cases, we will expect each company to identify clearly outputs that they have not delivered, setting out their view of the relevant financial adjustments, in their draft and final business plan submissions. Yours sincerely Fiona Pethick Director of Corporate Affairs  |
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