COST OF QUALITY: INFORMATION FOR YOUR FINAL DECISIONS ON LEGAL OBLIGATIONS - AN UPDATE OF COSTS

In your guidance to me, set out in 'Raising the Quality' last September, you recognised the regional differences in the impact of quality obligations. You asked the quality regulators to give special consideration to this. You wanted to ensure that the detailed obligations at company level were defined in a way which avoids unacceptable impacts on water prices in different parts of England and Wales and reflects local environmental priorities. It is crucial for the success of the review that decisions on the quality obligations, company by company, are known by the end of next month.

I summarise below my updated estimates of the costs of the investment programmes for the period 2000-2005 needed to improve the quality of drinking water and deliver the quality of environment the Government and customers wish to see in coastal areas, in rivers and at sensitive sites.

Estimated cost of quality for the period 2000-2005

1997-98 prices

Capital expenditure £ billion

Compliance with water and sewerage quality obligations which are clear now: Water service European Directives National programmes Sewerage service European Directives National programmes Meeting customers' priorities for discretionary expenditure on other environmental improvements: To reduce the number of properties flooded by sewers To enhance security of supply and to leave more water in the environment ie expenditure on 'sustainability'   Contingency for additional essential action to meet new quality obligations during the period 2000-2005, which are not clear now

1.7 0.6   3.4 1.9     0.5 0.2 8.3   0.5 8.8

Total investment (excluding contingency) falls within the range, of £8.0 to £8.5 billion at national level. As agreed, I have already provided to your Office, the Environment Agency and the Drinking Water Inspectorate detailed costs of the quality obligations which are clear now at company level. These detailed costs were based on the companies' own updated estimates, looked at critically and challenged where appropriate by my Office. This process has driven down costs by £1.8 billion, or around 20%, to enable the Government's objectives to be achieved by the companies in the most cost-effective manner.

A breakdown of these estimates is provided in Tables 1 and 2.

There may however be some scope for further reduction by concentrating on schemes that reduce unsatisfactory discharges and deliver significant improvements in river quality at relatively low cost. In considering this you will, of course, also be considering advice from the Environment Agency on local environmental priorities.

Profile of falling prices

As you know, I believe that a large programme of environmental improvements can be financed within a framework of falling prices. In 'Raising the Quality' you asked me to consider the scope for setting profiles that are relatively stable over the five years 2000-05.

Subsequently, in my consultation paper, 'Prospects for Prices', published in October, I set out my reasons for expecting significant reductions in water bills in the year 2000 right across England and Wales. In many cases, covering a substantial proportion of consumers, bills could both come down and stay down in real terms. But in some areas, particularly in coastal areas, it appeared that this would not be possible. Although some costs now appear lower, the costs of the full programme in some areas would still push bills back up towards existing levels.

The factors lying behind falling - and in some cases - subsequently rising bills are well known. The greater efficiency of the water industry in recent years and the falling cost of capital enable existing programmes, all of which involve environmental and other quality improvements, to be carried out at lower costs to customers. Thereafter, unit costs should continue to fall, and in setting prices next November I will assume that they do.

Responding to price pressures in some regions

In some areas of the country, despite falling unit costs, the scale of new quality and environmental obligations will lead to rising, not stable bills. The pressures are more significant on the sewerage service. If the environmental programmes in these areas are to be delivered, prices will have to be set to ensure companies will be able to finance the necessary borrowing.

You indicated in 'Raising the Quality' that you wished to avoid unacceptable impacts on water prices in different parts of England and Wales. You also expressed a wish to see some convergence of bills to reduce the range between the highest and lowest. You said you would provide further guidance, as the programmes were refined at a company level.

I believe that it will not always be possible to avoid rising bills in some regions, given decisions already taken on mandatory environmental improvements. However, I do believe there is scope for you to mitigate the lack of convergence and achieve your other objective by reducing the scale of desirable environmental and quality improvements in some companies, notably Southern Water Services; Northumbrian Water; South West Water Services and Yorkshire Water Services.

Views of the CSCs

Following your guidance in 'Raising the Quality' and in the light of my estimates in 'Prospects for Prices', I carried out a specific consultation with the statutory representatives of consumers, the Customer Service Committees.

All the CSCs believe that there should be an early and significant price cut for customers. Whilst preferring stable or falling prices thereafter some CSCs would accept the need for future price rises where these resulted from the delivery of high priority quality and environmental obligations.

The CSCs where permanent reductions in bills may not be possible (South West; Southern; Yorkshire; Northumbria) and the CSC in the North West are very concerned that your decisions on local environmental obligations should recognise the effect on bills.

Some of these CSCs recognise the local pressures for improvements beyond EC obligations, especially the guideline standards on beaches, but argue strongly that you adopt a phased approach. Some, I have to add, believe that the environmental programme should be limited to just EC obligations.

CSCs have stressed the importance they attach to schemes being justified on sound cost-benefit grounds, and are concerned that they have yet to see evidence of this being done (in a transparent way).

Finally, there would seem to be strong opposition to the idea that the environmental programme in some regions should be enhanced solely to enable the realisation of national targets.

Wider issues

In making your final decision on local environmental obligations I ask you to take account of four wider issues:

• The cost of improving the environment of individual consumers by reducing the risk of flooding of their houses from overflowing sewers. This is particularly unpleasant for those suffering it. I allowed for improvements in this area costing £600 million at the last review. Although the incidence of sewer flooding has fallen substantially since 1989, I believe further reductions are a priority for customers and could properly be regarded as part of the quality programme.
• The likelihood of new obligations arising during the years from 2000 to 2005, some of which may need to be financed during these years. This could amount to further expenditure of upwards of £500 million.
• The cost of providing customers with adequate security of supply in uncertain weather or conditions. You have indicated that you may wish to guide me on these matters.
• The distributional consequences of the charging policies, set out in 'Water Charging in England and Wales' (November 1998) and foreshadowed in the Water Industry Bill, now before Parliament. You have stated – and I agree – that these consequences are manageable. But they form a significant part of the wider picture.

Your officials have agreed that by 26 February companies will receive a clear picture, from the quality regulators, of the legal obligations with respect to water quality, which they will be required to implement during the period 2000-05. Unless they are clear about exactly what is required, they will not be able to take proper account of quality obligations in the Business Plans which they are due to send me on 9 April. Unless the obligations are clearly specified in the plans, I will not be able to take account of them in the price review.

Instead, we would have to rely on the arrangements for the annual interim determinations of prices during the period when price limits have been set. I understand that you do not want this to happen other than in exceptional cases. I also believe that incentives to efficiency would be damaged by a retreat to annual decisions.

I C R Byatt

Table 1 - Estimated cost of quality for the period 2000-05 - Water Service
SPECIFIC DRINKING WATER QUALITY & ENVIRONMENTAL IMPROVEMENTS		Estimates Of Additional Capital Expenditure Needs (all at 1997-98 prices)
		Current Water Company estimates December 1998 £m	Ofwat's Challenged cost estimates January 1999 £m
1	Works to overcome exceptional problems of deteriorating raw water quality	350	200
2	Renovation of water distribution systems to overcome quality problems by 2010	1350	1130
3	Required measures to reduce risk from cryptosporidium	470	240
4	Improvements to treatment works and distribution systems required to meet the new Drinking Water Directive a. new interim lead standard by 2003 b. progress towards the long term lead standard c. meeting other parameter standards	(a) 30 (b) 230 (c) 300	(a) 20 (b) 230 (c) 150
5	Works required to reduce over-abstraction a. at designated sites under Habitats and Birds Directives b. affecting SSSIs c. other priority sites (low flow rivers) d. to comply with Surface Water Abstraction Directive	(a) 160 (b) 20 (c) 180 (d) 10	(a) 130 (b) 10 (c) 150 (d) 10
LATEST ESTIMATES OF THE WATER SERVICE IMPROVEMENT PROGRAMME		3100 Say £3.1bn	2270 Say £2.3bn
A	To enhance security of supply and to leave more water in the environment i.e. expenditure on sustainability		200
B	Contingency for additional essential action to meet new quality obligations which are not clear now		250

Table 2 - Estimated cost of quality for the period 2000-05 -Sewerage Service
SPECIFIC ENVIRONMENTAL IMPROVEMENTS		Estimates Of Additional Capital Expenditure Needs (all at 1997-98 prices)
		Current Water Company estimates (December 1998) £m	Ofwat's Challenged cost estimates (January 1999) £m
1	Installing high quality sewage treatment infrastructure to comply with the Urban Waste Water Treatment Directive	1700	1450
2	Works to comply with mandatory standards under the Bathing Water Directive and further improvements to assist achieving Blue Flag status at key holiday resorts	330	260
3	Improvements to 2/3rds of the unsatisfactory intermittent discharges (combined sewer overflows)	1470	1220
4	Improvements in the disposal of sewage sludge a. phase out of raw sludge to land by end of 2001 b. restrictions on treated sewage sludge to land c. disposal of additional sewage sludge	1170	1020
5	Improvements to eliminate at least half of current shortfall on River Quality Objectives	510	420
6	Improvements to comply with imperative standards and endeavour to observe guideline standards for a. Freshwater Fish Directive b. Shellfish Directive	340 240	290 180
7	Other improvements to effluent discharges a. at designated sites re Habitats & Birds Directives b. affecting SSSIs	40 30	30 20
8	Other improvement obligations a. to meet demands for first time sewerage b. other requirements	170 320	150 280
LATEST ESTIMATES OF THE SEWERAGE SERVICE IMPROVEMENTS		6320 Say £6.3bn	5320 Say £5.3bn
A	To reduce the number of properties flooded by sewage		500
B	Contingency for additional essential action to meet new quality obligations which are not clear now		250