RD 14/01

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

Dear Regulatory Director

APPROVAL OF COMPANIES' CHARGES SCHEMES 2002-03: TARIFF POLICY ISSUES

In Ofwat's Forward Programme for 2001-02 we committed to undertake further work on the following tariff policy issues:

• Optional tariff for low users (with a zero standing charge);
• Reduced charges for customers with private sewers;
• Interruptible and time of day tariffs;
• The methodology for the allocation of costs between the component elements of trade effluent tariffs;
• The justification for lower tariffs for intermediate business users (ie below 50 Ml/a).

Optional low user tariff (without a standing charge)

In June 2000 we consulted on the suggestion in the Secretary of State's guidance to me that all companies should offer the option of a low user tariff (ie tariff without a standing charge) for all measured customers in their main homes.

Overall, the response to the consultation showed very little support for the introduction of such an option, and raised a number of concerns. We undertook to look further at those concerns. The conclusions from this work are summarised below:

Social benefits

The factors affecting low water use are not directly related to socio-economic status. Beneficiaries of a low user tariff option would include single and two person economically active households, higher income retired households and customers with two homes, as well as customers on low incomes such as pensioners or single parents. Low income customers, however, with a high water use would see an increase in their bills. Overall the social benefits would be limited.

Environmental benefits

Low users, almost by definition, have low discretionary water use. They are, therefore, unlikely to respond to the higher marginal price signal implicit in a measured tariff without a standing charge. The reported experience of the two companies who already offer a lower user tariff option confirms this view. There would seem, therefore, to be very limited environmental benefits from low user tariffs.

Bill impacts on other customers

The bill impact on other customers will depend on a number of factors, including the proportion of low users within the existing measured customer base. On the assumption that bill impacts are restricted to the measured customer base, typically the average increase for other measured customers could be £2-4, but for some companies it could be as high as £5-7. Customers with high water use, which could include low-income households, would see a larger increase in their bills.

Implications for competition

Offering some customers a choice of this kind creates an additional, and potentially significant, cross-subsidy. This would create scope for entrants to the industry to win customers by exploiting the cross subsidy, rather than by offering genuine efficiency savings.

Our conclusion is that the disadvantages of an optional low user tariff outweigh the very limited social and environmental benefits.

The Director has decided, therefore, that it would not be appropriate to require companies to offer the choice of a tariff with no standing charge as a condition of approval for charges schemes for 2002-03; nor will he approve charges schemes which propose the introduction of such tariffs. For the small number of companies who have offered a low user tariff for some years, the Director will not object to their continuation in the interests of stability for customers.

Reduced charges for customers with private sewers

Some customers are connected to their sewerage company's network via private sewers for which they are responsible. In June 2000 we consulted on whether such customers should pay reduced charges in recognition of the fact they are also responsible for the costs of maintaining their private sewers. Overall there was limited support for this and it was clear that there would be practical difficulties. We nevertheless undertook to examine, in consultation with the companies, whether there are situations, easily defined, where the nature and extent of the private sewer network would justify a material reduction in charges.

The principle underlying the concept of reduced charges for customers connected to the public sewer network via private sewers is the same as that underlying the provision of rebates for customers who are not connected to the public sewer network for surface water drainage. In both cases customers are not provided with the full sewerage service and yet face additional costs associated with the private arrangements. The rebate, or reduced charge, should reflect the costs that the sewerage company are not incurring because of the private arrangement.

We have examined companies' unit costs of operating and maintaining small diameter public sewers equivalent to sewers on estates where some or all are private. These costs vary between companies but the average cost is between 15p and 46p per metre per annum, depending on sewer size.

Clearly the costs on a per customer basis will depend on the extent of the private sewer network. We have applied the unit costs to a known large residential area which has one of the most extensive private sewer networks. In that case the equivalent annual operating and maintenance costs per customer would be between £3 and £4; and the justified reduction in charges would accordingly be between £3 and £4. Companies believe that in most cases the extent of private sewer networks is less, and so the reduction in the charges would be less. The likely maximum annual rebate that could be justified is, therefore, likely to be in the range of £2 to £5. In many cases a justified rebate would be even less, depending on the length of the private sewer. This compares with surface water drainage rebates of between £15 and £30.

The benefits of offering rebates to customers with private sewers have to be weighed against the costs of administering such a system. Given the variation of private sewer lengths, and the general lack of information currently about the extent of private sewers, there will be difficulties in establishing a system of rebates that is easily operated by companies and is understood by customers. It is likely to be significantly more complex for companies to administer than that for surface water rebates. It would also be difficult to allow for fairly within the tariff basket year on year.

The Director's conclusion is that, while it might appear attractive in principle, the amount of the potential reduction in charges for customers with private sewers does not justify the costs and difficulties in establishing a simple system of reduced charges. He has decided, therefore, not to require companies to introduce systems for reduced charges for customers with private sewers.

The Department of the Environmental, Food and Rural Affairs is commissioning a major study on the extent and nature of private sewers and our view is that decisions on how to provide assistance for customers with private sewers should await the outcome of that study.

Interruptible and time of day tariffs

Business customers have asked Ofwat to set out its position in respect of these tariffs.

We recognise the use of interruptible tariffs as a supplementary tool to help companies maintain the supply-demand balance. We accept the general principle that reductions in costs associated with interruption should entail an appropriate tariff discount. To date three companies have introduced interruptible tariffs but only a handful of customers in each company have opted for these tariffs.

Operating rules have been agreed with these companies which are intended to ensure that interruptible customers are capable of managing supply interruptions. Other companies wishing to consider introducing such tariffs should refer to the appropriate charges schemes. However, at the current time customer interest appears extremely limited.

We remain to be convinced about the relevance of time of day tariffs in the water industry as these would only affect local distribution costs and most companies have estimated very low marginal costs in respect of distribution.

Allocation of sewerage costs [between the component elements of trade and effluent tariffs]

The scope for competition in the sewerage service lies at present in the ability to treat effluent at lower cost on site (through pre-treatment). We do not expect incumbents artificially to reduce treatment charges by comparison with conveyance charges as this could prevent further competition from emerging. Where companies propose lower treatment charges they must be justified by proper reference to Long Run Marginal Costs (LRMC) and we will expect robust calculations in such cases.

We have reviewed how water and sewerage companies allocate their operating and capacity relate costs between different activities (collection, sewage treatment and sludge treatment and disposal) and different services (foul sewage, drainage and trade effluent). 

The conclusion of the review is that the approaches adopted by companies are generally acceptable. For a few companies, however, there are aspects of their approach requiring further clarification which are being discussed with the individual companies concerned.

Intermediate user tariffs

Before 1989 unit prices for large and intermediate were generally the same as those for smaller business and household users.

Since then large user tariffs have been developed (for customers consuming over 50 Ml/a) on the basis that large customers receive water through larger pipes (reducing average distribution costs). We have accepted company arguments that customers consuming over 250 Ml/a typically do not use any part of the local distribution system and that customers consuming over 50 Ml/a do not typically use the smaller parts of the local distribution system.

Large user volumetric rates (at the margin) should reflect robust company estimates of long run marginal costs as closely as possible to provide incentives to promote economy in the use of water (MD159). The complementary role of long run marginal costs in structuring large user tariffs is outlined in more detail in the report, The Role of LRMC in the Provision and Regulation of Water Services issued in May 2001. Our conclusions on the continuing role of LRMC within tariffs policy will be published during October.

A few companies have had for some time intermediate user tariffs (for customers consuming less than 50 Ml/a). These tariffs have been justified by reference to the lower peaking characteristics of intermediate users (when compared to households).

Last year a number of other companies proposed the introduction of intermediate tariffs. We considered that the justification for intermediate tariffs should be reviewed carefully before deciding whether these proposals could be agreed.

We have concluded that review and the Director is minded to agree intermediate tariffs for customers consuming between 10 and 50 Ml/a, subject to their being structured on a seasonal basis. This conclusion will have implications for the few companies who already have intermediate tariffs but which are not seasonalised. Before reaching a final view, the Director wants to consider the views of companies, Customer Service Committees and business customer groups. Accordingly we shall be writing separately to companies and others on this matter next week.

Yours sincerely

Michael J Saunders
Director of Consumer Affairs