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RD 14/00
TO REGULATORY DIRECTORS OF ALL
WATER AND SEWERAGE COMPANIES AND
WATER ONLY COMPANIES
PROTOCOL FOR ASSESSING THE MATERIALITY OF EXCESS METER OPTANTS
Introduction
In MD157 the Director indicated that Ofwat would publish a Protocol relating to the Notified Item for household optional metering and the modified Materiality calculations under Part IV (Interim Determinations) of Licence Condition B. A draft version of the Protocol was issued as a letter to Regulatory Directors (RD08/00).
This final version of the Protocol provides details on:
· a method for calculating the appropriate estimates of changes in cash flow associated with the Notified Item for household optional metering;
· the workings of the modified Materiality calculation in the revised paragraph (13/14.2(6)) set out in the Appendix of MD157;
· data issues and requirements relating to the Notified Item for household optional metering.
The context for this Protocol is primarily the Notified Item for household optional metering. It should be noted, however, that the details set out on the workings of the modified materiality calculation may have wider application to other Notified Items or Relevant Changes in Circumstances.
It should be recognised that this Protocol relates solely to demonstration of materiality. It is not the purpose of this Protocol to set out exactly how the interim determination calculations will be carried out. Once the Director has accepted the materiality of the impact on cash flows, revised price limits will be calculated using the same methodology as the 1999 Periodic Review but with an updated set of assumptions regarding the relevant Notified Items. For example, the revised meter optant assumptions will affect a number of parts of the price setting arithmetic.
In particular, a key component of Ofwat's price setting mechanism is a multi-year Tariff Basket model which incorporates all the effects of tariff rebalancing including the lag effects resulting from weighting years and any constraint on rebalancing caused by the measured-unmeasured differential. The Regulatory Capital Value will also be affected.
As already noted in previous correspondence, the starting point for any interim determination will be the actual number of meter optants in excess of the Final Determination assumptions. Consideration will then be given to the forecast number of optants in subsequent years and, where evidence is available, to optant characteristics.
Timetable for Interim Determinations – 2000-01
The deadline for companies to submit a reference notice for 2000-01 is 1 October 2000. The Director then has three months to reach an Interim Determination. It is hoped that reference notices can be submitted before 1 October 2000 and early notices would enhance the likelihood of completion before Christmas. This will then provide enough time for new price limits to be incorporated into Principal Statements.
A reference notice should include all the relevant information the Director would need to make the Interim Determination. The information submitted should be audited by the Reporter. The Reporter's report should arrive no later than seven days after the companies' submissions.
During the three month period there may be a draft version of the Interim Determination which will be announced on the Stock Exchange. The company and other interested parties will then be able to make representations. There will also be the opportunity to discuss the Draft Determination.
The latest date for any Reference Notice will be 1 October 2003.
For companies unaffected by Interim Determinations, excess meter optants will be dealt with in the 2004 Periodic Review. In particular: · an appropriate level of capital expenditure per meter optant will be logged-up and included in the RCV;
· additional operating expenditure associated with meter optants will be carried forward into the base position.
Licence Condition B: Relevant Statements and Definitions
Statements relevant to this Protocol are provided in 12/13.1 to 12/13.5 and 13/14.1 to 13/14.4 of Licence Condition B Part IV (Interim Determinations).
The key statements that merit highlighting are:
· 12/13.1 - "Net Present Value" means the net present value calculated as at 30 September in the year in which the relevant Reference Notice is given. All cash flows in any Charging Year are assumed to occur on 30 September in that Charging Year. Where relevant, cash flows occurring in a year prior or subsequent to the year of a Reference Notice are inflated or discounted at the Appropriate Discount Rate. In RD22/99 it was indicated that the Appropriate Discount Rate would be the pre-tax cost of capital. A company specific figure based on the assumption in the Final Determination would be appropriate.
· 12/13.3 (as modified and coming into effect as soon as possible after 1 April 2000) – References to costs include references to expenditure and revenue loss. Those items of expenditure to be treated as operating expenditure are those identified in Regulatory Account Guidelines 3 and 4 and in the Reporting Requirements for the July Return 1999 (Table 21, line 22 and Table 22, line 23). References to receipts include references to receipts, cash or other assets of any sort and can be capital or revenue in nature.
· 13/14.2(1) - In the case of a Notified Item what are, or are likely to be, the costs, receipts and savings reasonably attributable to the Relevant Item.
· 13/14.2(3) – What costs and receipts determined under 13/14.2(1) and what timing of such costs and receipts are appropriate and reasonable for the Appointee to incur by reason of the Relevant Item.
· 13/14.2(4) – The annual cash flows (referred to as "Base Cash Flows") in respect of a Relevant Item are defined as costs net of any receipts and savings over each Charging Year included in the timing determined under 13/14.2(3).
Ofwat's interpretation of these statements in the context of the Notified Item for household optional metering is set out in the following sections. The first statement stipulates that all net present value calculations are to be defined with reference to the mid-point in the year of any Reference Notice. The statements highlighted above in the subsequent bullets set out the scope and requirements of the "Base Cash Flows" to be attributed to Relevant Items, including Notified Items.
Household Optional Metering: Defining the Base Cash Flows
In the formal notification of price limits companies were informed of the details of the Notified Item for household optional metering. The Notified Item was defined as the excess over the Final Determination assumption for the cumulative number of customers from 1 April 2000 who have (or are treated as having; for example, as a result of a telephone request) served a measured charges notice on a water undertaker under s. 144(1) of the Water Industry Act 1999 for whom measured charges will apply in the particular Charging Year. In the case of water and sewerage undertakers, it was clarified in RD22/99 that this excess should take account of the total number of customers serving measured charges notices on water supply companies within the undertaker's sewerage area.
Hence, under 13/14.2(1) the costs, receipts and savings are those that are reasonably attributable to this excess of household meter optants, which can be summarised as:
· Revenue Loss – a loss of unmeasured revenue from excess meter optants, net of additional gains of measured revenue and Tariff Basket compensation.
· Operating Costs – the reasonably attributable cost of additional operating expenditure for the provision of measured charging net of any operating expenditure savings attributable to any reduction in volumes (delivered/ collected) associated with measured charging.
· Capital Costs – the reasonably attributable cost of providing and installing additional meters to enable the provision of measured charging.
It is to be noted that under the above definitions, the "Base Cash Flows" would be determined gross of any savings in tax payments that arise either from lower revenue and/or higher costs. For this reason, the net present value calculation of the "Base Cash Flows" so determined will be based on a pre-tax discount rate, ie the pre-tax cost of capital.
The calculation of the relevant amounts for these cash flows in a Charging Year, as required under 13/14.2(4), is dependent upon the Charging Years included under the timing determined under 13/14.2(3).
For the purposes of this Protocol, the interpretation of 13/14.2(3) refers to costs and receipts attributable to the excess of cumulative meter optants in the Charging Year of a Reference Notice. For example, where a company gives a Reference Notice on the 1 October 2001 with the intent of a change to the adjustment factor for the year 2002-03, then the relevant figure for determining the "Base Cash Flows" will be cumulative meter optants expected by 31 March 2002. However as noted in RD22/99, reference notices for an interim determination can be forward looking if compelling evidence can be provided; for example, the extent to which customers were opting for a meter on the basis of very small financial gains.
The next section provides further detail on how this is to be implemented for each of the categories of cash flow identified above. Matters relating to data requirements are addressed in the subsequent section.
Calculating the Base Cash Flows
Three categories of cash flow can be identified for household optional metering:
· Revenue loss;
· Operating expenditure;
· Capital expenditure.
Revenue Loss
The relevant revenue loss for the purposes of determining materiality is the revenue loss in the Charging Year of a Reference Notice. This means calculating the revenue loss associated with the cumulative number of excess optants expected for that year.
The calculation method used by companies should be straightforward and transparent to allow all key parameters and assumptions to be clearly identified. A proposed methodology is set out below. However other approaches can be used provided they generate equivalent results.
Secondly, the method used for calculating materiality should take account, as stated in RD22/99, of the workings of the Tariff Basket. Specifically, the revenue loss should take account of any revenue compensation provided automatically through the Tariff Basket. This also needs to recognise that such revenue recovery operates with a time lag, ie revenue recovery is only possible at the earliest in the subsequent Charging Year.
Calculating the Average Revenue Loss
In the following calculation, the net revenue loss, expressed as  , where t denotes the Charging Year of the Reference Notice, can be defined as the difference between two components. The first is the product of the annual average revenue loss per excess meter optant (denoted as  ) and the cumulative excess of meter optants in year t (denoted as  ). The second is the discounted value (to take account of interest costs) of Tariff Basket compensation in the following (ie t+1) Charging Year that is generated by the year t increment to cumulative excess optants. This second component (denoted as  ) is similarly to be expressed as the product of two figures: the discounted value of the average increment in Tariff Basket revenue compensation and the year t increment to the cumulative number of excess meter optants (denoted as  ).
Combining these expressions allows the calculation of the net revenue loss  to be defined as: 
The calculation of this additional revenue loss, therefore, requires identification of  , the average net revenue loss per excess optant in the Charging Year, and  , the discounted value of the increment in Tariff Basket revenue compensation.  is the cumulative number of excess meter optants by year t.
 can be calculated in a straightforward manner as the difference between:
· the average unmeasured revenue loss per cumulative excess optant ( );
· the average measured revenue gain per cumulative excess optant ( ).
This calculation can be expressed in terms of year t charges, the average charging base characteristics for the excess optants and the household tariff differential for year t. This can be written as:
where the following definitions apply:
 | Year t household RV poundage rate paid by optants (out-turn prices) |
 | Year t household volumetric rate paid by optants (out-turn prices) |
 | Average rateable value for the excess optants (£) |
 | Estimated average pre-switching volume for the excess optants (m3 per annum)4 |
 | Average post-switching reduction in volume (m3 per annum) 4 |
 | Average expected household rateable value for unmeasured customer base in the Final Determination (£) |
| Average expected household volume for unmeasured customer base in the Final Determination (m3 per annum) |
 | Year t household tariff differential (out-turn prices) |
For water and sewerage companies, separate calculations for the average revenue loss for water and for sewerage would apply. These should then be added together when considering materiality. In the case of sewerage, the measured volumetric rate should be consistent with the Principal Statement in terms of any allowance for non-returns to sewer. For water, unmeasured volume refers to unmeasured household water delivered, whereas for sewerage volume refers to unmeasured sewage collected.
Calculating the Increment in Tariff Basket Compensation
The formula used to calculate the weighted average charge increase provides for an increase in charges over and above the RPI ± K limit. The extent of this increase will be determined by the average charge per unmeasured supply for the Charging Year relative to the average charge per unmeasured supply for the prior year, where both are evaluated at the level of prior year prices.
The incremental impact of excess optants during the year t on Tariff Basket revenue compensation will be evident in the allowable charges increase for year t+1 . The impact of this compensation expressed as a year t present value is given by the formula:
where the additional terms are defined as:
 | the average rateable value of the year t increment to cumulative excess meter optants |
| r | Company specific pre-tax discount rate |
The above formula has the following implications:
· The measure of Tariff Basket compensation is zero where the year t excess optants have an average rateable value equal to the average rateable value expected for unmeasured households.
· The measure is positive if the year t increment to excess optants is positive and the average rateable value for the year t increment is greater than the average for expected year t unmeasured households. It is also positive if the year t increment is negative and those optants have below average rateable values.
The measure is negative for a positive year t increment to excess optants with below average rateable values or when the converse combination applies.
Worked Example
The workings of these calculations for the revenue loss from excess meter optants is best illustrated by a simple worked example. For the purposes of the example, it is assumed that a Reference Notice is served by a company on 1 October 2001, implying that the relevant Charging Years under consideration for the "Base cash flow" calculation required by 13/14.2(4) are 2000-01 and 2001-02. Year t therefore denotes 2001-02.
To amplify the example, two possible scenarios are considered. The first one is where the cumulative excess optants comprise positive excesses for both years. The second is one where the cumulative excess consists of a negative excess in year 2000-01 and a positive excess in 2001-02.
Table 1 provides the base data for meter optants.
Note: The Final Determination assumptions are for illustration equal to about 2% per annum of 1999-00 unmeasured households. The out-turn Scenarios reflect a profile on average of about 3% per annum of 1999-00 unmeasured households.
Scenario 1: Data for Calculation of 
The data required for the calculation of the elements of  can be divided into known data and assumptions. Table 2 summarises the data requirement in this way.
Note that the use of actual tariffs in this calculation will capture any revenue effects resulting from the need to maintain the differential between unmeasured and measured charges. Such effects may occur where households opting for a meter have lower volumetric demand than the unmeasured average. The average demand for the remaining unmeasured properties will increase. So will the implied average measured bill per unmeasured customer and the differential. This may mean that measured charges are constrained.
Scenario 1: Calculation of Average Revenue Loss
Using the above formula for  and the data from Table 2, Table 3 summarises the calculation of the first component of  .
Hence, the first element of the Base Cash flows comprising revenue loss amounts to £685,000.
Scenario 1: Calculation of Increment to Tariff Basket Revenue Compensation
Using the above formula for  and the data from Table 2, Table 4 summarises the calculation of the second component of  . For this calculation, the following assumptions are made.
This implies that customers with high rateable values have switched first.
Hence, under scenario 1 the "Base Cash Flow" calculated under 13/14.2(4) for revenue losses net of receipts and/or savings would be £474,720 (£685,000 - £210,280).
Scenario 2: Data for Calculation of 
Table 5 summarises the data for scenario 2. Under scenario 2 the profile of the same figure for cumulative excess optants differs from that in scenario 1. In principle this would imply a different set of year t tariffs to reflect the impact on Tariff Basket revenue compensation of the lower take-up (relative to 1) of optional meters in the first year. This extent of the impact on tariffs would be determined by the level of tariff rebalancing required to maintain a level for the year t differential given a different set of average household characteristics. Scenario 2, hence, reflects the impact of a lower take up of optional meters in year 1 through the expectation of a higher average rateable value and a lower average unmeasured volume for the year t. This gives lower unmeasured tariffs and higher measured tariffs to maintain the same tariff differential. Whilst only intended to be illustrative, the scenario 2 assumptions provide a more realistic tariff balance given the first year data for optional meter take-up.
Scenario 2: Calculation of Average Revenue Loss
Using the above formula for  and the data from Table 5, Table 6 summarises the calculation of the first component of  . Due to the underlying assumptions this simply replicates Table 3 under scenario 1.
Hence, under scenario 2 the first element of the Base Cash flows comprising revenue loss amounts to £389,600.
Scenario 2: Calculation of Increment to Tariff Basket Revenue Compensation
Using the above formula for  and the data from Table 5, Table 7 summarises the calculation of the second component of  .
Hence, under scenario 2 the "Base Cash Flow" calculated under 13/14.2(4) for revenue losses net of receipts and/or savings would be £213,100 (£389,600 - £176,500).
Operating Expenditure
The relevant operating expenditures for the purposes of identifying "Base Cash Flows" and determining materiality in the year of a Reference Notice are those reasonably attributable to the cumulative number of excess optants expected for that year.
In the case of operating expenditures, "Base Cash Flows" will comprise two elements:
· the additional costs of providing measured charging (ie meter reading and billing);
· the additional operating cost savings that arise from any additional demand reductions (ie reduced pumping and treatment costs).
This is calculated from the formula:
where the following definitions apply:
For water and sewerage companies, an assumption may have to be made concerning any operating costs associated with excess meter optants arising in water only company areas.
Worked Example
The information required to calculate the "Base Cash Flow" attributable to operating expenditure is the same under each scenario. Table 8 summarises the input data and the resultant calculation to identify the "Base Cash Flow".
The calculations in Table 8 assume:
· a unit incremental operating cost (for meter reading and billing) of £6.85 per annum per meter optant for the water service. A similar cost would apply for the sewerage service.
· variable opex of 10p/m3 (companies will have their own estimates of this value which would be expected to cover power and treatment costs).
· reduction in volumes supplied (rather than billed) of 9.5m3 per annum (implicitly meter under-registration accounting for 0.5m3 per annum).
Hence, the "Base Cash Flow" calculated under 13/14.2(4) for operating expenditure would be £58,000.
Capital Expenditure
In the context of household optional metering, capital expenditure would be expected to relate to the costs of providing and installing the meter. The actual reasonably attributable expenditure associated with this capital investment – rather than the annual capital charges – represent the relevant cost for the purposes of defining the "Base Cash Flow".
The profile of additional capital investment associated with the cumulative excess of meter optants will reflect the time profile of the cumulative excess. This requires, for the purposes of determining a consistent net present value of the capital expenditure, uprating of this expenditure by the discount rate where costs are incurred in Charging Years prior to the year of a Reference Notice and to discount similarly costs where the converse timing occurs. In practice, the latter will not apply where the determination of materiality will be undertaken with reference to the number of cumulative excess optants expected in the year of a Reference Notice.
These principles can be expressed in terms of the formula:
where t is the year of the Reference Notice, s denotes Charging Years and  represents the average unit capital cost for providing and installing meters as assumed in the Final Determination.  refers to the incremental number of meter optants in each year.
Worked Example
For the purposes of illustrating these principles, the same two scenarios for meter optants are considered.
Scenario 1: Capital Expenditures as "Base Cash Flows"
The primary requirement in calculating the "Base Cash Flow" is to account for the timing of the capital expenditure as implied in the above formula. Table 10 summarises the calculation of "Base Cash Flows" for t = 2001-02.
The illustration assumes a constant (in nominal terms) £125 unit capital cost for providing and installing a meter. Companies should use the average unit cost and locations assumed by Ofwat in the Final Determination in their materiality case as reasonably attributable costs. As set out in the Water Industry Act: Delivering the Government's Objectives, customers may be asked to meet additional costs of the fitting and operating of a meter in their preferred location.
Hence, the "Base Cash Flow" that relates to capital expenditure on metering is equal to £1,293,750.
Scenario 2: Capital Expenditures as "Base Cash Flows"
The scenarios differ only in the timing of expenditure. As Table 11 illustrates, however, the timing of capital expenditure results in differences in the calculation of the "Base Cash Flow".
Hence, the "Base Cash Flow" under scenario 2 that relates to capital expenditure on metering is equal to £1,241,250.
Data Requirements
The key item of additional data required will be the quantity of meter optants. Companies should, by 1 April 2000, have put in place a comprehensive system to record the number and characteristics of optants. It is also important for this to be kept up-to-date as the data available by September in each year will form the basis of a company's forecast for the remainder of that year. The forecast for each year should be based on at least five months of actual recorded data.
Companies will also need to update Tariff Action Plans to reflect actual out-turn information and the implications of different optant assumptions. [Tables KD9A – KD9E of the Business Plan].
This information, as well as any other material assumptions, should be audited by your Reporter.
Regarding optant characteristics, MD157 stated that the calculation of revenue losses could reflect different assumptions from the Final Determination, if supported by reliable and verifiable billing information. Such data will only be available from April 2001 at the earliest. Therefore any application for an Interim Determination earlier than this should be based on the following Final Determination meter optant characteristic assumptions.
Regarding the capital and operating costs, the Notified Item does not provide an adjustment mechanism if costs deviate from Ofwat assumptions. In all calculations of materiality, the Final Determination assumptions regarding the unit costs of providing and installing meters, and operating costs should be used. The calculation should be carried out in out-turn prices.
Calculating the Materiality Amount
The Licence Modification presented to companies with the Final Determination of price limits applies specifically to 13/14.2(6). This paragraph defines the rule for calculating the net present value of the "Base Cash Flows" attributable to a Relevant Item.
Previously this net present value of each element of "Base Cash Flows" was calculated over all years up to the first Charging Year to which the next Periodic Review of price limits would apply.
Where the "Base Cash Flows" represent recurring annual costs this calculation can be expressed as the formula:
where T would denote the final Charging Year of the current review period, t denotes the year in which the Base Cash Flow is deemed to be incurred (assumed to be the Charging Year of a Reference Notice) and i (i = 1,….,n) denotes the separate costs constituting the Base Cash Flows.
For one-off capital expenditures (such as meter installation) under this calculation rule the net present value is simply defined as the actual expenditure discounted or inflated as appropriate by the discount rate to take account of capital expenditure not timed to occur in the year of a Reference Notice.
The modified 13/14.2(6) now calculates the net present value of a "Base Cash Flow" according to the category of cost. The above formulation is retained under 13/14.2(6) (a) for costs (net of receipts and savings) that relate to one-off capital expenditure. For categories of recurring cost (net of receipts and savings) – ie revenue loss and operating expenditure – 13/14.2(6) (b) would now apply. This can be expressed with the formula:
Hence, the net worth of these categories of cost is simply calculated as a 15 year annuity, where the value of the "Base Cash Flow" represents the recurring annual sum.
The aggregate net present value – defined as the "Materiality Amount" – is the sum of the net present values calculated for each "Base Cash Flow". The 13/14.2(7) threshold for an Interim Determination is triggered when this aggregate net present value equals at least 10% of the last known turnover for the Appointed Business as reported under the terms of Condition F.
Worked Example
The workings of the modified 13/14.2(6) in the context of the Notified Item for household optional metering can be illustrated with reference to the worked examples for the "Base Cash Flows" set out above.
For illustration the workings of the calculations are described with reference to scenario 1. In the previous worked examples, it was assumed that the Reference Notice for an Interim Determination was served in the Charging Year 2001-02. This means that the relevant Appointed Business Turnover would be that reported for the financial year ending 31 March 2001. This illustration takes turnover to be £50.0m (broadly 500,000 households with an average bill of £100 per annum). The assumed discount rate is a pre-tax cost of capital equal to 7%.
With a "Materiality Amount" of £6.175m, the 10% threshold for an Interim Determination would be triggered.
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