TO ALL MANAGING DIRECTORS OF
WATER AND SEWERAGE COMPANIES AND
WATER ONLY COMPANIES

28 November 1997

TARIFF REBALANCING AND THE TARIFF BASKET

PROPOSED AMENDMENT TO LICENCE CONDITION B

In May 1997, I published the consultation paper Tariff rebalancing and the tariff basket, which set out my proposals for reviewing the workings of the tariff basket. The consultation period ended on 18 July 1997 and I have now considered the responses that were received.

I propose to implement two changes to the current tariff basket, which in turn will involve a revision to Condition B of each company's licence. I, therefore, attach a copy of the draft proposed modification of Licence Condition B, which I wish to come into effect on 1 April 2000. The purpose of this letter is to seek your views with regard to the proposed Licence modifications and with regard to the wording of the amended Licence itself. I would be grateful if you would indicate whether you are minded to agree to the proposed modifications, by Friday 30 January 1998. The formal amendment process, including the statutory 28 days notice within which representations or objections may be made, will then follow in March 1998.

There were four main issues raised in the consultation paper, and I have set out my conclusions below. For your information, I have also attached a more detailed paper explaining how I reached those decisions.

1. Unmeasured/Measured Tariff Rebalancing

I propose to alter the tariff basket formula in the way set out in Appendix 4 of the consultation paper. This will change the way in which the tariff basket calculates the increase in unmeasured charges and bring it into line with the measured basket. The tariff basket will then calculate the 'Weighted Average Charges Increase' as the ratio of the total weighting year revenue in the charging year to the total weighting year revenue in the prior year.

2. The Balance Between Water and Sewerage Charges

I propose to continue to set one formal K factor for each water and sewerage undertaker. At the next price review, I will, however, publish indicative K factors for water and sewerage. These will be based on the methodology set out in the annual Ofwat publication Report on tariff structure and charges. Water and sewerage companies should continue to ensure relative price changes for water and sewerage services follow these indicative K factors. This will avoid cross-subsidy between the services.

3. Rebalancing from Large Users onto Other Customers

I propose to remove large users from the tariff basket as of 1 April 2000. The threshold for the removal of large users will be set with reference to the threshold for competition, ie premises supplied with no less than 250Ml per annum. Large users will not, however, be removed from regulation and will still be subject to Condition E, ie charges should not be unduly preferential or unduly discriminatory. If in the future the Government was to change legislation to lower the threshold for competition, then supplies of no less than the revised threshold would also be removed from the tariff basket.

Special Agreements

In addition, as part of my duty under Condition E of companies' licences, I intend to compile a register of Special Agreements entered into by water (and sewerage) companies and their customers, including large users. I envisage that this register will be placed in the public domain, although commercial confidentiality, eg of customers' names, will be maintained. The register will be compiled following receipt of Principal Statements in January 1998 and my office will send you a copy of the entries pertaining to your company. You will then have an opportunity to advise me of any real and significant barriers to publication of the information.

4. The Introduction of New Tariffs

I intend to continue to employ a system of dynamic weights (charge multipliers) within the tariff basket, ie weights from the most recent complete accounting year. In the consultation paper I asked whether those weights should be backward looking or forward looking. On balance, I accept that it is best to continue to employ a system of backward looking weights within the tariff basket. While there are potentially good arguments for using forward looking weights the responses received were generally in favour of retaining the current system. As I have already indicated, I intend to change the tariff basket formula itself and the precise weights that will be employed are set out in the draft proposed modification of Licence Condition B.

I believe, however, there remains the issue about how companies should best introduce new tariffs, particularly demand related, eg seasonal, tariffs. My office is considering this issue and will provide further guidance as part of the Principal Statement guidelines which will be issued in mid-December.

Companies can be assured that the proposed Licence amendments will be taken account of at the next price review. This is clearly set out within the draft information requirements for the Supply/Demand Balance Submission, which is also being sent to companies today.

I C R Byatt

Summary

In total, Ofwat received 43 responses to the consultation paper Tariff rebalancing and the tariff basket, the consultation period for which ended on 18 July 1997. The Director considered all of these responses when making his decisions. Copies of the responses, unless otherwise requested, have been placed in the Ofwat library. A list of respondents is attached at the end of this paper.

The Director intends to proceed as follows.

• To change the way in which the unmeasured basket calculates increases in charges, bringing it into line with the measured basket. This will simplify the tariff basket formula such that the charges increase is simply the ratio of the total weighting year revenue for the charging year to the total weighting year revenue for the prior year.
• To continue with the current system of setting one formal K factor for each water and sewerage undertaker.
• To remove large users, ie premises supplied with no less than 250Ml of water per year, from the tariff basket.
• To continue to employ a system of dynamic, backward looking weights within the tariff basket.

Proposal 1: There is a case for changing the way in which the unmeasured basket calculates increases in charges, bringing it into line with the measured basket. This would simplify the tariff basket formula such that the charges increase is simply the ratio of the total weighting year revenue for the charging year to the total weighting year revenue for the prior year.

The views expressed in the responses to this proposal were split between the water (and sewerage) companies and consumer groups. Consumer groups were in favour of the proposal to remove this element of rebalancing. The water companies, on the other hand, were generally against such a move. Their arguments for the retention of the current system generally fell into the following categories.

• The effect of the arithmetic of the current unmeasured basket reinforces Condition E, which prohibits undue preference and undue discrimination.

  In the Director's view, the arithmetic of the unmeasured basket is not relevant in this respect. The mechanism used to maintain fairness in charges between measured and unmeasured customers is the tariff differential. As customers move from the unmeasured to the measured basket, the limit on the differential operates to ensure that customers who consume similar volumes of water pay similar amounts for that water, while companies are able to recover the additional costs of metering from metered customers. The effect of the arithmetic of the current unmeasured basket is to allow companies to recoup some of the revenue lost in the unmeasured basket when a higher than average rateable value customer is metered. This effect does not reinforce Condition E, it merely mitigates the level of rebalancing required to maintain the differential. Under the new arithmetic, the level of rebalancing required to ensure fairness in charges will be taken into account at the Periodic Review instead of occurring automatically.

• Altering the arithmetic of the tariff basket would be a disincentive to metering.

  As recognised in the consultation paper, the change in the tariff basket arithmetic will lead to a change in incentives for the companies at Periodic Reviews, when an allowance may be sought in K for the effect of customers transferring from unmeasured to measured tariffs. If in the event those customers do not then transfer, companies may obtain higher revenues than assumed when prices were set. The Director will, therefore, need to ensure that companies properly carry out any of the metering programmes that are allowed for in price limits.

  The Director also recognises that the metering programmes of the water only companies can impact upon the revenue accruing to the water and sewerage companies who provide sewerage services in the water only companies' areas. Provision will need to be made in K for the water and sewerage companies for the expected increase in the number of properties metered by the water only companies.

• Altering the arithmetic of the unmeasured basket will increase the revenue risk and thus the cost of capital for companies.

  Companies have argued that changing the arithmetic of the tariff basket would increase the revenue risk and, therefore, their cost of capital. The current tariff basket mechanism allows companies to recoup some of their lost revenue in the unmeasured basket as and when high rateable value customers opt to be metered. Altering the arithmetic of the unmeasured basket would remove this automatic compensation mechanism. Provision will, however, be made at Periodic Reviews for the expected increase in the number of metered properties, as described below. The accuracy of the forecasts of those increases will be important in minimising the companies' exposure to greater risks.

  As stated in The proposed framework and approach to the 1999 Periodic Review consultation paper, published in June 1997, the Director will need to consider the impact of uncertainties and risks which companies could face, such as revenue risk from greater numbers of metered customers, in his assessment of the cost of capital. It is unlikely, however, that the additional factors that have emerged since price limits were set in 1994 have materially increased the overall risk of the water industry relative to other utilities, particularly the gas and electricity companies which will soon face competitive markets in the energy sector.

• The change in arithmetic will still not mean that changes in bills will exactly equal RPI"K and the change will not materially affect the overall level of rebalancing.

  The Director recognised in the consultation paper that the proposed change in the arithmetic will not mean that, in future, bills change by exactly RPI"K, but he believes that there will be a closer relationship between the two. Ongoing tariff rebalancing to maintain fairness between measured and unmeasured charges will continue, as was recognised in the consultation paper, if there is a fall in the average unmeasured rateable value and/or an increase in average unmeasured household consumption. The arithmetic of the tariff basket will, however, be more transparent and there will be less scope for unexpected rebalancing. Increases in bills above RPI"K will, therefore, be easier to explain to customers.

  Companies have argued, however, that changing the tariff basket arithmetic will not have a major impact upon the overall level of tariff rebalancing. The Director believes that, if this is true, then he cannot understand the objections made by the companies to the proposed change. However, Ofwat believes that this element of tariff rebalancing is not insignificant and may continue to be significant as more customers become metered (eg through optional metering). The consumer groups certainly believe that this element of rebalancing is significant and that it is very difficult for customers to understand.

  The consultation paper explicitly recognised that changing the way in which the tariff basket works will not, all things being equal, alter the amount of rebalancing that occurs, but it will make that rebalancing more transparent. The headline K factor may have to be higher than it otherwise would have been, giving a closer relationship between changes in bills and RPI"K. By ensuring that rebalancing is explicit and transparent, the companies and Ofwat will be better able to manage rebalancing.

In response to the consultation paper, a number of companies stated that if the arithmetic of the tariff basket were to be changed then they would wish to see that this was explicitly taken account of in the way price limits are to be set. Ofwat proposes to revise the tariff basket algorithm part of the Ofwat financial model used at the last Periodic Review, because although the approach taken was based on relatively simple principles, it was in practice not easy for the companies to replicate. The details of these changes are contained in the Tariff Action Plan section of the draft information requirements for the Supply/Demand Balance Submission sent to companies on 28 November 1997. This shows how Ofwat intends to take account of the Director's proposal to change the tariff basket arithmetic.

Proposal 2: There is no strong case for changing the current system of setting one formal K factor for each water and sewerage undertaker.

The majority of the respondents were in agreement with the proposal to retain the current system of setting one formal K factor for each water and sewerage undertaker and publishing indicative Ks for water and sewerage. There were, however, a number of respondents who argued that the Director should set separate formal K factors for water and sewerage. The argument put forward in favour of this proposal was:

• Setting separate formal K factors would increase the transparency of the tariff basket and prevent potential cross subsidies between services.

  The arguments put forward in support of separate K factors tend to revolve around the issues of increasing transparency and preventing potential cross subsidies between the services. Since one of the aims stated in the consultation paper is to improve the transparency of the tariff basket, some respondents argue that setting separate K factors would help to fulfill this aim. They also argue that under a single K factor, it is possible for the water and sewerage companies to cross subsidise one or other of the services that they provide.

Proposal 3: Given the impact that large users can have on other customers' bills and the fact that large users are part of a more competitive market not requiring the same degree of regulatory protection, there is a case for removing large users from the tariff basket.

As with the first proposal, responses were split between the water (and sewerage) companies and consumer groups. Consumer groups were in favour of the proposal to remove the possibility of ongoing rebalancing from large users onto other customers. On the other hand, the water companies and large users themselves were generally against this proposal and their arguments can be summarised as follows:

• There is not yet sufficient competition to justify removing large users from the tariff basket.

  The main concern expressed by large users is that once they are removed from the tariff basket they will no longer have the protection of the regulator and will, therefore, be vulnerable to companies increasing their charges. The perceived lack of competition means that large users do not feel able to easily switch to an alternative supplier.

  As the Director made clear in the consultation paper, large users outside the tariff basket will not be outside regulation. The prohibition of undue preference and undue discrimination will still apply to those large users who have been removed from the tariff basket.

• Large users should not be subject to regulatory control but should be subject to competition law.

  This argument was put forward by the water (and sewerage) companies themselves. They argue that if large users are to be removed from the tariff basket then they should no longer be subject to Condition E and should be outside regulatory control. This is not a practical option in any event, as large users inevitably use assets shared by other customers who are part of the appointed business.

• Further work on long run marginal cost may show that there is a need for further rebalancing from large users onto other customers.

  Many of the objections to the proposal to remove large users from the tariff basket centre around the issue of long run marginal cost (LRMC). While many companies accept the principle that large user tariffs should be based upon long run marginal cost, they do not accept that large user tariffs should be removed from the tariff basket while there continues to be a debate on the methodology of LRMC.

  A number of the companies argue that further work on long run marginal cost could lead to the need for justified and necessary rebalancing from large users onto other customers. The paper did not, however, rule out rebalancing of this kind. Instead, the paper argues that such rebalancing could occur at Periodic Reviews, provided that companies supply a robust justification for this rebalancing.

• The threshold should be lower than 250Ml.

  While it is true that many companies have introduced large user tariffs at thresholds below 250Ml, the Director believes that it is logical to set the threshold for removal from the tariff basket with reference to the competition threshold as set out in the Competition and Service (Utilities) Act 1992. This does not preclude the lowering of the threshold if in the future the Government lowers the threshold for competition.

In the consultation paper the Director also put forward his proposal to compile a register of Special Agreements entered into by the water (and sewerage) companies and place this register in the public domain. Customer groups welcomed this proposal, but the companies and large users themselves objected to this proposal.

• The Director should not compile a register of Special Agreements and place this in the public domain.

  Many of the respondents, particularly the water (and sewerage) companies, strongly disagreed with the proposal to place a register of Special Agreements in the public domain. None of the respondents, however, put forward any arguments in support of their disagreement. The Director believes that placing a register of Special Agreements in the public domain through the Ofwat library will help fulfil his aim of increasing transparency. The Director, therefore, intends to proceed with the compilation of a Special Agreements register. He will begin this process using Principal Statement information collected in January 1998. Commercial confidentiality, ie customers' names, will, however, be maintained.

The overwhelming consensus in this area is that the current system of backward looking weights should be retained. It is acknowledged that the current system is not perfect, but it is argued that backward looking weights are at least based on historical data which can be verified. Forward looking weights on the other hand, are based on forecasts and are thus far more difficult to verify. Most respondents argued that if forward looking weights are introduced then the tariff basket would also need to incorporate an error correction mechanism. Given the stated aims of the paper to simplify the tariff basket formula and increase transparency, the introduction of an error correction mechanism would appear to run contrary to these aims. The Director, therefore, intends to continue to employ a system of dynamic, backward looking weights within the tariff basket.

The Director recognises, however, that there remains the issue about how companies should best introduce new tariffs, particularly demand related, eg seasonal, tariffs. For this reason, the Principal Statement guidelines regarding the introduction of new tariffs will be revised in December 1997.

RESPONDENTS TO TARIFF REBALANCING AND THE TARIFF BASKET

Water companies

1. Anglian Water Services Ltd
2. Bournemouth & West Hampshire Water plc*
3. Bristol Water plc*
4. Essex & Suffolk Water plc
5. Folkestone & Dover Water Services Ltd
6. Mid Kent Water plc
7. North Surrey Water Ltd
8. North West Water Ltd
9. Northumbrian Water Ltd
10. Severn Trent Water Ltd
11. South Staffordshire Water plc
12. South West Water Services Ltd
13. Southern Water plc
14. Tendring Hundred Water Services Ltd
15. Thames Water plc
16. Three Valleys Water plc
17. Wessex Water
18. Yorkshire Water Services Ltd
19. Water Companies Association
20. Water Services Association

21. Central CSC
22. Eastern CSC
23. Northumbrian CSC
24. North West CSC
25. Southern CSC
26. Thames CSC
27. CSC for Wales
28. Wessex CSC
29. Yorkshire CSC

30. Halcrow Management Sciences Ltd

31. Consumers Association
32. National Campaign for Water Justice
33. National Consumer Council
34. National Water Charges Advisory Service

35. Chartered Institute of Purchasing & Supply
36. Chemical Industries Association
37. Enviro-Logic
38. Federation of Small Businesses
39. Food & Drink Federation
40. ICI
41. Metal Finishing Association
42. Utility Buyers' Forum
43. Zeneca*

Copies of these responses are available for inspection in the Ofwat library, tel 0121 625 1373. Response marked * have been submitted in confidence.

CONDITION B: CHARGES

(Note: Changes, both new material and deletions, are highlighted thus)

Part I. Explanatory Provisions

1. Introduction

The purposes of this Condition are set out in the following sub-paragraphs.

1.1 To provide for the Director to limit increases in standard charges made by the Appointee for the supply of water/, the provision of sewerage services and the reception, treatment and disposal of trade effluent. The weighted average increase is limited to the sum of the movement in the Retail Prices Index and an Adjustment Factor, called K.

These matters are dealt with in Part II under the heading "Restriction of Standard Charges for Basket Items".

(Note: paragraphs 1.2 to 1.7 are unaltered.)

2. Defined terms which apply for the purposes of all Parts of this Condition

In this Condition:

references to "the Appointed Business" shall be construed as if the Appointed Business included the management and holding by the Appointee of any protected land for so long as it is not transferred under paragraph 7 of Condition K;

The definition "Average Charge Per Chargeable Supply" is deleted.

(Note: the separate definitions of "Basket Items" in the water and water and sewerage licences are unaltered.)

The definition "Chargeable Supply" is deleted

"Charging Year Weighting Revenue" means the revenue (exclusive of VAT) which would have accrued to the Appointee in the Weighting Year in respect of Basket Items, if all Standard Charges (including any Non-volumetric Charge, eg standing charges) other than Excluded Charges made or to be made in respect of Basket Items in the Charging Year had applied in the Weighting Year;

"Excluded Charges" unless and until otherwise agreed between the Director and the Appointee, are

(1) amounts payable in respect of an unmeasured supply of water by means of stand-pipes or water tanks and in respect of the erection or maintenance of stand-pipes or water tanks;

(2) charges for a supply of water provided by the Appointee under section 59;

(3) charges for unmeasured supplies of water to cattle troughs;

(4) charges for unmeasured building water supplies;

(5) amounts payable in respect of an unmeasured supply of water by means of bowsers or water tankers; .....

(6) charges for unmeasured supplies of water to farm taps and other agricultural water points; and

6(A) charges for supplies of water (or for the provision of sewerage services) to premises to which the provisions of sections 7(4)(bb) and (5) of the Water Industry Act 1991 apply (availability of inset appointments, when requirement for water is, or is likely to be at least 250 megalitres per year); but so that the reference to 250 megalitres is subject to reduction as provided in s.7(6)

(Note: the remainder of the definition of Excluded Charges and the definitions of "the Initial Determination" (which does not feature in the water and sewerage licence conditions) "the Measured Basket Item", "measured supply" (which does not feature in the water and sewerage licence) and "Non-volumetric Charge" are unaltered.)

"Prior Year Weighting Revenue" means the revenue (exclusive of VAT) which would have accrued to the Appointee in the Weighting Year in respect of Basket Items, if all Standard Charges (including any Non-volumetric Charge, eg standing charges) other than Excluded Charges made or to be made in respect of Basket Items in the Prior Year had applied in the Weighting Year;

" Weighted Average Charges Increase" means the sum calculated as follows:-

W_t =(S_iB_t(i)/S _i B_t-1(i)) - 1

W_t is the Weighted Average Charges Increase for the Charging Year

i defines the Basket Items

S _i requires the summation of the revenue across Basket Items

B_t(i) is the Charging Year Weighting Revenue in respect of Basket Items

B_t-1(i) is the Prior Year Weighting Revenue in respect of Basket Items;

1 the definition of "Weighting Year" is retained, but the definition of "Weighting Year Revenue" is deleted.

2 after paragraph 2 in Condition B, the numbering of the paragraphs in Condition B in the water companies' Appointments is one less than that in the numbering of the equivalent paragraphs in the water and sewerage Appointments. Therefore, in the following text, the same paragraphs are numbered as follows - 3/4, 4/5 etc.)

Part II Restriction of Standard Charges for Basket Items

3/4 The Charges Limit

3.1/4.1The Appointee shall ensure that the Weighted Average Charges Increase in any Charging Year (beginning with the Charging Year starting on 1st April 2000) when expressed as a percentage does not exceed the Charges Limit.

3.2/4.2The Charges Limit is the percentage calculated as RPI + K, where

RPI is the percentage change (expressed, in the case of an increase, as a positive number, in the case of a decrease, as a negative number and, in the case of no change, as zero) in the Retail Prices Index between that published for the month of November in the Prior Year and that published for the immediately preceding November

K is the Adjustment Factor.

3.4/4.3The Adjustment Factor for each Charging Year shall be such number as shall from time to time have been determined under this Condition or, if none, zero and the Adjustment Factor may be a different number for any Charging Year and may be a positive or negative number or zero.

3.5/4.4If the Weighted Average Charges Increase in any Charging Year is less than the Charges Limit then the Charges Limit for the following Charging Year shall be increased by the amount of such deficiency.

3.6/4.5The Charges Limit for any Charging Year shall only be increased by virtue of sub-paragraph 3.7 to the extent that such deficiency is not attributable to any Charging Year ended three or more years previously.

4/5. Matters Affecting the Charges Limit and the calculation of the Weighted Average Charges Increase

4.1/5.1Where the Appointee determines:

(1) to make a material change (other than one which relates solely to the amount of a charge) to the basis on which it makes or calculates any Standard Charge, or Standard Charges taken as a whole, (other than Excluded Charges) for the supply of water;

(2) to make a material change to the scope of any such scheme, agreement or consent as is referred to in the definition of "Standard Charges" (insofar as such change relates to charges, other than Excluded Charges, for the supply of water); or

(3) to change the basis on which the Appointee treats supplies of water as separate supplies or provisions for the purpose of making Standard Charges (other than Excluded Charges) ....

it shall:

(a) notify the Director; and

(b) furnish to the Director such explanations and Information relating to such change as the Director considers requisite or expedient having regard to the purposes of this Condition.

5/6. Verification of compliance with the Charges Limit

5.1/6.1Statements

The Appointee shall deliver to the Director the following statements:

(1) not later than two months before the start of each Charging Year (see note about 5.2 below) a statement in writing (a "Principal Statement") of:

(a) the revenue which accrued in the Weighting Year from all Standard Charges (including, in the case of the Measured Basket Item/s, any Non-volumetric Charge), other than Excluded Charges, in respect of the .... Basket Item/s.....;

(b) the aggregate revenue which accrued in the Weighting Year from all Standard Charges; and

(c) the amount of each and every type or category of charge for the supply of water which the Appointee proposes to make of a kind specified in the definition of "Standard Charges" as at the commencement of that Charging Year which are not Excluded Charges (and for this purpose where the Appointee proposes to charge different prices per cubic metre of water supplied depending upon the volume of water supplied or the time of supply or the category of customer or any other variable factor then each such price shall be treated as a different type or category of charge); and

(2) not later than two months, or such later date as the Director may allow, before the date during any Charging Year as from which the Appointee proposes to make or fix a new Standard Charge (which is not an Excluded Charge) for the supply of water or to increase or decrease the amount of any such charge a statement in writing (a "Supplemental Statement") of the new charge or the amount by which the Appointee proposes to increase or decrease the amount of that charge.

5.2 This sub-paragraph appears only in the conditions of the water companies' Appointments and is deleted, because the point is covered above, at 5.1(1) at line one (see italics) so that both sets of conditions are worded the same on this point.

5.3/6.2 Auditors' Report

This paragraph is unaltered.

6/7 Transitional Provisions

This paragraph is deleted, because it is spent.