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Letters to Regulatory Directors
RD 30/03 21 August 2003 Dear Regulatory DirectorMEASURED/UNMEASURED TARIFF DIFFERENTIAL In the Ofwat Forward Programme 2003-04 to 2005-06, we said that we would review the measured/unmeasured household tariff differential (the differential) with a view to implementing any changes in 2005-06 when new price limits come into effect. The reason for the review was twofold: 1. When we last reviewed the differential(1), we said that we would reconsider it before the next Periodic Review. 2. In the Tariff structure and charges 2003-04 report, we noted that unmeasured customers' bills were being pushed up in some companies' regions because of customers opting for a free meter. We explained that the differential plays an important part in determining how meter switching affects unmeasured bills. And we said that we would review the operation of the differential to see whether there was a way of phasing the impact on unmeasured customers' bills without compromising the purpose of the differential (explained below). This letter reports our findings and seeks views on the changes that we propose to make. The attached annex provides a more detailed description of the review. Purpose of the differential Companies' conditions of appointment require them to show neither undue preference nor undue discrimination in their charges to different classes of customer (condition E). The Director has a duty to ensure that companies meet this condition. We use the differential to ensure that the balance between measured and unmeasured household customers' charges reflects the different costs imposed by those customer groups. We calculate the differential by applying the company's measured household charges to its forecast average water delivered to an unmeasured household. The difference between the resulting bill and the forecast average unmeasured bill for the company should be no more than the extra costs of providing a metered service. We calculated this to be £34 per household for the 2003-04 charging year. Meter switching and the differential There is a cross-subsidy within the class of unmeasured customers. Customers in households with high rateable values (RVs), but whose water use is relatively low, pay more than it costs to provide their water and sewerage services. Correspondingly, some unmeasured customers pay less than the costs of the services they receive. Customers with high RVs and low consumption can reduce their bills by opting to have a meter installed so that they pay according to their water use. When this happens, the average RV of the remaining unmeasured customers will be lower. We assess price increases in the unmeasured basket according to changes in the 'average charge per chargeable supply', which will fall when high RV customers opt for a meter. This provides companies with scope to increase their charges to compensate for the revenue loss, while still complying with their price limits. In principle, companies could increase either measured or unmeasured charges. But the differential limit restricts the scope for them to increase measured charges. When customers with high RVs and low consumption switch, it is fair to expect that remaining unmeasured customers – who have previously paid less than their costs of supply – should pay more. We cannot allow or require companies to convert a cross-subsidy between unmeasured customers into a cross-subsidy between the classes of measured and unmeasured customers. The tariff basket mechanism and the differential together ensure that this does not happen. Changes to how we calculate the differential We have reviewed various alternative approaches to calculating the differential, which we discuss in the attached annex. We propose a modest change to the methodology. Rather than using forecasts of average unmeasured consumption and unmeasured properties, we would use historical data from the last full year for which information is available (ie figures from two years before the charging year). There is a case for using forecasts to ensure that the differential test ensures a cost-reflective balance between measured and unmeasured charges at a given point in time. But using historical figures rather than forecasts removes the problems associated with forecasting values for unmeasured consumption and unmeasured properties. It would be consistent with the tariff basket formula, which uses historical values. And it would ensure that the differential test remains valid as an assessment of whether charges comply with Condition E over time. This approach reduces the pressure from meter switching on unmeasured bills initially. Consequently, it may have a marginal effect in slowing the rate at which customers switch to meters. Although this is not something that we would seek to encourage, it would help to reduce volatility in unmeasured bills. We propose to apply this approach from 2005-06. We also propose a change to the way in which the differential is calculated on the sewerage side. This change would make the differential calculation more accurate by using volume figures based on water delivered to unmeasured sewerage customers rather than water delivered to unmeasured water customers. The difference between the two is that not all of a water and sewerage company's unmeasured water customers buy their sewerage service from that company. We provide more detail on this proposal in the annex. Setting the differential limit Companies incur higher costs in providing a service to their measured customers. We set the differential limit to reflect these higher costs, which we currently assume to comprise: 1. The customer related costs of metering which include:
2. The cost to companies of the additional benefits that measured customers enjoy, which includes:
We have reviewed a number of measurement issues. We propose to: 1) Include the annualised cost of creating the meter space, weighted to allow for the fact that some measured customers have already paid for this service. 2) Set limits on a company-specific basis, but retain standard industry-wide assumptions for many of the costs. 3) Set separate water and sewerage limits, rather than (as currently) a combined limit to which we apply a 2/3 to 1/3 split. 4) Operate the "limits" as targets. Meter space When we last reviewed the differential, we decided to exclude the cost of the meter space on the grounds that, for many companies, a significant proportion of measured customers had paid to have a meter installed. These customers would effectively have to pay twice if we were to include this cost in the differential limit. However, if we were to continue to exclude it from the differential limit, then unmeasured customers would continue to contribute to the cost of creating a meter space even though they do not benefit directly from this service. We said that we would reconsider this issue at the time of the 2004 Periodic Review. We think it is appropriate to set the differential limit so that measured customers, as a class, pay for the cost of creating the meter space. At the industry level, we estimate that about half have already paid for their meter space. This is either because they opted for a meter before the option was free, or because they bought a new house and the price of their house would have included this cost. For these reasons, we conclude that it is appropriate to include half of the costs of the meter space in the differential limit. We propose to review this amount in the light of significant changes. Company-specific differential limits We propose to set differential limits on a company-specific basis. We would continue to set the customer-related costs component of the differential limit according to benchmark costs, but we would use company-specific data on the proportion of internal and external meters. And we would use individual companies' bills to determine the values of the customer-related benefits, while continuing to apply standard assumptions about billing timetables, and the volumes of supply pipe leakage and meter under-registration. Separate limits for water and sewerage We propose to set differential limits separately for water and sewerage. This follows from our proposal to set company-specific limits based on company-specific values for customer-related benefits. For water only companies, those customer-related benefits will depend on the size of the average water bill, not a proportion of an average water and sewerage bill. Treating the limits as targets We propose to operate the differential limits as targets because we think we should treat the balance between measured and unmeasured charges symmetrically. We recognise that for some companies this could result in price increases for measured customers. But these increases would be appropriate in order to secure a more cost reflective balance between measured and unmeasured charges. However, we also share the Secretary of State's view Water Industry Act 1999 Delivering the Government's Objectives. that, where customers' water use does not change markedly from one year to the next, they should not face changes in bills significantly out of line with changes to the overall company price limit. For this reason, we would welcome proposals where necessary for a phased approach to reaching companies' targets. Next Steps We invite your views on our proposals to:
Please send your responses by 16 October 2003 to: Paul Hope Head of Tariffs Office of Water Services Centre City Tower 7 Hill Street Birmingham B5 4UA We shall write to WaterVoice and other consumer bodies to invite their comments on these issues by the same date. Yours sincerely Paul Hope Head of Tariffs (1) Approval of companies' charges schemes 2001-2002 (A consultation paper by the Director General of Water Services), June 2000. RD 30/03: Measured/unmeasured tariff differential - Annex  |
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