MD145

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

8 March 1999 

THE FRAMEWORK FOR SETTING PRICES

MD143 summarised the large response to the consultation paper Prospects for Prices. This letter sets out the changes to our stated methodology and indicates the approach that I intend to take on these issues for the draft determination of prices in July. These changes are in response to the views expressed by companies, customers and others in the consultation process. The key areas covered are:

• the incentive framework;
• the cost of capital and financing (including that for small companies);
• the regulatory capital value;
• the adjustment to prices for service performance;
• the provision for bad debts;
• business rates;
• an update on the cost of quality; and
• tariff switching effects.

The incentive framework

Prospects for Prices emphasised the importance of incentives for companies to improve both efficiency and service to customers and the environment. The incentive framework has delivered substantially greater savings than were expected at the 1994 price review.

In their responses to Prospects for Prices, most companies and some other stakeholders stated that there should be enhanced incentives to achieve greater efficiency. Other respondents, particularly some customer representatives and environmentalists, held more mixed views on the need to enhance incentives. Those who suggested how this should be done favoured a rolling mechanism for the transfer of operating expenditure savings to customers. They stated that this would allow symmetry of treatment between operating and capital cost savings. It was argued that this would have the added advantage of removing distortions in company behaviour as to the timing of savings relative to the periodic review cycle. Without this, companies have a significant incentive to make savings immediately after periodic reviews, but a diminishing one thereafter.

As well as consulting widely on the issues in Prospects for Prices, I have discussed the general package of incentives and efficiency targets to be faced by companies with my panel of industrial advisors. These discussions concluded that the aim of the regulator should be to replicate, as far as possible, the rewards and disciplines of a competitive market. Those companies that achieve greater savings than expected should retain a reasonable proportion of any savings they make before they are passed to their customers. Those that fail to reduce costs should experience deterioration in financial performance. The assumptions for cost reductions should challenge those companies, which have not, previously, responded to the positive incentive to reduce costs.

I have, therefore, decided to strengthen two aspects of the incentive system. Companies will be set challenging targets for cost reductions within their price limits. If, however, these expectations are exceeded, the companies in question should be able to retain the benefits for a fixed length of time, irrespective of the timing of price reviews. Those companies would, therefore, benefit beyond the date of the subsequent price review. I consider that retention for about five years would represent a fair balance between the preservation of incentives and the need to simulate, as far as possible, what might happen in a fully-competitive market.

The 1999 Periodic Review will transfer companies' operating cost outperformance to customers five years after the year in which the incremental cost savings were made. Outperformance will be based on the total costs of both services for water and sewerage companies. Further details are provided in Annex A.

This approach will benefit customers by providing the appropriate incentives for companies to become more efficient, thus enabling subsequent reductions in prices. Outperformance will be retained for the same length of time regardless of when savings are made. This will provide incentives for

companies to adopt a continuous approach to cost reduction which is likely to be more effective than a stop-start approach to cost saving induced by periodic price reviews. The new approach will allow companies to make a more rational choice between operating and capital solutions.

Although both capital and operating outperformance will both be retained for five years, the methodology used to calculate them is necessarily slightly different. For operating costs it is the incremental saving in any given year, which will determine the benefit to be retained. For capital expenditure, it is the cumulative value of out-performance.

The methodology will need to be slightly amended to deal with savings arising from the merger of companies. In most cases, merged companies were required to make an adjustment to prices, as part of the remedy for the loss of a comparator as set out in MD140 (October 1998). This is analogous, in principle, to a resetting of the 1994 price limit assumptions.

I do not intend to change the treatment of merger savings. The measurement of outperformance qualifying for the five year rolling mechanism will, therefore, exclude the anticipated savings to be transferred to customers through the price cuts agreed at the time of the merger. For any further merger savings, the company will benefit from the five year rolling mechanism as for any other outperformance.

Where a merger has, as yet, failed to deliver the total expected savings, the principles set out in MD140 will apply. The base level of expenditure will be set at the level expected by 1998-99 at the time of the merger.

This new approach will increase the rewards to companies that do better than my assumptions. So it would not be right, at the same time, to be overcautious about the cost reductions that can be achieved. I therefore intend to set tough but achievable efficiency targets for the industry within the range identified in Prospects for Prices.

As indicated in Prospects for Prices, those companies that are judged to be relatively inefficient will be expected to improve their efficiency at a faster rate than assumed at the last review.

If companies have failed to match efficiency assumptions made at the 1994 periodic review, then their financial performance will have been affected during the period covered by the last review. This has occurred in a few cases in the current price limit period. If in these cases, operating expenditure for the last year of available data (1998-99) is still above that projected at the last Periodic Review, I intend to take a two stage approach to establishing the starting position when making projections and assessing relative efficiency. If the expenditure in 1998-99 exceeds that projected at a service level I will

require the company to provide a reasonable case why this should be continued. If the expenditure in 1998-99 exceeds that projected at the company level then the justification will need to be clear and incontrovertible.

This means that efficiency assumptions will not become a permanent limit but will be in place for a period of five years. Both the base position and relative efficiency will be subject to reassessment at subsequent price reviews.

Exceptions will be made where expenditure increases rapidly in the run up to a periodic review. In such instances, companies will have to provide satisfactory explanations for the cost increase. If they are unable to do this, then the base year operating cost level will be capped.

In order to influence behaviour in 2000-05, regulatory policy in the 1999 Periodic Review must provide companies with clear guidance on how outperformance should be treated in future reviews. I hope the rules set out above will provide a stable long-term framework within which companies can operate. Annex A to this letter sets out the calculation rules, which I intend to apply in different circumstances. It is, however, not possible to cover all conceivable circumstances and, hence, regulatory judgement may be needed in certain exceptional cases.

The Business Plan should include your views on achieved efficiencies from the rolling mechanism both in operating and capital expenditure. An additional pro-forma table will be included in the Business Plan Guidelines, which will allow companies to show the combined outperformance.

The cost of capital and financing

Many companies have suggested that greater emphasis should be placed on historical average rates and returns than on current market ones, even in assessing the cost of capital on future investment. It is suggested that this approach would be more in keeping with regulatory precedent and the findings of the MMC in its recent reports.

I continue to believe, and have been so advised by my corporate finance advisors, Singer & Friedlander, that highly liquid and well-analysed financial markets provide the most efficient and best-informed view of the trend of future interest rates and stock prices. That is also the view of advisors to certain of the water companies. Consequently, I will continue to pay most heed, in assessing the cost of capital, to the current levels of the various elements of the cost of capital, in particular the risk free rate on index- linked gilts. Not only is this methodology more appropriate, in that the market already discounts views about past trends of prices and yields as well as future ones, but it avoids the practical difficulties of judging over what past period historical rates should be considered.

Since the publication of Prospects for Prices, I have continued to keep the cost of capital under review. This period has seen the return of more normal conditions in the financial markets as well as continued reductions in the risk free rate and water company betas, though these have been slightly offset by an increase in corporate debt spreads. Together, these point to a cost of capital for the water and sewerage companies closer to the middle of the range of 4.0% to 5.5% post tax set out in Prospects for Prices rather than the 5.25% used in that document.

However, in response to the many submissions I have received on the issue, I intend to make adjustments to this cost of capital to take account of companies' costs of existing fixed rate debt, which averages approximately 8% in nominal terms across the industry.

My assessment of the appropriate interest rate to apply to such existing borrowings will take account of historical interest rates and debt margins as well as comparative analysis of the average rates achieved by water companies on fixed rate borrowings. It will also take account of the proportion of fixed rate debt in companies' balance sheets. This approach should provide companies with incentives to achieve greater efficiency in their treasury management operations, as in other aspects of their businesses.

In their responses to Prospects for Prices and in their formal meetings with me, the water companies have argued the importance of maintaining cash-flow and profit profiles that enable their businesses to continue to be financeable in the debt markets. In particular, companies believe I should recognise that they typically pay interest on a nominal basis and, where applicable, are required to meet financial covenants in loan agreements defined by reference to nominal accounting values.

Some companies have also argued that the embedded costs of existing fixed-rate debt will put further pressure on interest cover ratios.

In financial modelling Ofwat will seek to ensure that the price limits allow companies to maintain an appropriate level and trend of interest cover (calculated on a nominal basis) in each year, as well as ensuring that they are able to earn, on average, a return at least equal to my assessment of the cost of capital. To do this may require the determination of different price limits for each of the four years, 2001-05. I will also ensure that the price limits are such that the trend of interest cover is sustainable beyond 2005.

The proposals outlined above to strengthen incentives for improvements in operating efficiency will, however, have the effect of bolstering some companies' interest covers in the early years.

I will continue to consult the debt market on the appropriate levels of key financial indicators but I will not necessarily feel obliged to respect any particular level of financial covenants negotiated by companies. This is particularly the case if companies have become overgeared as a result of paying dividends significantly greater than those justified by the cost of equity and efficiency gains.

The small company premium on the cost of capital

In Prospects for Prices, a small company premium on the cost of capital was suggested for the four smallest, independent water only companies. Assuming an efficient capital structure, it was estimated that this premium would be of the order of 0.5% to 0.75% after tax.

This premium reflects the higher costs faced by such companies which have more limited access to capital markets such as the international bond market, as well as lower liquidity and higher relative issue costs associated with their equity. It also takes account of the higher operating risks faced by small companies.

Many water only companies have argued that their position, in this respect, is more akin to that of the four smallest, independent companies than to the water and sewerage companies. Water only companies that are subsidiaries of large groups have generally argued that they operate on an arms-length basis from other group companies including their parent company and, consequently, should be treated on equal terms with the independent companies.

I have considered these arguments and conclude that some form of premium on the cost of capital would be appropriate for all water only companies that can demonstrate their independence.

In addition, there is evidence that such companies are less able to sustain the same levels of gearing as larger companies. This is, perhaps, best addressed by their interest cover requirements.

I believe that there should not be a uniform small company premium. The largest water only companies do not need such a large premium or interest cover as the very smallest: the water only companies seem naturally to fall into two distinct bands, based on their capital values.

For those water only companies that are subsidiaries within groups, an adequate demonstration of independence would be that they should amend their licence conditions to guarantee that they are ring- fenced from the rest of the group. The licence amendments would be similar to those required of the water companies involved in multi utility mergers.

The regulatory capital value

The ceiling of investment by service

Setting Price Limits for Water and Sewerage Services (February 1998) stated that any investment over and above the levels of investment projected in 1994 for the period 1995-2000 (including agreed claims for logging up) would not be included in the regulatory capital value. Exceptions to this rule would require clear and incontrovertible evidence that customers had been consulted, that the investment was a clear priority for them, and that they were prepared to pay higher bills.

This approach could be applied at the aggregate level of the company, or at a service specific level. The latter approach would mean for some water and sewerage companies, some past investment (largely in respect of the water service) would not be included in future regulatory capital values. After considering responses from companies on this point, I intend to continue to make comparisons at the service level, but will consider claims by companies on a case by case basis. The onus would be on the company to provide sufficient evidence. A much stronger case will be required where actual expenditure exceeds that projected at an overall company level.

This approach envisages, therefore, a three-stage test.

i. If expenditure remains below the projected level for each service, then it will be included in the regulatory capital value.
ii. If expenditure exceeds the projected level for the service, but the company level expenditure remains below projected, then the company will need to submit a well reasoned case as to why the additional expenditure should be included in the regulatory capital value. This case would need to address both the justification for the work and that the costs involved would stand scrutiny by comparative analysis.
iii. If expenditure exceeds the projected level for the company as a whole, then the company will need to provide clear and uncontrovertible evidence why the additional expenditure should be included in the regulatory capital value. I envisage that very few companies will be able to provide sufficient evidence to pass this test.

In practice, the expenditure comparison will be made for the seven years from 1993-94 to 1999-2000 (including a best estimate for the last year where information will not be available) so as not to penalise the supplementary investment programmes in 1995-2000 that reinvests capital efficiencies made in 1993-94 and 1994-95.

The rolling mechanism and current cost depreciation

Setting Prices for Water and Sewerage Services envisaged that the practical application of the policy to allow retention of capital efficiencies for five years would be to compare net actual expenditure and depreciation with net projected expenditure and depreciation. The expenditure comparison would need to take account of the reasons for the variation (which should have been recorded in July Returns) and also the impact of new obligations that have been logged up over the period. The method works well for expenditure but is more problematic for depreciation.

The desired outcome of adjusting the regulatory capital value for the depreciation element of any capital efficiency is not achieved because the difference between actual and allowed depreciation picks up many other factors such as different views on accounting policies and MEA valuations.

It is proposed that the approach compares only actual and projected expenditure as set out above and the adjustment to the projected depreciation is limited to the depreciation attributable to the difference in expenditure. A standard mix of asset lives will be assumed for this adjustment.

The adjustment to prices for service performance

Setting Price Limits for Water and Sewerage Services and Prospects for Prices set out proposals for an adjustment to price limits to reflect past performance by each company. As set out in MD143, respondents' views differed. Companies generally opposed an asymmetric adjustment while customers and others supported one, some even querying the need for any financial incentive for good performance. This reflects customers' attitudes to the service that they require. They are particularly concerned to avoid bad performance.

Other issues raised by the companies relate to the need to take account of improvements in performance and the range of service elements included.

Having considered these issues, I have decided that there should be an adjustment to prices reflecting past performance which both rewards relatively good performance and penalises relatively poor performance. The potential penalty should exceed the potential reward to counter the incentives for companies to cut costs at the expense of service quality and because

customers tend to consider that good performance should be delivered without financial reward. I therefore intend to make adjustments to price limits ranging from +0.5 to –1 percentage point in the first year of price limits with no further adjustments in the remaining four years. I would expect that the higher penalty would be applied only in cases where a company was particularly poor compared to the rest of the industry.

Companies' relative performance will be assessed for each of the years 1996-97, 1997-98 and 1998-99. The performance scores for each year will then be added, with equal weighting, to give a single combined score on which the adjustment to prices will be based. Where particularly poor service may be related to historic infrastructure problems, I will examine whether such problems are having an undue influence on the company's overall assessment in deciding on the scale of any penalty. Where I believe this to be the case and am convinced that a company has made strenuous efforts to tackle the issue I will consider whether a penalty is still appropriate or should be reduced. I will also consider whether some allowance should be made in price limits to bring such companies' performance closer to the industry norm. However, I would not expect such allowance to be justified in subsequent price reviews.

There will be a number of small adjustments to the method for assessing performance. First, hosepipe restrictions will now be assessed over a rolling five-year period ending in the year for which performance is being addressed. Second, the resource position of the company will now have only half the weight of the leakage level in the assessment of leakage performance. As foreshadowed in MD139, the Drinking Water Inspectorate (DWI) are considering whether a broader measure of drinking water quality than that currently used in the overall performance assessment can be developed. If such a measure were available in time for my draft determinations it would be incorporated into the overall adjustment by adding to the weighting of drinking water quality but without affecting the balance now established between the other elements of service currently comprising the overall assessment.

The provision for bad debts

A number of companies have reported that they expect to increase the provision for bad debts when their ability to disconnect customers is removed following the implementation of the Water Industry Bill currently before Parliament. The changes mean that companies will need to consider alternative methods of debt recovery and pursue all avenues open to them. The incentives should be to promote collection of debts from those who use the service and not to result in higher bills for the generality of willing payers. To date, evidence of a material increase in the costs of collecting debt or the level of bad debt has not been convincing. I will, however, consider any audited evidence submitted by companies in their Business Plans.

Business rates

It is still unclear whether or not there will be a change in business rates from a prescribed basis to a conventional basis. Until a decision is announced, I intend to assume that there will be no material changes in costs imposed on companies as a result of the revaluation planned for April 2000.

In completing your Business Plans, you will need to include an element for business rates in your operating costs. Where this is significantly different from that incurred on business rates in 1997-98, it would be helpful to indicate both the scale and the reason for any difference.

An update on the cost of quality

Last week I received guidance from Ministers on the quality improvements that companies will be expected to achieve by 2005. Setting Price Limits for Water and Sewerage Services set out my views on the costs to be considered in the funding of quality obligations. Allowance will be made in price limits only for work that has been formally confirmed as required. It will also be necessary for companies to set out the timescale for the completion of the work and the date by which compliance is due. This must be endorsed by the relevant quality regulator (the Environment Agency or the DWI) and the dates must be consistent with the guidance received from Ministers. Companies must also set out in their Business Plans the work they are proposing to carry out and the phasing of their need for capital and, where appropriate, for operating expenditure.

I will not allow contingency in price limits for work that has not been confirmed as required or where the enhancement or timescale has not been clearly defined. This is on the basis that account would be taken, at the next review, or earlier if the materiality threshold for an Interim Determination is met, of expenditure incurred in 2000-05 on implementing new legal obligations confirmed by Ministers following the decisions, which they announced on 1 March.

There are two other quality issues, which a number of companies have raised.

In 'Raising the Quality', Ministers considered that the costs of fulfilling distribution undertakings should reflect mains relining solutions rather than mains replacement.

To achieve greater consistency in the accounting treatment of allocation of investment between quality and capital maintenance, I shall adopt the policy as set out in RD3/99, Allocation of expenditure between quality enhancement and capital maintenance issued in January 1999. Any difference between relining and replacement costs will be allocated to capital maintenance.

For the purposes of the Business Plan, companies should prepare their projections of capital maintenance taking proper account of this policy, indicating the amount of quality enhancement activity that could be absorbed as part of the ongoing capital maintenance programme. Companies should set out their assessment of the contribution that the current quality programme has made towards maintaining serviceability to customers, and their view on how the continuing quality enhancement programme will affect their capital maintenance projections in the period covered by the next price limits.

The other issue concerns the treatment of additional operating costs for new quality enhancements. In Setting Price Limits for Water and Sewerage Services, it was assumed that companies would absorb any additional operating costs which are associated with works which have been modified or replaced to meet new quality obligations, as part of the efficiency expected to arise from rationalising and optimising existing installations. Companies have indicated their concerns that this approach should not be applied when major alterations are made to treatment works, either water or sewerage. It is for your company, and your Reporter, to pay particular attention to this area when compiling your Business Plan. Your company should justify any claim for additional operating expenditure for quality enhancements; this can apply to both new sites and substantial to existing works. These claims will be subject to comparative efficiency analysis.

Expenditure claimed by companies, in addition to that assumed at the last periodic review, will be considered for logging-up when it breaches the triviality threshold set at 1% of turnover in 1997-98 and has been made necessary by a new legal obligation placed upon the company that was not taken account of in the last Periodic Review. The expenditure incurred by the company may be subject to adjustments after taking into account comparative efficiency analysis carried out on the same basis as for future enhancement expenditure. I do not consider it desirable for companies to pass through to customers the costs of carrying out additional work without those costs being subject to full comparative scrutiny.

Companies are reviewing their claims for logging-up for consideration in the price determinations. I will assess whether companies have complied with all the quality enhancement obligations assumed in price setting in 1994. This will therefore be a two-way refinement process, both for companies to make claims for logging up expenditure and thereby increasing their regulatory capital value and for my office together with the quality regulators to consider whether there have been shortfalls in companies meeting legal requirements by the expected dates. These, in turn, may lead to a reduction in the regulatory capital value.

Tariff switching effects

In MD144, I said that I would reconsider, in the light of the Government's proposals in the Water Industry Bill, the assumptions with regard to tariff switching set out in MD137. In MD137, I said that I would assume that, on average, water usage for households switching to measured charging would equal the average for unmeasured households. This assumed, broadly speaking, that companies could offset below average consumption by meter optants against the above average consumption of selectively metered households. On the basis of the Water Industry Bill and in particular the right to a free meter option (with reversion) companies have argued that this approach cannot be sustained.

There is considerable uncertainty about the likely number of meter optants. In MD144, I said I would retain the current tariff basket arithmetic at this periodic review. This will reduce the revenue risk to which companies are exposed as a consequence of tariff switching, but will increase the risk to customers remaining on an unmeasured charging basis of bill increases greater than the price limit set.

The impact on unmeasured bills and charges of customers switching from unmeasured to measured charging is a longstanding issue. This has been a major source of complaint and query from unmeasured customers who have seen their bills rise significantly more than RPI ± K. This has frequently been brought to my attention by the Customer Service Committees.

Companies should set out in their Business Plans the way they intend to manage metering programmes in the best interests of all their customers. This requires balancing the impact of tariff switching on those remaining on unmeasured charges against the benefit for those customers who obtain lower bills as a result of opting for a meter. Companies should set out in their plans what impacts they expect to observe on unmeasured customers' charges.

To allow for uncertainty I am ready to allow for the correction mechanism of a Notified Item when I determine price limits to allow for situations where the number of optional meters installed exceeds that allowed for in price limits. This would be subject to the materiality threshold that applies under the licence.

When setting price limits, I will have to consider what allowance to make for switching and will look at this issue comparatively as well as company by company. As of now, companies' views vary significantly with regard to the number of switchers. For example, across the industry the numbers forecast to switch in the next quinquennium range from 1% to 56% as a proportion of unmeasured households (as at 1999-00).

The same is true for the consumption characteristics of switchers. Some companies have indicated that they expect to meter customers consuming average amounts of water, whereas some companies believe that optants will consume only around 50% of average unmeasured consumption. Work done so far suggests that switchers will have consumption no less than around the middle of this range. Companies should, however, set out clearly in their Business Plans what assumptions they have made and what evidence they have to support their assumptions.

It may be helpful for me to give my present views on the consumption savings that can be anticipated when customers opt for a meter. Unless companies present compelling evidence to the contrary, I am minded to assume savings of no more than 5%. This figure is less than the demand effect generally quoted from the National Meter Trials, since the financial incentives for meter optants to conserve water are less significant. I will also allow for savings in supply pipe leakage.

A number of further methodological issues relating to the treatment of supply/demand balance expenditure and to my assessment of revenue forecasts will be set out in an RD letter to be published later this week.