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Letters to Regulatory Directors
RD 02/08 15 February 2008 Dear Regulatory Director Leakage methodology review In July 2006 we launched a review of our approach to setting leakage targets (see RD 11/06). We asked for stakeholder views on what the review should include, and as a result commissioned three specific pieces of work. In November 2007 we published on our website the purpose of each project and the key reports, and we explained our next steps. At that stage we were still awaiting final input into one of the reports before feeding back formally to the industry. We now know that this final input will not be complete until Spring 2008, but we do not want to wait until then to update you. Therefore in this letter we discuss the outcomes of the reports, and provide guidance on how companies should incorporate the reports' findings into their business planning process for PR09. We discuss each of the projects in turn below. We have also provided a link to each report on our website. Variations in per capita consumption (PCC) project The purpose of the PCC project was two-fold. The first objective was to understand the extent to which variations in PCC across companies are due to socio-economic factors. The report concluded that national variations in PCC can largely be explained by differences in the underlying drivers of PCC. The second objective was to understand how methodologies for estimating PCC differed across companies, and to find areas where companies could improve. It built on the work of the UKWIR Best Practice Report UKWIR, Best Practice for unmeasured per capita consumption monitors (99/WM/08/25), 1999 which was published in 1999. The more recent PCC report makes a number of short-term recommendations for companies, which can be seen as updates to this best practice report. These relate to:
We expect companies to take account of these recommendations, and we will monitor their progress through the June returns. Where companies have not taken account of the recommendations, we expect them to make this clear and to justify their decision. We will continue to push companies to improve their estimates of household consumption. To achieve this, we will work with the companies and other stakeholders to share information and improve current practices. The report also made some recommendations for the regulators. These are listed below.
The report recommended that Ofwat consider moving towards reporting per household consumption (PHC) instead of PCC. This would reduce the need for companies to obtain accurate occupancy data for their PCC estimates, which can be difficult and expensive. However, companies would still need occupancy estimates to ensure that monitor samples were representative, and for demand forecasting. We are therefore not convinced that a move to reporting PHC would reduce the data burden on companies. The report also suggested that we request some additional information in the companies' commentaries to table 10 of the June returns to facilitate inter-company comparisons and to highlight PHC values. We currently collect enough data in the June returns to calculate PHC for each company. Therefore, if we decide that PHC data provides a useful comparison between companies, it will not be necessary to ask companies to provide us with more data. The Water Resource Planning Guidelines currently require companies to disaggregate measured household data. The Environment Agency will review the information it requires in relation to measured household consumption. The report also recommended that Ofwat should review the confidence grade definitions for table 10, and proposed a set of revised definitions for the reliability grades. At the stakeholder workshop, industry representatives were not convinced that these proposed definitions were appropriate. In particular, companies had concerns about the mechanistic way the components were combined to get an overall reliability grade. Although a poor reliability grade at any stage of the estimation process leads to less reliable estimates overall, it may not be appropriate to give each component equal weighting when they are combined. This could lead to companies with robust estimates having lower reliability grades than companies with poorer estimates. Nevertheless, we will review our current confidence grade definitions, taking into account the suggestions proposed in the report, as well as industry views. We will feed any changes into the JR09 guidance. The final recommendation for Ofwat was to review the issues arising from sharing monitor data. The report found that the overheads of establishing monitors were similar irrespective of company size, so for smaller companies the costs were disproportionate. Sharing monitor data could address this imbalance. It could also allow larger companies to develop better models at the resource zone level. The report suggested a possible approach. This involved allocating resource zones to regions, then analysing the sample data at a regional level to produce modelled results which companies could then extrapolate to resource zones. Companies were reluctant to adopt this approach. They raised concerns about using PCC estimates which were influenced by other companies' customers. Companies were also not clear who would benefit from a shared monitor scheme, or who would fund it. Companies currently use their own monitors to estimate PCC. Different companies use area monitors and individual monitors to different extents. As meter penetration increases it will become harder for companies to find suitable areas in which to establish area monitors. As this happens, data from shared monitors may become a more viable option for estimating PCC. However, at the same time, unmeasured consumption will become a less significant component of water delivered, which means that the figures will not need to be as accurate. We therefore do not intend to carry out a full review of the issues arising from sharing monitor data at this time. However, subject to our usual review processes, we would accept companies' PCC estimates if they were based on shared monitor data. Providing best practice guidance on the inclusion of externalities in the Economic Level of Leakage calculation The purpose of this project was to provide practical guidance to companies on including environmental and social costs and benefits in the ELL calculation. In November we published two documents on our website. These were a report that explored the issues and provided an overview of the guidance, and a guidance document to be used directly by companies. These documents were in draft form while a small number of companies tested the guidance for usability and to assess the potential impact that the guidance would have on the ELL. We expected to have feedback from these companies early this year and to publish a final version of this report in January 2008. Unfortunately, the companies have not finished testing the guidance. Initial feedback suggests that it is quite a time intensive process to collate the data necessary to carry out a full assessment of costs and benefits using the best practice guidance. We are expecting the final feedback from the trial companies in the spring. This feedback may lead us to amend the best practice guidance. For PR09, we expect companies to take full account of environmental and social costs and benefits in their ELL calculations. In PR09/08 we set out guidance for companies on how they should use cost benefit analysis as a key tool for planning and making decisions in all areas of their business for PR09. We were not overly prescriptive in explaining how a company should perform its CBA, but we set out some useful references. For the ELL calculation we think that the best practice guidance provides a useful process for identifying the externalities associated with leakage and leakage management. Companies should use the process outlined in stage 1 of the best practice guidance to determine which externalities are significant and require further investigation. The next stage of the process is to assign values to each of the externalities. Stage 2 of the best practice guidelines provides a framework for this. In this it recommends that companies base their valuations on the sources provided in the Environment Agency's Benefit Assessment Guidance (BAG). Stakeholders have raised concerns about the quality of the benefit transfer values obtained from the data sources provided in the BAG. We share some of these concerns. We expect companies to establish robust values for any significant externalities they have identified. This is likely to involve a combination of revealed preference, stated preference and the benefits transfer approaches. We expect companies to use the most appropriate combination of benefits assessment techniques and to justify any methods they have used. More guidance on valuing externalities is included in PR09/08 and its accompanying references. If companies consider that they cannot robustly value the externalities, then they should clearly explain and justify this. Stage 3 of the guidance details a useful process for including the valued externalities into the ELL calculation. We would expect companies to follow this process. Alternative approaches to leakage target setting project The purpose of this report was to review and compare alternatives to the Economic Level of Leakage (ELL) as a means for setting leakage targets. The report describes over 20 options, and recommends four alternatives which were all subject to a partial impact assessment. The four alternatives were:
Option A is covered in the second report discussed in this letter, 'Providing best practice guidance on the inclusion of externalities in the ELL calculation.' Option B involves a change in the way that abstraction charges are regulated. As part of its Water Resources Strategy, the Environment Agency is currently reviewing the way it manages abstractions. It therefore does not consider it appropriate to make significant changes in this area driven solely by leakage at this time. However, this option has not been ruled out in the long term. Option C involves altering permitted abstraction limits in abstraction licences to ensure a sustainable level of abstraction. This is an ongoing process within the Environment Agency under the restoring sustainable abstraction programme. The Environment Agency currently considers that it is not appropriate to drive further changes to abstraction limits for the purposes of leakage regulation, although future changes in abstraction licensing may take this into account. Option D involves normalising the leakage management performance of water companies, and driving less efficient companies to catch up with the performance of the best (or 'frontier') companies. This approach has the potential to deliver continuing efficiency improvements for all companies, with innovation from the catch-up companies leading to improvements in industry best practice. We decided that this 'frontier approach' to target setting was worth investigating further. We see it working in conjunction with – rather than replacing – the ELL. In November 2007 we said that we, together with the Environment Agency, would complete a further piece of work that would set out precisely how a frontier approach would work in practice and examine the costs and benefits of adopting such an approach. We have now commissioned consultants to carry out the work on developing a frontier approach. They are due to complete their final report in April 2008. We will share this report with the industry and other stakeholders by publishing it on our website. If we conclude that the frontier approach to target setting is achievable and realistic, and that it can deliver net benefits, we will launch a full public consultation in May about the possible change in approach. If the results of the consultation lead us to adopt a new approach, we will report our conclusions by October, so that companies will have time to follow it in their final business plans and water resource management plans for PR09. Next steps
Yours sincerely Paul Hope Head of Water Resource Economics Phone: 0121 625 3612  |
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