In his open letter to the Secretaries of State, the Director is seeking guidance from Ministers on the environmental obligations that are appropriate for the next Periodic Review.

The Director also welcomes your views on all of the issues that are addressed in the accompanying paper. Please send them to:

Bill Emery
Assistant Director and Head of Costs and Performance
Office of Water Services
Centre City Tower
7 Hill Street
Birmingham B5 4UA

or by fax to 0121 625 1382

by Tuesday 30 June 1998

All responses should be marked Setting the quality framework.

Unless otherwise requested, responses will be placed in the Ofwat library and made available to the public.

CONTENTS

Open letter from the Director General of Water Services to the Secretary of State for the Environment, Transport and the Regions and the Secretary of State for Wales

Setting the quality framework - an analysis of the main quality costings submission 2000–05

1. Summary

2. Purpose of this paper

3. Factors affecting customers' bills at the Periodic Review in 1999

4. Obtaining the cost estimates for the possible cost of quality

5. Assessment of company estimates

6. Challenging the company estimates of the cost of implementing quality improvements

7. Structure of the possible cost estimates

8. Expenditure on quality assumed at the last Review

9. Company estimates for delivering the 1994 programme and known changes to the 1994 programme

10.Possible new statutory obligations relating to both existing and possible new EC Directives and national legislation

11. Other environmental improvements

12. Future obligations

13. Summary of national and regional impact of possible new quality obligations

14. The priorities of customers

Appendices

1. The external review of Reporters

2. Industry-wide summary of companies' submissions 2000–05

3. Timetable for the cost of quality

OPEN LETTER FROM THE DIRECTOR GENERAL OF WATER SERVICES TO THE SECRETARY OF STATE FOR THE ENVIRONMENT, TRANSPORT
AND THE REGIONS AND THE SECRETARY OF STATE FOR WALES.

SETTING THE QUALITY FRAMEWORK

The importance of quality in investment programmes

The cost and financing of improvements in water and environmental quality is a major element in the price limits which I will set next year.

At this stage of the Review, there is considerable uncertainty about the obligations which may be placed on companies. These comprise obligations agreed in the Community, including the UK interpretation of the standards, and those which may be imposed nationally by UK Ministers, particularly those proposed by the Environment Agency.

The Green Paper on Utility Regulation — A fair deal for consumers (CM 3898) indicates that Ministers will give me guidance on the environmental obligations for the price review and that you will, this summer, publish your guidance in respect of drinking water quality and environmental obligations for the period 2000–05. I would appreciate a clear steer in July, although I recognise that details can be settled rather later.

Water and sewerage bills have risen considerably since privatisation in order to finance the water quality and environmental obligations imposed on the companies and to make up for the relatively low level of investment in the past. At the last Review, I was able — by utilising the increasing efficiency of the companies and by reducing their rate of return on capital — to stop the rapid price escalator. This was despite the need to implement further obligations, in particular the EC Waste Water Directive, which itself added £22 (£24 in today's prices) to the average household bill. Sewerage bills continue to rise, especially for customers of companies with extensive coastal areas, but water bills are now largely stable.

At the last Review, £44 (£48 in today's prices) was allowed for the cost of quality obligations in the annual average household water and sewerage bill over the ten years from 1995–2005.

Investment in the water industry has risen dramatically since privatisation and is now roughly double the average of the 1980s. This is leading to substantial improvements in water and environmental quality. There has been continued improvement in the quality of drinking water. River quality has improved very substantially, many more beaches are meeting EC standards and compliance of sewage treatment works has risen from 90% in 1990 to 97% in 1996.

Further environmental improvements are in the pipeline. The implementation of the EC Waste Water Directive alone will improve sewage treatment for 30 million people by the end of the century.

Customers attach great importance to high quality drinking water and to the preservation of a good environment. But they are concerned at the level of their bills, especially in some parts of the country. I believe they, in common with customers in other utilities, deserve a dividend based on past efficiency. I also believe this can be afforded while maintaining a high level of investment in the environment and on customer service.

Many environmental programmes are relatively inexpensive and can be accommodated within the continuing capital programmes of the water companies — all of which are showing big strides in efficiency. But some programmes are expensive and, unless phased sensibly, risk pushing customers' bills up to unreasonable levels. I am particularly exercised about bills in coastal areas, especially where, as in the South West, there is a small population base to pay them.

The facts - and the uncertainties

The facts - and the uncertainties - are set out in the attached paper provided by my office. It shows that, efficiency apart, meeting all the obligations identified in the paper could increase the annual average household bill by as much as £65 or 30% - on top of general inflation — by the end of the first five years of the new millennium. This includes the obligations already incorporated in the price limits set in 1994 for 2000–05, which are now being reviewed. £16 of the £44 (£48 in today's prices) increase in household bills allowed for in price limits in 1994, relates to the years from 2000–05.

It also shows that there are other potential obligations, unlikely to be implemented in the period 2000–05, which could push up the annual average household bill cumulatively by a further £60 in the five years from 2005–10. This letter concentrates on the possible impact in the years 2000–05. But other pressures must not be forgotten, if only because obligations could be brought forward.

This does not include all that has already been proposed, let alone things which may be proposed in the coming years. The recommendations of the Environment Sub-Committee of the House of Commons, which were not costed, even approximately, would have a dramatic effect on bills in some parts of the country.

Turning to the programmes costed by the companies for the period 2000–05, these would, at their face value, add capital expenditure of up to £11 billion to the £4 billion already allowed for in the 1994 price limits. Without taking account of future efficiency by the companies these programmes, could, when fully operational, cumulatively push up the annual average household bill by some £49 or 20%, in today's prices, in addition to the £16 already allowed for in 1994. The increases in some parts of the country could be much greater, on top of bills that are already high.

Things could be easier. I believe that companies have overestimated the cost of these new obligations. The cost figures have, therefore, been challenged by my office, after talking to the Drinking Water Inspectorate, the Environment Agency and the independent Reporters. This process of challenge will continue. It involves discussions on the way in which problems could be solved and on the unit costs involved in such solutions.

On the basis of this initial challenge the additional investment for the programmes costed by the companies could, I believe, be reduced. The size of the reduction depends on your decisions and on further work on the costings.

The impact of expenditure on higher quality would not be evenly spread across the country. Some coastal areas would face increases in sewerage bills, eg Anglian Water, North West Water and Northumbrian Water, which are more than 50% above the national average. There is also a significant dispersion for the water service.

Other factors affecting customers' bills

In practice, for some companies, much of the cost of quality might be offset by greater efficiency. The extent should not, however, be exaggerated as some adjustment for efficiency has already been made in the process of challenging company figures.

At the same time as sending you this letter, I am publishing a technical paper setting out the work we have done so far on the efficiency of the water companies and the possible scope for further improvements. My officials will be very ready to help yours in setting this efficiency work alongside the possible costs of new obligations.

Pressures for higher quality are only one of the factors competing for investment resources.

• The picture on prices cannot be completed without further work on issues concerning the supply of water and trends in customer demands. The companies will provide me with estimates in the summer and I will use them to construct the full picture which I will publish as Prospects for prices in October.
• The companies are, I know, very concerned about the finance of adequate maintenance of their physical assets and this will, quite rightly, play an important part in the price review. Again, I will be collecting material from the companies in the summer and plan to incorporate it in Prospects for prices.
• The companies wish to meet their interpretation of their customers' priorities for improvements in standards of service.
• There are also implications for prices in your own paper, Water Charging in England and Wales — A New Approach, March 1998. You are expecting responses by May 1998, and you will want to consider these responses before coming to final decisions.

Assessment of benefits

The Environment Agency will send you its paper on options and benefits in the middle of May. Its advice needs to be looked at alongside this letter. Customers will need to see the benefits from the different programmes of improving river and coastal water quality set out together in order to test the scale of the benefit against the scale of the cost.

I am sure that water customers will expect the benefits of the Agency's options, severally and in total, to outweigh the costs. The Agency itself is, of course, under a statutory duty to consider both costs and benefits in recommending any particular option to you.

The key issues

In this emerging, but still uncertain, situation I ask you to guide me with respect to nine critical areas — all involving substantial expenditure, with significant implications for water and sewerage bills. They are:

- work on the water distribution system;
- compliance with the new lead standard;
- measures to deal with deterioration in raw water (especially as a result of nitrate and pesticides);
- reducing the risk from cryptosporidium;
- changes in implementation of the EC Waste Water Directive;
- improvement of intermittent discharges, including combined sewer overflows (CSOs);
- disposal of sewage sludge;
- measures to improve (and prevent deterioration in) river water quality;
- new designations and interpretation of standards under EC Directives - particularly under the Freshwater Fish Directive.

Water distribution systems

This is the most expensive programme for the water service. Companies have increased their estimates for the renovation needed to meet quality standards to over £2 billion in the five years from 2000–05. This expenditure helps to renew the capital stock as well as improve water quality and it is important to avoid double counting.

My estimate of what is likely to be needed to maintain the serviceability of the water infrastructure could be much less than this, perhaps £1.3 billion over the five years, although I need to consider the company arguments for expenditure on this element of capital maintenance before settling on a number.

Much of the increase in capital expenditure which the companies say is necessary — amounting to £680 million — is to finance pipe replacement rather than pipe relining. I seek your guidance, and that of the Chief Inspector, on how much of this expenditure is essential to meet the improvement in water quality under the Drinking Water Directive and how much should be judged as a matter for normal business appraisal of options for achieving better water quality.

Compliance with the lead standard

The Community is wisely leaving householders the choice to replace their pipes. If there were to be any change in this policy, I do not believe it would be fair to load the costs on to water customers.

The overall costs falling on householders and water companies of meeting the new Community lead standard of 10µg/l could range between £5 and £8 billion, equivalent to a cumulative increase of £15 to £25 in the annual average household bill when all the work is completed. This would be concentrated in the older urban areas of the country.

If the Government believes that any householders should be helped to replace lead pipes, I recommend that this should be done by specific grants financed by general taxation. Where householders replace their lead pipes, water companies replace their lead communication pipes free of charge. This is already financed within the existing price limits.

In order to ensure that water companies meet the interim lead standard of 25µg/l after five years, companies may have to spend some £50 million in the years 2000–05 on treating water to reduce its tendency to absorb lead from companies' and customers' pipes. I suggest that nothing further should be financed in price limits at the 1999 price review.

If significant progress by water companies towards meeting the new standard of 10µg/l is required, there is a mechanism for making adjustments to price limits. This would leave open the possibility of a further, cumulative, increase of £7 to £9 in the annual average household bill to pay for replacement of all lead communication pipes over 15 years.

Deteriorating raw water quality

Companies have identified significant sums (£600 million capital expenditure, plus £40 million additional operating costs) in their submissions to deal with deteriorating raw water quality, particularly to reduce nitrate and pesticides levels. This could cost household customers between £1 and £3 a year. Some companies believe that they may be at risk of breaching these standards in the next five to ten years, if preventative action is not taken.

These standards have been in place for many years and I believe it is up to the companies to maintain compliance without seeking additional revenue from customers. I will consult with the Chief Inspector of Drinking Water, and only in exceptional circumstances, particularly for small companies where there is little flexibility in the choice of the source of raw water, do I propose to allow some of the costs of rectifying problems caused by deteriorating raw water quality to be reflected in customers' bills. The companies already face some business risk in fulfilling their obligations and I see no reason why this should not continue.

Reducing the risk from cryptosporidium

Companies have estimated the cost of complying with some of the recommendations of the Badenoch Committee on the risk from cryptosporidium in water supplies as set out by the Drinking Water Inspectorate. Some companies included surprisingly high costs, giving an industry figure of £300 million in the five years 2000–05 and over £1 billion in total.

The Chief Inspector has indicated that well maintained and well operated conventional treatment works should not result in an unacceptable risk of cryptosporidiosis. I believe we should expect companies to be operating their assets in this way. Therefore, I propose that, as a general rule, any asset improvements the company may wish to make should be considered as part of the continuing obligation to maintain serviceability for customers.

Unless you guide me otherwise, I propose not to make specific additional allowance in price limits for this work, and to continue to treat the current water quality regulations as part of the service that companies are currently providing for their customers.

The implementation of the EC Waste Water Directive

Companies have estimated that additional capital expenditure of up to £1.8 billion, plus additional annual operating costs of £48 million could be needed to meet requirements of the Directive, including the chemical oxygen demand (COD) standard and to accommodate possible changes in Ministerial policy. After challenge, these figures could fall to £1.4 billion capital expenditure and additional annual operating costs of £38 million. On these assumptions annual household bills would rise by a cumulative amount of £6 to £8 when the works are operational. This is made up of a number of elements.

At the last Review, I took the view that the biochemical oxygen demand (BOD) and COD standards were broadly equivalent and that it was sufficient to allow in price limits for BOD alone.

This was on the understanding that if, after taking all reasonable management action, including trade effluent control, this was not sufficient to deal with a particular case, that further capital work to address COD would be recognised as a new legal requirement. This could trigger an interim determination or be logged up for the next Review. I propose to continue to follow this approach unless guided otherwise. It leaves the possibility, of course, that the annual average household bill could rise in the period 2000–05 as a consequence of interim determinations.

The previous administration, in the guidance it gave me in 1993, believed that full advantage should be taken of the opportunities for derogations allowed under Community Directives. In implementing the EC Waste Water Directive it was presumed that primary treatment was sufficient for the majority of discharges into areas of high natural dispersion (HNDAs) and it was assumed that there could be delays due to technical reasons for a handful of major schemes.

In the case of the Humber and Severn estuaries, the decisions of the Secretary of State were overturned by judicial review, at the cost of some £120 million.

Where comprehensive studies have shown that secondary treatment would have environmental benefits, derogations would no longer be justified — again at the expense of water customers. In these circumstances, companies may apply for an increase in their price limits. But where these studies show that secondary treatment would not produce environmental benefits, I believe that we should keep to the present policy in order to keep down bills.

There are increasing uncertainties in this area involving large sums of money. The companies' estimates of the cost of the withdrawal of HNDA status was £420 million capital expenditure plus additional annual operating costs of over £20 million. The companies need early Ministerial guidance if they are to meet their deadlines under the Directive.

Combined sewer overflows

Price limits set in 1994 allowed around £1 billion for the improvement of a proportion of the combined sewer overflows judged to be unsatisfactory by virtue of aesthetic considerations or their adverse impact on water quality. This investment, to be spread over the ten years to 2004–05, was planned to rectify around 60% of problems at combined sewer overflows on the assumption that this would discharge national obligations under the EC Waste Water Directive.

Companies are now estimating capital expenditure of £1.1 billion in the years from 2000–15 to complete this programme. After initial challenge the cost could still be as high as £900 million. You will wish to satisfy yourself that the benefits assessed by the Environment Agency exceed the costs, which could cumulatively add £3 to £4 to the annual average household bill.

Disposal of sewage sludge

Companies are facing pressure from various directions to limit the use of sewage sludge on agricultural land. The Royal Commission on Environmental Pollution has recommended that all sludge used on agricultural land should be treated; the Environment Sub-Committee has recommended that it should be pasteurised. In addition, the costs of sludge disposal may rise as a result of interpretation of the EC Sludge to Land Directive.

The cost of these policies could be over £1 billion capital expenditure plus additional annual operating costs of £75 million. They could be less — capital expenditure could be under £800 million and additional operating expenditure under £60 million. Depending on these numbers the cumulative impact on the annual average household bill could be between £5 and £7.

The Government is carrying out a review of the adequacy of the current controls under the 1989 Regulations and the associated code of practice. Unless you consider that the regulations should be changed at significant costs to the companies, I am minded to consider the issue as part of the continuing maintenance of service rather than as a new obligation. Some of the companies feel strongly about this and I would appreciate your guidance on this sensitive matter.

Improving river quality

Companies have estimated the capital expenditure of possible policies, not arising from EC Directives, proposed by the Environment Agency for improving the quality of water in rivers — and in some cases ensuring that there is no deterioration — at up to £2 billion. It might be possible to do this work for considerably less, say £1.5 billion, but the average annual household bill could rise cumulatively to £6 or more above present levels to finance this programme.

The Environment Agency will set out the options and benefits of this programme in its May paper. Again you will want to satisfy yourself that the benefits exceed the costs for all or part of the programme, and to decide on the timescale for implementation.

New designations and interpretation of standards under EC Directives

The biggest cost in this area derives from the Freshwater Fish Directive. Taken together with the Shellfish Waters Directive, the Habitats Directive and an item under the Bathing Water Directive, this would involve, on the companies' estimation, capital costs of up to £1 billion. The cumulative effect on the average annual household bill could be between £3 and £4.

There are issues which depend on Ministerial decisions on the extent of designation of freshwater fisheries, shellfish waters, the interpretation of standards and the establishment of the nature of the obligation placed on North West Water to achieve compliance with the Bathing Water Directive on the Fylde Coast.

My recommendations

While individual items on the list may not lead to large increases in customers' bills, the aggregation of costs is worrying. And I must emphasise that they only represent part of the problem. The effects would be much more marked in some areas, such as along the coasts than in some inland areas. There are quality issues, such as those contained in the recommendations of the Environment Sub-Committee which could cost much more than is discussed here. There are pressures on water supply (supply/demand issues), on ensuring adequate capital maintenance, on services to customers such as water pressure and flooding from sewers and on issues of charging policy, including your own proposals.

Much is made, both by water companies and environmentalists, of the apparent willingness of customers to indicate in opinion surveys that they are prepared to pay more for their water and sewerage to satisfy quality and environmental objectives. I believe that the results of the surveys carried out to date need to be treated with great caution for the reasons set out in section 14 of the accompanying paper. They do not, in any case, suggest that customers in general will want to see their money used this way on the scale required to meet all the potential obligations discussed in this letter.

Moreover, many household water customers are relatively hard pressed, spending a significant amount of their income on their water and sewerage bills. It is sometimes said that they should be helped from general taxation. You will be able to guide us all on this. I would welcome the views of the Government on this important social issue.

In considering the issues, please bear in mind the possibility that, because it may not be possible to achieve complete clarity on Community obligations, there is the prospect of interim determinations during the period 2000–05 which could add a significant cumulative amount to annual household bills.

Apart from the lead standard, the main pressures for more expenditure and higher bills are on waste water treatment rather than on drinking water. There seems to be a major trade-off between the possible costs under the EC Waste Water Directive, mainly involving coastal waters and those of the Environment Agency's suggestions for improving the quality of river water. Do customers generally want, or can afford, both? I urge you to guide me on your priorities, but I recognise that you will also need the evidence from the Environment Agency on relative benefits, and on the overall benefits to be achieved from whatever package of measures they urge you to adopt, before you make your decisions.

The Government is considering the use of pollution charges to promote environmental improvement. It would be valuable to explore this as a cost effective way of meeting national, ie non-EC obligations. Indeed, you may want to wait before such instruments are developed before imposing further national obligations on water companies to, for example, further improve the quality of river water.

In short, in the interests of customers' bills, I urge you specifically to:

• take a robust position on lead, seeking to target expenditure in areas, such as soft water areas where plumbo-solvency is a problem and concentrating on particular groups such as families with small children;
• make clear your priorities between effects on coastal waters achieved by changing the way in which the EC Waste Water Directive is implemented domestically and the proposals being considered by the Environment Agency for improving the quality of water in rivers;
• strike a cost-effective position which produces high benefits to both coastal and river water by choosing only those schemes with a high ratio of benefits to costs; and

Provided that environmental ambitions proceed at a measured and affordable pace, I believe that, at a national level, customers can have an efficiency dividend and see stable bills. But the situation in some regions will be difficult.

I C R BYATT

SETTING THE QUALITY FRAMEWORK — an analysis of the main quality costings submission 2000 to 2005

1. SUMMARY

At the 1994 Price Review, £44 (£48 at today's prices) was allowed in average annual household bills for the water companies to meet their quality obligations for the ten year period 1995–96 to 2004–05. Quality improvements will remain a key component of capital expenditure for both the water and sewerage services for the period 2000–01 to 2004–05.

The figures in this paper show the impact of the cost of quality in bills. They do not take account of savings which might result from future efficiency savings.

1.1 1994 position

When prices were set in 1994, capital expenditure on enhanced quality standards of £4.1 billion was allowed in the final determination for the second five-year period 2000–01 to 2004–05. Additional annual operating costs of £89 million were also allowed. These expenditures were allowed within an overall price limit of 0.4%, with an average increase of +0.6% for the water and sewerage companies and an average reduction of –1.3% for the water only companies. The additional cost of quality in average annual household bills was around £16.

1.2 Changes since 1994

The assessment of capital expenditure requirements on enhanced quality has been updated to take account of changes which have taken place since 1994. The total cumulative effect of these changes is estimated by the companies to increase the estimated capital expenditure requirement by around £300 million, and additional annual operating costs by around £10 million. An initial challenge to the companies' estimates indicates that these costs could be lower. The estimated impact of these changes is currently within a range, therefore, from a further increase of around £1 to a reduction of up to £3 compared with 1994, giving a total increase in average annual household bills of £13 to £17 by 2004–05.

1.3 New statutory obligations

The possible additional costs of new statutory obligations fall into two categories:

• existing European Community (EC) Directives and UK legislation which Ministers and the quality regulators have not yet defined and finalised; and
• the possible programme of new EC Directives and UK regulations.

The possible additional capital costs of new statutory obligations set out in this paper range from a minimum of less than £1 billion to a maximum of £6.6 billion. This range of costs reflects differences of view in both the scope of the programmes and in the possible cost of their implementation.

Possible capital expenditure programmes have been costed by the companies at around £6.6 billion, together with additional annual operating costs of £265 million. These programmes have been challenged over the last two months by Ofwat with advice from the standard setters, quality regulators and independent Reporters. This process of initial challenge has produced lower figures. If only the basic standards are considered, from a preliminary challenge to companies' costings, possible capital expenditure on new statutory obligations could be as low as £0.9 billion. Possible additional annual operating costs could also be lower at around £36 million. Both the companies' costings and the challenged estimates for the minimum impact of the obligations are included throughout this paper, as the ranges of uncertainty which they expose are relevant to decision making by Ministers.

The possible cost of new statutory obligations in average annual household bills would be up to £30 using the companies' costings, or as low as £4 based on the challenged estimates for the smaller programme. This is the current range of uncertainty.

1.4 Other environmental improvements

The companies were asked to cost other environmental improvements which the Environment Agency may recommend to Ministers. These recommendations will need to take account of costs and benefits, as specified in the Environment Act 1995. Establishing the environmental benefits, and such quantification as is possible, is a matter for the Environment Agency. There is a wide range of options. Again, therefore, the possible additional costs are highly uncertain for the period 2000–01 to 2004–05.

Possible capital expenditure programmes have been costed by the companies at more than £4 billion, together with additional annual operating costs of around £100 million. All of these environmental improvements, however, are a matter for decisions by Ministers. The lower cost estimate, therefore, is nil.

The possible cost of other environmental improvements in average annual household bills would be up to £17 using the companies' costings.

1.5 Summary of national position

In summary, customers could have to pay up to £65 in average annual household bills by 2004–05 should various proposals, originating from EC Directives or from the Environment Agency's possible programme of other environmental improvements, be implemented in UK law. This figure is based on the companies' costings.

If decisions are made to extend timescales or reduce the scope for improvements within the legislation, the costs after initial challenge could be £18 in average annual household bills. This range of costs in bills, from £18 to £65, illustrates the current range of uncertainty.

The figures explained in the paragraphs above are summarised in Table 1. All costs are shown in 1997–98 prices.

Table 1: Summary of the possible cost of quality in 2000–01 to 2004–05

1997-98 prices	For the quinquennium 2000–01 to 2004–05
	Total capital expenditure £bn -total		Additional operating costs £m/year	Household bill impact £
	Max. company estimate® min. challenged costs	Max. company estimate® min. challenged costs
1. 1994 price setting
Water service	1.8		2	£5.30
Sewerage service	2.3		87	£10.90
Combined service	4.1		89	£16.20
2. Changes since 1994
Water service	+0.4 ® -0.3		0	+£1.10® -£0.90
Sewerage service	-0.1 ® -0.5		+10 ® -6	£0.00 ® -£1.80
Combined service	+0.3 ® - 0.8		+10 ® -6	+£1.10 ® -£2.70
3. Estimated costs of new statutory obligations
Water service	2.9 ® 0.1		125 ® 14	£12.50 ® £0.50
Sewerage service	3.7 ® 0.8		140 ® 22	£17.90 ® £3.60
Combined service	6.6 ® 0.9		265 ® 36	£30.40 ® £4.10
4. Other environmental improvements
Water service	0.1 ® 0		4 ® 0	£0.50 ® £0.00
Sewerage service	4.0 ® 0		92® 0	£16.80 ® £0.00
Combined service	4.1 ® 0		96 ® 0	£17.30 ® £0.00
5. Items 2 to 4 inclusive
Water service	+3.3 ® -0.2	130® 15		+£14 ® -£1
Sewerage service	7.6 ® 0.3	240® 15		£35 ® £2
Combined service	10.9 ® 0.1	370® 30		£49® £1
6. Items 1 to 4 inclusive
Water service	5.1® 1.6	130 ® 15		£19 ® £5
Sewerage service	9.9 ® 2.6	330 ® 105		£46 ® £13
Combined service	15.0 ® 4.2	460 ® 120		£65 ® £18

Totals may not add up due to rounding

1.6 Post 2005

In addition to possible obligations for the period 2000–01 to 2004–05, a number of other obligations may also be required after 2005. Many of the costs are unknown but, where there are estimates, the additional cost of quality in average annual household bills could be up to £60.

1.7 Regional differences

There are significant regional differences in the impact of the cost of quality.

Customers in Anglian Water, North West Water and Northumbrian Water could face increases in their sewerage bills which are more than 50% above the national average. There is also a significant regional dispersion in the water service. Some customers, for example in Wessex, could face big increases in water charges, which with the pressure from the sewerage service could lead to a high combined bill.

Regional differences for the water and sewerage services, respectively, are shown in Maps 1 and 2. The possible impact on average annual household bills of new statutory obligations and other environmental improvements is illustrated for each service, compared with the possible national average. All costs are shown in 1997-98 prices.

1.8 Other factors affecting customers' bills

Other issues relevant to decisions on the cost of quality are efficiency and also factors competing for the companies' investment resources.

The technical paper Assessing the scope for improvements in efficiency sets out Ofwat's work and views in this area.

Factors competing for investment resources include:

• balancing the supply of water and customer demands, (for which the companies' costings are around £1.5 billion for the period 2000–01 to 2004–05
• the maintenance of physical assets, particularly the underground infrastructure, to ensure continuing serviceability to customers (for which the companies' costings are around £1.2 billion greater than the current level);
• meeting customers' priorities for improvements in standards of service other than environmental improvements (for which the companies' costings are around £1 billion); and
• implementation of certain charging proposals included in the recent Government consultation paper Water charging in England and Wales – a new approach.

In the paper published in February 1998, Setting price limits for water and sewerage services, the Director set out the framework for the Periodic Review in 1999. The starting position for the Periodic Review will be that companies should not earn more than is necessary to finance their functions. There must be clarity on the extent of these functions and any possible changes to the legal framework for the quality obligations to be imposed on companies. This paper sets out how much customers are already paying in their bills for quality obligations, and how much future quality obligations may cost should various proposals, originating from European Community directives or from national initiatives, be legally required in England and Wales.

Summarised information is set down on the possible impact on customers' bills of tighter standards. This paper complements the letter from the Director. It seeks to assist the Secretaries of State in providing their guidance on those obligations which will be imposed on the water companies and therefore become functions that need to be financed in price limits. Early guidance to decrease uncertainty will allow a more focused appraisal of any asset improvements needed and a sounder outcome for customers.

The ranges of costs included are based on the cost of quality information submitted by the water companies. It sets out the initial challenge given to these estimates so far, as well as identifying a number of key issues.

The information presented comprises:

• The allowance already made in customers' bills for 2000–05 to complete the programme of work assumed to be required when price were set for ten years in 1994.
• The estimates submitted by companies for completing the quality improvement programme set out in 1994 and for complying with a number of already defined new quality standards.
• The possible obligations that may have a major impact on customers' bills
• The processes being used to challenge the company estimates and provide a lower range of estimates to be considered in decision-making.
 

3. FACTORS AFFECTING CUSTOMERS' BILLS AT THE PERIODIC REVIEW IN 1999

Although this paper examines the possible impact of quality on customers' bills in 2000–05, it is not the only factor affecting them.

The quality issues should be considered within the overall framework set out in Setting price limits for water and sewerage services. There are other factors which place significant upward pressure on bills and also factors which, in parallel, exert downward pressure on them.

3.1 Additional upward pressure on bills

There are four areas which may be significant and should be considered alongside quality.

3.1.1 The balance between supply and demand

There are a number of pressures on company expenditure in the area of the supply/demand balance. These include:

• meeting growth in demand from customers;
• restoring security of supply to customers because of, for example, downward revisions in estimates of water availability in some companies or the uncertainties associated with climate change;
• a need to leave more water in the environment because of concerns about the sustainability of existing resources;
• enhancing the security of supply to enable higher levels of service, such as no hosepipe bans.

Of these pressures, the framework for dealing with growth in demand, set out in Setting price limits for water and sewerage services, should ensure no material impact on bills. Security of supply and sustainability issues may, however, be material. For example, where there is a perceived need to leave more water in the environment this may justify an allowance for extra leakage expenditure.

Investment to address security of supply and sustainability concerns could also have higher priority for customers than other areas of environmental improvement. This emphasises the need for expenditure on the supply/demand balance to be assessed alongside quality issues in a way which takes full account of customers' priorities.

3.1.2 Maintenance of assets, particularly infrastructure

Some companies have indicated that a greater amount of activity is required for the renewal of their assets, particularly the underground infrastructure — the network of pipes that supply drinking water and the sewers that remove waste water. In their main quality costings submissions companies have indicated that for all water and sewerage assets an amount £1.2 billion greater than current levels of capital maintenance expenditure will need to be spent in the period 2000–05. During the Periodic Review process, Ofwat will be assessing the serviceability to customers served by these assets. Where there is evidence of a deteriorating trend in serviceability, it may be appropriate to assume an increase in capital maintenance over current levels and bills will need to reflect this.

3.1.3 Increasing standards of customer service

Market research is being carried out by the companies and other organisations to clarify customers' priorities for improvements to service and to explore their attitudes to the trade-off between service and the level of bills. Such work may indicate that customers attach a higher degree of importance to improvements other than those affecting drinking water and environmental quality. Companies indicated in their main quality costings that they may wish to include in their business plans capital investment of over £1 billion to enhance service levels. The scope for such improvements within prices acceptable to customers requires a balance to be struck which reflects their priorities.

3.1.4 The Government's charging proposals

In April 1998, the Department of the Environment, Transport and the Regions (DETR) and the Welsh Office published the consultation paper, Water charging in England and Wales – a new approach, setting out the Government's proposals for a system which provides for fair and affordable water charges. The following represent a number of the main proposals which, if introduced, would exert upward pressure on bills:

• the removal of the right to disconnect household customers for non-payment of charges;
• the establishment of charitable trusts by all water companies;
• the right to opt for a meter free of charge for domestic purposes (when only 12 companies currently offer this);
• the right for households to revert to unmeasured charging where they previously opted to have a meter installed (free of charge) without further cost;
• the right for households on low incomes, or those with special needs, who would otherwise pay a measured bill having the option of a bill based on average household use; and
• safeguards to assist care homes.

   

3.2 Downward pressure on bills

Since 1994, companies have demonstrated far greater capacity to achieve efficiency savings than the Director assumed. Ofwat's technical paper Assessing the scope for improvements in efficiency (April 1998) sets out Ofwat's research and views in this area. Ofwat considers there is still very substantial scope for efficiency savings in future years. The paper illustrates how relative efficiency judgements could be translated into expected improvements in efficiency to be included in price limits.

The paper illustrates the possible impacts of a number of efficiency assumptions and demonstrates that there is scope for significant reductions in expenditure resulting from efficiency improvements by the year 2004–05. These efficiency savings could enable substantial investment for quality as well as service improvements or security of supply issues within real price stability from 2001 onwards.

4. OBTAINING THE COST ESTIMATES FOR THE POSSIBLE COST OF QUALITY

For the 1999 Periodic Review, the work on assessing the possible impact of quality started in April 1997. The timetable for the continuation of the cost of quality debate is given in Appendix 3.

4.1 Initial quality costings (Periodic Review Submission A – May 1997)

In April 1997, companies were required to inform the Director of their current estimate of the cost of completing the programme of work identified in 1994 and also the possible impact of new quality obligations already identified. It was also an opportunity for companies to inform the Director of any other obligations not included in the guidelines which they considered may have a significant impact on their future costs.

4.2 Main quality costings ( Periodic Review Submission D – February 1998)

The main quality costings initiative has been a joint project with other government bodies.

The reporting requirements were drafted in conjunction with the DETR, the Drinking Water Inspectorate (DWI), the Welsh Office and the Environment Agency (EA). The type and format of information collected was designed to be useful to all parties. The industry, both via the quadripartite process and at individual company level, was consulted on their content. Ofwat's reporting requirements were circulated with a complementary document from the EA setting out the options to be costed for the environmental programme (Environment Agency Guidelines for identifying improvements qualifying for AMP3 investment – November 1997).

Company submissions were required by 20 February 1998 and copies were circulated, along with the Reporters' reports, to the other government bodies. An industry-wide summary compiled from the company submissions is provided in Appendix 2.

5. ASSESSMENT OF COMPANY ESTIMATES

The Reporters review and challenge submissions prepared by the companies for the Director. They are playing a key role in the analysis of company submissions in the Periodic Review process.

The reporting requirements specified the audit work required from the Reporters. Their reports have been used to assess the estimates submitted by companies and aid the process of the initial challenge to company costs.

For the main quality costings submission Ofwat commissioned an independent report on the auditing of company submissions. This external review of Reporters was carried out by KPMG Management Consultants assisted by the Babtie Group.

The conclusions to their report included the comment:

"The Director General can have confidence that the process of using Reporters to audit water companies' submissions will help Ofwat to arrive at an understandable and reliable basis for establishing the total cost of quality improvements for the industry. This is Stage 2 of a four stage process and Ofwat staff are now in a much better and reliable position to assess the companies' main quality costings submissions."

5.1 Analysis of company submissions

The company submissions were checked for obvious omissions, inconsistencies, double counting and non-compliance with the reporting requirements. Further information was required from most companies to complete missing information or to clarify that supplied.

The company estimates were adjusted to correct significant inaccuracies and departures from the reporting requirements. Ofwat also made some assumptions about the phasing of capital needs based on the completion dates of the work included by companies. These phasing assumptions were applied mainly to work on infrastructure.

In some cases, Ofwat considered that companies were including work under possible statutory requirements that should more properly be considered as additional work which may be carried out, perhaps at companies' discretion, in the future. This includes the cost of replacing customers' lead piping and the treatment of sewage sludge to meet stricter standards than those required by EC Directives. Appropriate adjustments were made to the cost estimates.

6. CHALLENGING THE COMPANY ESTIMATES OF THE COST OF IMPLEMENTING QUALITY IMPROVEMENTS

The Reporters identified that the company costs were, in general, on the high side. This has been confirmed during the review and challenge to company costs.

It is useful to set out the company view of the costs, but it is also important to give a challenged view of the possible cost of implementation. This view is informed by past experience as well as by Ofwat's analysis and the comments made by other regulators and the Reporters. In some cases, the costs submitted by companies in similar submissions leading up to the last Review were very much higher than the costs now being reported for the completion of some of the obligations. This upward bias of costs should be taken into account when coming to a more realistic view of future costs.

When making decisions, the Secretaries of State should be aware of the company estimates of the cost of quality, but equally they should also have a lower set of costs, which reflects the challenge made so far. This process of challenge is by no means complete. It will continue to price setting in December 1999 and will become more focused when uncertainty surrounding future quality obligations reduces. Later on in 1998 further information will be available from companies on the current performance of their assets, and the costs of carrying out a range of work on them. It will then be possible to extend the challenge by incorporating a more rigorous comparison of company estimates. As obligations become clearer the challenged figures could increase or decrease still further from the estimates presented in this paper.

Ofwat held a seminar with DETR, the Welsh Office, the DWI, the EA, English Nature, the Reporters and the companies on 17 April 1998 to explain the initial challenge of the submissions. The Reporters questioned whether companies were allocating sufficient resources to the production of soundly based information. Companies are submitting a number of important reports during 1998, prior to the draft business plan in April 1999. The Director is concerned that companies are not fully engaged in providing him with the information required to set soundly based price limits for customers. For the draft business plan in April 1999, companies will be required to have fully documented any changes from the 1998 position. It will be too late for the Director to consider new issues the companies raise for the first time in their draft business plans.

6.1 Costs to be considered when setting prices

The wide range of cost estimates presented in this paper highlights considerable uncertainties. These should reduce as the requirements become clearer.

At the time of price setting there will be:

• better definition of the quality programme;
• a greater understanding of the work required, with expenditure driven by quality obligations properly allocated;
• a view on the continuing scope for future efficiency savings in both capital and operating expenditure;
• the opportunity to apply the process of comparative cost analysis to both capital and operating costs.

Experience has shown the need for such clear guidance on future obligations and how these should be implemented by the quality regulator, including the timescale for improvements. At the last Review, the work required for some improvement programmes was not clearly defined. It has proved more difficult to regulate these programmes effectively, compared with those programmes where the outputs required from companies were well defined from the outset.

A number of criteria will therefore need to be met before quality improvements can be included in price limits.

• The obligation and the timetable for compliance must be clearly defined.
• Protocols as to how the obligation will be enforced through regulations should have been established.
• There should have been a proper assessment by the companies as to the method of implementation and the asset improvements required.
• There should have been a proper costing of the asset improvements identified and these costings should have been fully audited and challenged.

6.2 Challenge to company costs to provide a lower range of estimates

At this stage in the process there is still too much uncertainty about the possible new obligations to be able to apply the above criteria to the costs submitted by companies. However, it is useful to review company submissions and to make an initial challenge to their costs.

Company submissions were adjusted for misallocations and other obvious cases of non-compliance with the reporting requirements. The company estimates included in this paper are given after these amendments.

Ofwat has reviewed the costs included by companies for the completion of the work identified as required in 1994, and has made adjustments where necessary to reflect that companies should be delivering this work more efficiently than assumed in 1994.

For work identified since 1994, two types of adjustments have been made to company estimates to provide a lower range of costs. This represents the extent of challenge so far.

Adjustments were made to cost-drivers for individual companies where it was considered unlikely that the extent of the work identified or the expensive solution costed would be required.

An assessment was made of the costs included by a company that might be removed during the final challenge at the Periodic Review. This was informed by Ofwat's experience at the last Review, when comparative costs and other analyses were employed.

The assessment was based on a number of factors:

• a comparison of unit costs;
• allocation between quality and other cost categories such as maintenance, supply/demand or enhanced customer service;
• planning timescales;
• the extent to which companies had incorporated past efficiencies in their estimates;
• Reporters' views of companies' costing procedures;
• Reporters' views of the extent to which companies' use of generic solutions produced inflated costs.

The partially challenged costs have been used to construct lower figures for use alongside the company estimates.

7. STRUCTURE OF THE POSSIBLE COST ESTIMATES

The possible costs, based on both the company estimates and the challenge to them have been summarised in a number of tables:

Table 2 Combined Service — Expenditure on quality assumed when prices were set in 1994

Table 3 Combined Service — Update of the completion of the 1994 programme and new obligations confirmed since 1994

Table 4 Estimated costs of possible new statutory obligations relating to existing and proposed EC Directives and national legislation

4A: The water service

4B: The sewerage service

Table 5 Other environmental improvements

Table 6 Possible improvements that may impact after 2005

Table 7 Possible cost of quality in 2000–01 to 2004–05 and beyond

• The costs running across the Tables provide a range of costs as a result of the initial challenge to costs.
• The costs running down the Tables provide a range of costs representing uncertainty regarding the scope for the implementation of the potential quality obligation.

As well as showing a range of costs, the Tables also give an estimate of the impact on customers' bills. This is the average impact over England and Wales and masks significant company differences. The household bill impact is estimated from the combined effect of the capital and operating costs. The operating costs flow straight through to customers' bills and need to be recovered in revenue from customers each year. The impact of capital expenditure has two components: first, the shareholders' return on the capital investment based on the cost of capital; and second, depreciation of the assets and the need to replace them at the end of their life. Generally, the annual revenue required to finance capital enhancement will be around a tenth of the total capital expenditure. However, this is permanent and once in customers' bills remains there unless eroded by efficiency savings. Quality improvements, even after the projects are complete, have a permanent impact on customers' bills.

8. EXPENDITURE ON QUALITY ASSUMED AT THE LAST REVIEW

When prices were set in 1994, it was assumed that £4.1 billion of capital expenditure would be required for quality enhancements for the period 2000–01 to 2004–05 and incremental operating costs of around £89 million would accrue over the same time. This expenditure was assumed within the average price cap of 0.4%, with an average yearly increase of +0.6% for the water and sewerage companies and an average yearly reduction of –1.3% for the water only companies. Only three water and sewerage companies, Anglian Water, Northumbrian Water and Southern Water, were given average price caps of +1% or more. Using the current economic assumptions, the outstanding cost of the current quality programme required for 2000–01 to 2004–05 at the time of price setting in 1994 is over £16 in customers' bills by the year 2004–05 (at 1997–98 prices).

A breakdown of the expenditure on enhanced quality is set out in Table 2. For the water service, the renovation of the water distribution system to deal with breaches of the water quality regulations attributable to the condition of the distribution system continues to be the most significant obligation. For the sewerage service, the key outstanding work for most companies is investment in smaller sewage treatment works to meet the requirements of the Urban Waste Water Treatment (UWWT) Directive.

Table 2: Combined service — Expenditure on quality assumed when prices were set in 1994

1997-98 prices	For the quinquennium 2000-01 to 2004-05
	Total capital expenditure for 2000-01 to 2004-05	Additional operating costs by 2004-05	Household bill impact £
	£m – total	£m/year at 2004-05
Water service:
Statutory obligations
Treatment –nitrates and pesticides	20
Treatment – to meet other regulations	20	2
Distribution to fulfil s19 undertakings	1,750
Other justified expenditure
To reduce the risk from cryptosporidium and other improvements	20
Total: water service	1,810	2	£5.30
Sewerage service:
Statutory obligations
UWWT Directive – sewage treatment	1,210	43 1
Bathing Water Directive	50
UWWT/Bathing Water Directives –sewerage	620
Sewage sludge disposal	180	15
Other requirements	200	29
Total: sewerage service	2,260	87	£10.90
Total: combined water and sewerage service	4,070	89	£16.20

¹ Additional opex to meet the requirements of the UWWT Directive and Bathing Water Directive

9. COMPANY ESTIMATES FOR DELIVERING THE 1994 PROGRAMME AND KNOWN CHANGES TO THE 1994 PROGRAMME

The costs of completing the programme in 1994 have been updated to incorporate the company estimates and the challenged figures and are shown in Table 3.

For the water service, companies estimate that to meet the obligations assumed in 1994 for the period 2000–01 to 2004–05 they will require £370 million more in capital expenditure than was assumed then. Instead of the £1,810 million assumed in 1994, £2,180 million would be needed. Almost all this difference represents expenditure to improve the water distribution system. The partially challenged estimate assumes that the outputs allowed for in 1994 could be delivered 15% more cheaply than assumed in 1994 through continuation of reported efficiencies.

For the sewerage service, even taking into account extra obligations placed on companies since 1994, the company estimated costs are below those assumed in 1994. The range of capital costs for completing the 1994 programme and implementing obligations confirmed since then is estimated to be £90 million to £480 million lower than the 1994 assumption of £2,260 million capital expenditure.

The figures presented for sewerage (improvements to combined sewer overflows) are one third of the expenditure estimated as required to complete the entire programme. The challenged cost for sludge assumes that the outputs allowed for in 1994 could be implemented more cheaply, than assumed at price setting in 1994.

The companies now estimate that the costs of completing the 1994 programme with the confirmed new statutory quality obligations is about £4.4 billion for the combined water and sewerage service. Their estimated increase in annual operating costs by 2004–05 as a result of the capital programme is now around £100 million per year. These figures represent an increase of £280 million of capital expenditure and £10 million in additional annual operating costs compared with the 1994 price setting. However, the initial challenge to costs indicates that the programme could be achieved with capital investment and annual operating costs respectively some £800 million lower and £6 million lower than the 1994 price limits assumed.

9.1 Water service

In 1994 the determinations assumed that, apart from a very small amount of treatment, the majority of the expenditure of £1,810 million in the five years was for improvements to the distribution system required to fulfil the s19 undertakings given to the Secretaries of State by companies. This work is required to deal with breaches of water quality standards attributable to the condition of the distribution system.

If the efficiencies reported by companies for the period 1995–2000 are incorporated into these assumptions, this work can be carried out for £1,490 million, which includes compliance with the current polycyclic aromatic hydrocarbons (PAH) standard and hence fluoranthene. The companies have included renovation activity of 34,000 km compared with an assumption of 28,000 km in the 1994 determination, and included costs of £2,170 million, based on a level work programme for renovation. This is some £680 million more than would

Table 3: Combined service — update of the completion of the 1994 programme and new obligations confirmed since 1994

1997-98 prices	For the quinquennium 2000-01 to 2004-05
	Total capital expenditure impacting on bills in 2000-01 to 2004-05	Additional operating costs impacting on bills by 2004-05		Household bill impact £
	£m – total	£m/year at 2004-05
	Company estimates® challenged costs 2	Company estimates® challenged costs 2
Water service: Update of the cost of the 1994 quality programme
Expenditure assumed in 1994 (see Table 2)	1,810		2	£5.30
Improvements at water treatment works	10 ® <10		2	£0.10
Water distribution ( s19 undertakings) 1	2170 ® 1490			£6.30 ® £4.30
Sub-total — water service (change from expenditure assumed in 1994 — Table 2)	370 ® -320		0	£1.10® -£0.90
Sewerage service: Update of the cost of the 1994 quality programme
Expenditure assumed in 1994 (see Table 2)	2,260	87		£10.90
UWWT Directive — sewage treatment	920 ® 840	56 ® 53		£5.20 ® £4.80
Bathing waters — sewage treatment	10 ® <10	-		<10 pence
Sewerage (improvements to combined sewer overflows) 1	560 ® 430	about 3		£2.00 ® £1.60
Sludge disposal 1	300 ® 160	25 ® 13		£1.90 ® £1.00
Other requirements funded in 1994	170 ® 140	3 ® 2		£0.70 ® £0.60
New requirements since 1994 which have been confirmed
Judicial Review of estuary boundaries 1	120	5		£0.60
UWWT Directive additional nutrient removal in sensitive areas	70	1		£0.30
UWWT Directive schemes — 8.5 derogation not forthcoming	20	4		£0.20
Sub-total sewerage service (change from expenditure assumed in 1994 — Table 2	-90 ® -480	10 ® -6		£0.00 ® -£1.80
Water and sewerage combined service: update of the cost of the 1994 quality programme plus new requirements which are confirmed
Change from expenditure assumed in 1994 —Table 2	280 ® -800	10 ® -6		£1.10 ® -£2.70

¹These significant cost issues are dealt with in the Director's letter to the Secretaries of State.

²The Table shows a range of costs for each quality obligation. The upper end of the range is the company estimate from the main qualitys costing submission (after amendments for misallocations and non compliance with reporting requirements) and the lower is a view of the costs following the initial challenge.

have been expected. The much higher unit cost of the work is a reflection of the change in the balance of relining and replacement planned by companies. Instead of the approximately 40% replacement assumed in 1994, companies are now planning over 70% replacement. This change could well be related to other aspects of the service, such as leakage reduction and maintenance, rather than being made for quality reasons. This will be investigated further before the prices are set. If the revised Drinking Water (DW) Directive does not include fluoranthene this programme could be reduced by £320 million for 2000–01 to 2004–05, based on company estimates.

Some companies have set out their plans for the following quinquennia, and have estimated that the total cost of completing the work on the distribution system, if fluoranthene remains a cost driver, would be £4.4 billion up to the year 2015.

The remainder of the expenditure assumed in the 1994 price limits for 2000–2005, including the additional operating costs, is not significant.

9.2 Sewerage service

This area is less certain. In 1994, price limits were set on the basis that in 2000–01 to 2004–05, £2,260 million of capital expenditure, and by 2004–05 an additional £87 million of annual operating expenditure would be required by companies to implement the compliance programmes.

These programmes mainly involved the completion of the UWWT Directive. For the main quality costings, companies have been required to include cost estimates for this work under a number of cost drivers, some work being required to deal with more than one obligation.

Generally, the work identified in 1994 as being required and the new work confirmed since, is estimated by companies to cost £90 million less in capital expenditure and £10 million more in annual operating costs than the 1994 assumptions.

There are a number of areas of concern relating to the 1994 compliance programmes.

9.2.1 Sewerage — combined sewer overflows — (intermittent discharges)

Companies have submitted their estimates of the costs of dealing with all the remaining unsatisfactory CSOs and a relatively small number of other types of intermittent discharge. The total capital cost is put at £1,680 million. However, companies have made different assumptions on the timescale for these improvements, with some companies assuming a completion date of 2005 and others anticipating programme completion by 2015. For the purposes of Table 3, it has been assumed that one third of the remaining programme (in cost terms) will be delivered in the period 2000–01 to 2004–05.

However, as with water infrastructure, clarity is required to reduce the uncertainty on the nature of the legal obligation.

9.2.2 Sewage sludge disposal

In 1994, provision was made for companies to end the disposal of sewage sludge to sea and to deal with the additional volumes being produced as a result of implementing the UWWT Directive. Most of this provision was made for the period 1994–95 to 1999–2000 but it was assumed that £180 million of capital expenditure would be required in the following five years, and £15 million in additional annual operating costs by 2004–05. In their estimates, companies have included significantly more than this, with £300 million capital expenditure and £25 million annual operating costs.

These costs do not include an extra provision made by some companies to meet the more exacting Royal Commission on Environmental Pollution (RCEP) recommendations for the disposal of sewage sludge, or for implementing metals limits in the EC Sludge to Land Directive. The RCEP recommendations are not legally binding. Such costs have been transferred and included elsewhere in the cost estimates. It will be necessary to consider whether companies can justify this additional investment or whether a lower estimate based on £160 million capital expenditure would be more appropriate. The 1994 price limits made provision for the disposal of all the additional sewage sludge generated by the UWWT Directive.

9.2.3 UWWT Directive — sewage treatment — continuous discharges

Companies have submitted their current estimates for the work necessary to complete the implementation of the UWWT Directive. Provision of secondary treatment between 2000–05 at some large sewage treatment works was assumed in the 1994 price limits. However, it is likely that some of these schemes will not be eligible for an extension of the Directive's deadline of 31 December 2000. Some companies have taken account of a revised time frame in their cost estimates. However, as this is a matter of timing rather than cost and the impact will still occur in the prices set for 2000–01 to 2004–05, the costs have been included in Table 3 against the description 'UWWT Directive — sewage treatment'.

10. POSSIBLE NEW STATUTORY OBLIGATIONS RELATING TO BOTH EXISTING AND POSSIBLE NEW EC DIRECTIVES AND NATIONAL LEGISLATION

10.1 Water service (Table 4A)

The possible new obligations fall into two categories. Those arising from existing legislation and those which may be required to implement the revised DW Directive. The estimates given are for 2000–01 to 2004–05. Several of the work programmes continue past 2005 and will continue to place pressure on bills after this date. These are summarised in Table 6.

The important costs have been identified as:

10.1.1 Improvements due to the deterioration of raw water quality

Companies have included estimates for the reduction of pesticides, nitrate and iron levels at water treatment works. The companies' estimates total some £600 million of capital expenditure and up to £40 million in additional annual operating costs. In challenging company costs and including a lower figure of £240 million capital expenditure, account has been taken of the difficulties in predicting future pesticides and nitrate levels. Companies included costs based on possible future breaches, rather than actual breaches of the standards. DWI has indicated that it is not possible to predict future breaches of the pesticides parameter in this way.

10.1.2 Over-abstraction at SSSIs and sites covered by the Habitats Directive

Company estimates of the capital costs of dealing with, or investigating, problems at over 50 sites total £240 million between 2000–01 to 2004–05. The initial challenge indicates a lower cost of £200 million. After consideration by the EA and English Nature of the solutions proposed by companies and the cost and benefits accruing, it should be possible to construct a compliance programme for the majority of these sites that has demonstrable environmental benefits and only a modest impact on customers' bills.

10.1.3 Reducing the risk from cryptosporidium

Companies did not appear to follow the guidance given in the reporting requirements and DWI Information Letter 10/97. Companies included costs of up to £1 billion capital costs and £55 million additional operating costs. £300 million capital and £24 million additional operating costs can be considered as required for 2000–05. These costs have been strongly challenged and £130 million capital costs and £8 million additional operating costs may be a more realistic estimate. The Chief Inspector considers that well maintained and operated conventional water treatment works should not result in an unacceptable risk from cryptosporidiosis.

10.1.4 The revised Drinking Water Directive

Revisions to the DW Directive are being considered by the European Parliament. The extent of any revisions and the timescale for their implementation is not yet certain, but it is likely that the requirements of the revised Directive will be known before companies are

Table 4A: Estimated costs of possible statutory obligations for the water service relating to existing and proposed EC Directives and national legislation

1997-98 prices	For the quinquennium 2000–01 to 2004–05
	Total capital expenditure impacting on bills in 2000–01 to 2004–05	Additional operating costs impacting on bills by 2004–05		Household bill impact £
	£m – total	£m/year at 2004–05
	Company estimates ® challenged costs 2	Company estimates ® challenged costs 2
Obligations arising from existing legislation:
Improvements due to deterioration of raw water quality 1 & 3	0 to 600 ® 240		0 to 40 ® 18	£0.00 to £3.10 ® £1.30
Over-abstraction at designated sites (Habitats and Bird Directives)	170 ® 150		1 ® <1	£0.50 ® £0.40
To resolve problems of overabstraction at SSSIs sites	70 ® 50		1 ® <1	£0.20 ® £0.10
Expenditure to reduce the risk from cryptosporidium 1 & 3	0 to 300 ® 130		0 to 24 ® 8	£0.00 to £1.70 ® £0.60
Compliance with revised Drinking Water Directive:
Revised standard for THMs (max permitted standard of 100ug/l)	235 ® 50	15 ® 3		£1.20 ® £0.20
New (interim) lead standard of 25ug/l after 5 years 1	50 ® 40	8 ® 6		£0.40 ® £0.30
New lead standard of 10 ug/l after 15 years 1 & 3 -partial or -full replacement	0 to 300 ® 230 to 1,100 ® 750	-		£0.00 to £0.90 ® £0.70 to £3.20 ® £2.20
Revised PAH standard (fluoranthene no longer included)	-320	-		-£0.90
Chlorinated solvents standard (trichloroethene + tetrachlorethene 10 ug/l)	25 ® 20	1 ® <1		< £0.10
Other new or revised standards and requirements	150 ® 70	10 ® 5		£0.80 ® £0.40
New standard for clostridia 3 (0/100ml)	0 to 330 ® 140	0 to 18 ? 7		£0.00 to £1.60 ® £0.60
New turbidity standard 3 80% 95%	0 to 10 ® <10 or 110 ® 80	0 to negligible or 5 ® 3		£0.00 to <£0.10 or £0.50 ® £0.30
Stricter chlorinated solvents standard (2 options) 3	0 to 30 ® 20 or 40 ® 30	0 to 1 or 2 ® <1		£0.00 to £0.10 or £0.20 ® £0.10
Range of possible costs for the water service	380 ® 60 to 2,860 ® 1,430	36 ® 14 to 125 ® 50		£2.20 ® £0.50 to £12.50 ® £5.60

¹These significant cost issues are dealt with in the Director's letter to the Secretaries of State.

²The Table shows a range of costs for each quality obligation. The upper end of the range is the company estimate from the main quality costing submission (after amendments for misallocations and non compliance with reporting requirements) and the lower is a view of the costs following the initial challenge.

³Where relevant a second range of costs is shown in the Table. The range shown down each cell is the range (for either the company cost estimate or the cost after initial challenge) of alternative options for implementing the possible new standard

required to submit draft business plans in April 1999. The most significant potential cost driver is compliance with a stricter lead standard. However, a long timespan for compliance is envisaged. It is proposed that there will be an interim standard of 25m g/l to be achieved five years after adoption and a final standard of 10m g/l after 15 years. The sampling regime to demonstrate compliance has not yet been proposed by the European Commission, and hence it is not possible for national standard setters to frame regulations and the procedures for enforcement, or for companies to plan their compliance programmes. Companies have estimated that the programme to replace all lead communication pipes would cost over

£3 billion over 15 years, hence over £1 billion over the period 2000–01 to 2004–05 if the work was spread evenly over the 15 years. A lower cost estimate would give a capital cost of £750 million over the five years.

However, there is uncertainty over the methodology and timescale for enforcement of the standard. To achieve the interim standard of 25m g/l after five years would require conditioning of water at treatment works when it had a propensity to dissolve lead from the pipework. This may cost £40–£50 million in capital expenditure with £6–£8 million annual operating costs. A small amount of lead communication pipe replacement may also be required in some companies.

Companies also included the costs to replace lead communication pipes only where median lead levels at the tap were more than 10m g/l. This intermediate position, which may approximate to 10m g/l as a weekly average intake indicated that only a quarter of the estimated 10 million lead communication pipes would need to be replaced. One third of this programme may cost between £230–£300 million over the five years 2000–05, with the remainder in the following ten years.

Some companies also included estimates for replacing customers' lead plumbing. This is not required in the current proposal for the revised DW Directive and associated costs have, therefore, been removed from the estimates and an estimate for the industry is shown in Table 6 as between £2 billion and £5 billion.

The extent of the adoption of some of the other standards is as yet uncertain. However, both DETR and DWI have expressed surprise at the high cost estimates submitted by companies for a possible trihalomethanes (THM) standard of 100m g/l maximum, when the current standard in England and Wales is already 100m g/l albeit expressed as a three month rolling average. The challenged figure for implementing this standard at £50 million capital costs is significantly lower than the company estimates. Again, the burden of proof rests with the companies to demonstrate that compliance with this standard could not be achieved by the optimised operation of their treatment works and that costs of additional work were properly allocated to quality and not to maintenance, or growth.

Companies have included estimates for dealing with chlorinated solvents; they are reported in some underground aquifers.

The high costs included for the clostridia parameter are also surprising. Companies were only required to include costs when there was an increase in clostridia numbers and there was concern that this could be linked to public health issues. The lower cost figure for clostridia after the initial challenge reflects this uncertainty, at £140 million capital costs, rather than the company estimate of £330 million.

The other new or revised standards include bromate. This may affect those companies using ozone to reduce pesticide levels or electrolytic generation of chlorine. Companies estimated that 76 sites would be affected by a standard of 10m g/l, with associated capital costs put at £100 million.

The need for all this work will be reviewed in the light of the standards included in the revised DW Directive and the DWI view of whether companies can justify the need to carry out the work.

There is considerable scope for various obligations and standards to be adopted which is reflected in correspondingly wide variations in the possible costs. If the stricter standards are adopted for all obligations this may cost up to £2.9 billion in capital expenditure and £125 million in additional operating costs based on company estimates. However, from an initial challenge to the company numbers, this may cost £1.4 billion in capital expenditure. If a basic set of standards over a longer timescale was adopted, these costs may be lower at between £0.4 billion from company estimates and £0.1 billion as the challenged cost. There are similar variations in the operating costs. This corresponds to a range of uncertainty for the household bill impact from under £1 to over £12 on top of the £5 already assumed in 1994 for 2000 to 2005.

10.2 Sewerage service (Table 4B)

There is uncertainty in a number of areas in the sewerage service.

10.2.1 UWWT Directive — standard requirements

The standard requirements of the UWWT Directive are for secondary treatment for coastal discharges serving more than 10,000 equivalent population and for inland or estuarial discharges serving more than 2,000 equivalent population. Below these thresholds appropriate treatment is the norm. Secondary treatment is the treatment of sewage, generally by a biological process used in conjunction with secondary settlement, to achieve certain specified emission limits for biochemical oxygen demand (BOD) and chemical oxygen demand (COD).

There is a general acceptance that in most cases the BOD and COD standards are broadly equivalent. It is likely, however, that for a number of sewage treatment works, measures taken to meet the BOD standard will not achieve compliance with COD limits even after all reasonable management actions, including optimised trade effluent control, have been taken. COD is not yet routinely monitored at works and although some companies have been collecting data, the extent of the COD obligation is still very uncertain. Net additional capital costs to address COD are estimated by the companies at £330 million (the challenged figure is £230 million).

10.2.2 UWWTD — investment in sensitive areas nutrient removal (nitrogen and phosphorus)

The decisions on the extent of any additional designation of sensitive areas will have a major impact on the requirement for nutrient removal at sewage treatment works. The company estimates are £840 million in capital costs for the quinquennium to 2004–05, the lower challenged cost being £710 million. Companies have made varying assumptions

Table 4B: Estimated costs of possible statutory obligations for the sewerage service relating to existing EC Directives and national legislation

1997-98 prices	For the quinquennium 2000–01 to 2004–05
	Total capital expenditure impacting on bills in 2000–01 to 2004-05	Additional operating costs impacting on bills by 2004–05		Household bill impact £
	£m – total	£m/year at 2004–05
	Company estimates ® challenged costs 2	Company estimates ® challenged costs 2
Obligations arising from existing legislation:
UWWT Directive — standard requirements 1, 4	680 ® 480		20 ® 14	£3.10 ® £2.20
UWWT Directive — 1, 3 investment in sensitive areas	<5 to 840 ® 710		1 ® <1 to 17 ® 15	< 10 pence to £3.50 ® £3.00
UWWT Directive 1, 3, 5 _-investment in less sensitive areas	<10 to 240 ® 210		<1 to 11 ® 9	< 10 pence to £1.20 ® £1.00
EC Sludge to Land Directive1, 3	<5 to 500 ® 450		<1 to 42 ® 38	< 10 pence to £3.30 ® £2.90
Freshwater Fish Directive1, 3	170 ® 140 to 660 ® 540		2 to 9 ® 7	£0.70 ® £0.60 to £2.60 ® £2.10
Shellfish Waters Directive1, 3	0 to 60 ® 50	0 to 5		£0.00 to £0.40
Bathing Water Directive 1, 3	40 ® 30 to 210 ® 150	1 ® <1 to 7 ® 5		£0.20 ® £0.10 to £1.00 ® £0.70
Habitats Directive (effluent discharges) 1, 3	70 ® 60	4 ® 3		£0.40 ® £0.30
Surface Water Abstraction Directive	70 ® 60 to 90 ® 80	1 ® 1		£0.30 ® £0.20 to £0.30
First time sewerage 3	0 to 190 ® 170	Negligible		£0.00 to £0.60
To resolve problems caused by discharges to SSSIs	30 ® 20	2 ® 1		£0.20 ® £0.10
Other finalised new legal obligations 3	0 to 130	0 to 22		£0.00 to £1.30
Range of possible costs for the sewerage service	1,070 ® 800 to 3,700 ® 3,050	31 ® 22 to 140 ® 120		£5.00 ® £3.60 to £17.90 ® £14.90

¹These significant cost issues are dealt with in the Director's letter to the Secretaries of State.

²The Table shows a range of costs for each quality obligation. The upper end of the range is the company estimate from the main quality costing submission (after amendments for misallocations and non compliance with reporting requirements) and the lower is a view of the costs following the initial challenge.

³Where relevant a second range of costs is shown in the Table. The range shown down each cell is the range (for either the company cost estimate or the cost after initial challenge) of alternative options for implementing the possible new standard.

⁴ The estimated costs to comply with standard requirements of the UWWT Directive includes the companies estimate of £330m capex and £11m incremental opex to comply with the COD standard in the Directive.

⁵ The companies' estimate of £240m capex and £11m operating costs relating to the withdrawal of HNDA status is included in this Table under the description UWWT Directive — investment in less sensitive areas. Some costs for this obligation are also included under Bathing Water Directive, in this table, and under the description UWWT Directive — sewage treatment in Table 2. A small residual amount of capital expenditure has been assumed to fall beyond the 2000–01 to 2004–05 period.

regarding the treatment processes to be employed (chemical dosing or biological removal) and the standards to be achieved, particularly for discharges affecting Sites of Special Scientific Interest (SSSIs) and other sites covered by the Habitats Directive. Positive identification of the affected receiving waters and the qualifying discharges which impinge upon them either directly or indirectly, as well as the discharge consent standards would narrow the wide confidence limits applying to the current estimates and could well reduce the impact significantly. Given the considerable uncertainty surrounding the sustainability and, indeed, the effectiveness of the different treatment processes under consideration, early guidance from the EA on the acceptability of the different methods of treatment would be helpful.

10.2.3 UWWTD — investment in less sensitive areas

A number of companies have been carrying out studies to determine the appropriate level of treatment for significant sewage discharges to areas of high natural dispersion (HNDAs). In addition, the Government is currently reviewing the designation of receiving waters to determine whether HNDA status is justifiable. The outcome of either of these exercises may be a partial or comprehensive requirement for secondary treatment to be provided to significant sewage discharges to HNDAs.

The Director has recently advised the Environment Minister that the companies' estimate of the additional costs of secondary treatment for the implicated discharges (over and above primary treatment) is some £420 million in capital expenditure and £22 million in annual operating costs. After receiving updated estimates from companies and challenging these new figures, a lower estimate of the capital cost is £360 million, and of the annual operating cost is £18 million. Some of this work was allowed for when price limits were set in 1994, but may now be required several years earlier than previously assumed. The associated expenditure would therefore have an impact on customers' bills somewhat earlier than anticipated.

10.2.4 Sewage sludge

It may cost up to £500 million to meet the most stringent soil metal concentrations in the Sludge to Land Directive. This figure includes some of the costs misallocated by companies, which went beyond the provisions of the UWWT Directive. After the initial challenge a lower estimate of £450 million was reached. This does not include the company estimates for the costs of meeting the RCEP recommendations in the 1996 report Sustainable Use of Soil. These are set out in Table 5. The estimates also make no allowance for the, as yet, unquantified but very considerable costs of implementing the House of Commons Environment Sub-Committee's recent recommendation that all sludge which is recycled to land be stabilised and pasteurised by 2002.

10.2.5 Freshwater Fish and Shellfish Waters Directives

The costs associated with these Directives cannot be assessed with any certainty until designations have been made on the waters which will be affected and the extent to which the calculated failure of operational standards will be addressed. However, for the Freshwater Fish Directive alone, companies have estimated that capital costs of £660 million may be required to improve sewage treatment works at nearly 600 sites. The lower estimate based on challenging company costs is £540 million in capital expenditure. The relative costs and benefits should be taken into account when making decisions on the designations.

10.2.6 Bathing Water Directive

This covers the provisions of the current Directive, particularly the designation of new EC bathing waters and targeted investment related to the endeavour to observe the guideline value of the microbiological standards. Companies have included estimates of £210 million capital and £7 million operating costs to deal with these potential obligations.

10.2.7 First time sewerage

The estimated costs submitted by companies for discharging their duties under s101 of the Water Industry Act (WIA) should be seen in the light that this is a relatively new obligation. Relatively few applications for connection to mains sewerage have been received by companies to date and even fewer determined. Accordingly, the ultimate impact of this obligation cannot be assessed with any certainty. Companies included estimates of £190 million capital and the challenged cost is £170 million. It is conceivable that very few applications will comply with all criteria required to trigger capital schemes and that the impact on customers' bills will be slight.

10.2.8 Discharges affecting SSSIs

Companies have estimated the capital cost of dealing with discharges affecting SSSIs to be around £30 million. The challenged value is £20 million although there is still uncertainty on the level and type of nutrient removal required at some sites. English Nature is reviewing the company submissions and will be providing advice to the EA on this issue.

10.2.9 Possible impact on household bills

The uncertainty surrounding the extent of designations and other decisions affecting the size of the possible programme is reflected in the wide variances in the estimates for meeting new obligations for the sewerage service. If the stricter standards are adopted, from company estimates this may cost up to £3.7 billion in capital costs and £140 million in additional annual operating costs. An initial challenge to these costs indicates that it may be possible to deal with these standards for £3.1 billion capital expenditure and £120 million operating costs. However, if the statutory obligations are interpreted to require designations only at priority sites, the challenged cost estimates that £0.8 billion capital costs and associated operating costs may be sufficient. This corresponds to a range of uncertainty for household bill impacts from £4 to almost £18 in addition to the quality programme already included in price limits for 2000 to 2005.

11. OTHER ENVIRONMENTAL IMPROVEMENTS

As well as the possible statutory requirements to comply with existing or new legislation, companies were also asked to submit their cost estimates and the associated work programmes to implement additional improvements which the EA may recommend to Ministers.

Table 5: Other environmental improvements

1997-98 prices	For the quinquennium 2000-01 to 2004-05
	Total capital expenditure impacting on bills in 2000-01 to 2004-05	Additional operating costs impacting on bills by 2004-05		Household bill impact £
	£m – total	£m/year at 2004-05
	Company estimates® challenged costs 2	Company estimates® challenged costs 2
Water service
To resolve problems due to over-abstraction at priority and problem sites	110 ® 80		4 ® 2	£0.50 ® £0.30
Sewerage service
Discharges affecting pilot SWQO catchments	30		1	£0.10
To complete programme of improvements to combined sewer overflows 1	1120 ® 860		3	£3.90 ® £3.00
RCEP sludge recommendations1	620 ® 330	33 ® 20		£3.30 ® £1.90
To achieve river and estuarine quality objectives 1 & 3	810 ® 560 to 1580 ® 1160	23 ® 16 to 40 ® 27		£3.60 ® £2.50 to £6.90 ® £4.90
To ensure no deterioration of river quality objectives 1 & 3	70 ® 30 to 390 ® 310	2 ® 1 to 10 ® 7		£0.30 ® £0.10 to £1.70 ® £1.30
Local EA priority schemes	130 ® 100	About 3		£0.60 ® £0.50
Other environmental improvements	80 ® 30	About 2		£0.30 ® £0.20
Range of possible costs and bill impacts	up to 4,060 ® 2,900	up to 96 ® 65		up to £17.30 ® 12.20

¹These significant cost issues are dealt with in the Director's letter to the Secretaries of State.

²The Table shows a range of costs for each quality obligation. The upper end of the range is the company estimate from the main quality costing submission (after amendments for misallocations and non compliance with reporting requirements) and the lower is a view of the costs following the initial challenge.

³Where relevant a second range of costs is shown in the Table. The range shown down each cell is the range (for either the company cost estimate or the cost after initial challenge) of alternative options for implementing the possible new standard.

These improvements include a very wide range of options which the companies discussed with the EA. The companies submitted their estimates of the cost of carrying out work at the sites identified by the EA. Companies have estimated that the whole programme would require over £4 billion of capital investment and up to £100 million of additional annual operating costs for the quinquennium 2000–01 to 2004–05. Challenging the costs gave a lower figure of £2.9 billion of capital investment. This could have an impact on customers' bills of up to £12–£17. These work programmes included a large number of schemes, for example the most extensive of the programme options to achieve river and estuarine quality objectives included nearly 800 sites. It will be possible for the EA to assess which of these schemes offers clear environmental benefits compared with the costs, thus allowing soundly based decisions to be made, providing value for money for customers. None of these additional improvements have been defined in legislation and hence it all needs to be assessed and decisions made on timescale and scope. The baseline position for this programme is therefore zero expenditure.

The key areas where improvements were costed include:

11.1 Water service

11.1.1 To resolve problems due to over-abstraction at priority and problem sites

Companies estimated that £110 million (challenged cost £80 million) of capital investment would be required to deal with over-abstraction at 27 sites which all appear either on the EA priority list or problem list.

11.2 Sewerage service

11.2.2 Discharges affecting pilot statutory water quality objective (SWQO) catchments

Provision for the Secretaries of State to set SWQOs was made in the Water Act 1989, later consolidated as the Water Resources Act 1991. It is envisaged that SWQOs will work in a very similar way to river quality objectives (RQOs), the essential difference being that meeting the objectives will be a legal requirement. The National Rivers Authority (NRA) submitted proposals for SWQOs in eight pilot catchment areas in 1996 though none have yet been formally set.

Companies estimated £30 million of capital expenditure would be required to implement the first tranche of SWQOs with investment needed at around 30 sites.

11.2.3 Completion of programme of improvements to combined sewer overflows

CSOs are categorised as either satisfactory or unsatisfactory according to a number of established criteria which relate to aesthetic considerations or the impact of the discharge on the quality of the receiving waters. Companies were asked to submit cost estimates for a programme of improvement to all CSOs which remained unsatisfactory in the year 2000.

As stated in section 9.2.1, for the purposes of this paper, it has been assumed that one third of the remaining programme (in cost terms) will be delivered in the period 2000–01 to 2004–05; the estimated costs of these improvements are presented in Table 3. Table 5 shows the estimated costs for the remaining two-thirds of the programme — over £1.1 billion (challenged figure £860 million) in capital expenditure.

11.2.4 Royal Commission on Environmental Pollution — 19^th Report — Sustainable use of soil

Companies were requested to estimate the costs of improving sludge disposal facilities to conform with the recommendations of the RCEP report. A key recommendation is that all sewage sludge applied to agricultural land should be treated by at least one of the methods listed in the UK Code of Practice for agricultural use of sewage sludge, thereby ending the disposal of untreated sludge to land.

The industry estimated that £620 million of capital investment would be required to implement the RCEP recommendations. A lower estimate of £330 million takes account of what were viewed as conservative assumptions by some companies regarding the need to pasteurise all sewage sludge and to reduce dependency on the agricultural disposal route.

11.2.5 Achieving river and estuarine quality objectives

Prior to the establishment of the EA, the NRA had set RQOs. These defined a target level of water quality to be met for a river stretch and were influenced by the current water quality and the potential benefits of making improvements. Although a non-statutory requirement, the EA sees it as a duty to achieve these planned quality objectives.

In about 70% of river stretches the RQO is either currently achieved or will be achieved by UWWT Directive schemes or other committed investment. However, RQOs still have the potential of being the single most significant cost driver with companies estimating required capital investment of up to approximately £1.6 billion at nearly 800 sites. The challenged estimate is under £1.2 billion.

11.2.6 Ensuring no deterioration of river quality

The EA sets consents which do not allow significant in-class deterioration or a reduction in river class below that of the existing, non-statutory RQO and sees it as a duty to promote schemes which are required to maintain river quality relative to the 1990 survey. Companies have put the capital cost associated with the EA's "No deterioration" policy at nearly £400 million (lower estimate approx £300 million). Up to 400 sites have been costed at the request of the EA.

11.2.7 Local EA priority schemes

Improvements that are not eligible for investment under any other driver have been put forward by a number of the EA regions. Such schemes may be supported by Local Environment Agency Plans (LEAPs). Companies estimated that £130 million (challenged figure £100 million) of capital investment would be required to implement local EA priority schemes at some 130 locations.

12. FUTURE OBLIGATIONS

This paper has dealt with the possible cost of quality in the next quinquennium for which prices will be set. However, both capital and operating expenditure continue to have an impact on customers' bills long after the work is complete. Newly constructed assets require maintenance and shareholders receive a return on their investment. After investment has been carried out, the finance costs remain in bills unless eroded by continuing efficiency savings. Once quality standards have been introduced it is unlikely that they will be relaxed, so the assets will have to be maintained, and replaced in due course.

The major work programmes so far identified post 2005 for the water service are the completion of work on the distribution system for quality reasons, and, perhaps, the completion of a programme to replace lead communication pipes. There is also the possibility that companies may be required to replace at least some of the customers' lead pipework as well.

On the sewerage side, the expected adoption of the Water Resources Framework Directive will impact on costs and there is a possibility of a revised Bathing Water Directive. Even if the current proposal for a revised Bathing Water Directive is not adopted, it is possible that tighter standards for bathing water may be introduced. Nine inland bathing waters (the first in the UK) were designated in March 1998 and it may be anticipated that this number will increase. It is also possible that the application of bathing water standards will be extended to waters used for other recreational purposes.

In its recent Report on Sewage Treatment and Disposal, the Environment Sub-Committee made some far reaching recommendations. Most notable amongst these are that:

• all sludge that is to be recycled to land should be subjected to stabilisation and pasteurisation by 2002;
• all sewage should be treated to tertiary level at all times to help reduce nutrients and pathogens by 2002;
• CSOs should in future be designed to operate only on a frequency of once every 20 years.

For those obligations which have been costed, it is possible that these Directives and other obligations could place up to £60 upward pressure on customers' bills in the future. This possibility should be borne in mind when making decisions on the extent of the quality obligations to be imposed in the five years from 2000.

Table 6: Possible improvements that may impact after 2005.

1997-98 prices	No timescale given for completion of work
	Total capital expenditure	Additional operating costs	Household bill impact at completion £
	£bn – total	£m/year at completion
	Best available estimate
Water service:
Completion of work on the distribution system to fulfil s19 undertakings 1	up to 2.2bn	-	up to £6
Completion of lead communication pipe replacement 1& 2	up to 2.2bn	-	up to £6
Replacement of customer pipework 1 & 3	5bn ® 2bn	-	£15 ® £6
Sewerage service:
Improvement of standards required for bathing waters 1 & 4	1bn to 2bn	20m to 30m	£4 to £8
Identification of further inland bathing waters 6	unknown	unknown
Water Resources Framework Directive5	1.6bn to 4.8bn	80m to 240m	£8 to £25
Revised Bathing Water Directive:
- Identification of recreational waters 6	unknown	unknown
- Tighter faecal streptococci standard 6	unknown	unknown
Dangerous Substances Directive 6	unknown	unknown
Recommendations of the Environment Sub-Committee6: Tertiary Treatment 7 CSOs (1in 20 year spill frequency) Stabilisation and pasteurisation of all sludge to land 7	unknown unknown unknown	unknown unknown unknown
Possible maximum cost without the additional unknown costs	up to 16bn	up to 270m	up to £60

¹Costs are company estimates from the main quality costing submission.

²Costs for lead pipe replacement are in addition to the company estimate shown in Table 4A for possible work on lead pipe replacement during the quinquennium 2000–01 to 2004–05.

³A range of costs is shown for replacement of customer pipework to meet a possible revised lead standard.

⁴Company estimates for implementing a range of tighter standards at Bathing Waters. The lower range is an estimate to achieve guideline standards at all Bathing Waters and the higher cost is an estimate to comply with a zero enterovirus standard.

⁵Preliminary Ofwat estimate.

⁶Indicators of possible categories of future quality obligations where the no estimate of the costs is yet available.

⁷The Environment Sub-Committee has recommended that these requirements are fully implemented by 2002.

13. SUMMARY OF NATIONAL AND REGIONAL IMPACT OF POSSIBLE NEW QUALITY OBLIGATIONS

The preceding sections have described the individual new standards that may be required. The obligations have been grouped in four tables. The level of uncertainty on the extent and timescale of possible work increases with each successive table.

A summary position for all the possible new obligations so far identified is shown in Table 7.

Table 7 demonstrates the wide ranges of possible costs and hence impact on customers' bills that are possible for quality in the period from 2000–01 to 2004–05. A number of factors give rise to this uncertainty. One is the possible extent of the legal obligations which will be imposed and a second is the variation in the costing of this work. The production of soundly based estimates is costly and time consuming. It is only practical to estimate costs based on solutions tailored to a specific mix of the obligations when the number of options has been limited. Companies indicated in the submissions where improvements to assets would deal with more than one potential new obligation. This has been taken into account when producing the lower partially challenged cost estimates.

Analysis of the company submissions has indicated that to complete the programme of work assumed in 1994 and other obligations confirmed since then would cost between £3 less to £1 more in customers' bills than assumed in 1994. However, the policies for implementing existing legislation or proposed EC Directives could increase this significantly from between £4 and £30. Acceptance of all the additional work for which the companies were required to provide estimates by the EA may cost a further £12 to £17.

The maximum impact of all the possible obligations and additional work costed by companies may place pressure of between £46 and £65 on customers' bills. However, it is unlikely that this particular mix of obligations would be implemented. At this stage in the Periodic Review process there is major uncertainty surrounding the possible size of the Q constituent in K. Q could be between £18 and £65 in annual bills by the year 2004–05 in real terms.

£18 represents the household bill impact of the challenged figure for a basic programme of work, and £65 the bill impact for the stricter standards and all the environmental improvements identified from the company costs.

Unless this uncertainty decreases it will not be possible properly to assess either the quality programme or the rest of the work planned or proposed by companies. The quality programme cannot be appraised in isolation. A potential programme of this size will affect other parts of the service, especially maintenance plans, as well as affecting companies' plans for growth in demand, security of supply or customer service.

13.1 Regional variations

The impact of legally required quality obligations does not fall evenly on all companies. The impact depends on the particular mix of obligations considered. For example, a company with a big proportion of lead communication pipes and a large number of sewage works discharging to coastal waters and requiring extra treatment, may need to improve its assets

Table 7: Possible cost of quality in 2000–01 to 2004–05 and beyond.

¹Totals may not add up due to rounding. The range across the cell shows the possible reduction in costs as a result of Ofwat's initial challenge. The range down the cell shows the possible variation in costs that could arise from a minimum and maximum interpretation of the possible programme required.

more than a company with little lead pipework, only discharging to inland waters already providing the necessary level of treatment.

The regional impact of both the completion of the 1994 programme and possible new obligations identified in the main quality costings is shown in Maps 1 and 2. These possible household bill impacts have been assessed using the company estimates, but using the challenged costs still shows the same general trends. Wessex Water has the largest potential quality programme for the water service, at more than twice the national average. This is mainly attributable to the large estimates included by the company for dealing with the environmental impacts of abstraction of water. Yorkshire Water and Mid Southern Water also show increases significantly above the average possible bill for quality. Yorkshire has included a large programme for reducing the risk from cryptosporidium. This is layered onto a programme including significant lead communication pipe replacement and the continuation of the renovation of the water distribution system. Mid Southern Water has put forward an extensive programme of mains replacement.

For the sewerage service, the pressure on bills continues. Southern Water customers still have significant pressure on their bills from quality, at up to 50% more than the national average. However, Anglian Water, North West Water and Northumbrian Water bills are estimated to be potentially even higher at up to double the national average. This is mainly due to the extensive programme costed by the companies, at the request of the EA, for the improvement of river and estuarine quality and to safeguard rivers from deterioration. Household bills in the Severn Trent Water and Thames Water areas show potential impacts of less than half the industry average because of their inland position and the fact that their sewage treatment works discharging mainly to fresh waters already afford high standards of treatment.

Looking at the combined water and sewerage service, customers of three of the water and sewerage companies (Anglian Water, North West Water, Wessex Water) and at least some of the customers served by three water only companies (Essex & Suffolk Water, Three Valleys Water, and Tendring Hundred Water) could have to bear the greatest burden. The combined impact of both the water and the sewerage service should be considered when deciding on the appropriate extent and timescale for the quality compliance programme.

For these companies it may not be possible to identify or expect sufficient efficiency savings to allow quality improvements to be carried out within stable or falling prices. Unless consideration is given to rationalising the quality obligations in these areas, customers may again have to experience household bills rising in real terms.

14. THE PRIORITIES OF CUSTOMERS

It is important that the views of customers on quality matters should be considered. This is particularly so in considering the priorities for any programme for improvements which are not required by European legislation, and about which there is discretion at national or local level.

Companies have begun to consult their customers about their concerns and priorities. This has consisted chiefly of qualitative work, particularly focus group discussions. Surveys at a national level are being conducted by Water UK, DETR, EA, Ofwat National Customer Council and the Consumers' Association. Although it is not possible at this stage to make definitive comments about customers' attitudes to particular issues, there are a number of important general themes emerging from the work carried out to date.

The first, and perhaps most important, is that customers are generally poorly informed about water and sewerage services.

There is little understanding of responsibility for water and environmental standards and current quality. For example, a recent survey for the BBC showed that despite the investment since 1990 in improved effluent standards and the significant improvements to rivers and beaches, 42% of customers nationally agree with the statement that "Britain's rivers and beaches have become dirtier in recent years", and only 20% think they are cleaner. If customers are unaware of what has already been achieved they are unlikely to have a clear understanding of any further improvements such as those already agreed under current legislation.

This point is important when attempting to understand customers' attitudes to improvements in service. It is of particular concern in areas such as the environment where it can be difficult to express issues in terms which customers can relate to.

In this context it is clear that customers will find it difficult to express an informed view rather than an intuitive response. This can be addressed to some extent by providing background information about the present position and asking questions which are explicit about the benefits customers can expect to see. This is not easy even in relatively well defined areas such as supply interruptions, but becomes more difficult on environmental issues, especially when customers' concern may be as much about the effect of industrial waste and farm slurry, as it is about sewage treatment standards.

A further factor which appears to influence customers' views is the price context against which they are judging the cost and benefits of improvements – are their bills rising or falling and how much have bills increased already to pay for improvements in a particular area? Neither do customers necessarily understand that their bills will rise in line with inflation unless this is carefully explained – stable bills to many customers will mean their nominal bill stays the same.

Finally, customers' views are not uniform. Their priorities differ, and there are important differences in attitudes to bills. There are also significant regional variations reflecting local issues.

All this means that the results of customer surveys may need to be viewed with caution and with an understanding of the way in which views have been sought. The results of companies' and others' quantitative work are needed before more substantive conclusions are drawn.

Nevertheless, the work to date does suggest that customers attach high importance to drinking water quality, security of supply and bathing water being free of sewage. Tackling leakage and avoiding sewer flooding also appear to be important. While customers are obviously concerned about the environment, mention of river water quality or low flows as a priority, often needs to be prompted.

Generally, customers would object to overall increases in their bills, but may be prepared to see investment in improvements in the context of stable or falling prices. This is, however, crucially dependent on seeing tangible outputs from that investment, which appears not to have been the case so far for many customers.

One lesson emerging from all the work, is the need for better communication with customers on what is being achieved.

APPENDIX 1: THE EXTERNAL REVIEW OF REPORTERS

The Ofwat external review of Reporters was carried out by KPMG Management Consulting assisted by Babtie Group.

The terms of reference were to:

• examine and assess the approach taken by the Reporters in the light of the individual company costing exercise leading up to their main quality costings submissions;
• evaluate the approach for compliance with the protocol and guidance issued by Ofwat;
• evaluate, assess and report upon the consistency of Reporters' performance, compared with other Reporters and across the range of the main quality costings submission;
• evaluate, assess and report upon the effectiveness of the arrangements set out in the protocol for:
• building confidence in the Reporters' role in the context of the companies' submission of soundly based and valid information;
• achieving value for money from Reporters.

Introduction

In this Executive summary, we have set out the key aspects and conclusions from our work.

Conclusions

The key conclusions we have drawn from our work are:

1. The work done by Reporters and the reports they have submitted to Ofwat are useful to Ofwat and form a reliable platform upon which Ofwat can build.
2. In our opinion, the Reporters are able to undertake detailed independent reviews of the companies' main quality costings submissions. The Director General can have confidence that the Reporters are likely to have identified all key aspects and key assumptions underlying the companies' submissions.
3. Our review has highlighted instances of potential inconsistencies and a lack of comparability as between the four companies. Following receipt of Reporters' reports, Ofwat is now in a better position to investigate and assess these differences.
4. The Director General can have confidence that the process of using Reporters to audit water companies' submissions will help Ofwat to arrive at an understandable and reliable basis for establishing the total cost of quality improvements for the industry. This is stage 2 of a four stage process and Ofwat staff are now in a much better and reliable position to assess the companies' main quality costings submissions.

The comments are set out in the order they appear in our report.

1. Findings — reporting process:

• Reporters are required to provide professional opinions; however, the necessary professional qualifications and experience are not clearly defined (section 3.1)
• There is a potential lack of independence due to Reporters being appointed by the water companies; however, this does not appear to have caused Reporters to compromise (section 3.3).
• Currently there is no disclosure to Ofwat of the redrafting of Reporters' reports to arrive at wording which is more acceptable to the water companies (section 3.3).
• Many assumptions go unstated and it is often not appreciated by Reporters that an atypical assumption has been made by a water company (section 3.4).
• The arrangements for ensuring comparability of information between companies could be improved; the regulatory process requires comparable information (section 3.5)
• We regard the emphasis on the one-to-one relationship between the Reporter and a company to be a potential weakness; the emphasis should shift more to the Reporter certifying and assessing information and practice within a company in the context of practice in other companies (section 3.5).

• At this stage, Ofwat's requirements have been only partially met; work is still required to assess the relative priorities of schemes and the relative costs of schemes, drawn up on a consistent basis (section 4.2).
• According to the Reporters, there appears to be systematic overestimation of the costs that have been submitted; it is recognised that there is an in-built incentive for a company to submit high estimates (section 4.2).
• There is a potential for inconsistency between companies: the Environment Agency has acted inconsistently between regions; there are differing design approaches to the same quality requirements; differing cost estimating principles have been used (section 4.3).
• The identification of quality schemes involves many stakeholders: this increases the complexity of the Reporters' task and creates ambiguity (section 4.5)
• The scheduling of the main quality costings submission could have been improved (section 4.6).
• Reporters' audit plans should have been approved by Ofwat at the start of the process (section 4.7).

• Reporters should be given an explicit instruction to compare the engineering and cost estimating principles in use at the company with those in use elsewhere in the industry (section 5.1.1).
• Reporters should be required to give a view on the extent of the likely over-estimates of costs (section 5.1.3).
• Due to the involvement of various stakeholders (e.g. EA, DWI) there is need to clarify who is contributing what, and when, to the process
• Ofwat should be able to request a record of the drafting changes made to a Reporter's report (section 5.1.7).
• The size of the capital expenditure programmes under review can be challenged more proactively by Reporters and we consider it would be good value for money to develop their role (section 5.2.1).
• Where the outcome of a capital scheme differs from the estimate submitted and it can be shown that the original estimate was unreasonably high, Ofwat should have some sanction against both the company and the Reporter (section 5.3.3).

• In section 6, we comment separately on the Reporters' protocol. In our opinion, the protocol provides a sound and useful basis. However, certain aspects and definitions need to be clarified.
• Reporters should be explicitly required to confirm their adherence to the protocol by asking them to complete a check-list identifying which aspects have or have not been complied with.

In section 7, we set out our commentaries on the four individual assessments we made of the Reporters involved at Southern Water, Severn Trent Water, Yorkshire Water and North West Water.

In all four cases, we concluded that the Reporters had largely met the standards expected of them. Inconsistencies were observed, particularly where the requirements were ambiguous. Such ambiguities can now be removed and further work could be commissioned to reduce the level of uncertainty, the lack of comparability and the lack of consistency underlying the companies' submissions.

The Southern Water Reporter's team demonstrated good experience and support. It commented on estimated costs being higher than the likely actual amounts. It suffered from timetabling disruptions but appeared to have fully complied with the spirit of the Ofwat protocol.

The Severn Trent Water Reporter's team appeared to be too biased towards dirty water expertise. Its internal processes were not always adhered to and the testing observed by our team could have been more robust, but challenges were satisfactorily dealt with in his report. The Reporter provided the necessary resources and submitted his report on time. There appears to have been few dissents between the Reporter and the company.

The Yorkshire Water Reporter's team was a small but well balanced one. The processes were well organised and good records were maintained of challenges made. Reports were sent to the company for review before submission to Ofwat. Detailed discussions and professional challenges had taken place but it was apparent that the Reporter had stood up well against the company.

The North West Water Reporter's team was a very experienced team which undertook a significant amount of work. The work and processes involved appeared robust and some checking of consistency with other companies' submissions was undertaken. The team fully complied with the spirit of the Ofwat protocol.

The PR99 process is an iterative one. We conclude, based on the work we have performed, that the Director General can have confidence that the work undertaken to date by the water companies and the Reporters provides a useful base to work from in the coming months. At this stage the requirement is for reliable broad indications as to the total cost of quality improvements. There is a clear way forward for Ofwat to improve the information it has been sent and to enable more consistency and comparability. This will increase the objectivity of the PR99 process.

A copy of the Ofwat external review of Reporters is available from the Ofwat library price £10. Telephone 0121 625 1373 for further details.

APPENDIX 2: INDUSTRY-WIDE SUMMARY OF COMPANIES^' SUBMISSIONS 2000-2005

In the main quality costings submissions (Periodic Review Submission D), companies indicted the possible obligations (cost drivers) that would lead to specified asset improvements. These have been summarised in the paper. Industry totals derived from the company estimates are included here, with brief summaries of the quality enhancements, typical solutions proposed by companies and the number of sites or length of water mains affected. There has been some rephasing of work programmes. Detailed definitions of the enhancements costed are set down in the PR99 Information Requirement D Main Quality Costings Submission – Reporting Requirements, which is available from the Ofwat library.

APPENDIX 3: TIMETABLE FOR THE COST OF QUALITY

Lead party	Milestone	Key Dates
Environment Agency	The EA publishes advice to Secretaries of State on broad priorities and benefits of environmental improvements	14 May 1998
Ofwat	Company submissions and Reporters' reports placed in Ofwat library	End May 1998
DETR and Welsh Office	DETR and Welsh Office open to representation from interested parties on priorities for environmental improvements	May to June 1998
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
Companies and CSCs	Companies and CSCs summarise their customer consultation results and the implications for future service	Early August 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
Ofwat	Update of Quality Costings (Submission J)– issue reporting requirements. To refine the costs of environmental and drinking water obligations in the light of the Secretaries of State guidance	18 September 1998
Ofwat	Publication of the Director's paper Prospects for prices: strategic options and issues	October 1998 Consultation closes early January 1999
Environment Agency	EA publishes prioritised programme of environmental improvements for approval by Secretaries of State	November 1998
Companies and Reporters	Update of Quality Costings (Submission J) Reports due back from companies	December 1998
DETR and Welsh Office	DETR and Welsh Office make decisions on environmental objectives for each 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