MD170

TO ALL MANAGING DIRECTORS OF

WATER AND SEWERAGE COMPANIES

AND WATER ONLY COMPANIES

8 May 2001

THE ROLE OF LONG RUN MARGINAL COSTS IN THE PROVISION AND REGULATION OF WATER SERVICES

Last year we updated our advice on the role of long run marginal costs (LRMC) in the regulatory framework (MD159 – 11 February 2001). Following representations from companies and other stakeholders for further clarification, we are now publishing a series of reports to:

• explain our views on the relevance of LRMC in water service provision and in regulatory policy (Report A);
• publish and comment on existing estimates of LRMC (Report B);
• explain how we intend to promote greater consistency in the estimation of LRMC (Report C);
• consult on proposals for the future scope and format of LRMC submissions (Report D).

We want to foster greater consistency in the approach to estimating LRMC and in the level of analysis. This does not mean that you should view LRMC estimation as a standardised calculation, but it does mean that you must expose your assumptions and present thorough analyses that are demonstrably consistent with your Water Resource Plans. Some companies have already demonstrated a sound approach to estimating LRMC. In other cases, we have yet to be convinced that sufficient attention has been paid to this important area.

The reports deal with some of the difficult technical issues, particularly in Report C on estimating LRMC. We do so without dictating, but in order to expose our thinking. We shall welcome comments on these issues, and also on the proposed process for future LRMC submissions, outlined in Report D. There will be a chance to explore these technical issues at a workshop we shall be arranging for companies and reporters during June 2001.

However, while it is important to get the technical details right, we do not want to let the economic jargon obscure the intuitive reasons why an understanding of marginal costs must be relevant to us both. We both have an interest in understanding how customers' demands for water services can be balanced with supply in the most efficient way. In the future, climate change and the need to ensure sustainability in the water abstraction regime may raise new challenges. You need to develop good forward plans and the capacity to update your strategies regularly. Regardless of Ofwat's information requirements, we believe that you should be undertaking and updating this kind of analysis to guide your own decision-making and to support your Water Resource Plan updates. We will expect you to demonstrate a thorough appreciation of resource and investment planning issues, and consistency with your policies on leakage control, tariffs, demand management, bulk supplies, competition and resource development. Your analyses should then provide a framework against which options can be re-assessed in the light of better information or changed circumstances. In this sense, a sound understanding of LRMC is an important means of setting the quinquennial AMP cycle within a longer-term framework.

In particular, we want to emphasise the role of LRMC analysis in ensuring that no company seeks to gain short-term competitive advantage at the expense of long-term obligations. Security of supply must not be compromised, and we will expect your analyses to reflect this. In particular, companies facing resource deficits should understand the high costs associated with proposals, for example, to gain customers by common carriage that further impact on security margins. Conversely, low LRMC estimates will suggest that the scope for using existing resources and spare capacity more effectively should be given particular attention, for example, through bulk supplies. We will ask you to justify competitive initiatives or tariff proposals that appear inconsistent with your analysis of LRMC or your Water Resource Plans. Above all, the regulatory regime must provide incentives to deliver benefits for customers, while taking proper account of the underlying long-term economics of sustainable water provision.

From 2002, we will be requiring all companies to submit updates of their work on the economic level of leakage and LRMC on the same biennial reporting cycle, in line with our emphasis on the need to consider the supply/demand balance as a whole. We expect the outcome of the tripartite study into leakage to be relevant for the development of best practice in this area.

Where there are more immediate issues we will also write to specific companies to request LRMC updates this year. We are willing to discuss with any company its approach to the estimation of LRMC. In the meantime, I hope that this series of reports will play a role in generating greater understanding and, where possible, agreement about the proper role of marginal cost considerations for companies and for Ofwat. At a practical level, I hope that the guidance on estimation will help to improve the quality of numbers.

Philip Fletcher