RD 10/00

TO THE REGULATORY DIRECTORS OF ALL
WATER AND SEWERAGE COMPANIES AND
WATER ONLY COMPANIES

31 March 2000

REVISIONS TO RAG 5 - TRANSFER PRICING IN THE WATER INDUSTRY

I enclose a copy of the revised guideline RAG 5.03 , which takes account of the responses received to RD 5/00. This will apply with effect from 1 April 2000.

The majority of responses to RD 5/00 welcomed the revision of RAG 5 to reflect current industry practice. Generally the industry agreed that competitive letting should be the norm for companies trading with Associates, other than in those few examples given in the guideline. A summary of company responses is attached for information.

Yours sincerely

Claire Goodland

Transfer Pricing Manager

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A number of companies requested clarification of the date that the new guideline will come into force. Some are also concerned that, since the reporting requirements in RAG 5.03 have been issued for 1999-2000, RAG 5.03 will apply to this year's return.

• RAG 5.03 will apply to contracts let from 1 April 2000.

A number of respondents are concerned at the burden of reporting requirements, which they consider inconsistent with Ofwat's policy of reducing the regulatory burden on companies.

• The new guidance clarifies the existing information requirement and reduces the reporting burden on small contracts. The onus to provide more detail will fall on those companies who have a significant level of trade with associates.

Some companies argued that, to be consistent with the Licence Condition F, cost should include a rate of return.

• The definition of cost in the appendix has been amended to include a rate of return on capital employed.

Most companies wished to retain the option of using benchmarking and some requested guidance on a materiality level at which it would be appropriate to use benchmarking.

• It is Ofwat's experience to date that benchmarking has not been sufficiently robust to demonstrate that charges are at market rates. RAG 5.03, therefore states that competitive letting should be the norm for companies trading with Associates.

A number of companies suggested that group charge could be allocated by turnover.

• RAG 5.03 states that allocation solely on the basis of turnover should not be used. The expectation is that 80% of costs can be allocated according to activity, in support Ofgem's approach uses turnover as only one indicator amongst a basket of others.

Several companies argued that the companies should only be required to report indirect transactions with associates if the associate was a nominated subcontractor. They suggested that the Appointee might have no legal right to know the names of subcontractors.

• It is possible for Appointees to make disclosure of associate sub-contractors part of any contract with a service provider.

Several companies argued that the industry was moving towards longer-term, strategic relationships with contractors over the AMP 3 period.

• The text has been amended to state that companies will need to demonstrate the benefits of longer-term contracts, by making reference to the market on an annual basis after three years.

A few respondents stated their intention to pursue partnering relationships with contractors. Some companies have requested that RAG 5.03 includes a more positive recognition of partnering and more detailed guidance on steps to be taken if entering into a partnering agreement with an associate.

• RAG 5.03 sets out the approach that Ofwat would wish to see companies take when entering partnering agreements. This covers regulatory concerns without, we believe, being unduly prescriptive.

RAG 5.03 requires that recharges for staff secondments should include an element to reflect the opportunity cost to the Appointee of not having that individual available to them. Some respondents have suggested that there is no robust method of quantifying this cost.

• Ofwat's view is that this should be retained. If associates were to obtain individuals of similar experience and expertise from outside the group, they would have to pay consultancy rates. Hiring temporary staff to replace key personnel will not fully compensate the Appointed business for the lost skill. No changes have been made to RAG 5.03.

One company suggested that RAG 5.03 should acknowledge that some work will be awarded at very short notice to deal with emergency operational needs. In instances where associates are used, a full tender process and audit trail will not be possible.

• A paragraph has been inserted to take account of this. Appointees are requested to document clearly the reason why the associate was selected and why an emergency situation arose. The Appointee should also demonstrate that this decision is in line with its documented policy procedure.