RD 15/01                                                                                                                               13 September 2001

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

INTERMEDIATE USER TARIFFS

In RD 14/01 I said that the Director was minded to agree intermediate user tariffs for customers consuming between 10 and 50 Ml/a, subject to their being structured on a seasonal basis. We want to consider the views of companies, Customer Service Committees and business customer groups before reaching a final view.

This letter summarises our proposed policy position on intermediate user tariffs (targeting non-household customers below 50 Ml/a), highlighting particular areas where opinions are sought.

Background

In the past we have accepted the principle (as originally outlined in RD 9/93) that non -household customers may have more stable demand profiles and that this factor can reduce some average peak costs. We also accepted the principle that these lower costs could be reflected in tariffs. Six companies have intermediate user tariffs for water supply and these tariffs are largely justified on this basis.

Some of these intermediate user tariffs (at Severn Trent Water, Tendring Hundred Water, and Bournemouth and West Hampshire Water) are structured on a seasonal basis whereas others (at Anglian Water, Hartlepool Water and Bristol Water) are not. In 2000 two other companies submitted proposals for intermediate user tariffs that were not structured on a seasonal basis. Approval of these proposed tariffs for the charging year 2001-02 was deferred pending further consideration.

Most existing intermediate user tariffs offer a small discount (typically less than 10%) to non-household customers. The exceptions are Anglian Water and Hartlepool Water where the intermediate user discount for customers between 5 and 50 Ml/a can reach over 20%. A discount of over 10% is also available to non-household customers who consume between 1 and 5 Ml/a.

Companies typically justify the discount by reference to the lower peaking characteristics (when compared to households) of the "average" intermediate user within the identified class of non-household customer. For those tariffs structured on a seasonal basis the discount is typically removed when the peaking characteristics of the individual intermediate user is similar to that of households. This feature ensures compliance with licence condition E.

Most existing intermediate user tariffs target non-household customers consuming between 20 and 50 Ml/a. Only Anglian Water and Hartlepool Water offer intermediate user tariffs to non-household customers consuming below 20 Ml/a. One of the proposals received in 2000 also included a set of intermediate user tariffs for customers consuming between 2.5 and 20 Ml/a.

Intermediate User Tariff Structure

We consider that intermediate user tariffs can be justified on the basis that these customers have peaking factors that are, on average, lower than household customers. However, intermediate user tariffs so justified should be structured on a seasonal basis. This will provide for a more cost reflective tariff, noting that average intermediate user group peaking factors will hide a wide variance in individual customer peaking factors.

The relationship between summer and winter volumetric rates should show appropriate reference to the relationship between peak and off peak long run marginal costs. The seasonal tariff should be structured so that there is no discount for the intermediate user with peaking characteristics similar to that of the average household customer.

Acceptable Level of the Intermediate User Discount

Capacity (ie capital) costs are extremely important in the water industry. These are typically common costs and are therefore extremely difficult to allocate on a fair basis. For intermediate user tariffs companies have allocated these costs according to differential peaking characteristics. When so justified the size of any intermediate user tariff discount (for the customer with average group peaking characteristics) will ultimately depend on:

• Which capacity costs (resources, treatment, arterial distribution, service reservoirs, and feeder distribution and local distribution) are deemed to be truly driven by peak demands and which peak factors (peak month, peak week, peak day and peak hour) are deemed to drive each of these capacity costs.
• The peaking characteristics of intermediate users when compared to that of household customers, and whether these peaking factors are based on a historic (1995 as an example of a peak year, 1999 as a typical year, or the last audited year) or a future basis (ie projected demands for the coming year).
• The way in which intermediate user peaking characteristics are compared to system peaking characteristics (coincident or non-coincident), and the cost allocation procedures (including appropriate consideration of economies of scale) adopted to assess the impact of lower customer peaking factors on water supply costs and hence tariffs.

• Some resource capacity costs (ground and river water abstractions used to meet peek demands) and all treatment, arterial and feeder distribution capacity costs can be included in the peaking factor analyses.
• Because of substantial economies of scale, the majority of resource capacity costs (especially reservoir/bulk transfer costs) and all local distribution capacity costs should be excluded from the peaking factor analyses.
• Peak week should be used to allocate treatment capacity costs (and potentially some resource capacity costs), peak day should be used to allocate arterial distribution capacity costs, and peak hour should be used to allocate feeder distribution (including service reservoir) capacity costs.
• The cost allocation process should take into account appropriate capacity ratio exponents (to reflect economies of scale). It is suggested that an exponent of 0.7 is appropriate for ground/river water resources, treatment and arterial distribution, whilst 0.3 is appropriate for feeder distribution.
• Coincident peak factors are preferred. However, historic non-coincident peak factors are acceptable, although the use of dry year peaking factors (such as 1995) will require justification.

Our analysis has shown that when the above rules are applied differential peaking characteristics can justify only relatively small tariff discounts for intermediate users. Unless there is compelling evidence to the contrary discounts for intermediate users consuming less than 50 Ml/a will typically be around 5% and will generally be less than 10%. Lower intermediate user thresholds will see lower discounts.

Lower Intermediate User Tariff Thresholds

We believe that intermediate user tariffs for customers below 10 Ml/a are difficult to justify. Our reasoning is as follows:

• Cost differences (between household and intermediate users) and associated tariff discounts are unlikely to be significant enough to justify the introduction of a separate non-household customer class below 10 Ml/a.
• Below 10 Ml/a the variability of individual customer peaking factors increases substantially. Using "average" customer class peaking factors to justify intermediate user tariff discounts becomes less tenable at these lower consumption levels.
• Seasonalisation (and the requirement to simultaneously read the meter before and after the peak period) for non-household customers consuming less than 10 Ml/a is likely to be problematic and/or costly to implement.
• The introduction of even a small tariff discount for such a large group of individual customers (ie all non-households below 10 Ml/a) may lead to substantial tariff rebalancing. Initial calculations show that introduction of intermediate user tariffs for customers below 10 Ml/a could increase the average household bill by £ 1-3. This will depend on the level of the lowest threshold.

Q1. Is there any compelling evidence that intermediate user tariffs justified on differential peaking characteristics should not be structured on a seasonal basis?

Q2. Is there any compelling evidence to support average intermediate user discounts (over the standard household tariff) of more than 10%?

Q3. Do you agree with the general cost allocation rules outlined above?

Q4. Is there any compelling evidence to support the introduction of intermediate user tariffs for customers consuming less than 10 Ml/a?

Responses to the above questions should be submitted by the 31 October.

Approval of Charges Schemes for 2002-03

Companies proposing to introduce intermediate user tariffs for 2002-03 should be ready to justify them in their draft charges schemes having regard to the provisional conclusions set out above. In the light of comments received, Ofwat may want to review the justification of existing intermediate user tariffs which offer discounts in excess of 10% and/or are not structured on a seasonal basis. We do not expect, however, that these discussions will affect the approval of these companies' charges schemes for 2002-03.

Yours sincerely

Michael J Saunders
Director of Consumer Affairs