CONTENTS

1. Foreword

2. Summary

3. The framework for setting price limits

4. The business planning process

5. Taking account of the views of interested parties

6. Key issues in the approach to setting price limits

7. Information to support price setting

Appendices

Respondents to the proposed framework and approach to the 1999 Periodic Review

Respondents to the Business planning process, customer consultation and information requirements for the 1999 Periodic Review

National customer surveys in 1998

Serviceability of water and sewerage assets in England and Wales

The principles of broad equivalence

A résumé of responses on the proposed information submissions

The proposed content of the draft Business Plan

Glossary

Last summer, I published two consultation papers: The proposed framework and approach to the 1999 Periodic Review and The business planning process, customer consultation and information requirements for the 1999 Periodic Review.

This paper summarises the responses I received and, in the light of these, sets out my decisions, together with my reasoning.

I received a substantial number of responses to each paper. On some issues, the responses showed a marked diversity of views. This is perhaps to be expected from the widely-differing parties interested in the water industry. In framing my decisions, I have considered carefully all the responses in order to achieve a reasonable balance between two overarching objectives. First, a regulatory regime which preserves incentives for companies to act efficiently. Secondly, to ensure that customers benefit, and are seen to benefit, as soon as possible from efficiencies which the industry has already achieved.

In many instances, the consultation has reinforced the thinking I set out in my earlier papers. In a few important areas, such as the effect which the proposed treatment of capital efficiencies would have had on incentives and the burden imposed on companies by the proposed Periodic Review timetable, I have changed my proposals.

The consultation papers were issued before the Government's Review of Utility Regulation was announced. The results of the Government's review will be announced in a Green Paper to be published shortly. In my submission to the Government, I argued for changes in the regime to strengthen the protection of customers.

My consultation papers and this paper have been written on the basis that the RPI-X price-cap regime would continue and would not be replaced or complemented by any form of formal profit sharing scheme. The responses which I received uniformly supported my approach. Changes resulting from the Government's review could affect the balance between incentives to efficiency and early benefits to customers.

The next stage of the price review will be to publish, at the end of April, an open letter to the Deputy Prime Minister and the Secretary of State for Wales. This will make clear how much customers are already paying in their bills to allow the companies to meet quality obligations. It will also estimate how much they may expect to pay in future should various proposals, originating from European Community Directives or from the Environment Agency's National Environmental Programme, be implemented in UK law.

I then intend to publish, in October, a consultation paper for the Periodic Review, Prospects for prices, strategic options and issues. This will set out, for the first time, ranges of possible price limits for each company for the period 2000–05. It will allow all interested parties to see the possible impact on customers' bills of the potential environmental obligations which companies may face, taking into account levels of service to customers and expected improvements in efficiency. This paper should foster debate about customers' priorities and their willingness to continue to pay for improvements to the environment and for customer service. I will expect companies to prepare their draft Business Plans, due for submission to me in April 1999, taking into account the responses to that consultation paper.

There are many stakeholders in this price review. They all need opportunities to put forward their points of view. My starting position, as economic regulator, is that, at the start of the new price limits, companies should not earn more than is necessary to finance their functions.

I C R BYATT

Director General of Water Services

2. SUMMARY

On 15 October 1996, the Director General of Water Services (the Director) announced that in 1999 he would be determining price limits for water companies from 1 April 2000. On 11 February 1997, he set out his proposed timetable for the Periodic Review (the review) in MD124, a letter to the Managing Directors.

Throughout the review, the Director intends to conduct an open and transparent process and to consult widely. He published two consultation papers in the summer of 1997 seeking the views of interested parties on various aspects of it.

The proposed framework and approach to the 1999 Periodic Review (June 1997) (the Framework paper) sought views on the Director's approach to the methodology of setting price limits. The business planning process, customer consultation and information requirements for the 1999 Periodic Review (July 1997) (the Business planning paper) considered other aspects of the review. The respondents to these two papers are listed in Appendices 1 and 2 respectively. Copies of the responses are available from the Ofwat Library.

In light of the responses received, this paper sets out the approach the Director intends to adopt in setting prices, together with the business planning process and information requirements needed to do so.

2.1 Significant changes to the methodology

Following the consultation, the Director has proposed two significant changes to the way he will set prices.

First, the Director has concluded that the proposed approach to paying for quality obligations only after the companies had delivered the planned outputs should not be followed. He noted concerns that this approach would entail significant risk for companies and so lead to a higher cost of capital. He considers that the benefits of transparency to customers do not outweigh the possibility that customers' bills may ultimately be higher. There are also considerable practical complexities entailed in this approach, including the possible requirement for licence amendments. There are other ways of ensuring timely compliance with new quality obligations.

The Director will, therefore, continue to set prices so that customers pay for quality improvements through bills, which cover the financing costs of the relevant capital expenditure, while work is being carried out. The approach will be developed to achieve greater transparency in the monitoring and the delivery of the programmes. This is discussed in more detail in Section 6.2.2.4.

Secondly, the Director has re-examined his proposals for transfering the benefit of capital efficiencies to customers through the regulatory capital value and the impact of this upon incentives. He now proposes that companies retain capital efficiencies for five years and, consequently, adjustments will be made to the regulatory capital value on a rolling basis. The Director believes that five years is an appropriate period to provide companies with adequate incentives to make efficiencies but for customers to realise the benefit of them as quickly as possible. This is discussed in more detail in Section 6.5.1.

2.2 The framework for setting prices

In response to the suggestions made in his Framework paper, the Director intends to conduct the 1999 Periodic Review, subject to any legislative changes resulting from the Government's Review of Utility Regulation, in the following manner:

• The Director believes the system of regulation and the setting of price limits should provide incentives for water companies to become more efficient and to improve their services to customers. Of the various alternatives, he believes the current method of setting fixed price limits for a number of years is the best way of achieving this. This system allows savings made by companies to be transferred to customers at price reviews.
• He proposes to set new price limits every five years. This will require companies' licences to be changed. The existing licence terms which allow for price limits to be adjusted within the five year period following specified changes in circumstances and, in particular, the imposition of new environmental obligations, will be retained.
• In the first year of the new price limits, 2000–01, the Director will reduce prices and profits (through the so called P_o adjustment). This price reduction, which will vary from company to company, will reflect the fact that companies have been able to provide their services at lower costs than the Director expected. It will allow customers to benefit from this greater efficiency. This approach was endorsed by the Committee of Public Accounts.
• Following the first year's price reduction, the Director will set prices for the remaining four years after examining the amount of investment which companies will need to make in order to provide the necessary services to customers. He will also examine the scope for them to make further improvements in efficiency. At this stage in the review, it is too early to know whether these future efficiency savings will be great enough to allow the companies to meet their investment obligations without prices having to rise.
• The Ofwat National Customer Council (ONCC) has said it would not like to see prices rising by more than the level of inflation after the first year. The Director is sympathetic to this view. Whether this is possible will depend on the preferences expressed by customers, following consultation with them by the companies and the Ofwat Customer Service Committees (CSCs), and the views of the Deputy Prime Minster and the Secretary of State for Wales (the Secretaries of State) on the size of the future environmental and drinking water improvement programmes.
• The Director will maintain incentives for companies to become more efficient and produce better services for customers by:
  Setting efficiency targets for each company for the five years of the new price limits. He will assess each company's current efficiency by comparing it with other companies. He will compare the quality of the service provided by the companies as well as the costs of providing it. In looking at costs, he will consider operating costs and capital expenditure costs separately, but will also look at how these affect each other.

  Ensuring that those companies that are currently less efficient are set tougher targets. The Director will consider how quickly the less efficient companies may be expected to catch up with the most efficient. Companies that have made good progress and are at the forefront of efficiency will be expected to make only modest improvements over the five year period.

  Taking into account, when setting the level of the first year price reduction, that some companies have already shared efficiency savings with customers through cash rebates, by increasing prices by less than they were allowed to or by carrying out supplementary investment.

  Making adjustments to the first year price reduction to reflect the quality of the overall level of service provided to customers. Although this is subject to further assessment, the Director believes that adjusting prices within a range of, say, +0.5% for the best performing companies and –0.5% for the worst would be appropriate.

  Passing to customers the benefits of efficiency savings on capital investment programmes in a way which provides incentives for the companies to make such efficiencies. He believes this would be achieved by allowing companies to retain any savings for a period of five years. To achieve this, adjustments would be made, on a rolling basis, to the companies' regulatory capital values. Where companies have made supplementary investment from any savings achieved in their capital investment programmes, companies will earn a reasonable return on that investment, providing that it is in accordance with the preferences of and benefits customers.

• The Director will scrutinise each company's requirements for investment. He will look at the investment needed to maintain the existing network of water mains and sewers. His first concern will be to examine whether these networks are maintaining the quality of service to customers. Provided they are, he will require well argued justification before he will allow in price limits for more money to be spent on maintenance or improvement. It is for companies to consider age and condition when deciding their priorities for maintenance work. In some cases, where the networks are maintaining the quality of service, the Director may assume, when setting price limits, that a company could be more efficient in its expenditure on maintenance.
• The Director would like to achieve a fair balance between present and future generations of customers in terms of the amounts paid in their bills for maintaining companies' assets, both above and below ground. He will do this by bringing the allowance made in price limits for depreciation and infrastructure renewal charges into line with the levels of expenditure to maintain services to customers. The Director proposes to assess such expenditure over 15 years for underground assets and 23 years for surface assets.
• He will also look at each company's past record in meeting its statutory environmental obligations and obligations to improve the quality of drinking water. If companies fail to meet them, they risk enforcement action being taken by the Environment Agency (EA) and the Drinking Water Inspectorate (DWI) to make them do so. The Director would also make a financial adjustment to the company's regulatory capital value to ensure it did not gain financially from any such failures.
• The Director will allow in price limits for future investment, provided it is necessary to meet new obligations, there is a set timescale for its completion and it is clear how it can be achieved. The Director will ask the Secretaries of State to guide him and the companies on the types of projects and schemes which are likely to fall into these categories. Such schemes may result from European Directives, UK legislation or national initiatives.
• Customers will, however, continue to pay for such investment projects in a way similar to a repayment mortgage, ie over the life of the assets created, rather than pound for pound as capital is spent.
• The Director will want to ensure that customers' reasonable demands for water are met in the most cost effective way:
  The balance of evidence shows there is no need for the amount of water delivered to each household for domestic purposes to increase. If there is increased demand for garden watering or commercial water use, such uses should be selectively metered. This would ensure that only those customers who are using more water than they did before, pay extra for it. The Director intends to encourage companies to introduce charging systems which encourage the efficient and economical use of water.

  Some companies have argued that they need to develop new water resources. The Director will ask companies to justify why this is necessary and to demonstrate that they have looked at alternatives, such as reducing leakage and increasing metering. The Director will not allow companies to pass on to customers the costs of developing new resources, such as reservoirs, when it would be cheaper for them to reduce their levels of leakage.

  Infrastructure charges for water and sewerage should remain at their existing levels, indexed for general inflation.

  It may be necessary, because of changes to the climate or the need, for example, to abstract less water from certain rivers, to allow some companies to increase charges to customers generally to pay for any required investment. However, some companies argue that they need to invest in new water resources to provide a greater safety margin to cater for possible future droughts. These companies will be expected to demonstrate that their customers are prepared to pay higher bills for what amounts to an increased level of service.

  All companies will be set targets for reducing leakage. Failure to meet these targets will result in enforcement action by the Director.

• The Director believes the water industry remains relatively low risk compared with other industries, and indeed with many other utilities. Any uncertainty created by the regulatory system itself may be better assessed once the Government has set out its proposals for changes to utility regulation. In setting price limits, he will assume that companies choose the cheapest form of finance available at that time, which will, in some cases, mean a continuation of the trend towards higher borrowings. He will also assume that the companies can choose from a broad range of financing options, including issuing new shares. The cost of capital for water and sewerage companies seems unlikely to have altered substantially, ignoring taxes, from its level in 1994. However, the Director will take account of significant changes to the tax system announced since then.

There was broad support from respondents for the Director's objectives for the review process, which were:

• to operate an open and transparent process
• to operate an effective process
• to ensure efficient use of data.

The first phase will be to develop the framework and expose issues (February 1997 to October 1998).

• The Director will publish in April 1998 an open letter to the Secretaries of State on the implications for customers of potential environmental and drinking water quality improvements.
• Phase one finishes with the publication of the Director's paper Prospects for prices: strategic options and issues in October 1998. This paper is central to his approach to the review. It will pull together all the relevant issues at both a national and local level. It will set out for the first time ranges of possible price limits for each company for the period 2000–05. It will consider the likely impact on customers' bills of the options for environmental improvements, as well as options for improvements to other services and assess the results of the consultation with customers on their priorities. This paper will take account of the EA's prioritised programme for environmental obligations which will be published shortly after. The Director and the EA will co-ordinate the preparation of their respective publications.

• Following Prospects for prices and the guidance provided by the Secretaries of State, EA and DWI on quality improvements, the companies will submit their views on price limits in their draft Business Plans in April 1999. The companies will be required to publish public summaries of their plans. The Director will issue his draft determinations of price limits in July 1999 and, following representations on these from companies, issue his final determinations in November 1999.

• Companies will publish their monitoring plans for the next five years in March 2000 and implement the price limits from April 2000 onwards.

Most interested parties accepted, with some misgivings, the lengthy programme for the review outlined in MD124 (February 1997) and explained in the Business planning paper. All saw the need for the clear timetable and for a common understanding about when contributions to the debates and discussions would be most productive. Chapter 4 of this paper confirms the timetable.

The Director recognises the importance of good consultation with customers at regional and local levels. In line with his own practice, he suggests that companies, CSCs and the EA regions set down how they intend to assess the views and priorities of both household and business customers. He encourages companies and others to publish their research so that all can understand the basis of the findings and the conclusions drawn from them.

The Director believes it will be sensible to evaluate the results of the work done by others before deciding whether he needs to carry out any further research.

The EA's consultation paper Outlook for the Environment (January 1998) sets out how its consultation on the key environmental issues will be carried out. Decisions on these matters rest with Government ministers.

2.5 Information requirements for price setting

It is important for Ofwat to receive early information from companies so that a debate on the issues can take place. The Business planning paper proposed a series of separate early information returns that would be required from the companies and which would inform the analysis to be included in the Prospects for prices paper. These returns are in addition to the companies' draft Business Plans required in April 1999 and the Monitoring Plans (AMP3) required after price limits have been set.

Overall, the Director's information strategy was well received and accepted. All recognised the need for the separate early returns, although several companies pointed out the implications of the timetable on the quality of data in the earlier (phase one) returns.

The Director recognises the companies' concern about the amount of information required for the review. Ofwat is reviewing the scope of the phase one submissions following recent consultation on the draft reporting requirements and will streamline the information requirements wherever feasible. However, the timetable set out in this paper must be adhered to and good quality data must be provided, given the importance of the Prospects for prices paper.

Further information on the data required in phases two and three of the process is outlined in this paper. In particular, a description of the proposed content of the draft Business Plan is provided in Appendix 7. These plans will be shorter and more focused than the 1994 Strategic Business Plans. There will need to be a clear linkage between the earlier information submissions and the draft Business Plan. The exposure and challenge of issues and assumptions is likely to result in changes to the information submitted in earlier returns. Hence, the draft Business Plan will need to restate material elements of the data submitted earlier so that the latest positions can be assessed.

The Director recognises the problems that external readers will have in locating the relevant information. He will produce one page summaries to explain the nature of submissions required by Ofwat and ask companies to produce one page summaries of their submissions which will be placed in the Ofwat library.

The Director will publish in July 1998 a detailed specification of the rules and calculations used in the modelling of financial projections. This will be independently audited.

The Director confirms his general presumption that the company information returns will be non-confidential. He will only respect information submitted as confidential provided it is clear that those requesting confidentiality have properly addressed the 'substantial harm' test outlined in the Freedom of Information White Paper. In this case, he will publish the reasons given by those requiring information to be treated confidentially.

3. THE FRAMEWORK FOR SETTING PRICE LIMITS

3.1 The approach

The Director has a statutory duty to act in the manner which he considers best calculated to secure that the functions of water and sewerage undertakers are properly carried out and that those companies are able to finance the proper carrying out of their functions.

In setting price limits, he interprets this to mean that prices may be set in such a way that passes on to customers the benefits of companies' increasing efficiency, while providing finance for companies to meet their legal obligations, maintain an adequate service and provide a reasonable return for shareholders.

The Framework paper maintained that the RPI+K regime provides powerful incentives for companies to become more efficient. Respondents to the consultation paper generally agreed that this framework was appropriate and should be retained. It was preferred to mandatory forms of profit sharing or sliding scale mechanisms.

The Director recognises that it is desirable to apply the regime in such a way that maintains sufficient incentives for companies to improve their operating and capital efficiencies but also increases the benefits to customers. Many respondents to the Framework paper commented on the balance and judgements necessary in this area. These are discussed further in the following sections.

3.2 Framework

The Framework paper identified key constituents of K which are considered to influence price limits.

K Ţ - P_o – X + Q + V + S

The constituents are to take account of :

P_o - Past outperformance

X - Future efficiency gains

Q - Quality standards

V - Enhancements to the security of supply

S - Enhanced service levels

Not all of the factors apply to all companies and, in addition, some of the elements interact. The Director does not, therefore, intend to publish separate values for all of these elements of K when he determines final price limits. Separate K factors will not be set for water and sewerage. He will, however, indicate which are the chief factors driving the trend in customers' bills and set out indicative Ks for water and sewerage services.

3.3 Outperformance and P_o

In the Framework paper, the Director asked how benefits should be passed to customers and, in particular, whether prices should fall in real terms across the industry for the first time – the P_o adjustment.

Many respondents agreed that the current regulatory regime creates strong incentives for companies to minimise their costs within their price limits. Customers benefit from these incentives at reviews when the Director resets price limits and takes account of the companies' achievements.

The Director proposed that past outperformance should be transferred rapidly to customers through an initial adjustment to prices. The initial adjustment would be represented by the P_o element of K in the first year of the new price limits. The Director considered that this would produce earlier and greater benefits for customers without materially reducing incentives.

Responses from customers and customer groups supported such an approach and welcomed a reduction in prices. The ONCC wanted prices in the years 2001–05 to remain below the rate of inflation. Environmental groups supported the rapid transfer of benefits, but argued that efficiency gains should be used to finance environmentally beneficial schemes rather than reducing prices.

The Director has also noted the comments of the Committee of Public Accounts (PAC) both in its review of the work of the Directors General of utilities and more recently. The PAC was concerned that profits should be no more than sufficient to provide the return required to attract the necessary funds for future investment.

The Director proposed that a company-specific package of P_o and X factors (for future efficiency) would provide greater incentives than a uniform industry wide P_o adjustment. This was broadly agreed by all respondents, although a small number of companies argued for the uniform P_o approach.

More generally, companies suggested that a P_o adjustment would erode incentives to achieve further efficiencies. They argued that the balance between investors and customers in the sharing of any efficiencies would be too heavily weighted towards customers. The more efficient companies also considered that they would be penalised by the approach relative to the more inefficient companies. Companies, generally, favoured the retention of a `glidepath', similar to that in the 1994 price limits, whereby the benefits arising from efficiency savings are gradually transferred to customers over a period.

The Director considers that without a P_o adjustment the rates of return earned by the companies will remain above the cost of capital for some time. The length of this period will depend on the profile of the K factors. This glidepath would result in higher profitability for companies than is necessary to finance their functions.

The Director remains of the view that P_o adjustments should be made unless further research and consultation with customers demonstrates strongly that this is not their preference. The Director considers that incentives to companies can be maintained, particularly through the interaction between a P_o adjustment, which captures past efficiencies, and the X factors for future efficiency.

Companies that have achieved greater efficiencies than was anticipated at the last review will have relatively higher P_o adjustments than those which did not. However, the future targets for efficiency will be set relative to the achievements of the most efficient companies. This implies that the future X factors will be commensurately higher for the relatively inefficient companies than for the efficient ones.

The phasing of future efficiencies is of critical importance and is discussed further in Section 6.1.3.

The Director hopes that the K factors in the four years after the P_o adjustment can be zero, or possibly negative, but this will depend principally on the scope for future efficiency and the size of the quality programme for each company.

3.4 Formal profit sharing mechanisms

There was little support from respondents for a formal profit sharing or sliding scale mechanism to be incorporated within the regulatory framework, particularly in the light of the proposal for a P_o adjustment.

The adverse impact on incentives was clearly recognised. Companies would be likely to find rather fewer cost savings, to the ultimate detriment of customers' bills. Profit sharing mechanisms were also considered to be less relevant if there were to be shorter periods between reviews.

3.5 Voluntary sharing mechanisms

The Director has encouraged companies to share benefits voluntarily with customers between reviews. These have been in the form of cash rebates, deferral of K factors or supplementary investment.

Respondents welcomed the continuation of voluntary benefit sharing of outperformance. The Director will take account of rebates or deferrals of K resulting from outperformance. This will take the form of an equivalent credit for amounts paid under such schemes on a rolling basis. This should ensure that companies that have shared outperformance with customers are not disadvantaged compared with companies which have not done so. This is set out further in Section 6.5.1 on regulatory capital values. Supplementary investment will be treated similarly and this is discussed further in Section 6.4.2 on service performance and Section 6.5.1.

3.6 The period between price reviews

The Director proposed in the Framework paper that Periodic Reviews take place every five years and that companies' licences should be amended to reflect this.

Currently, the Director sets prices for a period of ten years with an option to re-determine them after five years if he or the companies wish.

The Framework paper and the public letter to companies (MD124) discussed the optimum period between reviews. The Director suggested that a five year period adequately balances the need to maintain a stable long-term framework that gives incentives to companies with the speed with which the benefits of efficiencies are transferred to customers. The Director also recognised that the effect of a P_o adjustment is also relevant to this balance.

The majority of respondents accepted that five years is an appropriate period and the Director concurs with this. Certain companies questioned whether this needs to be formalised by a licence amendment, but the Director believes an amendment would remove any doubt about the timing of reviews.

4. THE BUSINESS PLANNING PROCESS

4.1 Responses to the Business planning paper

The Business planning paper set out the Director's objectives for the review process. These were:

• to operate an open and transparent process
• to operate an effective process
• to ensure efficient use of data.

Phase one: Developing the framework and exposure of the issues (February 1997 to October 1998)

Phase two: Decisions and determinations (October 1998 to November 1999)

Phase three: Implementation (December 1999 onwards).

 

Respondents gave near universal endorsement to the proposed phased process and objectives underpinning it. Most respondents accepted that interested parties would require time to reflect on the emerging issues and so supported the lengthy process set down by the Director. The importance of the first phase in the success of the review was highlighted by many respondents.

Many respondents wanted greater clarity on how consultation with customers (and their representative bodies) is to proceed during the phases of the review. There were concerns expressed as to the closed nature of the proposed quadripartite process. Some respondents also made strong pleas for more accessible and understandable explanations of issues and assessments made by companies and regulators. Companies requested more explicit feedback mechanisms following the Director's assessment of their submissions. Some respondents wanted greater clarity on the integration of decisions on quality obligations into the process. These concerns are discussed further in Chapters Five and Seven.

4.2 The phases and milestones of the review

In the light of these supportive comments, the Director confirms the business planning process as set down in the Business planning paper. The milestones in each phase have been expanded to include the steps and timetable set out by the EA in its recent consultation paper Outlook for the Environment (January 1998) and also the involvement of the Department of the Environment, Transport and the Regions (DETR). The three phases and their respective milestones are described below.

4.2.1 Phase one: Developing the framework and exposure of issues

The milestones, key dates and lead parties for phase one, leading to the publication of Prospects for prices, are set out in the table below.

Lead party	Milestones	Key dates
Ofwat	Consultation on MD124 —1999 Periodic Review	February to May 1997
Ofwat	Consultation on The proposed framework and approach to the 1999 Periodic Review	June to October 1997
Ofwat	Consultation on The business planning process, customer consultation and information requirements for the 1999 Periodic Review	July to mid November 1997
Ofwat	The Director's paper The framework and business planning process for the 1999 Periodic Review	February 1998
Environment Agency	Consultation on Outlook for the Environment setting down the broad priorities, principles and benefits which should be sought from the environment programmes for water companies after 2000.	January 1998 until 21 February 1998
Ofwat	The Director's open letter to the Secretaries of State exposing the implications for customers of the potential environmental and drinking water improvements and the possible scope for efficiency	April 1998
Environment Agency	The EA publishes advice to Secretaries of State on broad priorities and benefits of environmental improvements.	May 1998
DETR and Welsh Office	DETR and Welsh Office open to representation from interested parties on priorities for environment improvements.	May to June 1998
Companies and CSCs	Companies and CSCs summarise their customer consultation results and the implications for future service	Early August 1998
Ofwat	The Director's paper Prospects for prices: strategic options and issues	October 1998 Consultation closes early January 1999

The Director has set out his conclusions and decisions on the information requirements to support price setting and the approach he will take in this paper.

In late April 1998, the Director will advise the Secretaries of State, in an open letter, of the indicative costs of the possible environmental and drinking water programmes. The Director will be seeking initial policy guidance from the Secretaries of State on the scale and timing of such obligations. The Director is seeking this guidance by late July 1998 to enable the EA and the DWI to advise on quality requirements in the early autumn of 1998.

In early August 1998, companies will summarise the results of their customer consultation and set out their preferred option for the balance between service levels and customer charges. The CSCs will also report to the Director on the customer consultation process and the companies' submissions.

4.2.2 Prospects for prices: strategic options and issues

Phase one of the business planning process closes with the critically important paper, Prospects for prices: strategic options and issues, which will be published in October 1998. The Director intends to bring together the results and views of interested parties. The paper will identify strategic issues on balancing needs and priorities within prices acceptable to customers. It will identify critical issues for individual regions while focusing generally on the national picture. To achieve these objectives, the Director anticipates that his paper will draw on, and bring together, the position reached on:

• consultation with customers on their priorities;
• the likely impact of statutory environmental and drinking water obligations, especially for the period 2000–05, on the basis of the policy guidance received from the Secretaries of State;
• the drinking water quality requirements as specified in the new Drinking Water Directive;
• work by the EA, other statutory environmental bodies, environmental interest groups and the CSCs on the priorities for the environment in the light of their costs together with the guidance from the Secretaries of State. This will include the implications of the EA's prioritised programme of environmental improvements to be published in November 1998.
• the most cost effective way of balancing supply and demand in the light of guidance from the EA and Secretaries of State; and
• Ofwat's work on the possible scope for the size of an initial downward adjustment to prices and expectations about future efficiency and other factors influencing price limits. This would build on the comparative efficiency work following the July Return 1998 submissions from companies.

The milestones, key dates and lead parties for phase two are set out in the table below:

Lead party	Milestones	Key dates
DETR and Welsh Office	Guidance issued by Secretaries of State on priorities for water quality improvements and the environment, including views on the scope for environmental improvements for each water company	July 1998
Environment Agency	In the light of guidance from Secretaries of State, interested parties invited to put forward their priorities for environmental improvements to the EA together with an assessment of the associated benefits	August to October 1998
Environment Agency	EA publishes prioritised programme of environmental improvements for approval by Secretaries of State	November 1998
Ofwat and companies	A series of formal meetings between the Director and the individual companies	January and February 1999
DETR and the Welsh Office	DETR and Welsh Office make decisions on environmental objectives for each water company for the period (2000–05)	Early March 1999
Companies	Companies submit draft Business Plans to support their proposals for price limits	By 9 April 1999
Ofwat	The Director's draft determinations of price limits published for consultation	End July 1999
Companies	Representations on the draft determinations	September and October 1999
Ofwat	The Director's final determinations of price limits published	End November 1999

The Prospects for prices paper will need to take account of the EA's prioritised programme for environmental improvements to be published a few days later. The Director and the EA will co-ordinate the preparation of their respective publications at that stage. These publications will provide the basis for discussions between the Director and individual companies early in 1999, as well as enabling other interested parties to express views on the emerging strategic options and issues.

During January and February 1999, the Director will hold a formal meeting with each company to discuss the issues raised in the Prospects for prices paper and how the company intends to deal with them in its draft Business Plan to be submitted to the Director in April 1999.

These meetings provide the final opportunity for companies to discuss matters with the Director prior to the submission of their plans. Earlier in the business planning process, there will have been several opportunities for dialogue between Ofwat and the companies on their key issues.

Each company's plan will incorporate its proposals for 2000–01 to 2004–05, explaining the basis of the price limits requested and its reasons for them. The submission would include the companies' forecast outturns for 1998–99. Companies will be required to publish public summaries of their plans.

The Director will prepare his draft determinations in the period from early April to late July 1999. The Director will publish, in late July 1999, the draft determinations in a report setting out the individual company K factors, infrastructure charge limits and the outputs required during the next price limit period. The report will provide broad justifications for the Director's decisions and set out an account of the consultations which have taken place.

At the same time, the Director will write to each company with an explanation of the factors underlying the draft determination specific to the company and not included in the formal publication.

A longer period than that allowed at the 1994 review will be required between receipt of the companies' draft Business Plans and final determinations, in order to allow for external consultation and comment on the draft determinations.

There will then be a series of formal meetings between the Director and each company during September and October 1999. These meetings will provide each company with the opportunity to make representations on the draft determination before the Director makes his final determination. The Director proposes to announce his final determinations in November 1999.

4.2.4 Phase three: Implementation

The milestones, key dates and lead parties for the implementation of price limits and subsequent monitoring regime are set out below:

Lead party	Milestone	Key dates
Companies	The monitoring plan (AMP3) published by each company, setting down its service, quality and environmental improvement plans together with how these will be achieved and the prices to be charged.	31 March 2000
Ofwat	New price limits in force	April 2000
Ofwat, EA and DWI	Active annual monitoring of company performance — July Return 2000, July Return 2001 etc.	July each year

Each company will prepare and publish a Monitoring Plan (AMP3) identifying the outputs that it is required to deliver year by year through the next price limit period. The plan will also indicate the expected expenditure levels and key activity profiles as set down in the final determination. The implications for customers' bills will be set down in accordance with the Director's final determination.

The Monitoring Plan (AMP3) will be reviewed by the Director, the EA and the DWI to confirm that the output profiles are correct.

The plan will be used by the Director, the EA, DWI and other interested parties to assess the performance of the company year by year throughout the price limit period.

4.3 Modelling of the financial projections

The Director recognises that companies and other interested parties want to understand how the detailed methodology and information submissions are incorporated in the financial projections which underpin price limits.

He considers that this can be achieved by the publication of a detailed specification of the rules and calculations used in the modelling of financial projections. This specification will be published in July 1998.

The financial model and the specification will be independently audited to provide external certification that the published specification corresponds to the working of the model.

4.4 Improved arrangements for Reporters and Auditors

The Business planning paper explained how the Director intends to use Reporters and Auditors. He made proposals in MD126 (March 1997) to strengthen the appointment of Reporters.

Many company respondents were concerned that it would be very disruptive to adopt the appointment procedures set out in MD126, but agreed there was a need to resolve the requirements for reporting on companies' submissions.

Some respondents considered that the Reporter's role was suspect and flawed. These respondents saw a need for Ofwat to adopt a more conventional approach, which would require Ofwat to appoint and pay for the Reporters.

The Director issued a new protocol for Reporters in November 1997 (MD130). This addressed the main points made by respondents. The Director considers that, at this time, it is not necessary for him to employ the Reporters directly.

4.5 Other issues raised by respondents

A number of customer representatives commented on the use of jargon and difficulties they had in understanding Ofwat papers. Some respondents wished to see simpler and more explicit information in the public domain. One respondent suggested it would be more helpful to use proportions of customer bills rather than annual movements in bills. They saw this as a more transparent way of exposing the impact of quality obligations.

These points have been noted. Ofwat will make every effort to produce reports and papers that are more easily understandable to a lay audience. Where it is necessary to use complex terms, Ofwat will provide a simple summary of the key points and also a glossary.

5. TAKING ACCOUNT OF THE VIEWS OF INTERESTED PARTIES

The Business planning paper explained how the Director proposed to involve the major interested parties in the review. These are:

• customers

• the EA and environmental interest groups

• investors and lenders.

5.1 Customers

Respondents generally welcomed and supported the commitment to customer consultation, without commenting on the detail of the proposed arrangements. There was broad support for the proposed co-operation between companies, Ofwat, CSCs and the EA to understand customers' views at the regional level. A number wanted more account to be taken of customers' views than was apparent to them in the 1994 review. Some were concerned that the Director had prejudged what customers want. Most comments on the arrangements were made by customer groups, principally the CSCs, the Consumers' Association (CA) and the National Consumer Council (NCC).

CSCs agreed that the focus of consultation should be at the regional level, involving themselves, the companies, the EA and other regional customer and environmental organisations. On the other hand, the NCC and the CA, while recognising that this is important, thought the Director should not rely solely on company market research but that Ofwat should carry out its own. CA argued that this research would only be a true indication of customers' views and priorities if it was done independently and in a consistent fashion. On a related point, CA and NCC queried whether the CSCs had sufficient expertise in, and resources for, market research to provide the Director with advice on the conclusions to be drawn from the customer consultation. One respondent representing business customers felt that the CSCs, and the ONCC, were more concerned with the interests of household customers, to the possible detriment of other customers.

Some national customer organisations wanted to be able to raise issues direct with the Director during the period of the review. They have urged the Director to continue to make use of seminars to discuss specific issues.

Since publication of the Business planning paper, discussions have taken place at a regional level between companies, CSCs and the regional offices of the EA to formulate plans for consultation. CSCs generally report effective working relationships with the companies, including involvement in the design of questionnaires and observation of focus group discussions.

At a national level, a number of organisations have decided to commission market research. These are DETR, The Water Services Association (WSA), The Water Companies Association (WCA), the EA and the CA. Ofwat has been fully involved in the work of the WSA/WCA. The ONCC will commission national research to provide a framework within which the CSCs can consider the results from individual companies. Appendix 3 to this paper provides more detail of the objectives and timing of the work to be done at a national level.

In the light of this, the Director believes it is sensible to evaluate the results of work done by others, both at a regional and national level, before deciding whether any further research is necessary to clarify issues or address omissions.

Nevertheless, it is important that the regional consultation is conducted in an objective and professional manner and that all interested parties are satisfied that conclusions drawn are soundly based. Ofwat will monitor companies' approaches and support the CSCs in assessing whether consultation work addresses the central issues and is representative of the whole range of the customer base. The Director has proposed to companies that details of their market research should be made public. Similarly, he expects that work done at a national level by other organisations will also be made public.

He also expects that each CSC, water company and EA region will state publicly how they intend to identify household and business customers' views and priorities within their areas.

Finally, the Director will invite the key customer groups to seminars to discuss the views of customers. These will need to coincide with early market research work in this area.

5.2 Environment Agency and environmental interest groups

Both consultation papers drew attention to the importance of decisions on the size and timing of future environmental improvements. Decisions on these matters will be made by the Secretaries of State. DETR has established a quadripartite process to help expose the quality issues. Respondents' concerns as to the transparency of the quadripartite process have been relayed to DETR. The quadripartite process will not itself make decisions; it is a mechanism to assist in the orderly and timely collection of information to support public debate and the decisions to be taken by the Secretaries of State.

The EA plays a central role in advising the Secretaries of State. Respondents to the Director's consultation paper sought greater clarity about the process to be followed by the EA in advising Ministers on environmental priorities. Other statutory environmental bodies and environmental interest groups wanted to ensure their views would not be diluted in the EA's advice. The EA has recently set down its proposals as to how it will consult on the priorities for environmental improvements within the context of the review — Outlook for the Environment (January 1998). These concerns have been addressed by the EA in its consultation paper. This greater clarity provides the basis for interested parties to make their views known to the EA, the Director and to DETR at the appropriate times.

The Director held a seminar with the EA, statutory environmental bodies and other environmental interest groups in September 1997 to explain the process and to gain feedback on his proposals. He also wanted to understand their environmental priorities. Further seminars will be held as the review proceeds.

The Director and the EA will co-ordinate the preparation of their respective publications, particularly Prospects for Prices in October 1998 and the EA's prioritised programme of environmental improvements which will be published very shortly after.

5.3 Investors and lenders

Ofwat has held meetings with a number of investors and lenders to obtain their views. Nothing has arisen in these discussions that would require the procedures established to be revised to take account of their views.

6 KEY ISSUES IN THE APPROACH TO SETTING PRICE LIMITS

The following sections set out in more detail the approach to be taken in setting price limits. The views of respondents to each of the key issues raised in the Framework paper are also summarised.

6.1 Efficiency past and future

6.1.1 Incentive regulation and efficiency

In a competitive market, companies become successful by anticipating their customers' requirements, improving performance and reducing costs. They, therefore, improve value for money, profitability and market share. It is competitive pressure that causes companies to become more efficient. In the absence of competition in the water industry, the RPI+K regime provides incentives to reduce costs. The benefit of reduced costs is passed on to customers through the setting of price limits by the Director.

Respondents to the consultation paper agreed that the RPI+K regime was working well. Companies are making considerable efficiency gains and, as a consequence, shareholders have benefited substantially. The Director wishes to measure improvements in efficiency so that prices from 2000 properly reflect the cost savings that companies have achieved. This will be passed to customers through the initial reduction in prices ( P_o).

The Director intends to set targets for future efficiency beyond 2000 (X factors), specific to each company. The relationship between P_o and X has been discussed in Section 3.3. In order to assess the X factors, the Director will use a similar approach to that taken at the last review, using comparative efficiency studies and by considering efficiency improvements achieved in the wider economy.

The proposed methodology for the assessment of both past and future efficiencies and the views of respondents to the issues raised in the Framework paper are discussed in the following sections.

6.1.2 Measuring past efficiency gains

6.1.2.1 Operating cost assessments and past operating efficiency

The Director's approach to assessing past operating efficiency was set out in the Framework paper. It is intended that operating cost efficiencies will be incorporated in the first year of new price limits and will be based on the level of operating costs in 1997–98, excluding short-term atypical costs. This will be constrained by the operating costs assumed in current price limits and adjusted on receipt of the 1998–99 operating cost data. The Director does not now intend to take account of assumed efficiency savings in 1999–2000 in his assessment of P_o. Such savings will, however, be included in his assessment of future efficiency as set out in Section 6.1.3.2.

His assessment will examine material non-recurring operating costs, for example drought costs that are not part of operating costs in a typical year.

In the Framework paper, the Director asked what categories of operating costs may be considered atypical in any one year.

There was little consensus on this except for those costs associated with extreme climatic conditions. Companies argued that atypical costs were a legitimate part of base costs and the same levels of cost should be used for both assessing efficiency and setting base costs. They stated that, otherwise, this would imply an inconsistent treatment. They also argued that the exclusion of some occasional costs, such as drought costs, would not recognise business risk. The EA asked to be consulted where companies put forward proposals regarding atypical operating costs relating to environmental matters.

In assessing companies past efficiencies, the Director will wish to consider all their actual expenditure, ie including atypical costs. Where a company has incurred extra costs because of particular weather conditions, for example, drought or a severe winter, these costs are part of the money spent to maintain a service to customers. When a company makes short-term savings, for example local authority rates rebates, the benefits of this should be shared with customers.

These variations in costs from year to year are, however, unusual and not part of the normal costs of the company. They should, therefore, usually be excluded in assessing future base costs and the scope for future efficiency savings. However, where a company has a long period of, for example, low pension contributions, this could be viewed as part of normal costs. Companies reporting unusual pension contributions in 1997–98 should indicate this in their July Return together with their expected scale and duration.

Leakage expenditure may be a special case. Following the Water Summit, many companies may need to increase their expenditure in 1997–98 and 1998–99 to reach their leakage targets. However, while targets are believed to be above economic levels, this expenditure should be no greater than that which might have been expected over the full quinquennium had companies given sufficient priority to leakage control. The Director will ask companies to detail and justify any extra operating or capital maintenance costs attributable to leakage for 1997–98 and 1998–99. He may reprofile the operating costs across the current quinquennium when assessing base costs for the next five years. Capital maintenance costs will be treated as for other infrastructure renewals expenditure.

6.1.2.1 Past capital efficiency

Capital efficiencies achieved in the current price limit period will be transferred to customers, over time, through an adjustment to the regulatory capital value. This is set out in further detail in Section 6.5.1

In addition, the Director will expect companies' estimates of the costs of meeting future obligations to have taken into account their achievements in the current price limit period. In particular, the Director will wish to revisit his 1994 assumptions in respect of the period after 2000 to ensure this is the case.

The submission of standard costs by companies in the Cost Base Submission G will be structured to allow a comparison against those provided for the 1994 review. This will inform the extent to which a new lower level of unit capital cost after 2000 should be assumed.

Companies will be required to provide strong justification for any cost estimates for current and new quality obligations which imply higher unit costs than in the past. Reporters will be asked to identify and review such cases in detail. Following the review in 1999, the Director, through the Reporters, will monitor the actual cost of achieving quality obligations against the amounts assumed in price limits.

6.1.3 Estimating future efficiency – X

The X factor of price limits is the mechanism by which the Director's expectations of future efficiency gains are passed to customers. Customers will benefit whether or not those expectations are actually met. There is, therefore, a strong incentive on companies to meet and exceed efficiency targets in order to produce higher returns for shareholders.

There is a strong relationship between past achieved efficiencies (and hence P_o) and future efficiencies. This has been discussed in Section 3.3.

In the Framework paper, the Director questioned whether there is more or less scope for efficiency savings (both operating and capital) in the water industry than in other utilities or other industries.

The companies were clear in their view that there is less scope for efficiency savings in the water industry than in other utilities or other industry sectors. Other respondents disagreed. Many respondents did not address this issue.

A number of companies, however, have already demonstrated, through substantial reductions in operating expenditure, that there is scope for large efficiency savings in the less efficient companies. On the other hand, the scope for the most efficient companies may be less. The Director believes that there is scope for efficiency savings in any industry that is undertaking large scale improvements to its capital assets. When assets are reconfigured as a consequence of capital programmes, existing sub-optimal arrangements will be replaced with more efficient ones. These new assets may then be maintained more efficiently than those they have replaced.

Efficiency savings also arise from capital programmes where projects are combined so that more than one problem can be solved with a single capital solution. There is also greater potential for companies to procure at lower prices.

6.1.3.1 The interaction of operating and capital efficiencies

In the Framework paper, the Director stated that he wished to capture both operating and capital efficiencies for customers. He proposes to treat these separately but cumulatively. The comparative efficiency studies will examine both operating and capital maintenance expenditure and, therefore, will inform the Director's judgement on the potential for efficiency.

The Director asked for views as to how far the proposals to consider such efficiencies separately provide an adequate treatment of efficiency.

There were several comments on this, principally from the companies. There was a general view that total efficiency needed to be considered, or at least the interaction between operating and capital efficiencies examined. It was further argued that treating them separately may provide incentives which do not result in the most efficient option overall.

The EA would like to see companies achieving an efficient balance between operating costs and capital expenditure in areas relating to its statutory duties. Customer respondents requested greater transparency in the assessment of efficiency and asked for it to be measured in a more comprehensible way.

Ofwat commissioned research into the feasibility of one way of assessing total efficiency, through production functions, following the 1994 Periodic Review. This concluded that capital costs should be considered in assessing efficiency, but that defining appropriate inputs and outputs for the industry was problematic and that defining data requirements and collecting such data was very difficult. There are a considerable number of factors beyond management control, for example geographic areas and the inherited capital stock, that would need to be adjusted for.

Although the research concluded that some data envelopment analysis might be possible, there are practical difficulties in collecting sufficient sound data to an appropriate degree of detail. This leads the Director to conclude that separate efficiency comparisons using operating costs and capital maintenance costs are likely to lead to more robust conclusions than analysis undermined by patchy and unreliable data. He will, therefore, assess these separately but cumulatively.

Furthermore, having considered these comments and the research, the Director considers that the best way to identify any interaction of capital maintenance and operating efficiencies is to assess comparative efficiency in both areas using similar econometric techniques. The relationship between the two assessments will then be reviewed and an allowance for any significant interaction, where it can be identified, would be made when future efficiency targets are set.

The Director will issue a technical paper in April explaining in more detail how he will assess these efficiencies and their possible interaction. Ofwat has been developing capital maintenance econometric models and the results of this modelling work, together with its relationship to the comparative operating cost efficiency of companies, will also be included in that paper.

6.1.3.2 Future operating efficiency

At the last Periodic Review in 1994, the Director examined the scope for future savings in operating costs. He considered that the industry as a whole could make real savings on average of about 2% a year from 1995–96 to 2000–01 and 1% a year thereafter. The Director will now revisit his assumptions for the period after 2000–01 based on companies' achievements since the last review, evidence from the wider economy, other industries and utilities and, where possible, comparison with the water industry outside England and Wales. He will also take into account likely gains in efficiency between 1998–99 and the first year of new price limits, 2000–01.

The Director has recruited a panel of senior industrialists to advise him on these and other issues.

Within the framework of his assessment of the scope for savings in operating costs at an industry level, the Director will need to make judgements about the comparative efficiency of each company. As in 1994, companies that are relatively less efficient can expect commensurately tougher targets.

The Director will revisit his 1994 assumptions about how quickly less efficient companies may be expected to improve. At the last Periodic Review, the Director assumed that less efficient companies could make sufficient operating cost savings over a five-year period to reduce substantially the margin between their costs and those of more efficient companies. For the coming review the Director wishes to strengthen this approach. He will consider the savings expected and the position reached by those companies that are expected to be at the forefront of efficiency in 2005–06. He will expect other companies to move substantially towards this target over the period of the new price limits.

In the Framework paper, the Director requested views on how quickly companies might be expected to make such efficiency savings to catch up with or overtake their most efficient peers.

In general, all respondents agreed that the more inefficient companies should catch up with their most efficient peers — one suggesting as quickly as two years, others proposing a five year period.

Since the last Periodic Review, companies have consistently outperformed the targets for operating costs. Those companies who were least efficient have tended to make the biggest changes as shown in the 1996–97 Report on water and sewerage service operating costs and efficiency (December 1997). The Director wants to ensure that customers benefit from these savings when they occur, but he also wishes to maintain incentives for companies to operate efficiently. He will need to consider the relative range of efficiencies and the scope for the least efficient to catch up with the most efficient in a five year period.

The Director also requested comments on how cost savings should be phased over the review period.

The majority of companies favoured even phasing but there was some support for a swift catch up in the early years for the least efficient. Customer groups also preferred efficiency targets to be greater in the early years of a review period. The Director concurs with this latter view and, therefore, is likely to assume a phasing of savings so that the benefits are gained by customers sooner rather than later.

6.1.3.3 Future capital efficiency

At the last Periodic Review, the Director examined the scope for further savings in capital costs from the prevailing levels. Both industry wide and comparative tools were used. The industry as a whole was expected to achieve continuing capital efficiency gains of 1% per annum over the price review period. On top of this, the comparative costs from the cost base exercise were used to derive company specific capital efficiency targets.

Since the review, some companies have stated, and indeed demonstrated, that they have been able to achieve larger capital efficiency gains and deliver these more quickly than those assumed when price limits were set. The Director will, therefore, revisit the industry capital efficiency assumptions for the next price review period.

The scope for additional company specific capital efficiency targets will again be judged by the comparative analysis of standard capital unit costs. As indicated in MD127, Capital unit costs in the water industry (March 1997), consideration will be given to increasing both the extent to which the less efficient companies can improve their capital efficiency and the rate at which this may be expected to occur. In particular, the Director will receive advice from Reporters on the appropriateness of companies' proposed capital solutions. He will expect companies to be able to achieve costs appropriate to capital solutions that would be adopted by an ordinarily efficient company. Ofwat has also been developing econometric models of capital maintenance and these will also be used to assess the scope for improvements in capital efficiencies.

6.2 Capital investment

The water industry is capital intensive, with significant requirements for investment to maintain and improve its network of assets. Judgements on capital investment are central to both company and regulatory decisions. Comparisons between companies at Periodic Reviews enable the performance and efficiency of the best companies to be reflected in price limits.

6.2.1 Capital maintenance

The maintenance of a company's capital assets is crucial in ensuring continuing delivery of services to its current and future customers. The Director, as set out in the Framework paper, intends to assess companies' plans for future maintenance of water and sewerage assets principally through an examination of trends in serviceability to customers and levels of past maintenance expenditure.

Companies will also be submitting summaries of their asset stock resulting from surveys of their assets. The Director will review these against the summaries submitted by companies for the last Periodic Review. For regulatory purposes, however, the Director considers that an approach starting with serviceability to customers is appropriate. Asset age and condition are matters for the management of companies to consider in prioritising their capital maintenance programmes.

Levels of capital maintenance expenditure included in price limits will also take account of judgements arising from the comparative analysis of companies' capital costs and the scope for improvements in capital efficiency.

6.2.1.1 Measuring serviceability to customers

The Director believes that the most appropriate way to assess the future capital maintenance needs of the industry is through an examination of serviceability to customers and its long run trends. Serviceability is a measure of the ability of company assets to provide the service required by customers. Old assets may be as serviceable as new ones. This concept of serviceability to customers was generally accepted by respondents. The indicators of serviceability to be examined by the Director are set out in more detail in Appendix 4.

Many respondents, principally companies, stated that they considered the proposed indicators of serviceability to customers were not the only indicators that should be used. However, there were no suggestions from companies as to any additional ones that would be desirable to include in the Director's assessment.

There were also concerns that serviceability to customers is a short-term approach. In assessing this at the review, the Director will look at objective measures of the performance of the overall asset networks, such as the numbers of burst mains and sewer collapses, over the last 20 years. Generally, the trend of serviceability to customers has improved, suggesting that the corresponding levels of capital maintenance expenditure are adequate.

6.2.1.2 Interaction between quality and maintenance programmes

There continues to be a high level of capital investment on quality programmes in both the water and the sewerage services. There are a number of areas where these quality programmes may affect the level and timing of future maintenance expenditure compared to current levels.

First, the same expenditure may fulfill both quality and maintenance purposes. Companies' allocation practices vary and adjustments may be necessary to ensure consistent treatment. This is particularly the case for water distribution which is considered in more detail below.

Secondly, the quality programmes have had the effect of advancing some capital maintenance programmes since the renewal and refurbishment work to maintain existing standards is often carried out before it would otherwise have been necessary.

Quality enhancement programmes may also have an effect on future capital maintenance requirements by improving the general condition of the asset stock. Customers should not pay twice for maintenance of the same assets.

In the Framework paper, the Director asked how the interaction between quality enhancement and capital maintenance programmes should be assessed.

This question was not addressed directly by any of the respondents to the consultation paper. Most responses centred around the possibility that an increased asset base would require a rise in maintenance expenditure, although some companies did acknowledge that a significant increase would not become necessary in the short term.

The key area where the two types of expenditure may overlap is in the water distribution system, where investment is required to deal with deficiencies present in 1989. Most companies were required to give undertakings to the Secretaries of State to carry out work on the distribution system to comply with the Water Quality Regulations.

At the last Periodic Review, expenditure on replacing and relining water distribution mains required to fulfil quality obligations was treated as quality enhancement. The Director plans to continue with this approach and aim to achieve greater consistency in this area taking into account differing company policies.

Maintenance of other parts of the network since 1989 has been dealt with as infrastructure renewals. Judgements will be made on the appropriate levels of infrastructure renewals expenditure when setting price limits, using the serviceability assessments. The Director will also take into account the proportion of the distribution system requiring renovation, the general level of maintenance expenditure on the system and company progress since 1989 in demonstrating quality improvements and fulfilling undertakings.

Capital investment on quality enhancements for surface assets has resulted mainly in the construction of new assets. These represent only a small proportion of the underlying asset base and, consequently, the current levels of capital maintenance required have been largely unaffected.

For new assets acquired for the quality enhancement programme, there will not be a significant effect on future capital maintenance requirements in the period of the next price limits. These new assets will not need to be renewed until towards the end of their economic lives, which will be well into the future.

There are occasions when capital investment needed to achieve quality enhancements has been undertaken on existing assets. In addition, companies have often taken the opportunity to carry out capital maintenance on existing assets at the same time as quality schemes at the same site. In both cases, companies use straightforward methods of proportional allocation to distinguish quality enhancement from capital maintenance expenditure.

The Director is, therefore, of the view that expenditure totals recorded for the maintenance of surface assets can be assumed to reflect the amount of work that has been carried out on the underlying asset base for the purpose of maintaining serviceability to customers. There is no evidence of a general deterioration in serviceability to customers.

The relationship between maintenance expenditure and depreciation and their broad equivalence over a period is discussed further in Section 6.5.5.

6.2.2 Quality standards

6.2.2.1 Maintaining quality standards

Companies are required to meet the legal obligations set out in regulations and enforced by the DWI or the EA.

Each year, these regulators report to the Director on companies' performance as set out in MD109, Compliance with quality obligations — monitoring company performance (August 1995). The analysis of these reports allows company performance on quality aspects to be monitored.

If companies are required to regain compliance with current standards, or suffer enforcement action from the DWI or EA because of failures, no additional allowance will be made in price limits. Customers will have already paid for this service and companies will be expected to rectify problems within the current price limits.

The Director asked whether implementing financial rebates to customers would be desirable if companies do not continue to comply with existing quality standards and obligations required by law.

There was a divergence of views between the companies and other respondents.

Organisations representing business users generally supported the idea that there should be financial penalties on companies for failure to meet their legal quality obligations. Some felt that rebates should go to customers, perhaps automatically, and some thought they should go only to those customers affected by the failure. The response of environmental groups varied. Some believe that the introduction of a financial penalty in addition to fines is not necessary, while others believe that there should be a rebate, at least part of which should be invested for environmental improvements.

The companies believed that the introduction of financial penalties would add to the risk in their business and they would need higher investment levels in maintenance to reduce the risk of incurring penalties. They were also opposed to 'paying twice' for non-compliance, through prosecution and the associated fines as well as through rebates to customers.

The Director has considered all these views. Maintaining compliance with quality standards is an important aspect of company performance and service to customers. If there has been a significant failure by companies to maintain the expected standards, then they may already have had enforcement action taken against them by the quality regulators. They may have been prosecuted or required to give undertakings and the shortcomings would have to be remedied within the prevailing price limits. When deciding whether further financial penalties are appropriate, the Director has considered the potential practical and administrative issues involved in identifying customers and deciding the level of rebates. He has concluded that a more general approach linked to overall service performance would be more appropriate.

It is intended that the performance of a company in maintaining compliance with the quality standards prevailing from time to time should be included in the assessment of good or poor service for which companies are rewarded or penalised. This is described further in Section 6.4.1. Further discussions with DWI and the EA are necessary to consider the most suitable indicators to use in the assessment of performance in the quality area. The nature of the measures used will be consulted on further in a technical paper to be issued in March 1998.

6.2.2.2 Quality enhancement programmes

At the review, the Director will be considering two types of financial adjustment: downward, when companies have not delivered improvements which customers are paying for in their bills, and upward, to finance any new legal obligations placed on them. The Director is considering making these adjustments to bring the financial position of a company in the first year of the new price limits, 2000–01, into line with its performance.

The Director proposed the adoption of a materiality threshold for claims from companies for an adjustment of price levels to meet additional obligations ('logging up') at this review. He also proposed that a similar threshold also be applied to the valuation of any shortcomings in company performance in delivering the expected quality enhancements.

This question was commented on mainly by the companies. The companies supported the concept that their expenditure to meet additional new obligations should be taken into account when setting price limits at the review. There was some concern over the application of thresholds or triviality considerations. Some companies wished to receive an assurance that the Director would aggregate the obligations and not apply the threshold to individual pieces of work.

The Director proposes to retain the concept of a threshold when considering claims for additional expenditure to meet new quality obligations. This will be applied at an obligation and not a scheme level. The total work required to deal with new standards arising from a new policy or a new or revised set of regulations will be considered. At present, the Director considers that 1% of turnover (as was used in the 1994 Price Review) is a suitable threshold.

The EA and the DWI will inform the Director of company failures to meet the outputs funded in price limits. These shortfalls will be valued and, if significant, corresponding financial adjustments will be made to the regulatory capital value. Companies should not gain financially for their failure to deliver quality improvements paid for by customers.

6.2.2.3 Framework for new quality obligations

There will be, as at the last review, uncertainty about the timescale and extent of any new quality obligations to be placed on companies. Before prices are set, it will be necessary to ascertain both the extent of any new obligations and how much companies estimate it will cost them to deal with any tightening of standards.

This process has already started, following the timetable proposed in MD124, involving the Secretaries of State and the quality regulators as well as the Director. The Director asked companies in November 1997 (RD20/97) for a detailed estimate of the extent of any asset improvements required to comply with a number of possible options for new quality standards. Companies were asked to estimate how much it would cost to carry out this upgrading within likely timescales.

These cost estimates will be used when the Director asks the Secretaries of State in April 1998 for their perspective on future policies for drinking water and environmental quality improvements. The Director will provide estimates of the effect on customers' bills of possible improvements. This will be complemented by assessments from the EA and the DWI on the likely quality benefits of such improvements and the levels of support among customers. When considering these issues, the Secretaries of State will have information available on the possible impact of their policies on customers' bills as well as the benefits which could accrue.

It is not yet possible to predict accurately the extent of any additional quality obligations required to implement any new or revised European Commission Directives, currently at the draft stage. However, there will be greater certainty about the period 2000–05 at the time of the review. The uncertainty in the period from 2005–10 should be less of problematic, since the Director proposes that licences be amended to require price limits to be determined every five years.

The timescale for completion of those improvements which are confirmed as required, must be set out by the DWI or the EA. If it is not possible to define the outputs or delivery dates, such work will be considered at a later date when the critical information is available. This could be at the next Periodic Review or, possibly, if the costs are material, at an interim determination.

6.2.2.4 Costs to be allowed and the funding of quality obligations

In judging the capital costs to be allowed for quality improvements, the Director will follow the approach applied to capital efficiency set out in Section 6.1.3.3.

Where companies have replaced or modified existing works to meet tighter requirements, they will be expected to deal with the associated operating costs as part of the efficiency that may be expected to arise from rationalising and optimising existing installations.

The costs of operating the refurbished works will normally be expected to be the same or lower than before. Companies will continue to have to justify claims for additional operating expenditure when new works are required to comply with tighter standards. Company claims will be compared with those submitted by other companies and will be subject to comparative efficiency analysis.

Currently customers are paying for quality improvements through bills while the work is being carried out and before the improvements have been completed. This is contrary to normal commercial practice, where suppliers of new services only charge once the service is provided.

This, together with experience of the companies' rephasing of their capital programmes since the last Periodic Review, led the Director to consult on a new approach to the funding of quality obligations.

The Director proposed that it would be in the public interest to introduce a new approach to making allowance for quality improvements in price limits only after the expected completion date.

This approach was based on the principle that customers should not be expected to pay for an improvement until after it has been completed. There was an extensive response to this proposal.

The Director particularly noted concerns that the cost of raising capital for relevant construction projects would rise. There would be an increase in business risk if the future means of providing a return on such capital were uncertain and subject to future regulatory scrutiny.

The practicalities of such an approach (for quality and economic regulators as well as companies) were also raised, including the possible requirement for licence amendments. However, some business organisations did agree that it was normal business practice for companies only to be paid for innovations and new products after the customer had received them and felt this should be the case in the water industry.

The Director accepts there is a fine balance to be struck between retaining incentives for the companies and the way customers pay for new quality obligations. However, he believes that the benefits to customers of only paying for new works after completion would be outweighed by the higher costs which might arise, particularly an increased cost of capital. The benefits of transparency to