Lena Cluxton
Office of Water Services
Centre City Tower
7 Hill Street
Birmingham
B5 4UA 

or by fax to: 0121 625 1359

 by 4 January 1999. All responses should be marked Prospects for Prices.

If you wish to clarify any points in this paper, please contact Julia Havard, Head of External Relations (0121 625 1450) in the first instance and she will ensure that your query is dealt with.

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

Contents

Foreword

1. Summary
2. Purpose of this paper
3. The starting position
4. Customers' views on the future
5. Companies' preferred strategies
6. Quality and Ministers' guidance
7. Prospects for prices in 2000-05
8. The key issues

The profile of bills
Efficiency, service performance and incentives – achieving the right balance
Capital maintenance
Final decisions for individual companies on water quality and environmental standards
Balancing supply with demand
Government's proposals on metering and the effect on tariffs
Other enhancement options
The cost of capital

Appendix A: Prospects for prices for individual companies
Appendix B: The cost of capital
Appendix C: Glossary of terms and definitions
Appendix D: List of consultees

TABLES

1. Possible initial reduction in expected average household bills from 1999-2000 to 2000-01
 
2. Possible average household bills in 2004-05 compared with 1999-2000, taking account of the cost of full quality obligations thought to cost £8.5 billion plus other enhancement options  
3. Summary of results of Water UK's national survey of customers  
4. Possible initial reduction in expected average household bills from 1999-2000 to 2000-01
5. Possible average household bills in 2000-05 compared with 1999-2000, taking account of the clearly defined quality programme of around £5.3 billion
6. Possible average household bills in 2004-05 compared with 1999-2000,taking account of the cost of full quality obligations thought to cost £8.5 billion plus other enhancement options
7. Possible changes in the estimated industry average household bill from 1999-2000 to 2004-05  

1. Water quality performance – 1990 to 1997
2. Levels of service performance 1990-91
3. Customer service performance 1990-91 to 1997-98
4. Capital investment 1980-2000 (1997-98 prices)
5. Average household bills 1989-90 to 1999-2000
6. Industry actual and projected capital expenditure from 1980 to 2005
(1997-98 prices)
7. Average household bills 1989-90 to 2004-05
8. Profile of average bills
9. Profile of post-tax rates of return
10. Comparison of total operating costs (1997-98 prices)
11. Total industry distribution input forecast

This consultation paper sets the stage for the second phase of public consultation on water prices. In November 1999, I will set the limits for the prices that water companies will be able to charge their customers for supplying clean water and taking away dirty water in the first five years of the 21^st Century.

 The first stage of the price review started in 1997, with papers on the methods and timetable. It culminated with the guidance, particularly about environmental obligations, which Ministers gave me last month.

 I can now set out, for customers and all other interested parties, the key issues in quantitative terms. Because many decisions, rightly, are still to be made, the figures used in the paper show what could be done, not yet what will be done. That stage will come next July, when I publish draft price limits for the five years from April 2000 through to March 2005.

In making my decisions, I will need to strike a balance between conflicting views and different priorities. Hence my emphasis on transparency and consultation. I also need to preserve the incentives in the regulatory regime for companies to reduce costs and improve services.

Since privatisation, investment in water and sewerage has doubled. A programme of unprecedented size has been financed from capital markets. This has brought large benefits, primarily environmental, resulting from better treatment of sewage. At privatisation in 1989, it was thought necessary to increase prices rapidly to customers. At the last price review in 1994, the price limits I set slowed the increase to 1% a year over the ten years from 1995 to 2005. If it had not been for the massive capital cost of implementing quality obligations, primarily the EC Urban Waste Water Treatment Directive, prices would have fallen.

The water companies, broadly speaking, appear to want to see stable prices from now on. Since 1994, two factors have led me to believe that the industry's large capital programme could now be financed within a framework of falling prices. Water companies, responding to the incentives in the regulatory regime, have become much more efficient. Capital markets have shown that capital for utilities can be raised more cheaply than was thought possible ten years ago and that much greater reliance can be placed on debt rather than equity. The Government's windfall tax on privatised utilities appears to have been financed relatively easily.

The water industry is more capital intensive than other utilities. It has a much greater ratio of investment to sales. Financing the scale of the programme envisaged by Ministers within a framework of lower prices will not be easy. It would give a real challenge to the companies, both in raising money and in operating and investing efficiently.

What do I mean by a framework of lower prices? The scale of past efficiency shows that the price of water supply and sewerage could fall substantially – by more than has so far been recognised. But the scale of the programme of environmental improvement which Ministers have told me they wish the water companies to undertake would inevitably push them up again, although not, at least at the national level, back to where they are now. There could be some customers, however, especially those served by some companies in coastal areas, who would be paying higher bills in 2005 than now.

There is still much to decide before the investment programme can be finalised. While Ministers have indicated that they believe the programme could cost some £8.5 billion nationally, only obligations costing some £5.3 billion are firmly settled. There will be much debate on the non-EC obligations. We have not yet seen the Environment Agency's assessment of the benefits, and it seems unlikely that prioritised lists of schemes can be presented to Ministers before next January.

Investment also needs to cover the supply of water, maintaining serviceability to customers, and improvement of services to customers, such as reducing the risk of flooding from sewers.

The fact that prices can fall, but might thereafter have to rise, opens up an important debate on whether customers want to receive bills which fall only to rise (in part) again. Ministers are concerned that customers could be confused if a large price cut in 2000 were to be followed by increases in the following years. Customers are, however, used to changes in prices in the high street and may prefer to have the money in their pockets rather than leaving it with the water companies.

There are many other matters to be debated, which are set out in this consultation paper.

The consultation period on Prospects for Prices runs until 4 January 1999. I will then have formal meetings individually with all of the water companies to discuss the public responses to this consultative paper. This should help each company to finalise its Business Plan, which it will submit to me in April 1999. Views from others will inform those discussions and help me in my analysis of the Business Plans in the spring and in the formulation of my draft determinations on price limits next July.

Those draft determinations will be public documents and I will continue to listen to all interested parties until next November when I will finalise price limits to run from April 2000.

I C R BYATT

Director General of Water Services

1. SUMMARY

• This price review is taking place against a background of significant improvements in services and environmental standards, accompanied by ten years of increases in customer bills. Companies have been successful in reducing costs and have been able to earn rates of return well above the cost of capital and so deliver significant returns to shareholders.
• This paper exposes the strategic issues and choices so that all interested parties can contribute further to decisions that will impact on future bills and services for customers. To assist informed debate, this paper sets out ranges for possible bills, reflecting the uncertainties about companies' costs and the decisions that have yet to be made.
• Some companies have yet to form a clear strategy for the services and prices that they would like to deliver over the period 2000-05, although others have done so. There remain many uncertainties relating, in particular, to guidance on future environmental and quality obligations for each company and the Government's proposals on water charging. In general, however, companies have considered priorities for service improvements within a framework of broadly stable prices.
• Customer surveys and other consultative processes show that customers do not want bills to increase further. They seem to want improvements in services and the environment, although individual priorities vary. The picture is less clear on how far past and future efficiency gains should be used to reduce bills or improve services. If savings are significant, customers appear to expect a material reduction in bills. Ministers, too, believe that bills should fall.
• As a consequence of past efficiencies, and evolving views about the cost of capital, there is scope for an initial reduction in the average annual household bill in 2000-01 from the level which would be reached in 1999-2000 on present price limits. At an industry level, the reduction, in real terms, could be as much as £40 to £50 (some 15%-20%) off the expected average annual household bill in 1999-2000 of £245. Non-household bills would generally move in line with changes in household bills except for those business customers who would not be covered by the tariff basket.
• At a company level, the reduction in household bills would vary depending on their relative success in the past in cutting costs. Much will depend on the final estimate of the cost of capital for water companies. Although the evidence points to lower estimates than in 1994, there is still significant uncertainty in this figure.
• Ministers have now decided on an ambitious package of future improvements to quality and environmental standards that goes well beyond previous programmes. In the years from 2000 to 2005, the industry would be required to deliver the largest ever five-year programme of improvements. It could cost £8.5 billion over the next five years. This would be equivalent to approximately £35 (in 1997-98 prices) on the average annual household bill. Improvements to drinking water quality account for approximately £2.3 billion, which is equivalent to around £8 on the industry average annual household bill. Improvements in waste water discharges to the environment account for the remainder, £6.2 billion, or around £27 on the industry average annual household bill. There is, however, uncertainty about the definition of the obligations and the costs associated with them, especially about their distribution across companies. The proposed programme means that, while the scope for an initial price cut is similar for both the water and sewerage services, the subsequent changes in average bills, at an industry level, could be quite different. The increase from 2000-01 to 2004-05 in water bills could be small, whereas sewerage bills could increase at a significant rate, especially for customers of companies in coastal areas.
• There is also uncertainty about the scope for future improvements in companies' efficiency and the cost of maintaining services to customers. A number of companies propose increasing levels of service through enhancement options. Many decisions are still to be made. At this stage of the review, however, it appears that, if bills were to fall by £40 to £50 in 2000, they would have to rise again, at an industry level, from 2000-01 to 2004-05 by some £20 to £35.
• The average household bill in 2004-05, however, could still remain below the expected average bill for 1999-2000, by between £5 and £30, or some 2% to 12% below the expected level in 1999-2000. This is a wide range, inevitably so at this stage of the Periodic Review.
• For individual companies, the position varies and there is even more uncertainty. Ministers have yet to make decisions on important elements of the overall package, which will affect individual companies to differing degrees. Depending on their decisions, and the resolution of other uncertainties, some companies could see a continuation of past increases in bills. Particular examples are Southern Water, where bills are already comparatively large, and Northumbrian Water.
• There is considerable uncertainty about the scope for future efficiency. Ofwat's work shows that there are significant differences in costs between companies that are not explained by differences between operating environments. The estimates made in this paper for the evolution of bills after an initial price cut include the possibility of a significant degree of catch up by the higher cost companies.
• These estimates of future bills are based on expenditure of £8.5 billion on quality improvements, together with £8.0 to £9.1 billion of capital expenditure on capital maintenance, the supply/demand balance and service enhancement options. It has been assumed that the scope for efficiency savings in operating costs could vary between 2% and 4% a year. For capital expenditure, the average overall scope for efficiency is assumed to range between 10% and 15% over the five year period.
• The broad picture for each company is summarised in the tables below. Table 1 shows the potential for an initial price reduction. The ranges for the reductions shown overlap, reflecting the underlying ranges and uncertainty at the company level. Table 2 shows the possible outcome for bills in 2004-05, taking account of a quality programme of the order of £8.5 billion and other enhancement options proposed by companies. The changes in bills are in real terms, ie excluding the effects of inflation.  

Table 1: Possible initial reduction in expected average household bills from 1999-2000 to 2000-01
Up to 12.5%	10%-15%	12.5%-17.5%	15%-20%	Over 17.5%
Dee Valley Folkestone & Dover South Staffordshire	Thames Tendring Hundred Bournemouth & W Hants	North West Cambridge Portsmouth	Severn Trent South West Yorkshire Welsh Bristol North Surrey Sutton & East Surrey Three Valleys	Anglian Northumbrian Southern Wessex Essex & Suffolk Hartlepool Mid Kent Mid Southern & South East York

1 Possible changes in bills are in real terms, ie excluding the effects of inflation.

2 The bill estimates take account of the merger savings agreed at the time of the mergers for these companies.

 Key issues

 The issues on which the Director General of Water Services (the Director) would like to receive views from parties are as follows.

Profile of bills

• For many companies it is clear that bills would have to increase materially after a one-off reduction in 2000-01. Most companies are concerned that this pattern of bill changes could be confusing to customers. Ministers have asked the Director to consider these concerns in setting price limits. The initial reduction could be modified so that bills could be broadly stable over the five year period for which prices will be set. There are a number of business disadvantages to this approach, which are discussed in Chapter 8. In particular, it would mean that in the early years, companies could be earning rates of return that are higher than they need to finance their functions; this may weaken incentives to seek efficiencies. Yet by 2004-05, companies could be earning rates of return below the cost of capital, implying the need for a significant increase in price limits for 2005-06 at the next price review. Furthermore, customers would be paying in advance for improved services.

• The regulatory regime should provide incentives for companies to improve both efficiency and service to customers and the environment. In particular, companies which are more efficient and which have higher standards of performance should benefit at the price review compared with those that are less efficient or have lower standards.

 In order to promote good service to customers and discourage cost cutting at the expense of service quality, the Director intends to adjust price limits to reflect companies' relative overall performance on delivering service to customers and the environment. His initial view was that such an adjustment might be in the range of +0.5% on bills. In the light of consultation, he now considers that this adjustment should be larger for poor-performing companies, perhaps –1.0%. He welcomes views on what is the right scale and whether the adjustment should be symmetrical.

 The figures in this paper do not include any adjustments for outperformance and service provision.

Final decisions by Ministers on future water quality and environmental standards for individual companies

• The prospect for prices varies at a company level. In some cases, the effect of future environmental standards could mean real increases, over and above current bill levels. For others, it could mean that there is little or no scope for permanently lower bills. Ministers have recognised that final decisions on the scope of critical programmes for individual companies should take account of this and wish to avoid unacceptable impacts on water prices in different parts of England and Wales. The Customer Service Committees (CSCs) and customer groups will want to make their views clear. It is also important to consider the difficulties that some customers already face in paying bills, let alone coping with further increases to meet higher quality and environmental standards.

• Companies forecast that customers' demand for water should fall, yet at the same time estimate the need to invest a further £2.2 billion capital expenditure on balancing supply and demand for water (including enhancing security of supply and sustainability). Some of this investment includes expenditure on the connection of new customers (which will be offset by infrastructure charges, other capital contributions from developers and a proportion of the additional revenues from those customers), and some on measures to manage demand, including the provision of meters. The Director recognises that there may also be a case for expenditure where contractions in reliable yields could jeopardise companies' current levels of service or where companies' current security of supply is inadequate.

 Ofwat's current assessment is that roughly only half of the companies' estimate for capital expenditure (ie around £1 billion) is necessary to balance the supply and demand for water (including enhancing security of supply and sustainability).

The Government's charging proposals

• The implementation of the Government's proposals on charging could have an impact on all customers' bills and could lead to increases in bills for some customers. In particular, a universal right to opt for a meter at no cost could lead to increases in bills for customers who remain on an unmeasured charging basis.

• Companies propose expenditure of nearly £1 billion for enhancements to services, based on their assessment of customers' priorities. The Director will need to decide the extent to which these proposals should be financed from future price limits or from future efficiency. At an industry level, this could add between £2 and £3 to average household bills by 2004-05. However, this varies between companies. For some companies the impact on bills is negligible, but for a few companies this could have a material effect on bills. The Director invites views on the priority to be given to these proposals having regard to the outlook for bills for each company as set out in this paper.

• The cost of capital is a major factor in the water industry because of the need to finance the large investment programme. In order to borrow, it is necessary for companies to meet critical financial indicators, especially interest cover. Although companies need to make reasonable returns in order to finance the proper carrying out of their functions, the Director does not interpret his duty in this respect as requiring the cost of capital to set a floor on companies' returns under all foreseeable circumstances. As in competitive markets, inadequate management or unexpected shocks may mean that, in a particular year, a company earns less than its cost of capital. He welcomes views on this.

The Director's initial assessment of the weighted average cost of capital for all but the smallest independent water companies is 4.0% to 5.5% in real terms after business taxes. This compares with a range of 5.0% to 6.0% used in the 1994 Periodic Review.

His assessment, which is based upon wide consultation in the financial markets and advice from his City advisers, is lower principally because of market changes since 1994. These include the fall in real interest rates; the market's evolving views of the premium required to invest in equities; and the higher levels of gearing that are sustainable by utilities.

There remain uncertainties. The effect of the recent global market turbulence, particularly on the cost of equity, is unclear and difficult to quantify. In addition, there are differing views on the risk of investing in water companies and the impact of the recent changes to the imputation tax system. A further uncertainty for the small independent water companies is the need for, and size of, any premium on the cost of capital.

Because of these uncertainties, a cautious approach has been taken on the cost of capital used to assess the bill effects set out in this paper. A figure of 5.25% has been used for all but the smallest companies, which is towards the top end of the Director's proposed range. If a lower figure were used, the initial reduction in prices could be higher. A one point percentage change is estimated to change bills by about £8.50.

The Director seeks views on these uncertainties before making his final assessment on the cost of capital for the draft and final determinations. Until then, the Director will keep under close review any market evidence of trends in the cost of capital and appropriate financial indicators.

Issues for consultation

The Director invites views on the key issues raised in this paper. In particular, he seeks comments on the following:

The profile of bills

• Should prices fall initially to the point where returns do not exceed the cost of capital (subject to any adjustments for incentives and past service performance)? 
• If the combination of an initial price reduction and the costs of new environmental and quality obligations were to push bills up subsequently, would it be right to preserve a flatter profile of prices, leaving companies with greater revenues and profits in the early years? 

•  Is it right to expect companies judged by the Director to be relatively inefficient to improve their efficiency at a faster rate than the more efficient ones? Should this mechanism be more powerful than in the 1994 Periodic Review?
• Is it right to leave those companies which have outperformed the Director's assumptions and are considered to be more efficient, some of the benefits of outperformance beyond the price review by an adjustment to the initial price reduction?
• Should the price limits be adjusted asymmetrically for past performance on services to customers and the environment, within a range +0.5% to –1.0% per year? 

• In competitive markets, inadequate management or unexpected shocks may mean that, in a particular year, a company earns less than its cost of capital. In the water industry, should price limits be set such that the cost of capital is a floor for companies' returns in all foreseeable circumstances?
• Is there a need for, and if so what is the size of, any premium on the cost of capital for small independent water companies? 

• Is the Director right to focus on the serviceability of a water company's assets, leaving the company's management to ensure that the condition of the assets is sufficient to secure serviceability to customers?

• Is it right to allow for some increases in customers' bills to cover the costs of demand management, especially the installation of meters? 
• Should companies develop tariffs to ensure that those imposing increases in demand, particularly at peak times, provide the revenue necessary to secure the additional resources required, rather than increasing the margin between supply and demand at the expense of all customers? 
• Is it right to increase customers' bills to allow for expenditure to reduce the frequency of emergency abstractions from rivers and streams where the benefits are clearly cost-effective? 

• What priority should be given to improvements in service, such as reductions in sewer flooding, where these would have to be financed through higher bills from customers?

• Is it right to limit further environmental improvements beyond what has so far been clearly defined (including EC obligations), so that bills do not rise excessively in some areas? 

• The Director looks to the companies to review, together with the CSCs and the EA regions, the evidence of customers' views that are relevant to future decisions on the final scope of environmental programmes and other service enhancement options; and to carry out such further consultation as may be necessary. 
• Interested parties should submit their views to the Director on the issues raised in this paper. Ofwat will publish a summary of responses in January 1999. 
• The Director will hold formal meetings with companies in January and February 1999 to consider issues specific to each company, including responses to the paper. 
• The companies will be updating their estimated costs of delivering the proposed quality enhancements in December. The Director and the EA will give advice to Ministers in January 1999, following analysis of these submissions. Ministers will then take decisions on outstanding quality enhancement issues. Each company will then incorporate the programmes in its Business Plan. 
• In the light of the above, companies will finalise their Business Plans to be submitted to the Director in April 1999. 
• The Director will then make his final assessments of the scope for future efficiency, the cost of capital, the adjustment for service performance and the level of capital investment required to meet outputs, before publishing the draft determinations of price limits in July 1999.

 In Setting price limits for water and sewerage services, published in February 1998, the Director set out his objectives for the review process. A key objective is to operate in an open and transparent way. This involves a phased process which allows timely debate of the issues and permits all interested parties to contribute. The first phase, which is concerned with developing the framework and exposing the issues, is completed with the publication of this paper.

Setting price limits for water and sewerage services confirmed the broad methodology which the Director would follow in setting price limits. Prospects for Prices is concerned with the issues surrounding decisions that have to be made about the standards of services for customers and the environmental improvements that the companies should provide in the years 2000 to 2005. It also looks at the revenue required to finance those functions and the consequent implications for bills.

Decisions on the future legal framework governing the quality obligations of the companies are made by the Secretaries of State for the Environment, Transport and the Regions and for Wales (Ministers). Ministers provided guidance in Raising the quality, published on 23 September 1998. This leaves open a number of detailed decisions yet to be made on the timing and extent of improvements for individual companies in respect of a number of significant environmental programmes.

There are still uncertainties in a number of crucial areas. Prospects for Prices sets out the strategic issues and the process for deciding those uncertainties in the lead up to the draft determinations in July 1999. To enable informed debate on all of these issues, this paper sets out, for the first time in the process, ranges of possible bills for household customers of each company for the period 2000-05.

Objectives

The specific objectives of the paper are to:

• Set the stage so that all the stakeholders can submit informed views to the Director on the issues and choices. 
• Assist Ministers to finalise decisions on future quality obligations for individual companies in time for companies to take account of them in their Business Plans to be submitted to the Director in April 1999. 
• Provide a basis for further work between Ofwat and the companies. The outcome of this should inform the companies' Business Plans, as well as the Director's draft determinations of price limits later in July 1999.

 The paper brings together the various strands of work since the Director announced the review of price limits in October 1996. These are summarised below.

 Ofwat's work on costs, performance and efficiency

 In March and April 1998 respectively, the Director published two technical papers: Assessing companies' overall performance in delivering services to customers and Assessing the scope for future improvements in water company efficiency.

Since then, the companies have submitted their 1997-98 July Returns and Regulatory Accounts, as well as specific information returns for the Periodic Review in respect of the supply/demand balance; the cost base; and asset inventory and system performance. They have also commented on the two technical papers.  

The quality framework  

Future water and environmental standards have crucial implications for future price limits. Decisions on these are not made by the Director, but are matters for Ministers. In April 1998 the Director asked them, in an open letter, Setting the quality framework, for guidance on nine key areas which may have a significant influence on price limits. In the open letter, the Director set out a range of the possible costs of new quality obligations based on information provided to him by the companies. On 23 September 1998, Ministers provided both detailed and general guidance to the Director in Raising the quality.

 Companies' preferred strategies

During 1998, companies have been consulting customers, primarily through customer surveys, on future priorities. In August, companies reported to Ofwat on the outcome of this work and outlined their preferred strategies for 2000-05 across the range of services, together with their provisional estimates of the costs of implementing these strategies.

The CSCs, which were involved in the consultation process, have reported separately to the Director with their views on how well these strategies meet customers' requirements.

Other evidence of customers' views

During 1998 a number of organisations, including Water UK, the Department of the Environment, Transport and the Regions (DETR), the Ofwat National Customer Council (ONCC) and the Consumers' Association, have conducted national customer surveys. The results of these will help to inform the decisions that have to be taken.

Environmental priorities

In May 1998, the EA published A price worth paying, which recommended to Ministers an environmental improvement action plan to be carried out by 2005. The EA's proposals had been informed by the results of work undertaken to gain an understanding of the issues of concern at local, regional and national levels. This work included market research in late 1997 to establish water customers' priorities, and a consultation exercise was launched with the publication of Outlook for the environment in January 1998.

More recently, the EA has been engaged in assessing the relative benefits of potential schemes so that prioritised lists can be drawn up at a company level.

Structure of the paper

Decisions on price limits have to recognise customers' experiences over the last ten years, a period characterised by continual price increases but also one in which companies have made significant improvements in services. Chapter 3 sets the context in which the issues and choices for the 1999 Periodic Review should be considered.

Chapter 4 assesses the evidence of customers' priorities as regards both possible enhancements to services and future prices. Chapter 5 summarises the companies' current views on what they see as their preferred strategies to meet customers' priorities. Chapter 6 considers the position on future water and environmental quality obligations in the light of Ministers' decisions in Raising the quality.

At this stage, the prospect for future bills is still uncertain and can only be expressed as a range. Ministers still have to make final decisions on quality obligations for individual companies. The companies have still to finalise and submit their Business Plans. The Director has yet to make final decisions on crucial elements such as the scope for future efficiency, required expenditure to maintain serviceability to customers and the cost of capital (which is more fully discussed in Appendix B of this paper). Also, final decisions will take into account companies' performance in 1998-99.

It is against this background that a preliminary indication of future bills by 2004-05 and the scope for a reduction in bills in the first year of the new price limits is set out in Chapter 7. This provides a basis for consideration in Chapter 8 of matters yet to be decided, and on which views are sought.

The paper concentrates on the national picture. The position at the company level, however, will vary significantly. This is true of existing bills, the scope for reducing them and the impact of Ministers' decisions on future quality obligations. The issues within each area vary depending on local circumstances, and customers' priorities will reflect these differences. The Government would like to see some reduction in this variation and this is one of the issues to be addressed in the price review.

The position for each company is summarised in Appendix A of this report (Cholderton Water is an exceptionally small company and is not included in this paper, but will be subject to revised price limits).

3. THE STARTING POSITION

Context

In 1989, the water industry was seen as suffering from a lack of investment. Requirements on companies for higher statutory standards of water quality and sewage treatment could only be met with additional capital investment. The consequence has been continual increases, above inflation, in bills for the majority of customers throughout the period since 1989-90. The following sections summarise what has been achieved and the impact on bills for customers.

Improved services

Water quality

Since privatisation in 1989, companies have carried out an extensive two-pronged improvement programme:

• To improve water treatment works to meet all the requirements of the EC Drinking Water Directive. 
• A longer term programme to rehabilitate water distribution mains in order to improve the aesthetic qualities of water received by customers, as well as complying with the water quality regulations. Since 1991, more than 10% of the mains distribution system has been relined or replaced.

The environment

 Since privatisation, an unprecedented level of capital investment in the sewerage service has produced considerable environmental benefits. In the first five years, investment in quality was principally driven by two improvement programmes:

• Improvements to 1,900 sewage treatment works which were either experiencing regular difficulty in complying with consent conditions or where forecast population growth was expected to jeopardise regular compliance. The improvements were carried out as part of the Control of Pollution Act II (COPA II) compliance programme. 
• Schemes to improve the quality of bathing waters to meet EC mandatory standards.

The EA has reported that results covering the period 1995-97 show that, since 1990, there has been a net improvement in chemical quality in 21% of the total length of rivers in England and Wales.

 Figure 1: Water quality performance – 1990 to 1997

Several major rivers have benefited from the clean-up programmes. The Trent, for example, is now considered suitable as a raw water source for potable supplies. Further improvements can be expected by the year 2000.

 In 1989, 76% of designated bathing waters in England and Wales complied with the EC mandatory coliform standards. By 1997, compliance with mandatory standards had improved to 89%, and 37% of designated beaches met guideline standards. Water quality in our estuaries has also improved.

 Current investment is mainly driven by the EC Urban Waste Water Treatment Directive (UWWTD). The benefits to the environment will largely be experienced during the next few years as programmes are completed. These include:

• The provision for the first time of primary treatment for nearly 150 continuous discharges to coastal waters serving a population equivalent of seven million. 
• The provision for the first time of secondary treatment for over 350 continuous discharges to estuarial water, serving a population equivalent of 15 million. 
• The upgrading of 600 sewage treatment works discharging to freshwaters, serving a population equivalent of 19 million. 
• The upgrading of over 2,400 combined sewer overflows to reduce the environmental impact of their discharges. 

To date, expenditure on environmental improvements has been driven by a system of regulation that does not take account of differences between polluters in the costs of pollution reduction. The DETR has commissioned a study into the potential for economic instruments (either some form of charge or a system of tradable permits) to deliver environmental objectives in a cost effective way by exploiting differences in the costs of pollution control. The study has yet to be completed but the Director is supportive of measures to achieve environmental objectives at least cost. 

Maintaining the infrastructure

The maintenance of companies' capital assets is crucial in ensuring continuing delivery of services to their current and future customers. The Director assesses companies' plans for future maintenance of water and sewerage assets principally through an examination of trends in serviceability to customers of those assets. Serviceability has been maintained or improved for the majority of customers.

It appears that, generally, there has been no significant change in the amount of companies' assets in poor condition. For some companies, the programmes carried out to meet quality standards on certain assets have had a positive impact on the condition of those assets.

 Levels of service

 Service provided to customers has improved significantly for both water and sewerage since 1990-91 as shown in Figure 2. The key improvements are: 

• Companies maintained essential supplies during the prolonged periods of low rainfall since 1990, especially the 1995-96 drought. However, the need for restrictions in garden watering focused public attention on leakage levels. As a result, leakage has fallen across the industry from an estimated 5,100 megalitres per day (Ml/d) ( one million litres per day ) in 1994-95 to an estimated 4,000 Ml/d in 1997-98, that is by 7% of distribution input. Companies report that, taken with the investment to increase security of supplies, this has reduced the risk of supply restrictions.  
• Interruptions to supply and problems of low pressure have fallen significantly.  
• The number of houses most at risk of flooding from sewers has halved since 1990. Actual incidents of sewer flooding have fallen by around 35% since 1992. 

 Customer service

Customer care has improved substantially, with companies increasingly taking notice of customers' requirements, as shown in Figure 3. For example, companies' handling of contacts with customers, such as billing complaints, has improved significantly; the number of customers disconnected for non-payment of bills has declined substantially since 1990 and companies have introduced charitable trusts to assist customers who have difficulties in paying their bills.

Companies have also introduced a range of additional services. These have included: cheaper (or free) optional meters; longer opening hours for customer contacts; free or subsidised supply pipe repair or replacement; improved customer information, such as newsletters or magazines; and improved access to flexible, low-cost payment methods.

 Improving customer satisfaction

Customer satisfaction with the overall quality of the services provided by companies has increased, as shown by tracking surveys carried out on behalf of Water UK, the trade association for the industry. Customers, however, are less satisfied with the value for money of the services delivered.

Figure 2: Levels of service performance 1990-91 to 1997-98

Figure 3: Customer service performance 1990-91 to 1997-98

Cost of improvements

The level of capital investment has had to increase dramatically to secure the improvements identified above. This is illustrated in Figure 4, which shows capital investment since 1980. The total net capital investment (including capital maintenance expenditure) over the period 1990 to 2000 (ie since privatisation) is estimated to be almost £36 billion (in 1997-98 prices). This is equivalent to an increase in the average household customer's bill of approximately £85 (in 1997-98 prices) over the ten year period.

Customers' bills

Bills have not risen by the full cost of the net capital investment because of efficiency improvements made by companies.

The initial price limits were set in 1989 by Ministers. These assumed some improvements in efficiency, but a high return to shareholders. The Director reviewed these in 1994 on the basis of challenging efficiency assumptions and a lower estimate of the cost of capital. He also passed on to customers the efficiency savings made by companies up to 1992-93. While the overall rate of increase in bills slowed, customers' bills nevertheless continued to rise, primarily to finance the programme of water quality and environmental improvements.

Average household bills will have increased by over 40% in real terms by the year 2000 compared with 1989 (with the bulk of the increase - almost 30% - occurring in the period up to 1994-95).

This is shown in Figure 5 for water and sewerage separately and highlights the increase in average household bills from 1989 to 2000. The picture varies across the country. For South West Water, customers have seen their combined water and sewerage bills increase in real terms by 60%, on average, compared with 40% nationally, whereas customers in Anglian Water and Yorkshire Water have seen smaller increases of 27%, on average. Certain companies have, however, passed some efficiency savings to customers through cash rebates or by not raising prices to the full extent of their price limits.

In order to secure and maintain balanced tariffs between customers who pay on an unmeasured basis (ie those paying by reference to rateable values) and those who pay on a measured basis, the former group has tended to experience increases over this period that were slightly above the average, while measured customers have experienced a smaller increase.

Figure 4: Capital investment 1980-2000 (1997-98 prices)

Figure 5: Average household bills 1989-90 to 1999-2000

4. CUSTOMERS' VIEWS ON THE FUTURE

This chapter reviews the evidence of customers' views on future priorities and prices. It draws largely on a number of national surveys and companies' customer consultation work conducted during 1997 and 1998. The CSCs, which have generally been closely involved in this work, have reported on the companies' assessment of customers' views in their regions.

Companies' reports on the work that they have done, together with the CSCs' reports to the Director, are lodged in Ofwat's library. Some companies have stated that they will continue to consult with their customers to test the acceptability of their proposed packages of improvements and future bills.

Customer satisfaction

Generally there are high levels of satisfaction with current services, with some companies reporting 85% or more. This is in line with national research, which has shown increasing levels of customer satisfaction over recent years. There remain, however, a number of dissatisfied customers. Key reasons for dissatisfaction are concerns about security of supply, leakage levels and high bills. Customers do not cite environmental performance as a reason for dissatisfaction, which may reflect the poor understanding of companies' environmental responsibilities revealed by many of the surveys. Despite the improving levels of satisfaction, customers would appear to perceive a need for continued improvements for some services in almost every region.

Priorities for improvements

At a national level, the Water UK research concluded that leakage and maintaining reliability of supply were uppermost in customers' minds for improvement, together with minimising sewer flooding. The company-specific research has confirmed this, although priorities for service improvement vary across the regions. Leakage always features in the top three areas for improvement in over half of the companies. This is sometimes associated with reducing the incidence of hosepipe bans, but more generally is associated with maintaining a sound security of supply. In general, however, customers appear to give relatively low priority to reducing the frequency of hosepipe bans per se.

Customers place significant emphasis on maintaining and improving the quality of drinking water. This includes taste, discoloration and hardness issues, the replacement of lead pipes and reducing the risk from cryptosporidium.

Environmental issues, river and bathing water quality and low flow rivers are of importance to customers, but their relative priority, against some other service improvements, varies. Where specific, costed improvements are presented, they tend to be seen as less attractive. When set against other environmental issues, global warming and air pollution are perceived to be as important as protecting the water environment. Furthermore, in relation to other social issues (for example, health care or education), protecting the environment is generally afforded a lower priority.

Customer service improvements such as speeding up letter writing or answering telephone calls more quickly are not high among customers' priorities.

Where surveys gave respondents choice about the pace of improvements, results show that customers did not generally choose the most advanced improvements offered, particularly if this would increase the pressure on bills. For example, the DETR survey suggests that the aspirations of the majority of customers fall short of the full programmes that were considered in Setting the quality framework and in the EA's paper A price worth paying. The message seems, therefore, to be support for steadily paced improvements, but no more.

The balance between bills and services

The critical question remains as to whether customers are prepared to pay for their aspirations. In their attempts to ascertain the level of customers' willingness to pay, companies and others have used a variety of methods. One approach, which was used in some of the national surveys, was simply to ask customers whether they were willing to pay more on their annual bill to fund improvements to services. Where this approach was used, results are somewhat contradictory. Few companies have used this approach in their regional surveys.

Questions about willingness to pay tend to reveal more about customers' values than the decisions they would actually make when confronted with real choices. They also tell us little about customers' ability to pay. Moreover, when customers are asked who should pay for the improvements they have chosen, well over half indicate that householders should not have to pay. Customers consider that other bodies such as large industrial customers, businesses, farmers and the water companies themselves should pay for improvements.

The approach adopted in other national surveys and by most companies was to offer customers a variety of bill increases/reductions (above or below inflation), each associated with different levels of service and environmental improvements. This provides an indication of customers' views on the balance between future bills and service, albeit at a very broad level since the improvements were not quantified.

The Water UK results, at a national level, are set out in Table 3.

Table 3: Summary of results of Water UK's national survey of customers
Options presented to customers in the survey
Your bill goes up by more than inflation, but there are many major improvements in the water company's services and its contribution to the quality of the environment. Your bill goes up at the same rate as inflation and there are a few major improvements in the water company's services and its contribution to the quality of the environment. Your bill does not increase as fast as inflation, so you pay roughly the same amount of money as now, and you receive roughly the same service and the same contribution to the quality of the environment. You pay less than now, that is your bill falls even though inflation is going up, and the service you receive is reduced. Don't know. Note: Percentages have been rounded to nearest whole number.	13% 44% 39% 4% 1%

Where companies adopted this approach, the results were generally consistent, with some companies finding stronger support for stable prices or prices "marginally above inflation".

An alternative approach asked respondents to allocate efficiency savings already achieved between improvements and bill reductions. The national Water UK survey results indicate that, on average, customers would like to see approximately half of possible efficiency savings used to reduce their bills. The larger the available saving, the larger the amount that they would want returned to them in cash. Regional research has confirmed this. There is some evidence that customers would not support more than £10 per annum per customer of any saving being reinvested in improvements to services or the environment.

Only broad conclusions can be drawn from either of these approaches since respondents were usually not presented with detailed and costed improvements that they could trade-off against specific bill reductions. This issue was tackled in a survey by Thames Water, where customers were offered a choice of a number of specific improvements with precise bill implications against possible bill reductions. Thames Water, which has a relatively affluent customer base and low current bills, found that, on average, customers would prefer to see most (90%) of a potential £10 bill reduction spent on improvements they wanted. But when offered a £20 reduction, its survey showed that customers would prefer to see the extra £10 returned to them in the form of bill reductions, rather than invested to provide further service improvements.

The profile of bills over the period 2000-05

In their surveys, the companies explored customers' views about bills falling in 2000-01 but then, in subsequent years, increasing in real terms. The results suggest that, given a choice, customers prefer a small reduction and stable bills thereafter, rather than large reductions followed by increases.

Low income customers

The Director emphasised to companies that they should ensure that the views of customers on low incomes were gathered during the customer consultation process. In-depth interviews or specific surveys with customers on low incomes have been undertaken by some companies. The results would seem to show that, in terms of priorities for improvements, low income customers have similar priorities to the rest of the customer base. There is less willingness to pay for improvements, but the difference is not that marked.

Research commissioned by the ONCC suggests that low income customers might be much more concerned to see bills reduced rather than further improvements in services. This may be because the issues were explored in the context of the household budget and the affordability of water bills.

There is an acknowledgement among the water companies, however, that willingness to pay does not always reflect the ability to do so. Some companies say that problems of affordability should be resolved through the social security system or through charging and tariff policies. Although it would not be appropriate to base the price-setting process on the ability of those on low incomes to pay water bills, the Director is concerned that the views of these customers are taken into account.

Business customers

Generally, business customers have shown that their priorities lie in areas which would directly affect their businesses - interruptions to supply, pressure and water quality. They place more emphasis on customer contact and information than domestic customers do.

Although business customers are generally less willing to pay for improvements in areas which might be classed as part of the water companies' basic services, they have shown some willingness to pay for environmental improvements.

Companies' views of findings

Companies have generally concluded that customers want improvements in services in specified areas, provided bills remain stable in real terms. A few companies believe that customers would support modest real price increases. The companies have concluded, therefore, that there is little or no support for an initial one-off reduction in prices and that the scope for improvements should generally be determined by the scale of past and future efficiency savings.

The views of the CSCs

The CSCs have submitted reports to the Director with their assessment of customers' views and the extent to which they consider companies have reflected these views in their preferred strategies. They have also undertaken work of their own to establish customers' views, which are summarised in their reports. Some have carried out surveys of customers, articles have been placed in the local press or water company magazines, and complaint trends have been analysed to obtain a feel for customers' priorities in each region.

It was the Director's intention that companies should involve the CSCs closely in their customer consultation processes. With the exception of Mid Kent Water, Portsmouth Water and Severn Trent Water, the CSCs report general satisfaction with the way they were involved and consulted. They feel that their comments and suggestions were taken properly into account. The CSCs also consider that much of the companies' research work was of a good quality, especially that carried out by the water and sewerage companies.

CSCs broadly support the conclusions from the research about customers' priorities for service and/or environmental improvements. They report that these are consistent with their own findings. Some CSCs, however, point out that customers' views vary and that the level of support for individual improvements does not always extend to a majority of customers.

In general, CSCs consider that the priorities for investment set out in companies' preferred strategies are consistent with their assessment of customers' priorities. CSCs have commented in their reports, however, where they consider that specific elements cannot, in their view, be sustained on the evidence so far of customers' views. This is particularly the case for a number of companies that propose investment to reduce the frequency of hosepipe bans.

CSCs are less confident that companies have interpreted properly the evidence of customers' views on the overall balance between service improvements and future bills. The CSCs have endorsed the conclusions of most companies that customers do not want bills to increase, but consider that companies did not consult customers fully on the issue of possible price reductions. Eastern and Wessex CSCs both note that the realistic option of a one-off reduction in prices followed by stable prices, together with continued improvements, was not an option offered to customers. The CSC for Wales considers that the evidence, in its region, pointed strongly to the majority of customers wanting lower bills as an overriding priority. CSCs were critical of the way options for lower prices or a one-off reduction in prices were associated with either negligible improvements to services (or even deteriorating services) and/or subsequent increases in bills.

The CSCs' own consultation work, which they acknowledge is not as robust as fully structured sample surveys, leads them to the conclusion that companies' strategies should include an initial reduction in price. Eastern CSC, for example, concludes that: "when customers understand that returning efficiency savings to them will not jeopardise levels of service, a significant majority want to see the benefits in lower bills".

5. COMPANIES' PREFERRED STRATEGIES

Companies were asked to provide the Director with their preferred strategies for services and prices for the period 2000-05 which best meet the needs of their customers. Companies were asked to identify any key choices or options as well as uncertainties that could affect their preferred strategies.

The purpose of these submissions was threefold:

• To enable the Director to expose in this paper the strategic issues, at a national and regional level, on balancing needs and priorities for enhanced services and improvements to the environment with prices acceptable to customers. 
• To help expose material issues for discussion between each company and the Director during the period prior to the companies finalising their Business Plans in April 1999.
• To allow customers to see the development of companies' thinking on future services and bills, and provide a basis for further consultation at a regional level, by both companies and CSCs, in the light of this paper. 

 Status of the companies' preferred strategies

The companies have varied in their degree of commitment to the strategies set out in their submissions, and it is not clear whether these have always been endorsed by their Boards. Some have formed a clear view of the strategy for services and prices which they would like to deliver over the period 2000-05. These are based on a careful assessment of what they see as their customers' priorities, and of the costs of meeting those priorities.

Others have not been able to do so and have presented their submissions as more a basis for discussion both with the Director and the quality regulators, and for further customer consultation work. Typically, these make no reference to bills. Two companies (Anglian Water and North West Water) have each set out alternative strategies rather than a single strategy.

All companies identify two important areas of uncertainty where future decisions could cause them to alter their strategies. These are as follows.

• At the time of preparing their submissions, Ministers had not provided guidance on future environmental and quality obligations. This uncertainty affected strategies for sewerage services in particular.  
• A belief that the Government's proposals on water charging published in April 1998 could have a significant impact on costs and revenues; in particular, the proposal to give all customers the right to have a meter installed free of charge. Some companies have assumed that the proposals will become law and taken full account of them; others have not. A number of companies anticipate increases in bad debt if the proposal to ban disconnections for non-payment is implemented.

Companies' approach to their strategies

Most companies report that customers want improvements in services and the environment, and that while they generally do not want prices to increase in real terms, the majority would be prepared for bills to remain stable, with past and future efficiency savings being used to finance improvements, rather than being used to reduce bills. A few companies suggest that a majority of customers would accept small real increases in bills to secure the improvements they want. The companies generally conclude, therefore, that there is no support for an initial reduction in bills, especially if this means that bills subsequently have to rise in order to finance the improvements to services and the environment that they believe should be delivered by 2005. Very few companies have specifically mentioned the possibility of a one-off reduction in prices.

Companies have, therefore, considered customers' priorities for service improvements within a framework of broadly stable prices. In general, although there are exceptions, they conclude the following: 

• Maintaining or enhancing security of supplies linked to controlling leakage is a high priority. 
• Meeting future obligations on drinking water quality is important. 
• The full environmental programme, which the companies were asked to cost in February 1998, either cannot be afforded within a regime of stable prices and/or is not supported by customers. 
• Other priorities, which vary from region to region, are, in some cases, as important to customers as environmental improvements. These include improving the taste and appearance of tap water; reducing (or eliminating) house flooding from sewers; enhancing measures to reduce the risk from cryptosporidium; maintaining the policy of free supply pipe repairs; and reducing the frequency of hosepipe bans. 
• Expenditure required to maintain their assets in a satisfactory condition should increase from the levels assumed in current price limits.  

The companies have supplied the Director with their estimates of the costs of implementing their strategies to meet customer priorities. In addition to the uncertainties referred to above, most companies emphasise that their estimates of future costs are subject to further review, prior to finalising their Business Plans. Some have developed preferred strategies on the basis of a careful review of costs and made explicit their current estimate of further efficiencies, while others have said that they have yet to review some aspects of their costs. Consequently, their current estimates of the future expenditure needed to implement elements of their plans could be subject to considerable change.

Very few companies have made explicit the financial assumptions, in particular the cost of capital, which they have used to assess the acceptability of their preferred strategies for customers. A number have, nevertheless, emphasised the importance of decisions on these matters when finalising their strategies.

Price implications of the companies' future expenditure and revenue estimates

On the basis of the cost estimates and revenue forecasts submitted by the companies, and without making any adjustments to these, Ofwat has examined the implication for future prices, assuming a post-tax cost of capital of 5.25% (and 6.0% for smaller companies).

At an industry level, the expenditure estimates imply that there could be a small reduction in 2000-01 of around 4%, but thereafter bills would have to increase so that by 2004-05 they would be 10% higher than bills in 1999-2000 (in real terms).

The main factors influencing the change in bills are that:

• some companies have forecast significant increases in operating expenditure associated with business rates, increases in bad debts, leakage control and growth in demand; 
• some companies have forecast significantly higher levels of capital maintenance expenditure, both for underground and surface assets. 

As indicated earlier, companies drew up their preferred strategies before Ministers published Raising the quality. In drawing up their strategies, companies generally attempted to anticipate Ministers' decisions, although some companies made a judgement about how the potential scope for future quality was compatible with their customers' concerns about bills. Companies will now need to review their strategies in the light of the guidance received so far. The guidance is considered in Chapter 6.

6. QUALITY AND MINISTERS' GUIDANCE

The 1994 price limits were set for ten years and allowed for a substantial and continuing quality enhancement programme decided by the then Ministers until 2005. The main work in the period 2000-05 assumed a continuation of programmes to improve distribution mains for the water service and completion of the smaller schemes for the UWWTD, which required investment after the year 2000 in order to meet compliance dates. The 1994 price limits assumed that approximately 40% of the capital investment for the total water programme and approximately 25% of the sewerage programme would remain to be completed in 2000-05.

There have been subsequent adjustments to the confirmed programme of obligations which will need to be reflected in the new price limits for 2000-05. In one company, these changes were significant enough for it to seek an interim determination of price limits before the year 2000. However, the companies are, generally, becoming more efficient and this has enabled the programme of obligations to be implemented for less than was originally assumed. More significantly, the evolving estimates of the costs have fallen in the light of the solutions developed by companies to some of the quality problems.

 Ministers' decisions on future quality obligations

In Raising the quality, Ministers have set out their expectations for the quality enhancement programme after the year 2000. They estimate that the proposed programme represents investment of £8.0-£8.5 billion over the five year period.

The guidance to the Director provides for the following principal improvements which would either be additional to those needed to comply with existing requirements, or involve an acceleration of agreed improvement programmes.

 Water service

•  The acceleration of companies' mains rehabilitation programmes so that the current programme is completed by 2010, rather than by 2015 as was originally assumed. 
• The commencement of the programme of lead communication pipe replacement on a broadly even profile from 2000 to achieve the new standard set in the revised Drinking Water Directive by the statutory deadline of 2013, as well as meeting the interim standard by 2003. 
• Schemes to address deterioration in raw water quality. These would need to be supported technically by the DWI before they could be considered as a requirement that needs to be taken account of in price limits. 
• Schemes to reduce the risk from cryptosporidium. Companies will need to demonstrate to the DWI's satisfaction that there is a specific additional risk, or an unacceptable risk of contamination of a water source, and that existing treatment is not effective in removing cryptosporidium before additional expenditure could be considered for inclusion in price limits. The group of experts established under Professor Ian Bouchier is expected to issue  recommendations in the near future. If recommendations from the group suggest that additional safeguards should be required, then the DWI would issue advice to companies on the measures that may need to be taken. 
• Schemes identified by the EA as being required to protect Sites of Special Scientific Interest (SSSIs) and other sites covered by the Habitats Directive where the proposed remedial action is based on agreed evidence demonstrating that abstraction or effluent discharge is the cause of specified damage. 

• Raising bathing water quality where the performance levels expected to result from currently planned investment to 2005 are not acceptable. Ministers are looking to achieve at least 97% compliance with mandatory coliform bacteria standards and a significant improvement in compliance with the guideline standards of the Bathing Water Directive in order for beaches to gain blue flag status.
• An acceleration of the combined sewer overflow (CSO) improvement programme so that at least two-thirds of intermittent discharges which remain unsatisfactory in 2000 are remedied by 2005.
• The removal of high natural dispersion area (HNDA) status from all receiving waters so designated in 1994, thereby confirming the requirement for all significant coastal discharges to be provided with secondary treatment. 
• The implementation of a significant programme to maintain and improve the quality of rivers and significantly raise compliance with river quality objectives (RQOs) above the current level of 82%. 
• Phasing out the use of untreated sewage sludge on agricultural land by the end of 2001 and requiring advanced treatment prior to application to fields in certain circumstances.

For other aspects, accounting for the remainder of the estimated £8.5 billion total programme, there is still uncertainty about the implications for individual companies since, at this stage, the guidance is based on broad expenditure assumptions at an industry level. These aspects of the programme are referred to as the "other quality requirements" for the purposes of the paper.

For the water service, the main area of uncertainty concerns schemes to address deterioration in raw water quality, the risk from cryptosporidium and the extent of lead communication pipe replacement to meet the new standard. Companies have identified schemes, but each will need to be considered and supported as necessary by the DWI. At this stage, therefore, the scope of the work required by each company is not known.

For the sewerage service, the main areas of uncertainty are as follows.

• The extent of the regional programme of work on continuous and intermittent discharges to raise bathing water quality and to secure improved compliance with guideline standards. 
• The extent of the regional programme of work on intermittent discharges from the sewerage system to reduce the environmental problems which these can cause. 
• The extent of the regional programme of work to achieve satisfactory progress on improved compliance with the RQOs set in 1989. 

Uncertainties about the costs of delivering the proposed quality enhancement programme

Ministers have estimated that the cost of the proposed quality enhancement programmes would be between £8.0 and £8.5 billion over the five year period from 2000-2005. They have stated that the range of costs was a material factor in making their decisions on the rate of progress for improvements. Their estimates were drawn mainly from the Director's open letter Setting the quality framework (April 1998) and, in particular, the challenged costs which the Director reported in that paper. This represents a continuation of the significant levels of capital investment (including capital maintenance, supply/demand balance expenditure and expenditure on service enhancement options) made by companies since privatisation, as shown in Figure 6.

There is still significant uncertainty about the likely costs of delivering the proposed programme of improvements. The key reasons for this uncertainty are as follows.

• The challenged costs included in the open letter reflected broad aggregate judgements which took account of both the scope of work needed to meet potential obligations and assumptions about the improvements in efficiency which could be made. These judgements were based on the limited information available at that time and, on the basis of recent submissions on capital unit costs, may be optimistic. 
• Since April, a number of companies have improved the models which they use to estimate the investment required to meet new quality standards. This process of refinement will continue through the update of the costs of quality costing enhancements submission (in December 1998) and the submission of companies' Business Plans.

The guidance from Ministers has confirmed that the scope of work necessary to meet individual obligations is likely to be more than the Director assumed as the minimum required to meet the obligations set out in the open letter.

Overall the £8.0-£8.5 billion represents a realistic lower band of what the total quality programme might cost. The final programme may be more expensive if the robust challenge to companies cannot be sustained, or, at an individual company level, the scope of the work required is increased.

There is now considerable work to do by all parties to identify those improvements that offer the best value for money within the constraints of the £8.0-£8.5 billion total programme for 2000–2005. The timetable for the Periodic Review requires the overall quality enhancement programmes to be confirmed by Ministers in late February or early March 1999. The Director, the EA and DWI, together with the companies and their Reporters, will all be working to prepare a robust basis for these decisions early in the New Year.

For a number of companies, these decisions could have a large influence on future bills. For some companies, there is a conflict between lower bills and meeting environmental aspirations - a conflict which is recognised by Ministers. This issue is considered further in Chapter 8.

The Director will allow for future investment within price limits where it is necessary to meet new obligations whose timing and means of attainment are clear. If it is not possible to define the outputs or delivery dates, such work will have to be considered at a later date when critical information is available. This could be at the next Periodic Review or, possibly, if the costs are material, at an interim determination.

7. PROSPECTS FOR PRICES IN 2000-05

In Setting price limits for water and sewerage services, the Director confirmed that he wished to ensure that some of the improvements in efficiencies achieved by companies are passed on to customers in 2000-01 through an initial reduction in prices (P₀). This would reflect a competitive market. Ministers have also indicated that they would like to see prices fall. It is important for customers to see that, in a price cap regime of regulation, incentives work to their advantage, and not merely to the significant advantage of shareholders. Thereafter, all companies can be expected to become more efficient but the extent will depend on the relative efficiency of each company, compared with the best.

Without new quality obligations, customers could expect prices to fall in real terms throughout the period of the revised price limits. Existing commitments to higher quality standards, however, will create upward pressure on prices, and Ministers' recent decisions on further improvements in quality standards will add significantly to these pressures. In addition, maintaining the balance between supply and demand could require some additional investment, and the Government's proposals in respect of water charging will have implications for costs and revenues. Finally, the options put forward by companies for enhancing services would add further to bills.

At this stage, there is still considerable uncertainty associated with most of the above factors, as well as other issues which will impact on bills. Accordingly, the prospects for prices through to 2004-05 in this paper are set out in a range, reflecting the fact that the Director's determinations of price limits will need to be made in the light of: 

• his decisions on the scope for future efficiency;
• his judgement of the expenditure necessary to maintain the serviceability for customers of companies' assets, both surface assets and the infrastructure network;
• final decisions by Ministers on higher quality and environmental standards and the Director's judgement on the necessary costs of meeting them;
• his decisions on the costs of maintaining an appropriate balance between supply and demand;
• his decisions on the cost of enhancing services to customers and the priority of such enhancements;
• decisions by the Government on its charging proposals; and
• the Director's decisions on financial issues, particularly the cost of capital.

So that these issues can be considered in context, this chapter sets out the possible range of changes to household customers' bills over the period 2000-05. There are three elements to this.

• Prices in 2000-01, the first year of revised price limits, when bills could be reduced below 1999-2000 levels. 
• Prices by 2004-05, that is prices needed to maintain existing services and meet the clearly defined quality standards as set out by Ministers in their recent guidance to the Director. 
• Prices by 2004-05, including meeting all of the future quality standards set out by Ministers including those which they have yet to decide at the company level (ie the clearly defined quality standards plus the other quality requirements), together with any enhancement options indicated in companies' preferred strategies.

The Director's estimates for average household bills have been compiled using the principles and framework which were confirmed in Setting price limits for water and sewerage services. Further details are set out in Chapter 8. Given the degree of uncertainty in some areas, changes in assumptions could have a significant impact on the ranges of bills. In particular, a post-tax cost of capital of 5.25% is assumed for most companies (6.0% for small, independent water companies - Cambridge Water, Dee Valley Water, Portsmouth Water and York Waterworks).

 An initial reduction (P₀) in bills in 2000-01

The current regulatory regime creates strong incentives for companies to minimise their costs within price limits. At the 1994 Periodic Review, past outperformance in reducing costs was scheduled to be transferred to customers through a progressive reduction in the return on capital towards the cost of capital, over ten years from 1995 to 2005. The Director has argued that, generally, customers should benefit from this outperformance, hitherto enjoyed by shareholders, in an early reduction in prices. He also argues that customers, who have only seen increases in their combined water and sewerage bills since privatisation, should see direct evidence that the current regime operates in their long-term interests; and that companies do not continue to make returns that are significantly in excess of the cost of capital as a result of factors unrelated to further improvements in efficiency.

Where companies have already shared outperformance with customers through rebates or reductions in price limits, these will be taken into account in the assessment of the size of the initial reduction.

Possible scope for P₀ in 2000-01

The scope for an initial price reduction in 2000-01 could be significant because it comprises not only the past outperformance up to the 1994 Periodic Review noted above, ie that scheduled in the 1994 price review to be transferred to customers during the period 2000-2005, but also the majority of the outperformance achieved by companies since 1995 as well.

Actual prices in 2000-01 will, of course, be influenced by assumptions about future efficiency for that year; capital investment needed to maintain companies' assets and to meet known commitments to higher quality standards; and the cost of capital. In addition, there remain uncertainties about a number of factors that will influence the scope for price reductions in 2000-01. These include: 

• companies' performance in 1998-99 and assumptions about performance in 1999-2000;
• the extent of capital investment up to and including 1999-2000 compared with that allowed in current price limits;
• the extent of metering and the consequent change in companies' revenues between now and 1999-2000 as a result of customers switching to metered tariffs.

On the basis of companies' reported performance up to 1997-98, the Director estimates that, at an industry level, the expected average household bills could be between 15% and 20% lower than in the previous year, 1999-2000. This means that the expected average household bill in 1999-2000 of £245 could fall, in real terms, by as much as £40 to £50.

The picture varies across the companies. Table 4 shows a possible range of reductions in average bills in 2000-01 for each company.

Table 4: Possible initial reduction in expected average household bills from 1999-2000 to 2000-01 (Possible changes in bills are in real terms , ie excluding the effects of inflation).
Up to 12.5%	10%-15%	12.5%-17.5%	15%-20%	Over 17.5%
Dee Valley Folkestone & Dover South Staffordshire	Thames Tendring Hundred Bournemouth & W Hants	North West Cambridge Portsmouth	Severn Trent South West Yorkshire Welsh Bristol North Surrey Sutton & East Surrey Three Valleys	Anglian Northumbrian Southern Wessex Essex & Suffolk Hartlepool Mid Kent Mid Southern & South East York

 Business customers

Many business customers have seen their bills come down relative to other customers as companies have introduced large user tariffs. The Director intends that from 1 April 2000, when the new price limits come into effect, large users (ie those using more than 250 Ml per year) will be outside the tariff basket, and not, therefore, subject to revised price limits. These tariffs should be based on a robust estimate of the continuing cost of supply (or long run marginal cost). Business customers remaining in the tariff basket could see an initial reduction.

 Prices by 2004-05

At this stage, the uncertainties in a number of areas (which are discussed more fully in Chapter 8) mean that only broad ranges for changes in bills can be set out.

Customers' bills need to reflect Ministers' guidance on the quality programmes as set out in Raising the quality. As explained in Chapter 6, the quality enhancements can be considered in two parts: the "clearly defined quality requirements" (of about £5.3 billion) and the "other quality requirements". The Director considers it appropriate to distinguish the impact on bills for each part separately.

 The impact of the clearly defined quality requirements programme

Taking account of uncertainties and assumptions about efficiency, capital maintenance, supply/demand and financing outlined in Chapter 8, the Director has estimated the broad impact on industry average household bills of the "clearly defined quality requirements" programme. After an initial price cut of between £40 and £50 in 2000-01, the industry average household bill would have to rise by between £4 and £18. The bill at 2004-05, therefore, could still be between £22 and £46 lower compared with the bill in 1999-2000.

The picture varies considerably for individual companies and is summarised in Table 5.

Table 5: Possible average household bills in 2000-05 compared with 1999-2000, taking account of the clearly defined quality programme of around £5.3 billion
Bills could remain well below the expected 1999-2000 bill	A small reduction compared with the expected 1999-2000 bill	Bills could remain around the expected 1999-2000 bill	An increase compared with the expected 1999-2000 bill
North West Severn Trent South West Thames Welsh Wessex Bournemouth & W Hants Bristol Cambridge Dee Valley Essex & Suffolk Hartlepool Mid Kent Mid Southern & South East North Surrey Portsmouth South Staffordshire Sutton & East Surrey Tendring Hundred Three Valleys	Anglian Yorkshire Folkestone & Dover	Northumbrian York	Southern

The impact of the other quality requirements and enhancement options

The additional impact of the other quality requirements on individual companies is uncertain, particularly for some companies, and will depend on decisions about the scope of the work required for each company, which have yet to be made. Even at an industry level, there is some uncertainty about the total costs. Using the Ministers' aggregate figure of £8.5 billion, however, the Director has estimated that these schemes might add a further £13 to £14 to the industry average bill in 2004-05 compared with the estimate of the industry average bill assuming only the clearly defined quality standards.

 In addition to the quality programmes, companies have proposed certain enhancement options. These are principally in respect of higher levels of service and sustainability of supply. At an industry level, these would account for between £3 and £5, in real terms, on the industry average household bill in 2004-05. For some companies, the impact from bills is negligible but for a few companies this could have a significant impact on bills by 2004-05.

The specific company position is, at this stage, very uncertain but Table 6 shows the broad impact for each company on the change in household bills from 1999-2000 to 2004-05, in real terms, for both the clearly defined quality standards and other quality programmes, together with the cost of companies' proposed enhancement options.

Table 6: Possible average household bills in 2004-05 compared with 1999-2000, taking account of the cost of full quality obligations thought to cost £8.5 billion plus other enhancement options. (Changes in bills are in real terms, ie excluding the effects of inflation).
Bills could remain well below the expected 1999-2000 bill	A small reduction compared with the expected 1999-2000 bill	Bills could remain around the expected 1999-2000 bill	An increase compared with the expected 1999-2000 bill
Severn Trent Thames Welsh Dee Valley Essex & Suffolk Hartlepool Mid Kent Mid Southern & South East North Surrey Portsmouth South Staffordshire Tendring Hundred Three Valleys	South West Wessex Bournemouth & W Hants Bristol Cambridge Sutton & East Surrey	Anglian North West Yorkshire Folkestone & Dover York	Northumbrian Southern

The overall movement for average household bills, at an industry level, from 1999-2000 to 2004-05 is summarised in Table 7. This shows that, at an industry level, average household bills in 2004-05 could be approximately £5 to £30 lower (2% to 12%) than in 1999-2000. These figures are shown in real terms and hence exclude increases due to inflation.

These are only broad estimates, at this stage, given the uncertainty in many areas as set out earlier.

Table 7: Possible changes in the estimated industry average household bill from 1999-2000 to 2004-05
Expected average household bill in 1999-2000 Initial reduction in bill in 2000-01 Increase between 2000-01 and 2004-05 assuming only the clearly defined quality standards Additional increase in bill between 2000-01 and 2004-05 assuming the other quality requirements and enhancement options	£ Range £ 245 to 245 (40) to (50) 16 to 4 19 to 16
Estimated average household bill at 2004-05	240 to 215

The change in average household bills since privatisation, including the broad estimates for 2000-01 and 2004-05, is shown in Figure 7. This shows the broad ranges of the impact on bills of the clearly defined quality programme and the other quality requirements and enhancement options separately.

 Figure 7: Average household bills 1989-90 to 2004-05

8. THE KEY ISSUES

This chapter sets out the key issues on which views are sought. Decisions on these issues could have a significant impact on price limits and bills.

The profile of bills

The profile of bills after 2000-01 is important and will vary between companies, primarily because of the differing quality programmes facing each of them. The future profile may also have implications for the scope of an initial reduction. The profile of bills and, hence, revenue will also impact on the returns and profits achieved by companies from year to year. Consequently, the incentives faced by companies to become more efficient will also be influenced by the profile of prices.

Two possible profiles of bills could be considered. The first is an initial price reduction which reflects past outperformance but then bills rise above the rate of inflation in the following years. This profile ensures that, for each year, companies' expected rates of return are no more than the cost of capital subject to satisfactory financial indicators, particularly interest cover. A second profile is a lower initial price reduction (compared with the first profile) but one which secures stable prices in real terms thereafter, again subject to satisfactory financial indicators. These profiles of bills are illustrated, at an industry level, in Figure 8 below.

In broad terms, the first profile should maintain a relatively even pattern of returns for companies. The second profile, however, will show a declining profile of returns, with higher than average returns in the early years and consequently lower than average returns in later periods. Each profile would provide companies with broadly the same revenues in net present value terms over the five year period. This is illustrated in Figure 9 below, which also shows the returns earned by companies since privatisation for comparison purposes.

The second profile has attractions because it is simple to explain. In practice, however, bills would only be broadly stable in real terms since they would increase each year because of inflation. Furthermore, bills would only be stable on average - different classes of customers would face different changes in bills.

The second profile would also allow companies to earn higher returns than necessary in earlier years. If it is considered that companies must earn at least the cost of capital in every year, they would earn returns above the cost of capital in all years. However, the Director is unlikely to interpret his duties in this way. A more likely scenario would be that companies earned the cost of capital on average over the quinquennium. This would imply that they would earn returns below the cost of capital in the later years. Thus, in either case, a company which was able to match the Director's demanding efficiency targets would still face a declining trend in profitability.

Furthermore, the second profile may increase regulatory risk since there would need to be a presumption that the regulator at the next review would allow the companies to restore their returns to the cost of capital.

Figure 8: Profile of average bills

Figure 9: Profile of post-tax rates of return

Although the second profile would seem to appeal to customers from the evidence of some customer surveys, it is equivalent to customers paying in advance for services. In real life, that is rarely seen as an attractive idea.

Over the whole quinquennium, it may be that the profiles have similar incentive properties but, in practice, the first profile is likely to carry the greater incentives for companies to outperform. It would also better reflect competitive market situations where an event triggers a one-off change to which companies would adjust quickly, rather than its effects being diluted over a five year period.

Ministers are concerned that customers will be confused if bills fall and then increase. Customers are, however, used to prices in the high street and seem to cope successfully. The Director believes that transparency is an important principle of good regulation. Customers will welcome their share, next year, of the companies' cost savings achieved since the last review. Looking ahead, they will be able to see clearly the implications on their bills of the costs of the new capital investment programmes. The Director believes that customers would not be confused by the outcome of these two stages of his decision making, but he welcomes views on this.

Efficiency, service performance and incentives – achieving the right balance

The regulatory regime should provide appropriate incentives for companies to improve efficiency and service to customers. In particular, companies which are more efficient and which have higher standards of performance should benefit at the price review compared with those companies which are less efficient or have lower standards.

 Efficiency

Achieving the right balance in incentives for improving efficiency is crucial to the success of the regulatory regime. The right balance will be achieved through a combination of: 

• the treatment of past savings and how quickly these are passed on to customers;
• the assumptions on the scope for efficiency improvements built into the expenditure projections underpinning price limits;
• how these assumptions affect the best and worst performers;
• the degree of certainty as to how future outperformance will be treated at the next Periodic Review. 

Achieving the right balance in incentives for improving efficiency is one of the most difficult issues to resolve at the Periodic Review. The Director has set up a panel of senior industrialists to advise him.

The Director does not believe that all companies start from a position of equal efficiency. This view is based on work carried out over a number of years, using extensive information from the companies, which has been validated by the independent Reporters. The results of the work have been published, most recently in the paper, Assessing the scope for future improvements in water company efficiency (April 1998). The higher costs of some companies cannot be explained by differences in operating environments. Most companies have a mixture of operating environments so that differences, eg between urban and rural environments, cancel out at the company level. The onus of proof must lie with higher cost companies to demonstrate that their high costs arise not from lower efficiency, but from external circumstances which are not shared by lower cost companies.

Experience since the last review shows that the companies judged least efficient at the 1994 Periodic Review have generally made the biggest improvements in efficiency.

The Director believes that he should set price limits which incentivise and stimulate companies to reduce costs without reducing levels of service to customers and to the environment. He believes that all companies, even the most efficient, should be able to become even more efficient and he looks to them to make opportunities for doing this – for example by benchmarking studies.

In Ofwat's technical paper on efficiency, the Director stated his interest in learning from the companies what benchmarking studies they had carried out. Their responses indicate that benchmarking is not widely practised and is frequently limited to comparisons of performance with other water companies. There is little evidence of the companies benchmarking their practices and processes against more challenging comparators, in particular against outstanding companies operating in competitive markets. The potential benefits could be substantial.

The efficiency targets for companies set by the Director at the Periodic Review would be a proxy for a competitive market: the incentive, therefore, even for the most efficient, is the search for excellence in order to beat tough efficiency targets. He also believes that less efficient companies should be challenged to become more efficient by having to make greater strides even if it means that, unless they improve their efficiency, they may fail to make returns sufficient to cover the cost of capital.

The estimates of bills for individual companies set out in this paper assume that the more efficient companies may make only modest improvements in the next five years. If they do better, their profits will exceed the cost of capital. It is assumed that higher cost companies will catch up, at a faster rate than assumed at the 1994 Periodic Review. If they fail, they would be under increasing pressure to do better.

Those companies that become efficient quickly should enhance shareholder value more than those that are slow to improve their performance, even though they will pass on these benefits at a subsequent price review. However, there is a business case for allowing the best companies, and those which have out-performed the Director's assumptions, to retain the benefits beyond the price review. Conversely, those that under-perform should continue to be penalised. There is also a business case for making such adjustments asymmetrical, so that the penalty for an under-performing company is greater than the benefits to those that over-perform.

Such an adjustment would be to the benefit of customers, who have a crucial interest in companies achieving cost reductions that can lead to lower prices for them at subsequent price reviews.

During recent years, companies have generally out-performed the Director's assumptions on cost reductions, so the relevant question is the scale of any carry-over of benefits beyond the review. The Director would welcome views on how much the incentives to efficiency should be increased by allowing companies which out-perform and are efficient the opportunity to enjoy their gains longer by making a specific adjustment to the initial price adjustment (P₀).

The results of the analysis so far

In Assessing the scope for future improvements in water company efficiency, Ofwat set out its work to date in the form of three scenarios. Comments on that approach have been received and were summarised in a letter to all companies issued in October 1998 (RD 35/98). In addition, further work has been done on the 1997-98 data submitted in July 1998. This work has not eliminated all the uncertainties, but it shows that the more aggressive cost cutting scenario, outlined in the April technical paper, may not be feasible in current circumstances.

Operating costs account for about half of all company spending. Companies have reported their operating costs for 1997-98, which show that the companies continue to reduce costs, in real terms, by around 3% to 4% per annum. Studies commissioned by the Director provide evidence, on the basis of comparisons with other industries, that this rate of improvement could be expected to continue over the next few years. A comparison of actual total operating costs since privatisation with the assumptions made by Ministers at privatisation and those made by the Director in 1994 is shown in Figure 10.

For this paper, it has been assumed that the scope for efficiency savings in real terms in operating costs could vary between 2% a year, as assumed at the last review, and 4% a year, as observed since the last review. However, there remain considerable uncertainties around a number of company-specific factors such as changes to local authority rating arrangements. Any significant changes outside of the companies' control will be taken into account in setting prices.

The April technical paper on efficiency also identified a range of approaches for capital costs. Since then, companies have provided information about their current unit costs across a wide range of standardised capital projects. Comparisons with similar information collected in 1994 show that companies have reduced their unit capital costs, on average, by up to 15% over the last five years. Some companies have cited capital efficiency savings of around 20% arising from improved construction techniques and operational practices in the sewerage service. However, differences in capital unit costs remain and, as with operating costs, the higher cost companies could be expected to catch up with the more efficient ones and, possibly, to do this more quickly than was assumed in 1994.

In addition, the Director has commissioned studies to review the assumptions he should make on the scope for improved capital efficiency in the future. Preliminary findings indicate that the increased take-up of new technology and the impact of emerging technology could enable all companies to continue to improve at 1% to 2% a year.

Figure 10: Comparison of total operating costs (1997-98 prices)

The balance of the evidence collected so far suggests that the average overall scope for future improvements in capital efficiency ranges between 10% and 15% over the five year period compared with the current cost levels of companies. The companies which set out their views on future efficiency in their submissions have been more conservative in their assumptions.

Further details of the Director's assumptions on the scope for efficiency based on results of the analysis at a company level so far will be published in December in the Director's annual report on operating costs and efficiency.

Next steps on efficiency

The final decisions in respect of efficiency will depend on:

• performance by companies in 1998-99;
• companies' review of their capital unit costs in the light of feedback from Ofwat on its analysis of the differences between companies;
• further studies to be commissioned by the Director, including a review of cost reductions achieved in other industries using benchmarking.

In Setting price limits for water and sewerage services, the Director said that he proposed to adjust future price limits to reflect past performance in delivering services to customers and to the environment. He suggested that this should amount to ± 0.5% of bills, ie an adjustment of + 0.5% in the first year of the new price limits.

This approach has been commended by Ministers who have said that they would like to see it extended to increase both coverage and the degree of differentiation between companies. The Director has extended the coverage to include drinking water and environmental indicators. He now considers that the adjustment could be larger, although not as large as any adjustment to reward efficiency and out-performance on costs, and need not be symmetrical.

There are already incentives to perform well and, therefore, what could be strengthened would be the penalty for poor performance, resulting in an adjustment which could range from +0.5% to –1.0% for each year of the quinquennium.

Capital maintenance

Customers attach considerable importance to the maintenance of existing service levels. The Director will assess the expenditure required on capital maintenance to maintain serviceability to customers, and how, taking a long-term view, this can be expected to translate into changes in customers' bills.

At this stage, there are uncertainties in three areas. 

• Some companies are estimating significantly increased levels of expenditure, the reasons for which are not yet fully understood. 
• There are differing views on the scope for reducing expenditure through improved capital efficiency, including more effective strategies to maintain serviceability to customers. 
• A number of companies have not yet demonstrated broad equivalence between capital maintenance expenditure and current cost depreciation charges. 

Information from companies on the serviceability of their assets shows that for most companies this has been maintained or improved. This suggests that current levels of asset renewal activity, and hence expenditure, do not need to increase to maintain serviceability to customers in the future. A number of companies confirm that this is also their view. Some companies, however, believe that there is a need for substantial increases in expenditure, even though for many of these, serviceability to customers has been maintained. 

Some companies have carried out more capital maintenance than was assumed in setting price limits in 1994. This could mean that future price limits should allow for higher levels of activity and, hence, subject to judgements about future efficiency, a higher level of expenditure. 

There are also some companies which believe that there is some evidence of a deterioration in serviceability. If this is confirmed, future price limits might need to allow for higher levels of capital maintenance activity, although by how much is, at this stage, uncertain. 

Asset condition

From the information submitted by companies, it appears that, for the industry as a whole, there has been no significant change over the last five years in the proportion of assets in the poorer condition grades. For some companies, there appears to be an indication of an increase in the amount of assets in poor condition, but this is generally confined to specific asset groups. Ofwat will be discussing the reasons for any reported deterioration in asset condition with companies in view of the significant capital investment in quality enhancements and capital maintenance during the last five years.

Specific public attention has focussed on the condition of the sewer networks. Sewers, like water mains, are long-lived assets and, generally, deteriorate very slowly. This view is supported by companies' submissions on the condition of these assets, which appear to indicate that, at an industry level, there has been no significant change in the amount of sewers in the poorer condition grades over the last five years.

Efficiency and effectiveness

Notwithstanding trends in serviceability and asset condition, there are large variations between companies in the level of capital maintenance activity. This suggests that some companies' maintenance strategies could be more effective. The Director's final decisions on the expenditure necessary to maintain serviceability to customers will take account of this, as well as the scope for future capital efficiencies, as set out earlier in this paper.

 Infrastructure renewals

The infrastructure renewals charge made against profit should reflect the long-term requirement for future capital maintenance expenditure (on underground assets). The Director notes, however, that some of those companies suggesting a need for increased expenditure have not, as he would have expected, increased the current level of these charges against profits.

Broad equivalence

Setting price limits for water and sewerage services suggested that capital maintenance expenditure for surface assets and current cost depreciation should be broadly equivalent over an appropriate period. Initial projections of maintenance expenditure and depreciation charges submitted by companies suggested that, for a number of companies, this was not the case and depreciation charges greatly exceeded expenditure. The reasons for this need to be more clearly demonstrated by companies, since any adjustments made by the Director to achieve broad equivalence (within broad parameters) for these companies would result in a material change to price limits.

Next steps

The uncertainties outlined in this area will lessen as a result of the following discussions with companies:

• ascertaining their reasons for projecting increased capital maintenance expenditure;
• understanding the reasons for any reported deterioration in serviceability to customers;
• understanding the reasons for any reported deterioration in asset condition over the last five years;
• understanding why broad equivalence has not been demonstrated.

Even with an initial reduction in prices to reflect past efficiencies, customers of some companies could see prices by 2004-05 close to, or higher than, current levels. This will depend critically on decisions yet to be made about the scope of "other quality requirements" for individual companies. There is widespread evidence that customers do not want real increases in prices. Ministers have indicated the desirability of price cuts and have stated in Raising the quality that the Director should ensure that the detailed obligations at a company level are designed in a way that reflects local environmental priorities and does not have unacceptable impacts on water prices in different parts of England and Wales.

The scope and pace of improvements could be particularly onerous for customers in two companies – Southern Water and Northumbrian Water – and, for a number of other companies, could mean that customers could see little or no reduction in bills by 2004-05. In addition, the very high level of bills in South West Water suggests that further improvements should be only of the highest priority if they are to be included in the programmes after the year 2000. Similar issues may arise in other companies as the costs of meeting the improvement expectations are refined.

The companies will be updating their estimated costs of delivering the proposed quality enhancement programmes in mid-December. Concurrently, the EA should be completing its work on benefit assessments to enable it to advise Ministers on individual priorities within the possible company programmes. By early January next year, the EA has promised to complete its work and produce prioritised lists of improvements, incorporating both benefits and costs.

The Director and the EA will be advising Ministers in mid-January following the analysis of companies' submissions and the latest information on the relative benefits of the initiatives. Ministers will then be able to make their final decisions and confirm the quality and environmental improvement programmes for each region in late February. Each company will then be able to incorporate the programmes in its Business Plan.

Without the prioritised lists in early January, Ministers may not be in a position to decide on the specific programmes in time for them to be incorporated into companies' Business Plans. In order for the improvements to be included in the Periodic Review there will need to be: 

• clear and timely decisions taken in accordance with this timetable;
• clarity as to how the initiatives would be imposed from a legal standpoint;
• a satisfactory degree of certainty as to the likely costs of meeting the obligation that has been subject to review and challenged by the Reporters and Ofwat.

 Balancing supply with demand

Companies should ensure that they have the ability to deliver sufficient water to meet reasonable demands. To meet this objective, companies need to assess potential variations in the weather, taking into account the experience of the drought in 1995. The issues involved are, however, complex and are still subject to a number of material uncertainties. These fall into four principal categories.

Uncertainty about the future demand from customers - both household and non-household (ie industrial and commercial) customers - and hence about companies' revenues. For example, forecasts of total water delivered could, over the five years 2000-05, reduce by 141 Ml/d (–1.0%) based on companies' forecasts, or increase by 37 Ml/d (+0.3%) based on forecasts which Ofwat regards as more plausible.

Uncertainty about the speed and extent of the introduction of metering, following the Government's proposals set out in the Review of Charging. Forecasts of the number of customers choosing to switch to metered supplies (and the characteristics of such customers in terms of their bills and demand for water), who have a significant bearing on companies' revenue projections, are uncertain and will need to be reviewed once the legislative details are published.

Uncertainty about the need for additional resources to increase companies' security of supply and to leave more water in the environment. 

• Uncertainty about individual companies' economic levels of leakage.

 Companies' views

In June 1998, the companies submitted to the Director their forecasts of demand and supply. These showed that, in aggregate, for England and Wales:

Overall demand, measured as the amount of water put into supply, could fall by 2% (282 Ml/d) by 2004-05 as a result of falling commercial and industrial demand and reductions in levels of leakage, partially offset by a slight increase in household demand.  

• The increase in household demand is slight because growth arising from new households is broadly offset by reductions in demand resulting from a significant increase in the penetration of metering. In 1997-98, the proportion of households metered in England and Wales was 11%. This has been forecast by companies to rise to 18% in 1999-2000, with a further significant increase to 38% by 2004-05. Moreover, companies also forecast that customers opting for a meter would reduce their water consumption: the reductions forecast range widely between 5% and 30%.

However, companies' forecasts of their resource requirements measured by the amount of water available for use show, in aggregate, a 1% increase in their total resources. The resultant increase in the margin of supply over forecast demand is for many companies in excess of their own targets for this margin. It would seem that companies are proposing to reduce the risks of restrictions on use, such as hosepipe bans, and emergency abstractions from rivers and streams.

Environment Agency's assessment

 The EA has reviewed the companies' supply/demand balance submissions as well as the Water Resource Plans submitted to the EA in July 1998. Although the EA concluded that the demand forecasts proposed by companies were generally sound, it had three major reservations

Figure 11: Total industry distribution input forecast

• The EA has not yet accepted companies' specific development proposals; in many cases more detailed appraisals will be needed during the next six months. This is the case even in the South East of England where, although the EA has broadly accepted the companies' coordinated regional strategy, it believes that more work will be required to remove the current uncertainty in the demand forecasts and cost estimates for the region.  
• The EA is disappointed that companies have not done more to assess the scope for increases in efficiency in the use of water in the home. 
• It believes that the level of leakage remains unacceptably high for some companies.

Demand and revenues

There is clearly significant uncertainty about the companies' demand forecasts and hence about future revenues. For example, companies may have underestimated (as they did in 1994) the demand from industrial and commercial customers. This will depend on the state of the economy and changes in the efficiency with which such customers use water.

As a result of uncertainty about the Government's proposals for metering policy, companies may also have significantly overestimated the extent of meter penetration in the period. In addition, the reductions in consumption forecast to occur when customers switch to metered charging appear high relative even to previous assessments of the impact of compulsory metering; for example the National Metering Trials suggest an average saving in demand of about 10%. It is likely that the reduction in consumption when customers choose to be metered would be less than this and, therefore, considerably less than the companies' estimates.

As a result of their demand forecasts and assumptions about the characteristics of customers switching to meters in terms of their bills and consumption, companies are forecasting significant reductions in their revenues. Over the period 2000-01 to 2004-05, companies' forecasts imply that industry revenues (at constant prices) will fall, on average, by around 1% per annum. These reductions would result in higher price limits to enable companies to finance their functions. On the basis of alternative assumptions about future demands and the characteristics of switchers, Ofwat's assessment is that industry revenue in this period could increase by, on average, 0.5%-1.5% per annum compared with companies' forecasts. These assumptions mean that price limits could be lower than companies have suggested.

 Leakage

A key component of the amount of water to be put into supply is a company's forecast of total leakage. A reduction in the level of leakage will reduce the need to develop other resources to meet demand. There is still uncertainty about many companies' economic levels of leakage, and the Director has already expressed disappointment that more companies have not been able to produce robust estimates of this.  

Where there are large differences in a company's estimate of its economic level of leakage compared with those with similar resource positions, the Director will wish to understand why. In aggregate, the companies' forecasts of leakage for 1999-2000 are 100 Ml/d above the leakage targets subsequently set by the Director for that year. This may mean that for distribution input, any underestimate of the demand for water by companies could be offset by lower levels of leakage.  

In view of their forecasts of falling demand, the companies' assessment that they require an increase in the amount of water available for supply is questionable. Some companies are proposing increases in their security margins significantly beyond the level of their own targets.

 Costs

 The uncertainties about the demand forecasts and the companies' requirements for increased security margins translate into corresponding uncertainty in the capital and operating costs to be allowed for in price limits.

To connect new customers and to match supply and demand, companies are proposing capital expenditure of £1.7 billion and £0.2 billion of operating expenditure. Of this, £0.6 billion of capital expenditure is for the connection of new customers and, in accordance with the Director's policy as set out in Setting price limits for water and sewerage services, should be offset by infrastructure charges (set at £200 (in 1995-96 prices) at the last Periodic Review), other capital receipts from developers and a proportion of bills from new customers. Capital expenditure proposed by companies to maintain the balance between supply and demand accounts for the remaining £1.1 billion. Companies have included expenditure in their plans for resource investigations but this is unlikely to be material for price limits.

Ofwat's assessment is that £0.2 billion of the companies' capital expenditure could be financed by extra revenues associated with a growth in demand and, as such, has no impact on price limits.

The Director recognises that there may be a need for expenditure for the demand management measures that are assumed in the demand forecasts. This is most evident for the provision of optional meters, the scale of which will be influenced by the Government's proposals on charging. Ofwat's current assessment is that an additional £0.3 billion would allow for the capital costs of optional metering, which would have an impact on price limits.

 In total, therefore, Ofwat assesses that the capital expenditure necessary to balance supply and demand could be £0.5 billion, compared with the companies' estimates of £1.1 billion.

The reasons for the difference between £0.5 billion and £1.1 billion are not fully understood and will need to be discussed with the companies. Part of the difference may be expenditure which the companies consider necessary where contraction in reliable yields could jeopardise companies' current levels of service or, for a very few companies, where current levels of security of supply are inadequate. Ofwat accepts that there may be a case for such expenditure. However, the difference between £0.5 billion and £1.1 billion suggests that much of the companies' proposed expenditure would enhance current levels of service by reducing frequency of hosepipe bans and by limiting emergency abstraction from rivers and streams during periods of drought. If this were allowed for, it would have a further impact on price limits. The Director has made no allowance for any such costs.

 Security of supply and sustainability

Companies have explicitly identified an additional £0.5 billion of capital expenditure (and a very small amount of operating costs) to enhance security of supply (eg by reducing the frequency of hosepipe bans) and to leave more water in the environment (termed as expenditure on 'sustainability').

In Raising the quality, Ministers implied that investment to provide unlimited supplies of water for garden watering should be made only where it could be financed by appropriate tariffs and that companies needed to avoid over-investment in response to downward revisions of reliable yields. The Director does not see why all customers should have to pay for investment that benefits only those who choose to water their garden and believes that companies should introduce the tariffs necessary to ensure that those customers who benefit meet the appropriate costs.

The companies' schemes for sustainability would be in addition to the costs of meeting the currently identified requirements of the Habitats Directive and the protection of SSSIs. Where water company abstractions from rivers and groundwater sources are known to be causing environmental problems and solutions have been identified, Ministers have indicated that allowance for such improvements should be made within price limits. This is subject to the EA setting out concisely the objectives for the schemes intended to curtail abstractions, together with an appraisal of the associated costs and benefits. The Director will only make allowances for these improvements where need is demonstrated and hopes that the proposed schemes are cost-effective. As yet, the benefits to the environment from this expenditure remain to be quantified.

The Director's provisional assessment is that an additional £0.2 billion capital expenditure could be required to enhance companies' security of supply or to provide for reducing emergency abstractions from rivers (ie sustainability).

Therefore, the Director's current assessment is that, of the companies' estimate of capital expenditure of £2.2 billion (£1.7 billion for supply and demand balance and £0.5 billion for security of supply and sustainability), around £1 billion is necessary. Of this, £0.4 billion is for new development, up to £0.5 billion is for growth in demand (including the costs of demand management) and £0.2 billion is for security of supply and sustainability.

Sewerage

The volumes of sewage collected forecast by the water and sewerage companies follow broadly the forecast for water delivered volumes. Sewage collected from households is forecast to rise by 1.4% (100 Ml/d) over the five years 2000-05, while demand from non-households falls by around 5% in respect of both domestic sewage (76 Ml/d) and trade effluent (49 Ml/d) over the same period.

There are similar uncertainties relating to the future demands for sewerage services as for water and, hence, the costs to be taken into account in setting price limits in 2000-05. Companies currently estimate costs of around £0.7 billion of capital expenditure and about £0.1 billion of operating expenditure to connect new customers to the sewerage service and to balance supply and demand. Of this, £0.4 billion of capital expenditure is for the connection of new customers and, as for the water service, this should be offset by a combination of infrastructure charges (set at £200 (in 1995-96 prices) at the last Periodic Review), other capital receipts and a proportion of the bills from new customers. Of the remaining capital expenditure forecast by companies of £0.3 billion, Ofwat's current assessment is that companies should be able to finance about £0.1 billion of capital expenditure given their forecasts of demand. This level of expenditure would have no material impact on price limits.

Next steps

The uncertainties outlined in this section may be expected to lessen as a result of the following.

• The EA will continue to work with companies in reviewing their demand forecasts so that those included in the companies' Business Plans to be submitted to the Director in April 1999 carry the endorsement of the EA. 
• The water companies will be able to take account of the Government's specific proposals for water charging once these have been set out in a Ministerial statement. It is expected that this will be published in November 1998. 
• Companies' revised assessments of their economic levels of leakage will be submitted in their Business Plans. 
• Further work to be done by Ofwat, the EA and the companies on proposals to enhance security of supply and proposals for reducing emergency abstraction from rivers. 

Over recent years, encouraged by the reductions in charges for optional meters, increasing numbers of customers have chosen to be charged by meter. The Director and the CSCs have welcomed this trend, but they have also become increasingly concerned about the effects on tariffs for unmeasured customers of such switching.

The magnitude of these effects depends upon the number and characteristics of customers switching to metered charging. Companies have assumed that customers who switch to meters will have higher than average rateable values and/or lower than average consumption. Consequently, the companies forecast that they would lose revenue if such customers choose to be metered. The impact of the Government's proposals on metering could, depending upon these characteristics, result in bills for customers who remain on an unmeasured basis for charging, often those on low rateable values, needing to rise by an additional 1.5% to 2.5% a year.

In their supply/demand balance submissions, companies claim that most customers who switch to a metered supply have rateable values significantly higher than average and consumption significantly below average. Companies argue that these characteristics are a function of the Government's proposals in the Review of Charging, particularly in relation to free meter options and the right to revert to unmeasured status. There may be greater certainty in this area when the Government's detailed legislative proposals are published.

However, Ofwat believes that the companies could be expected to pursue economic metering policies. This would secure some consistency between the average consumption of customers switching to metered supplies and the average consumption of those customers who remain on unmeasured supplies. This does, however, depend on the freedom companies have to pursue such policies.

Other enhancement options

Companies have set out, or are considering, proposals for enhancing services to customers in their preferred strategies, based on the assessment of customers' priorities with which CSCs broadly agree. A few of these have subsequently been overtaken by Ministers' guidance on future quality and environmental standards and will now become requirements on the companies. Decisions on the other proposals are for the Director to make.

Companies identify additional capital investment of £0.9 billion to implement the proposals set out in their strategies. Depending on the Director's assessment of these costs and taking account of the scope for future efficiency, these proposals could add between £2 to £3 to industry average household bills although the picture for each company varies considerably.

At an industry level the main elements of service improvement are:

• further reduction in the number of properties flooded by sewers;
• tackling outstanding problems of low pressure;
• improvements to the taste, smell or appearance of drinking water.

Many companies have concluded that, for them, there is either no need for improvements, or that there is insufficient support by customers for significant improvements. For these companies this is not, therefore, a material issue. For others, the bill implications could be more significant.

At the last price review, customers were faced with continuing real increases in prices and there was little evidence then that they wished to see even further increases. The Director considered that there was scope, either through better management of capital expenditure, or as a consequence of the benefits from the major quality programmes, to secure improved services without specific provisions being made in price limits. Accordingly, with the exception of allowances for sewer flooding for three companies, current price limits do not provide for service enhancements. In the event, companies have achieved continued and substantial improvements in services, as indicated in Chapter 3.

The position at this price review could be viewed differently. For most companies, there is scope for price reductions, and there is evidence that customers might be prepared to forgo an element of a potential price reduction in order to secure even further improvements in services. On the other hand, much of the scope for a price reduction will be absorbed by the expenditure required to implement Ministers' decisions on quality and environmental improvements. Also, the need for some improvements could be seen as less pressing than in 1994, given the improvements that have already been made and those that will occur as a knock-on effect of the quality programme.

The Director will also wish to consider the extent to which it is appropriate for customers to pay more for some of the improvements proposed by companies. For example, it might be considered that avoiding odours from sewage treatment works should be part of normal efficient operations rather than an additional service. Similarly, a company with an effective maintenance strategy might be expected to manage the risk of unplanned interruptions to supply.

Next steps

This issue is one that needs to be considered on a company by company basis having regard to the strength of customers' views and the overall position on future bills. Some companies already plan to consult customers further, in light of this paper, and the Director will need to consider the results of this.

CSCs will be involved in that work and will advise the Director on the issues for the companies in their region. More generally, the Director invites views on the extent to which future price limits should specifically allow for companies' proposed enhancements to service and the priority relative to the quality improvements for each company that have still to be decided by Ministers.

The cost of capital

Although seen as having significant capital investment requirements and limited growth prospects, the water industry is perceived by investors as relatively low risk and certainly offers considerably lower risk than the UK stock market as a whole. This is borne out by the results of a recent survey carried out by Credit Lyonnais Securities Europe( Risk and return in the UK sector: An independent survey of institutional investors).

After consultation in the financial markets and advice from his financial advisers, the Director considers that the post-tax cost of capital for an efficiently financed water company is in the range 4.0% to 5.5% in real terms. This represents a fall from the level assumed in the 1994 review as a result of market movements (in particular, the reduction in real interest rates) and changes in investors' expectations. For some very small companies the cost of capital might be higher than this, and the Director seeks views on the size of any small company premium.

The cost of capital is not intended to provide a floor on returns. A poorly managed water company might earn a lower return, just as a well-managed one would earn a higher return. The Director considers that this interpretation is entirely consistent with his duty to enable companies to finance the proper carrying out of their functions.

The recent turbulence in the capital markets makes assessing the cost of capital more difficult. This applies particularly to the cost of equity but also to the current spread of corporate bond yields over gilts, which is unusually high. For these reasons, the Director has taken a cautious approach to choosing a single cost of capital - 5.25% (with a premium of 0.75% for the few smaller, independent water companies - to derive the bill estimates set out in this paper. As uncertainty decreases, and as a result of further consultation during the remainder of the Periodic Review, it is possible that this assessment will change.

Not all of the water companies have expressed a view about the cost of capital that they believe is necessary to allow them to finance their functions. Those that have differ widely in their views. Submissions received by Ofwat argue for a post-tax cost of capital ranging from 6% to 7% for some companies to 9% for others (together with a further tax wedge of 2% to 4%). Some small companies believe that they require an additional premium ranging from 0.5% to 1.75% (all in real post-tax terms). The cost of capital has a significant impact on bills since it is estimated that a one point change would change the average industry household bill by around £8.50.

The Director's initial assessment of the cost of capital and related financial issues is set out in more detail in Appendix B. He will continue to keep under review market evidence about the trends in all of the elements of the cost of capital before making his final assessment in 1999.

Appendix A:

PROSPECTS FOR PRICES FOR INDIVIDUAL COMPANIES

This paper has identified the issues by reference to the national picture. The position for each company, however, varies considerably, and many of the decisions yet to be made will need to be at the company level.

The following pages summarise the key points for each company. They will assist customers and regional bodies to understand the issues relevant to their own companies and inform views that they might wish to submit to the Director.

The position for each company is described under the following headings:

Prospects for prices

The prospects for prices in terms of the company's broad objective and the Director's estimate of the possible evolution of average annual household bills to 2004-05 is set out for each company as follows:

• Company's preferred strategy for bills 2004-05

• Bills in 2000-01:

• Possible changes in bills by Ofwat's assessment of the possible change in 2004-05 compared with those bills, in real terms, from 1999-2000 to meet the clearly defined quality standards quality standards

• Possible changes in bills by 2004-05 compared with 1999-2000 to meet the full quality programme ( ie clearly defined plus the other quality requirements plus the company's options for enhancements to other services.

Company strategy

The summary for each company is drawn from its strategic option and customer consultation submission to Ofwat in August 1998.

Effect of Ministers' guidance on quality

Because the company's strategy was drawn up before Ministers issued their guidance on the future quality programme, this section summarises the main points that the company will need to consider when reviewing its strategies.

CSC's views on the company's strategy

This section summarises the main points from the CSC's report to the Director in its assessment of customers' views and its comments on the company's strategy.

Future decisions on the quality programme and service improvements

This section identifies the main decisions yet to be made on the quality programme for the company and on the service enhancement options proposed by the company.

ANGLIAN WATER

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£278

Company strategy on prices

An initial reduction, but position uncertain thereafter

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		A small reduction on 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Around the 1999-2000 bill level

Starting position

• Average annual household bills are above the industry average.

Anglian Water's preferred service strategy remains subject to a final phase of consultation and research which will seek its customers' views on a specific package of improvements, identified as those most preferred by customers in its earlier research:

• improvement in drinking water taste;
• measures to help customers conserve water;
• reducing risk of rivers and wetlands drying out;
• ensuring that no designated bathing beach is refused a "Blue Flag" due to company discharges;
• reducing odour problems from sewage treatment plants;
• resolving flooding and pressure problems.

As part of the development of its preferred strategy, the company has outlined an approach to setting prices that would require an extension to the regulatory 'logging-up' mechanism. This would allow prices to be set favourably on the basis of pragmatic assumptions where there remains significant uncertainty but with meaningful protection for shareholders in the event that outcomes turn out to be less favourable. The company argues that such an approach would contain the overall cost of providing services to customers, maintain effective incentives and significantly reduce risk for investors.

Effect of Ministers' guidance on quality

Anglian Water's strategy for the water service addresses mains rehabilitation, cryptosporidium risk reduction, deterioration of raw water quality and lead levels. The scope and extent of schemes now required to deal with raw water quality and cryptosporidium is uncertain, and subject to DWI technical support.

On sewerage, Anglian Water has not anticipated the withdrawal of HNDA status. Its programme to improve unsatisfactory CSOs is, however, consistent with the rate expected by Ministers. The company's proposals for the full treatment of sludge goes beyond what would now be required, but its proposals on meeting RQOs may be insufficient to meet Ministers' decisions.

CSC's views on the company's strategy

The CSC considers that the company has correctly identified customers' priorities. The CSC welcomes the company's cautious approach in drawing up its two options and agrees that a robust mandate from customers is needed before including investment programmes that will impact on bills. It does not, however, believe that the evidence of customers' views precludes a P₀ reduction, which the CSC views as an important element of the regulatory regime. The CSC would prefer stable prices, thereafter, but would agree increases if they can be justified and result in tangible benefits to customers.

Future decisions on the quality programme and service improvements

The outlook for bills in 2004-05 is dependent upon decisions on:

• the extent of the programme to achieve guideline bathing water standards;
• the extent of the programme to achieve RQOs;
• the extent of the work required for protecting and enhancing environmentally sensitive areas, as the Anglian region has a high proportion of these;
• other service improvements should the company include these in its strategy;
• the extent of advanced sludge treatment which may be required, given the relatively high proportion of sewage sludge disposal to land;
• the scope of work required to address deterioration of raw water quality.

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£298

Company strategy on prices

Stable prices

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are well above the industry average.

The company describes its preferred strategy as an investment programme to meet customers' wishes for the current core service to be maintained and made even more reliable and for certain limited high value environmental and quality improvements.

Planned key improvements are:

• the elimination of sewer flooding;
• acceleration of the improvement of unsatisfactory sewer overflows to improve bathing water and river water quality;
• a reduction in incidents of supply interruptions and pressure problems;
• better security of water supply;
• a continuation of the lead communication pipe replacement programme.

Welsh Water's objective is to keep prices stable. The company recognises that customers would like price cuts, but believes that its extensive customer consultation exercise has clearly demonstrated that these are a lower priority in its region than the maintenance and increased reliability of the core service.

Effect of Ministers' guidance on quality

Welsh Water's preferred options submission largely anticipates the guidance given by Ministers. In particular, the company's "Green Seas" initiative is consistent with the Ministers' decisions. Completion of the CSO improvement programme by 2010 is consistent with the guidance although the extended definition of "intermittent discharge" will increase forecast expenditure. Also the effect of the Ministers' decision on the appropriate disposal of sludge will cost more than previously forecast.

Schemes addressing deterioration of raw water quality are subject to DWI technical review.

CSC's views on the company's strategy

The CSC believes that the company's strategy for investment in quality and service improvements is supported by the results of the company's market research and the CSC's own assessment of customers' views. The CSC was closely involved in the company research and made several recommendations which were taken on board by the company. However, it is not convinced that the research tested all possible price and investment options, as customers were offered only two possible price/improvements packages. The CSC believes, from its own consultation as well as its interpretation of the results of the company research, that customers in the region want a one-off price reduction followed by prices held below the level of inflation, with protection of the environment and service levels maintained.

Future decisions on the quality programme and service improvements

Although there is some uncertainty about final decisions on the water quality and environmental programmes for the company, the impact on bills from these may be limited.

The company's proposals for enhancing other services would only have a minimal impact on bills and are aimed primarily at reducing flooding of houses by sewers where progress to date has been relatively slow but is a customer priority. Proposals to tackle low water pressure and interruptions to supply are also included.

NORTH WEST WATER

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£237

Company strategy on prices

Stable or slight increase

Ofwat assessment
Possible reduction in 2000-01			12.5% to 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Around the 1999-2000 bill level

Starting position

• Average annual household bills are below the industry average.

The company has concluded from its research that customers want improvements within a framework of stable or modestly increasing prices. Starting with known quality obligations, the company has identified two options based on its assessment of customers' priorities. It sees these options as "starting a contribution to the debate that needs to take place"; this is because option B would best meet customers' and environmentalists' views about improved services but would mean significant price increases. Option A, however, fits the need for broadly stable prices but does not address the priorities for future services and the environment. The two options are:

• A: A "minimalist strategy", which meets known quality obligations plus reduction of foul flooding problems and dealing with sites having a high risk of cryptosporidium.

• reduce problems of discoloured water;
• opportunistic lead communication pipe replacement;
• some EA priority schemes.

Its preferred strategy for bills is stable or slight increases.

Effect of Ministers' guidance on quality

The strategy adopted by North West Water in its option B for water quality closely matches the guidance received from Ministers. It focuses on environmental issues and includes improvements to the water distribution system. The scope and extent of measures required to deal with deteriorating raw water quality and to reduce the risk from cryptosporidium are uncertain and subject to DWI technical support. Although the company has attempted to prioritise its programme on a pragmatic risk assessment basis, the potential quality programme is substantial.

North West Water's plans regarding the Urban Waste Water Treatment, Freshwater Fish and Habitats Directives and sludge disposal appear to be in line with the guidance. However, considerable further expenditure may be required in light of the importance attached by the Government to bathing water quality, CSO improvement and the achievement of RQOs.

The CSC considers that the company's market research was thorough and it endorses the company's broad strategy for investment priorities. It is, however, emphatic that customers would not support any price increases and its own survey of customer opinion showed a preference for an initial reduction in price limits. The CSC would prefer a strategy which started with the lowest possible price, and possible interim adjustments thereafter, rather than higher price limits from the outset.

Future decisions on the quality programme and service improvements

The outlook for bills by 2004-05 is very uncertain. The company has the double burden of above average quality obligations for both water and sewerage in its region. The main decisions are on:

• The extent of the programme to achieve river quality objectives (RQOs) – the North West has the highest proportion of rivers graded as either poor or bad, both in terms of chemical and biological quality, of any region. A crucial factor may be the high level of support for the ongoing Mersey Basin campaign.
• The extent of the CSO improvements programme – it is forecast that there will be more unsatisfactory CSOs remaining by the year 2000 in the North West than in any other region.
• The programme to improve compliance with guideline bathing water standards – bathing water compliance levels in the North West have always been lower than any other region.
• The extent of the work required to deal with deterioration in raw water quality and reducing the level of disinfection by-products.
• The company's proposals to reduce flooding of houses by sewers, which is a customer priority.
• The company's apparent intention to reduce the frequency of hosepipe bans, which may be less important to customers.

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£239

Company strategy on prices

Stable, or slight increase over current level

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Around the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		An increase on the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company has set out a clearly defined strategy including explicit efficiency targets and assumptions about the cost of capital. It has concluded that customers prefer stable prices and improvements in services. Given the scale of existing and likely legal obligations, it considers that it will only just be possible to meet customers' requirements for improvements with stable prices after 1999-2000. Some of the customers' preferred improvements are, however, partly covered by these obligations. Improvements proposed include:

• Virtual elimination of sewer flooding and pressure problems.
• Secondary treatment for all eight major coastal sites. Four of these sites have since been the subject of an interim adjustment to price limits for 1999-2000 by the Director. The company, having looked at evidence of customers' views, found that although there was significant customer support in principle for this investment at coastal sites, investment in other priorities would be better value for money.

Effect of Ministers' guidance on quality

For the water service, Northumbrian's preferred strategy aligns closely with the Ministers' guidance and it is likely that only minor amendment to its strategy will be required. The company's priorities remain mains rehabilitation, lead communication pipe replacement and measures to reduce disinfection by-products.

For the sewerage service, the company's strategy anticipates the need for secondary treatment at coastal sites. However, significant further expenditure may be required in light of guidance on bathing water quality, accelerated CSO improvement and the achievement of RQOs.

CSC's views on the company's strategy

Although the CSC supports the consultative work carried out so far, it does not consider that it could endorse the company's conclusions, and the company's strategy, without further public debate. The reasons for this view are threefold. First, the financial (and bill) implications of the cost of the treatment of coastal sewage discharges had not been fed into the consultation process. Second, it has doubts that the conclusion drawn by the company can be sustained once subsequent costings are taken into account. Third, it believes insufficient weight has been given to the views of customers on low incomes and, more generally, the social profile of the region. The CSC has concerns about proposals in respect of cryptosporidium, lead communication pipe replacement, security of supply and low pressure.

Future decisions on the quality programme and service improvements

Bills by 2004-05 could be higher than current levels depending on decisions on:

• the extent of the CSO programme;
• the programme to improve compliance with guideline bathing water standards;
• the scope of the work required for the lead communication pipe replacement programme;
• the extent of the programme to reduce disinfection by-products.

SEVERN TRENT WATER

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£228

Company strategy on prices

Not stated

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are below the industry average.

At the time of the submission, and in the absence of ministerial guidance on quality obligations, the company felt that it would be premature to set out a definitive preferred strategy for bills and services. Based on available market research evidence, however, it concluded that customers would support a framework of stable prices, provided this was accompanied by visible and demonstrable improvements in services. On the basis of consultations with customers and environmentalists the company has identified priorities for the period 2000-05. These include:

• resource availability;
• taste and appearance of drinking water;
• flooding of houses from sewers;
• river water quality.

Effect of Ministers' guidance on quality

For its strategic options submission, Severn Trent Water included all items that it assumed would be confirmed by Ministers and stated additional items as a preferred strategy. The guidance subsequently received has heightened the priority of over-abstraction schemes to meet the requirements of the Habitats Directive and the amount of work required before 2005 to address the tighter lead standard, but otherwise conforms to that expected by the company. For the water service, the principal area for investment continues to be the mains rehabilitation programme, which should be completed by 2010.

In costing additional unsatisfactory CSO improvements, schemes to achieve compliance with RQOs or to ensure no deterioration in river water quality, and in making provision for phosphate reduction in newly designated sensitive areas, the company has anticipated the guidance received.

CSC's views on the company's strategy

The CSC expressed strong reservations about Severn Trent Water's customer consultation in terms of its scope and rigour. The CSC underlined the fact that the company relied extensively on tracking research, the results of which it did not share: it also relied on Water UK research of 2,000 properties, only a small number of which were in the Midlands. The CSC has concerns that the cost of improvements was not shown, or put into context. The CSC would accept some of Severn Trent Water's identified priorities (resource availability, taste and appearance, and flooding of houses from sewers) as reflecting customers' opinions, but the CSC's own work shows that customers also want to see a substantial one-off reduction in bills (P₀) followed by stable prices thereafter. The CSC's own assessment is that this could be as high as 20%.

Future decisions on the quality programme and service improvements

The main decisions affecting bills in 2004-05 are on:

• the company's resource proposals to cope with what it sees as the impact of climate change - these proposals, which could have a significant effect on bills, will involve discussions with the EA;
• the extent of the programme to meet RQOs;
• the company's proposals to enhance other services, of which improvement to the taste and appearance of drinking water is the most significant.

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£344

Company strategy on prices

Stable prices

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction compared with the 1999-2000 bill level

Starting position

• Average annual household bills are the highest in the industry.

The company has a clearly defined preferred strategy which includes the full EA priority programme plus other enhancements to services. Subject to certain qualifications, the company considers that the strategy can be delivered within stable prices. Based on the results of its customer communications surveys, it considers that the majority of customers would prefer these improvements to any reductions in bills. The key improvements are:

• higher standards of sewage treatment for coastal and estuarine discharges so that beaches can achieve "Blue Flag" status;
• improvements to river and estuary water quality;
• ensure no hosepipe bans "in foreseeable circumstances" through further reductions in leakage and other measures;
• improve taste of tap water and remove discolouration problems;
• virtually eliminate sewer flooding problems.

Effect of Ministers' guidance on quality

For both the water and sewerage services, South West Water's preferred strategy is wide-ranging and aligns closely with Ministers' guidance. Mains rehabilitation, work addressing over-abstraction to meet the requirements of the Habitats Directive, and lead levels are all included in the strategy. The only exception is that the company would need to include a modest amount of lead communication pipe replacement before 2005, and possibly some work addressing the Freshwater Fish Directive for which no explicit provision is made.

CSC's views on the company's strategy

The CSC considers that the company carried out comprehensive market research. It believes that the key elements of the company submission broadly reflect customers' priorities, except for the proposal to reduce the frequency of hosepipe bans, for which the CSC sees no customer support. The company research shows support for stable bills, with efficiencies used to fund improvements, and the preferred strategy reflects this. However, the CSC is concerned that this may be the result of the way options for bills were presented in the survey. Its own work showed that the majority of customers felt that their bills are already too high, and the CSC would support a one-off price reduction without prices rising steeply thereafter.

Future decisions on the quality programme and service improvements

The position on bills in 2004-05 will depend on decisions on:

• the extent of the programme to meet RQOs, which could have a big impact on bills;
• the company's proposals to eliminate hosepipe bans "in foreseeable circumstances", for which the CSC advise that there is no customer support;
• the scope of the work required for the lead communication pipe replacement programme.

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£273

Company strategy on prices

Stable prices

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		An increase compared with the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		An increase compared with the 1999-2000 bill level

Starting position

• Average annual household bills are above the industry average.

The company has submitted a clearly set out and well defined preferred strategy, incorporating explicit efficiency assumptions aimed at delivering improvements within stable, or only marginally increasing, prices. The strategy excludes a substantial element of the EA priority schemes. It does, however, include some impact for the DETR's proposals for a free meter option. It excludes UV treatment for coastal discharges, although the company says that there is strong local pressure for it. This issue will be subject to further consideration.

The key improvements include:

• reduce problems of sewer flooding;
• some EA priorities;
• secondary treatment for all coastal discharges;
• free meter option.

Effect of Ministers' guidance on quality

Water service issues addressed by Southern Water in its preferred strategy partially anticipated the Ministers' guidance. Some lead communication pipe replacement may have to be brought forward, and more schemes to remedy over-abstractions may be required. Work to deal with deteriorating raw water quality and to reduce the risk from cryptosporidium is subject to some uncertainty and depends on DWI technical support.

Southern Water's submission proposed the improvement of its remaining unsatisfactory CSOs (predominantly inland) before the end of 2005. The Government's aim to improve significantly compliance with guideline bathing water standards, however, may significantly increase the number of unsatisfactory coastal overflows and also require more expensive solutions. Furthermore, by making no allowance for the protection of shellfish waters, the company has not foreseen the priority attached to this by the Government. Also, the modest investment to improve river water quality is probably insufficient to achieve the work related to the Freshwater Fish and Habitats Directives and RQOs and on SSSI effluent improvement schemes that the Government desires. The company has, however, anticipated the requirement for secondary treatment for all significant coastal discharges.

CSC's views on the company's strategy

The CSC believes that the company's consultation has been thorough and supports the company's strategy to deliver a package of improvements, while keeping price increases in line with inflation. It acknowledges that the company's strategy has tried to balance customers' priorities with pressure to raise the standards of sewage treatment along the South coast.

The CSC believes that there is strong customer support for stable bills. It notes, however, that during customer roadshows there was support for funding environmental improvements from sources other than customers' bills. The CSC believes that customers would want to see efficiency savings shared between investments and bill reductions, without subsequent prices rising above inflation.

Future decisions on the quality programme and service improvements

The position in 2004-05 will depend upon decisions on:

• the company's proposals for water resource sustainability, which are well beyond what the EA considers desirable;
• the programme to achieve compliance with guideline standards;
• the extent of the CSO programme.

THAMES WATER

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£202

Company strategy on prices

Not stated

Ofwat assessment
Possible reduction in 2000-01			10-15%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are well below the industry average.

The company has identified a number of strategic principles as a basis for its developing strategy. It says that these include providing a fair balance of benefits to each of the interested parties, reflecting customers' preferences on price and service and maintaining incentives for improving efficiency.

In its submissions it has set out key components of its preferred strategy, although emphasising that its eventual Business Plan may include additional proposals for quality improvements, service enhancements and asset maintenance.

The company has identified the following priority improvements for customers, over and above the company's assessment of known or likely quality obligations:

• deal with sewer collapses and blockages;
• improve appearance of tap water by reducing risk of discolouration;
• eliminate risk of supply interruptions over 24 hrs and minimise 12 hr interruptions;
• improve repair times for visible leaks from five days to 24 hours;
• alleviate five low flow rivers and four wetland sites and SSSIs;
• continue free repairs on leaks of customer's pipes;
• reduce risk of sewer flooding;
• improve sewage works odour;
• improve river water quality.

Effect of Ministers' guidance on quality

Under the guidance, the scope and extent of schemes required to deal with raw water quality and cryptosporidium are uncertain and subject to DWI technical support. The programme to meet the requirements of the Habitats Directive may be larger than that anticipated by the company. For the water service, the main effect of the guidance is to start the lead communication pipe replacement programme before 2005, which could have a significant impact on expenditure.

Thames Water's preferred strategy is consistent with the guidance. The company's proposed expenditure on RQOs is consistent with the Government's expectations of achieving at least half of the outstanding RQOs. Its strategy for sludge treatment has anticipated the importance Ministers attach to ensuring the agricultural disposal route remains open but the company has taken a conservative view on the extent to which thermal drying may be required.

CSC's views on the company's strategy

The CSC praises the quality of the company's market research, with which it was closely involved. All customer groups were covered, and the CSC particularly welcomes the work carried out with the low income customer subgroup. The CSC was not surprised to see that while these customers wanted improvements they did not want to spend as much as the majority of customers. The Committee is satisfied that the priorities outlined in the company's strategy are broadly in line with the issues identified in the company research and the CSC's own work. The CSC believes that customers' priorities are a secure and safe supply, price stability and dealing with sewer flooding. It believes, however, that the company has not taken into account the full results of its research concerning price cuts, which showed that customer support for lower bills increased if the option for larger bill reductions was offered.

The CSC supports a one-off price reduction, but believes that it will need to be explained to customers that this will not mean a reduction in standards. Improvements should be incorporated within the principle of stable prices.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the scope of the environmental programme, in particular, the work required to meet the Freshwater Fish Directive;
• the scale of service improvements proposed by the company, of which the most significant are for sewer flooding and interruptions to supply.

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£271

Company strategy on prices

Slight reduction in bills

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction compared with the 1999-2000 bill level

Starting position

• Average annual household bills are above the industry average.

The company's approach to its preferred strategy is:

• to keep price increases at or below inflation;
• to use past and future efficiencies to fund known quality obligations;
• to use 40% of residual savings to reduce bills and 60% to improve services in accordance with its assessment of customers' priorities.

• meeting known and expected statutory obligations including the EA's aspirations for low flow rivers;
• maintain an unrestricted supply of water;
• continuation of free meter options and free leakage detection and repair/replacement of customers' supply pipes;
• reduce sewer flooding;
• reduce prices by 1-2% in the period to 2004-05.

Effect of Ministers' guidance on quality

Wessex Water's preferred strategy broadly anticipated the Ministers' guidance. The scope and extent of the work required for dealing with the deterioration of raw water quality and revising abstractions to meet the requirements of the Habitats Directive is, however, subject to review by the DWI and the EA.

Although Wessex Water recognises the pressure for improvements in CSOs and RQOs, its preferred strategy excludes any expenditure in these areas. The effect of the guidance could, therefore, be significant. The company's proposals for the Habitats Directive, nutrient removal in newly designated sensitive areas and additional sludge treatment facilities to maintain the agricultural disposal route, indicate that a great deal of the guidance has been anticipated. Expenditure at coastal sites may need to be increased to meet Ministers' expectations with regard to secondary treatment for all significant discharges and the achievement of guideline bathing water standards.

CSC's views on the company's strategy

The CSC found the company's research to be robust and is satisfied that the strategy outlined broadly reflects the results of the research. However, it has two major concerns about the company's submission:

• The lack of proposals to deal with the risk to the Gloucester to Sharpness canal.
• The extent to which customers understand the nature of the work proposed by Wessex Water to alleviate low flow rivers. While customers supported action to reduce low flows in rivers, the CSC questions whether they would have endorsed the proposal had they been aware that the work Wessex Water intends to undertake involves the construction of a trunk main.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the programme to improve compliance with guideline bathing water standards;
• proposals to reduce over-abstraction;
• the extent of work required to meet the requirements of the Habitats Directive.

YORKSHIRE WATER

Prospects for prices (average annual household water and sewerage bill)

1999-2000: Expected

£240

Company strategy on prices

Stable or slight increase

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		A small reduction compared with the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Around the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company's submission, July 1998 perspective, sets out its prospects for the Periodic Review in 1999. The company has not set out a preferred strategy at this stage because of the uncertainties and issues still to be resolved. The submission reflects its conclusions from the consultation process, that customers are willing to pay for further new improvements in services even if this means prices need to rise by a modest amount (0-3% per annum) in real terms. Customers:

• place the highest value on water supply reliability;
• attach a high priority to environmental improvements and especially to the removal of visible sewage debris from rivers;
• place reducing sewage flooding as its highest priority of other service improvements.

The submission is based on a total investment programme of £1.6 billion from 2000 to 2005 and the company considers that this could be financed within the price increases customers appear willing to support. The company is committed to carrying out further market research and customer consultation in November/December to check its understanding of customers' views, prior to submitting its Business Plan in April.

Effect of Ministers' guidance on quality

The company's July 1998 perspective differed from the Ministers' guidance in several areas, the most significant being:

• mains improvement schemes to be completed by 2010 rather 2015;
• the acceleration of the programme of unsatisfactory combined sewer overflow improvements, with two-thirds to be improved by 2005;
• an earlier start to the replacement of lead communication pipes so that the programme is spread broadly evenly over the period to 2013 to meet the 10 µg/l standard.

• sludge disposal;
• river quality objectives;
• bathing waters;
• freshwater fisheries.

CSC's views on the company's strategy

The CSC believes that the company made considerable efforts to ensure that the views of all customer groups in the region were taken into account, but it had some reservations about the complexity of the methods used in the market research. The CSC believes that customers wish to see progressive environmental and service improvements, provided that bills do not increase above the rate of inflation. It does not agree with the company's conclusion that customers would be willing to see prices rise above inflation. The CSC does not think there is explicit customer support for expenditure on increasing the security of supply, and questions whether this is in fact necessary. The CSC is also not convinced of the need for spending on new technology to reduce the cryptosporidium risk. It would support investment to reduce the risk of sewer flooding. At this stage the CSC would support a reduction in charges in the year 2000 if increases in subsequent years did not exceed the rate of inflation.

Future decisions on the quality programme and service improvements

The main areas of decisions are on:

• the scope of work required to reduce the risk from cryptosporidium;
• the extent of the CSO programme - the company has a relatively high number of unsatisfactory CSOs;
• the programme to achieve RQOs;
• improving compliance with guideline bathing water standards;
• investment to improve security of supply;
• proposed reductions in the risk of sewer flooding.

Prospects for prices (average annual household water bill)

1999-2000: Expected

£101

Company strategy on prices

A small initial reduction followed by stable prices

Ofwat assessment
Possible reduction in 2000-01			10-15%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction compared with the 1999-2000 bill level

Starting position

• Average annual household bills are below the industry average.

The company has set out its preferred strategy which it believes could result in a small initial price reduction and stable prices thereafter.

The company's preferred strategy includes:

• continued maintenance of the serviceability of its assets, including an increase in its mains renewals programme;
• reduction of the risk of cryptosporidium at Hale groundwater source;
• alleviation of the low flow river problem on the River Allen and investigation of the impacts of abstractions on the Rivers Avon (Habitats Directive) and Stour;
• improvement of the reliability (security) of supply by continuing development of Longham Lakes Scheme and then linking this to Knapp Mill Water Treatment Works;
• further alleviation of low pressure problems;
• increasing metering to resolve peak demand problems caused by garden watering;
• developing innovative tariffs to promote efficient use of water at peak demand and promoting the efficient use of water generally;
• providing enhanced levels of customer service generally.

The company has generally anticipated the Ministers' guidance in that it has provided for quality and environmental schemes outlined by the quality regulators and endorsed by the Ministers. However, the scale of work required to address the Habitats Directive is still uncertain.

CSC's views on the company's strategy

The CSC found the company's research to be robust and believes that the broad strategy is consistent with customers' views. The CSC supports, in particular, the proposed strategic link main between Longham and Christchurch, and the programme to address pressure problems and extend metering. It shares the company's concerns about the potential costs of reducing abstraction.

The CSC questions the company's view that customers would rather see efficiency savings spent on improvements than price cuts, noting that the latter were associated in the company research with future bills rising above inflation. The CSC believes that customers should see the benefit of efficiency savings in the form of an initial price cut followed by stable prices.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the company's proposals for significant expenditure on supply security to meet summer peaks and reduce hosepipe ban frequency to 1 in 20 years;
• the EA's concerns about over-abstraction;
• the company's proposals to address low water pressure, which would have only a small impact on bills;
• the extent of work required to reduce the risk of cryptosporidium.

Prospects for prices (average annual household water bill)

1999-2000: Expected

£111

Company strategy on prices

An initial reduction followed by stable bills

Ofwat assessment
Possible reduction in 2000-01			15%-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction on the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company has set out a clearly defined strategy, to use an element of past efficiency to improve services. It has taken account of some implications of the DETR's charging proposals. It has interpreted customers' preferences to be for a range of improvements combined with limited price reductions. There has been little support for real (greater than general inflation) price increases to support discretionary type expenditure.

The company's preferred strategy, over and above likely water quality obligations, includes the following:

• reduce risk of cryptosporidium at certain ground water sources;
• improve reliability of supply by extra maintenance of Sharpness Canal and provide emergency back-up;
• alleviate low flows in rivers;
• assist vulnerable customers.

The company's preferred strategy generally anticipated the Ministers' guidance accurately, although there remains significant uncertainty about the work required on raw water quality, cryptosporidium and lead.

CSC's views on the company's strategy

The CSC is satisfied that the market research carried out by the company is robust and that the broad strategy outlined in the company's submission is broadly consistent with customer views. However, the CSC does have some concerns about specific elements of the strategy:

• The CSC notes that the issue of the Gloucester to Sharpness Canal was not included in the customer consultation: the CSC believes that customers would support the work. However, customers should be able to share the cost with others who are dependent on the canal, such as Wessex Water and Severnside Industrial zone.
• The omission of plans to deal with lead pipework.

The CSC questions the company's view that customers would rather see efficiency savings spent on improvements than price cuts, noting that the latter were associated in the company research with future bills rising above inflation. The CSC believes that customers should see the benefit of efficiency savings in the form of an initial price cut followed by stable prices.

Future decisions on the quality programme and service improvements

The main decisions which could have a significant effect on bills are:

• the scope of work required to meet the proposed water quality programme, especially on lead pipe replacement;
• company proposals to enhance the security of supply from the Sharpness Canal.

CAMBRIDGE WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£101

Company strategy on prices

No initial reduction - bills remain stable

Ofwat assessment
Possible reduction in 2000-01			12.5-17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction compared with the 1999-2000 bill level

Starting position

• Average annual household bills are significantly below the industry average.

The company's preferred strategy is to meet all quality obligations plus:

• reduce leakage further;
• accelerate its existing lead communication pipe replacement programme for vulnerable groups;
• reduce hardness of water for its customers;
• undertake local environmental improvements.

Effect of Ministers' guidance on quality

The strategic options submission for quality enhancements generally anticipated the Ministers' guidance. More investment may be required for over-abstraction schemes to address requirements of Habitats Directive.

CSC's views on the company's strategy

The company research was not considered by the CSC to be as rigorous or statistically significant as other research in the region, being based on a self-selecting sample of customers. The CSC has reservations about the company's proposal to carry out significant investment in water softening on the basis of such a small sample and would prefer to see this given a lower priority.

The CSC notes that the company has framed its strategy within stable prices, with no reference to past or future efficiencies, which it believes should be taken into account. The CSC does not believe that research has shown a lack of support for a one-off price reduction and takes the view that when customers understand that returning efficiency savings will not jeopardise levels of service, the majority would wish to see price cuts. However, the CSC would not wish to see subsequent prices rise above inflation.

Future decisions on the quality programme and service improvements

The main decisions, which could have an effect on bills, include the company's proposals for:

• softening water;
• reducing leakage beyond what it considers is the economic level.

DEE VALLEY WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£118

Company strategy on prices

Not stated

Ofwat assessment
Possible reduction in 2000-01			Up to 12.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company has set out its preferred strategy in the context of the recent merger of Wrexham Water and Chester Waterworks. The company's preferred strategy is directed to the following key areas:

• continuation of the mains renovation programme in the Wrexham area, primarily for improvement of water quality;
• increasing the rate of replacement of unlined ferrous mains in the Chester area;
• major upgrading of Boughton Water Treatment Works;
• providing additional treated water storage in the Chester area;
• reaching agreement with the EA on abstraction licence adjustments and transfers in order to close the medium-term projected shortfall in supply/demand balance.

Effect of Ministers' guidance on quality

No major change in Dee Valley's preferred strategy is expected as a consequence of the Ministers' guidance. There is uncertainty surrounding the amount of work required by the lead standard. The recommendations of the Bouchier Committee, to be published in the autumn, may require a review of the work needed on cryptosporidium.

CSC's views on the company's strategy

The CSC is satisfied that the overall strategy and investment priorities are consistent with customers' views. However, it does not believe that customers would be happy to see prices rise in line with inflation. The CSC takes the view that customers in Wales (including the company's area) would prefer to see prices fall, and that they would be unwilling to "give up" a price reduction. The CSC would support an initial price reduction followed by prices held below the level of inflation.

Future decisions on the quality programme and service improvements

The main decisions, which could have some effect on bills, concern the company's proposed expenditure to improve its security of supply, and the extent of work required on lead communication pipe replacement.

ESSEX AND SUFFOLK WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£131

Company strategy on prices

Modest reduction in prices

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are above the industry average.

The company has concluded from consultations with its customers that they want improvements to services, but with stable prices. The company's strategy is designed to achieve this.

In addition to complying with expected water quality obligations, including an accelerated mains rehabilitation programme and additional nitrate removal plant, the company's strategy is directed at improving its supply/demand position to reduce the risk of future supply restrictions. This will be achieved by:

• a comprehensive free meter option scheme;
• reaching and maintaining an economic level of leakage;
• extending its approach to water efficiency audits;
• the development of incremental resource and supply schemes, and trialing of more sophisticated demand reducing tariffs.

The guidance received from Ministers may result in an increase in the company's proposed quality programme. This is chiefly due to accelerated lead communication pipe replacement being confirmed as necessary to achieve the tighter standard by 2013. The company predicted the potential requirement for mains rehabilitation to be completed by 2010. Schemes to address the deterioration of raw water quality will remain uncertain pending receipt of technical support from the DWI.

CSC's views on the company's strategy

The CSC considered the research carried out by the company to be thorough and sound. It is satisfied that the priorities identified by the market research have been reflected in the company's submission. The CSC particularly welcomes the company's commitment to progress demand management and incremental resource development, including the use of metering as a demand management tool. The CSC also expresses support for the company's water quality programme and the proposals to maintain the level of infrastructure maintenance, provide free repairs to customer service pipes and improve customer service.

The CSC believes that priorities for customers are improving services and stable prices. The CSC does not believe that the research carried out by the company has shown a lack of support for a one-off price reduction and notes that the only choices presented to customers were a reduction in bills with current service, or the current bill with improvements. It also raises concerns that past research showing customers of Essex and Suffolk Water to be unwilling to pay more has not been taken into account in the company's submission. The CSC would support an initial price reduction and subsequent stable prices with no deterioration in current levels of service.

Future decisions on the quality programme and service improvements

The main decisions are on the extent of lead communication pipe replacement, and the company's proposals for improved services. These are likely to have only a small impact on bills.

FOLKESTONE AND DOVER WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£123

Company strategy on prices

Slight increase of 2% per annum

Ofwat assessment
Possible reduction in 2000-01			Up to 12.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		A small reduction on the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Around the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company has a clearly defined preferred strategy, based on customer research which, within a framework of rising prices, provides:

• a reduction in the frequency of hosepipe bans from 5 times in the last 10 years to an average of 1 in 10 years;
• alleviation of low flows for the River Dour;
• improved water quality in line with expected obligations.

Folkestone and Dover Water anticipated much of the Ministers' guidance. Likely changes include an earlier start to the lead communication pipe replacement programme to ensure compliance by 2013 and a potential increase in the number of revised abstraction schemes to meet the requirements of the Habitats Directive. Both of these changes will impact upon estimated costs.

CSC's views on the company's strategy

The CSC is satisfied that the market research carried out by the company covered all of the relevant topics. It is content that the strategy put forward in the submission reflects customers' views on water quality, availability of supply, metering and leakage reduction. However, it would not support additional funding for customer service enhancements given the company's current good record in this area. It looks to the EA's expertise to assess the cost and benefit of the alleviation scheme for the River Dour. The CSC believes that customers' priority for bills is stable prices and feels that the company is looking to accommodate this, with prices rising in line with inflation.

The CSC would support a one-off reduction in bills, if achievable, followed by subsequent stable prices.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the extent to which the resource position and hosepipe ban frequency needs to be improved - a particular issue for the company;
• the scope of the work required for the water quality programme.

HARTLEPOOL WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£100

Company strategy on prices

Company not able to assess this

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are below the industry average.

• Hartlepool Water and Anglian Water will have a common licence from 1 April 2000, so price limits will not be set specifically for Hartlepool Water, but bills for Hartlepool's customers will reflect costs in the Hartlepool area and could be as indicated above.

The company has submitted a clearly set out preferred strategy that maintains the current level of service to customers within stable prices. This strategy includes no diminution of security of supply, free meter options and free supply pipe repairs. Hartlepool Water has no additional quality outputs for the period 2000-05.

Effect of Ministers' guidance on quality

Hartlepool Water closely anticipated the Ministers' guidance, except expenditure for lead communication pipe replacement pending further advice from the DWI.

CSC's views on the company's strategy

The CSC believes that as a small local company, Hartlepool Water knows its customers well, and the CSC is not surprised that no major issues of concern were highlighted during the customer consultation. The CSC supports the research and the methodology used and does not disagree with the findings. It considers that the submission fairly reflects customers' views and is content that the company has acknowledged the need to maintain current standards.

Future decisions on the quality programme and service improvements

There are no decisions to be made which will have an effect on bills in 2004-05, other than the interpretation of future guidance from DWI to ascertain the extent of any future programme of lead communication pipe replacement.

MID KENT WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£147

Company strategy on prices

Small real increases in average bills

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are well above the industry average.

The company's preferred strategy is based on its conclusion that customers' priority is to ensure reliable service, with particular reference to water resources and water quality issues, rather than a reduction in bills.

The company's strategy includes:

• an early start to lead communication pipe replacement programme;
• free meters aimed at allowing the company to introduce tariffs designed to manage demand better;
• improved supply pipe repair service;
• increased rate of renewal for water mains;
• sustained improvements to customer service.

No significant change would be required to the company's strategy as a result of the Ministers' guidance.

CSC's views on the company's strategy

The CSC is satisfied that the company's strategy reflects customers' priorities for quality, availability of supply, metering and mains replacement. The CSC was not involved by the company in the consultation process, other than a presentation given by the chairman of the CSC to a meeting of 95 customers. This meeting was the main means by which the company gathered customers' views. The CSC has reservations about how much reliance should be placed on the views of such a small sample of customers. Although the CSC is satisfied with the company's strategy, it believes that the process used by the company to inform customers and obtain their views was flawed, in particular the use of a provocative leaflet. The CSC does not believe that customers should have to pay for the provision of customer service enhancements included in the company's submission, which are already supplied by neighbouring companies.

The CSC would support a one-off price reduction, followed by stable prices.

Future decisions on the quality programme and service improvements

The main decisions are on the company's proposals for other enhancement options which include the introduction of a free supply pipe repair scheme (as already operated by all other companies.) Another decision is on the extent of work required to meet the water quality programme.

MID SOUTHERN WATER AND SOUTH EAST WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£147

Company strategy on prices

An increase of (less than) £10 per year

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Annual household bill is well above industry average.

SAUR Water Services is made up of the former companies, South East Water and Mid Southern Water. The company's preferred strategy is to provide for resource development and mains rehabilitation by an increase in customers' bills of less than £10. Just under 50% of SAUR customers support this strategy.

The strategy includes quality obligations and also some environmental work on low flow rivers, protection of habitats and fish stocks. SAUR's resource development strategy includes the raising of Darwell reservoir.

On the basis of consultation with customers, the company concludes that the majority of customers would prefer stable prices keeping pace with the rate of inflation. The company also conducted a 'willingness to pay' survey in which just under half of customers questioned indicated a willingness to pay an additional £10 a year for specific environmental and service improvements.

Effect of Ministers' guidance on quality

Following receipt of Ministers' guidance, no major change is anticipated to SAUR's preferred strategy.

CSC's views on the company's strategy

The company's research was conducted with limited consultation with the CSC. The CSC is concerned that two of the company's surveys and the CSC's own work, all of which showed that customers wish to see stable bills, have been ignored. Instead a contradictory survey, indicating that customers are willing to pay more, has been used to support the company's strategy, which incorporates increasing bills. The CSC believes that customers are very aware of recently increasing bills and would prefer to see stability. The CSC would like to see a one-off price reduction if achievable, followed by stable bills. The CSC believes that measures in the strategy to address leakage and quality issues reflect customers' priorities, and is also aware of strong local support for an alleviation scheme for the River Wey, but believes that customers would support any measure to offset the cost of future increases through efficiency savings, or slower implementation of improvements.

Future decisions on the quality programme and service improvements

The main decision is on the scope of the work required for the water quality programme, including lead communication pipe replacement and schemes to address the deterioration of raw water quality.

NORTH SURREY WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£126

Company strategy on prices

Slight increase in bills over period

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bill is around the average.

The company's strategy is based on its view that customers would prefer stable bills with improvements. The key elements are:

• maintenance of high levels of service quality - including free meters, free supply pipe repairs and high rates of maintenance;
• maintenance of high water quality - increased cryptosporidium protection and nitrate blending;
• reduced risk of pollution/contamination disrupting water supplies by upgrading water treatment and distribution systems.

Effect of Ministers' guidance on quality

Following the Ministers' guidance, the cost of North Surrey Water's preferred strategy may increase due to the inclusion of the accelerated lead programme and the necessary completion of the mains rehabilitation programme by 2010. Otherwise, the main uncertainty lies with the schemes to address deterioration in raw water quality and the reduction of risk due to cryptosporidium. Implementation of these schemes depends upon DWI technical support.

CSC's views on the company's strategy

The CSC believes that the approach outlined by the company is largely consistent with the results of its market research and the CSC's own findings. It has reservations, however, about the company's interpretation of customers' high priority for better quality tap water, given the company's recent good performance and the large number of customers who say they are satisfied. The CSC believes that the company has over-emphasised its finding that customers do not want a one-off price cut. The CSC would wish to see a price reduction, with services maintained or improved.

Future decisions on the quality programme and service improvements

The main decisions which could have some effect on bills are on:

• the scope of work required for the water quality programme, in particular, lead communication pipe replacement;
• the company's proposals to enhance security of supply.

Prospects for prices (average annual household water bill)

1999-2000: Expected

£80

Company strategy on prices

Modest increases in bills

Ofwat assessment
Possible reduction in 2000-01			12.5-17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

• Lowest average annual household bills in the industry.

The company set out a strategy which involves meeting its current quality obligations and working towards meeting higher lead standards that are expected to come into force as a result of the new EC Directive on Drinking Water. It also proposed some investment to enhance customer service.

It proposes modest increases in overall bills to pay for the quality improvements and believes that its customer survey indicates that customers would prefer to see the benefits of past efficiencies invested in improving water quality rather than being used solely to reduce charges.

Effect of Ministers' guidance on quality

The uncertainty for Portsmouth is in the scope and extent of:

• environmental improvement schemes to meet the Habitats Directive for SSSIs and other priority and problem sites;
• the schemes necessary to meet the new lead standards;
• schemes to protect customers from the risk of cryptosporidiosis which could result from cryptosporidium in raw water.

The CSC considers that the company's submission reflects its consultation process accurately, except that it overstates the CSC's involvement in it, which was limited. It is concerned that the views of low income customers and smaller business customers may not have been fully taken into account during the consultation.

The CSC believes that customers would like to see efficiency savings returned to them in the form of a price reduction. However, it also has concerns about the possibility of significant price increases following any initial price reduction. Improvements should, therefore, be phased so as to allow future bills to be kept stable. The CSC would wish to see cost-benefit analysis of the proposed improvements carried out to ensure value for money for customers.

Although the CSC welcomes the company's proposals to improve customer service in telephone operations and billing contacts, it would expect these without any impact on bills.

Future decisions on the quality programme and service improvements

The main decision is over the work required in the quality programme. Proposals to enhance customer service, which compares poorly with other companies, would have only a very small impact on bills.

SUTTON AND EAST SURREY WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£141

Company strategy on prices

Rising slightly

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		A small reduction on the 1999-2000 bill level

Starting position

• Average annual household bills are above the industry average.

The company has submitted a clearly set out preferred strategy, with bills to customers rising to enable the company to:

• meet new water quality obligations;
• increase levels of maintenance in order to maintain the existing asset base;
• maintain existing standards of service;
• provide free meters on request up to a limit of 3,000 meters per annum.

The Government is proposing to change the basis of rating for the water industry from the present cumulo basis to a conventional basis as from 1 April 2000. The company has stated that the indications are that such a change will result in a very significant increase in bills to its customers.

Effect of Ministers' guidance on quality

In its strategic options submission, the company broadly anticipated the Ministers' guidance, but there is uncertainty about the scale of work required on lead communication pipe replacement and schemes to address deterioration in raw water quality. Since its February 1998 submission dealing with the cost of quality, the company has completed its study of lead pipes, and, as a consequence, its estimate of the number of connections to be replaced has increased.

CSC's views on the company's strategy

The CSC is content with the company's approach to the customer consultation and believes that the process covered all customer groups. Although the CSC was happy with the overall company methodology, it was concerned that costs were not allocated to all of the tested improvements, for example, the offer of a price cut came with a warning of lower levels of service. There are some mixed messages on quality, with customers indicating that they are satisfied but also supporting improvements. The CSC considers that customers' priorities are a safe, secure supply and price stability: any improvements should be accommodated within stable prices.

The CSC would support a one-off price reduction, followed by stable bills.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the company's proposal to replace customers' lead supply pipes, which could have a significant effect on bills;
• the work required on the water quality programme.

Prospects for prices (average annual household water bill)

1999-2000: Expected

£86

Company strategy on prices

Stable or slight increase

Ofwat assessment
Possible reduction in 2000-01			Up to 12.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are well below the industry average.

The company has submitted a clearly defined preferred strategy for services which it considers to be consistent with its customers' views. The company proposes measures to:

• meet water quality obligations, which could be significant;
• address rising peak summer demands;

The company has not specifically detailed the likely impact of its proposals on customers' bills, although it believes that overall an increase in prices may result partly as a consequence of the company's past record on abatement of charges. On the basis of consultation with customers, the company concludes that customers would prefer improvements in service and the environment, rather than a reduction in the bill. Also that some customers are willing to pay small increases in prices as long as the company matches their contribution through greater investment.

Effect of Ministers' guidance on quality

South Staffordshire Water anticipated the Ministers' guidance in its strategic options submission. The only changes likely are due to the uncertainty of schemes addressing the deterioration of raw water quality, particularly nitrate and pesticide schemes, which will need the technical support of the DWI for inclusion. There may also be an increase if the need for additional schemes to reduce abstractions to meet the requirements of the Habitats Directive is confirmed.

CSC's views on the company's strategy

The CSC is happy with the company's market research. It gave the CSC the opportunity to put its own questions to customers on the company survey and involved the CSC in the consultation process. The CSC details how the submission broadly reflects the results of the company's research. The CSC concludes that customers want a safe, reliable supply combined with the lowest possible prices. Although it applauds the company's past record and objective of good service and low bills, the CSC does not agree with the company that customers would not wish to see an initial price reduction. The CSC's own research has shown that a significant portion of customers want to see efficiencies shared between improvements and lower bills.

Future decisions on the quality programme and service improvements

The main decisions are:

• on the scope of the work required on the water quality programme;
• on the company's proposals to expand treatment capacity to enhance security of supply.

Prospects for prices (average annual household water bill)

1999-2000: Expected

£147

Company strategy on prices

Stable prices

Ofwat assessment
Possible reduction in 2000-01			10-15%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are well above the industry average.

The company has submitted a clearly set out preferred strategy that maintains the current levels of service to customers within stable prices. Its preferred strategy includes:

• compliance with currently known water quality obligations;
• an increase in underground asset maintenance;
• an increase in meter penetration.

The company broadly anticipated the Ministers' guidance, especially with regard to deterioration of raw water quality schemes. There is still a degree of uncertainty concerning the mains rehabilitation programme and lead communication pipe replacement.

CSC's views on the company's strategy

The CSC is satisfied that the consultation work carried out by the company was thorough and sound, and that the priorities identified in the company strategy are consistent with customers' views. In particular, the CSC supports the company's plans to extend metering. However, the CSC does not agree with the company that there is no support among customers for a one-off price reduction. The CSC would support a one-off reduction in charges, provided this does not lead to any deterioration in service. A prudent programme of improvements thereafter should avoid real term price increases.

Future decisions on the quality programme and service improvements

The main decision is the scale of the work required on the water quality programme, especially lead pipe replacement.

THREE VALLEYS WATER

Prospects for prices (average annual household water bill)

1999-2000: Expected

£125

Company strategy on prices

Stable, but would have to increase

Ofwat assessment
Possible reduction in 2000-01			15-20%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Well below the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Well below the 1999-2000 bill level

Starting position

• Average annual household bills are around the industry average.

The company's strategy is based on investment in five key areas, aimed at delivering higher standards without real price increases; this is in line with the result of its survey of customers' preferences. This survey shows that there is little support from customers for a one-off price reduction.

The areas of improvement are:

• enhanced water quality through installation of barriers against cryptosporidium and through acceleration of the renewal and relining of iron water mains to reduce water discoloration;
• a more reliable supply, without having to develop any new resources, by reinforcement of the local grid system combined with demand management;
• fewer supply interruptions by increasing investment in the renewal of assets, particularly water mains;
• minimising environmental impact by reducing leakage, increased metering and schemes to alleviate low flow rivers.

Effect of Ministers' guidance on quality

The guidance may result in an increase in cost over those associated with the company's preferred option. This would be due to re-phasing of the lead communication pipe replacement and mains rehabilitation programme. Additional schemes to meet the requirements of the Habitats Directive may also be confirmed. The remainder of the company's quality programme is broadly in line with the Ministers' guidance, subject to DWI technical support for individual schemes.

CSC's views on the company's strategy

The CSC is broadly satisfied with the consultation process undertaken by the company. It was concerned, however, that the company was unwilling to test views on a possible price reduction of more than £5 and notes that only domestic customers were consulted. The CSC believes the company's results to be consistent with its own findings, as customers' priorities were related to quality, reliability and security of supply. The CSC supports an initial price reduction and believes improvements should be accommodated within stable prices thereafter. The CSC would be opposed to price increases, as implied by the company's preferred strategy, which is based on a programme of significant spending to meet statutory and other improvement targets. The Committee believes the company's alternative strategy, with a slower pace of improvements, to be more appropriate, although it recognises that there may be issues surrounding asset maintenance that will need to be addressed.

Future decisions on the quality programme and service improvements

The main decisions are on:

• the scope of work required to deal with cryptosporidium;
• the company's proposals for security of supply.

YORK WATERWORKS

Prospects for prices (average annual household water bill)

1999-2000: Expected

£95

Company strategy on prices

Not stated

Ofwat assessment
Possible reduction in 2000-01			Over 17.5%
Possible change by 2004-05 compared with 1999-2000 to meet "clearly defined" quality enhancement programme		Around the 1999-2000 bill level
Possible overall change by 2004-05 compared with 1999-2000 to meet full quality enhancement programme plus company options for other service enhancements, compared with bills in 1999-2000		Around the 1999-2000 bill level

Starting position

• Average annual household bills are well below the industry average.

The company's preferred strategy seeks to:

• maintain its good service performance on customer service criteria, particularly water pressure and interruptions;
• improve water quality in respect of pesticides, cryptosporidium and lead;
• increase mains renewal rate.

Effect of Ministers' guidance on quality

The 'Strategy 2' submitted by the company accurately anticipated the guidance received from Ministers, and included additional treatment in respect of lead communication pipes, deterioration of raw water quality and reduction of the risk of cryptosporidium. These last two, however, are subject to the need for DWI technical support.

CSC's views on the company's strategy

The CSC is satisfied that the results of company's market research, which it found to be of high quality, reflect the views of customers in the York area. Customers appear to be well satisfied with current levels of service, and there is little pressure for improvements. The CSC believes that the less expensive strategy outlined matches customers' views and preferences for bills. Neither the CSC, nor the views expressed in the market research, support the company's preferred strategy although it is believed that there would be support for additional investment on mains renewal, provided that this is within a framework of stable prices. At this stage the CSC would support a reduction in the year 2000 if there are no increases above the rate of inflation in subsequent years.

Future decisions on the quality programme and service improvements

The main decision is on the extent of the work required to meet the water quality programme.

Appendix B: THE COST OF CAPITAL

1. Summary

The Director's initial assessment of the cost of capital for all but the smallest independent water companies is 4.0% to 5.5% in real terms, after business taxes. This compares with a range of 5% to 6% used in the 1994 determination of price limits.

The principal reasons for this reduction are because:

• real interest rates have fallen by approximately 0.75%;
• the market's view of the premium required to invest in equities rather than risk-free investments has fallen;
• providers of capital are content with higher levels of gearing for utilities;
• companies will benefit from the tax deductibility of interest on debt finance as they begin paying mainstream corporation tax.

• the impact of the recent turbulence in the capital markets on the cost of capital, particularly the cost of equity but also the margin on debt finance;
• the extent to which the risk of investing in water companies is reflected in their actual, historic beta factors;
• the impact on the cost of equity of the recent changes to the imputation tax system (Advance Corporation Tax);
• the need for, and size of, any premium on the cost of capital for small companies.

The Director seeks views on these uncertainties, before he makes his final assessment of the cost of capital for use in the draft and final determinations of price limits in 1999. Until then, he will continue to keep under review market evidence about the trends in all of the elements of the cost of capital, in particular the equity risk premium and companies' beta factors.

2. Methodology

The cost of capital is a very significant element in the determination of price limits. This is doubly true in that it is applied not merely to marginal investment, but to the entire capital base of each company. Nonetheless, the cost of capital is not intended to provide a floor on a company's return on capital. In regulated industries, as in others, a company may from time to time earn returns below its cost of capital, perhaps through inadequate management or unexpected shocks in the markets in which the company operates. The Director considers that this interpretation is entirely consistent with his prime duty to secure that companies are able to finance the proper carrying out of their functions.

The cost of capital is the return required by the capital markets for investing in the particular company, given its risk. Assessing it is not a mechanical process, in part because it concerns market perceptions about the future. Although modern finance theory provides useful tools, there are still many judgements to be made.

In his assessment, the Director has placed considerable emphasis on consultation in the financial markets. This has involved discussions with institutional shareholders, City analysts, finance academics, banks, bond investors and rating agencies. He is also aware of the considerable academic literature on the subject. He has received advice from Singer & Friedlander, his financial advisers, as well as his advisory panel of senior industrialists. He has also had regard to the results of the recent survey of institutional investors carried out by Credit Lyonnais Securities Europe (CLSE), the results of which were published on 19 October 1998 (Risk and return in the UK sector: An independent survey of institutional investors, Credit Lyonnais Securities Europe.).

The Director's assessment relies primarily on the Capital Asset Pricing Model (CAPM), supplemented by the Dividend Growth Model. This approach was widely endorsed by water companies and other respondents to his June 1997 consultation. The CAPM is simple and widely used, both in the UK and US financial markets and by other utility regulators and the MMC. Other more sophisticated models, such as the Arbitrage Pricing Theory, have been developed but are not yet widely used or understood. Also, because they rely on input variables for which independently collated data do not exist over a sufficiently long run, they would be likely to prove impractical and of dubious robustness.

The Dividend Growth Model primarily provides a check on the results of the CAPM. For example, the suggestion made by some companies that the equity risk premium could be as high as 9%, would, given the current dividend yield of the UK market, imply that its expectation for long run dividend growth for the entire UK stock market is about 9% in real terms. This is difficult to reconcile with the same market's expectations for the growth of the UK economy.

The approach taken to tax has changed since 1994; this is discussed in section 7.

3. Equity

The Director's assessment of the cost of equity capital is founded on the market's view of the risk associated with UK equities generally, and the relative risk of the water companies. The Director has, as stated above, consulted on these issues widely within the City, and has taken account of the results of the CLSE survey of institutional investors.

The risk associated with investments in UK equities generally is encapsulated in the cost of equity through the equity risk premium. The size of the equity risk premium and the most appropriate methodology for calculating it has been the subject of considerable debate amongst analysts, academics, regulators and the regulated companies. There is, however, broad agreement that the wide range of historical estimates of the premium are of questionable relevance and all significantly overstate the current expectations of actual equity investors. This is borne out by the CLSE survey, which revealed that investors, on average, believe that the cost of capital for the water industry is 7.9% (nominal). After allowing for inflation of between 2.5% to 3.3% (being the underlying and headline RPI, respectively), this would imply an equity risk premium in the range of 2.4% to 4.7%. Recent research published by equity analysts at a broad range of investment banks shows a range of 2% to 4%. A recent Price Waterhouse survey ( Reported in Search of Shareholder Value by Andrew Black, Philip Wright and John Bachman (Pitman Publishing, 1998) found a range of 2.7% to 4.5%. Certain academic studies which use a partially forward-looking approach (estimating expectations about future returns on bonds) find premia of about 3.5%.The Director considers that it is important to establish the market's forward-looking expectations, based upon expectations about the continuance of a low-inflationary environment, despite recent turbulence in the capital markets. Nevertheless, he believes that to adopt the more aggressive views on the equity risk premium expressed by some analysts and commentators - as low as 1% to 2% - might be inconsistent with his duty to secure that the companies can finance their functions if the actual cost of equity were to increase above the level implied by this range as a result of a downswing in the UK economy during the period 2000-05. It might also fail to take account of any recent widening of the equity risk premium – although that is hard to quantify at this stage. Hence, he considers that, currently, a more appropriate range for the equity risk premium is 2.75% to 3.75%.

Water companies have variously argued for higher premia in the range 3.5% to 9.03%.

Under the CAPM, the measure of a company's non-diversifiable risk relative to equities generally is its beta factor. There are many ways that beta factors may be derived. Those most commonly used are the five-year monthly figures published by the London Business School. For the quoted holding companies of the water and sewerage companies, these have generally increased from about 0.6 in 1994 to about 0.8 currently (unweighted). In part, this is probably due to increased gearing and diversification into higher risk, non-regulated activities, but adjusting for the former shows that underlying asset betas have also increased. This suggests that the companies are perceived as more risky than in 1994.

There are, however, problems with this analysis. Such beta factors are historic measures of risk, capturing share price movements over a five year period. Currently such a period would include times when the water industry was subject to risks that may no longer be applicable: for example, the general election and the uncertainty of a Labour Government, the windfall tax, and the Government's reviews of regulation, including proposals for profit sharing and error correction mechanisms, and of charging. Indeed, there is market evidence that the risk of investing in water stocks has fallen recently. Five year beta factors have fallen significantly in the last two months. Some water companies have suggested the use of asset beta factors measured over two years instead of five: for the water and sewerage companies these have fallen significantly since 1996 from an average of 0.6 to 0.4.

The CLSE survey sheds some light on investors' views about risk. For example, the open and transparent regulatory regime has helped to reduce regulatory risk. Nevertheless, about half believe that the overall risk of the water sector has increased since 1994; but that 60% of increased risk is derived from the prospects of lower returns after 2000.

Almost two-thirds of those expressing a view thought that the cost of capital for the water industry was less than for the UK market as a whole: on average by about one percentage point.

The Director believes that an expectation that returns on water shares will reduce towards the cost of capital does not constitute evidence that either the risk or cost of equity of the industry has increased. It is more likely to be evidence of the effective working of the regulatory regime.

Similarly, the survey showed that, regulatory influences aside, the water industry is still considered to be fundamentally low risk, being exposed to limited competition, negligible insolvency risk, no currency and limited inflation risk and to limited fluctuation in revenues as a result of volatility in sales.

As the cost of capital is not a floor on company returns, the Director does not consider it appropriate to add, as some companies have suggested, a premium to the cost of equity to create "headroom" between the market's requirement and a company's forecast returns. Nor is he convinced by companies' arguments that, unlike those in competitive markets, the risks they face feature sufficient non-diversifiable asymmetries (which are thus not captured by the CAPM methodology) to justify further unquantified premia.

4. Debt

The cost of debt depends primarily on the term structure of loans and the credit worthiness of the borrower.

Water companies have long-life assets and this tends to influence the maturity profile of their loans. The Director has considered the cost of debt in terms of the premium required over the risk-free rate. Index-linked gilts are the most suitable proxy for the risk-free rate. At the time of writing, redemption yields on index-linked gilts are in the range 2.6% to 3.0%, for maturities of 5 to 30 years. Real yields on conventional gilts of similar maturities are in the range 2.0% to 2.7%, depending on assumptions about inflation. Although the yield curve is currently "inverted", so that long-dated gilts are yielding less than those of shorter maturity, over recent years the differential between index-linked yields of varying maturities has been fairly slight. Hence the blend of maturities chosen does not materially affect the risk-free rate.

Real yields on gilts of maturities of less than five years lie in the range 2.1% to 4.3%.

The Director currently considers that an appropriate range to adopt for the risk-free rate, representing the blend of maturities of water company debt, is 2.5% to 3.0%. This compares with the range 3.25% to 3.75% used in the 1994 Periodic Review.

All water and sewerage companies' debt is considered as investment grade quality. This is expected to continue. Earlier in the summer, margins on companies' debt over government bonds of equivalent maturity range from about 30 basis points (bp) on loans from the European Investment Bank (the single largest provider of loans to the sector), through leasing at around 40 bp to bonds and bank lending at 60-90 bp.

Since then, however, spreads on corporate bonds issued by water companies have widened considerably to about 110-175 basis points at the time of writing, in part as a result of a decrease in gilt rates.

The Director's analysis of the cost of capital assumes that the regulated businesses will be able to accommodate higher levels of gearing than currently (see section 5). This is matched by expectations in the bond and banking markets, where the margins on debt finance already discount some deterioration in credit ratings from their current levels, in expectation of companies' continuing to gear up. Reductions in credit ratings seem to add 5-10 bp per "notch". Taking into account the different types of borrowing available to companies and the fact that companies will be expected to retain investment grade status, the Director considers that an appropriate range for the margin over the adopted risk-free rate is 100-175 basis points.

The recent events in international debt markets may lead to a flight to quality as well as downward pressure on interest rates from central banks. The water companies would probably benefit from this and should be able to manage the timing of their approach to the debt markets. For example, water companies have issued over $3 billion of bonds during the last year.

Taking into account the tax deductibility of interest payments, the Director's current assessment of the cost of debt on a post tax basis is 2.5% to 3.3%.

5. Capital structure

There is a broad consensus that the water utilities can sustain higher levels of gearing than they currently enjoy. Our consultation indicated that, chief among the ratios considered by lenders, levels of gearing of 50-60% (debt: debt plus equity) and interest (EBIT) covers of about 2.0 times are consistent with maintaining investment grade status. Where they are present in existing loans, banking covenants tend to be at a similar level. Allowing some headroom over these threshold levels would harmonise with the results of the shareholder survey, which indicated an average gearing level of 54% and interest cover of 2.2 times as the maximum and minimum acceptable levels, respectively, for water utilities. In Ofwat's financial modelling, the Director is currently minded to ensure that similar ratios are respected and have acceptable trends in companies' financial forecasts for the period 2000-05. (It should be noted, however, that these limits are not consistent – for example, gearing of 54% implies interest cover somewhat greater than 2.2 times).

In deriving the cost of equity, companies' equity betas will be adjusted to take account of the greater risk to equity resulting from the assumption of more efficient capital structures.

6. Position of small companies

There are arguments that the cost of capital is higher than average for small companies. This derives from such companies' more limited access to capital markets such as the international bond market, as well as the lower liquidity and higher relative issue costs associated with their equity.

The Director is minded to include a premium to reflect these factors in his assessment of the cost of capital of the small water only companies although as yet he has received little evidence from such companies that their actual costs of capital have been higher than average. He considers that such a premium over similar costs for the water and sewerage companies would be unlikely to be larger than about 30 bp on the cost of debt and 1% on the cost of equity. Assuming an efficient capital structure, this would result in a small company premium on the post-tax cost of capital of about 0.5% to 0.75%. Such a premium would be applicable to the four small independent quoted water companies. This would be consistent with the assumption used in the 1994 Periodic Review. The Director does not consider that such a premium would be appropriate for the larger water only companies, or for those companies which are the subsidiaries of large international corporations, since these should have access to capital at costs not dissimilar from those of the larger water and sewerage companies.

The Director, however, continues to seek views from small companies and others on the size of any small company premium and the criteria for eligibility for it. In particular, he is interested in views about the paradoxically lower beta values for water only companies shares, which would indicate that these companies face lower risks and lower costs of capital than the average.

7. Taxation

As stated in the Setting price limits for water and sewerage services, the Director proposes to set price limits by reference to the post-tax cost of capital, while taking account of the changing individual tax positions of each company through the financial model (as set out in the Financial Model Rule Book). This approach avoids the need to evaluate a generic fixed tax wedge, as used in 1994. The companies' tax projections will be adjusted to take account of the Director's views about efficient capital structures, as discussed above, and through the application of yardstick adjustments in exceptional circumstances to reflect prudent tax planning.

There remains the issue of the impact on the cost of equity of the abolition of ACT credits. Since gross pension funds and other non-taxpayers are no longer able to reclaim such tax credits, there is no doubt that the change increases the post-tax cost of fresh equity issues. The Director has taken account of this in assessing the cost of equity. The position regarding existing equity (sometimes referred to as "retained earnings") is more problematic. The abolition of ACT credits was a general change in the tax system and consequently might be expected to affect the value of all dividend-paying UK equity capital. The market's expectations as to the reduction in value of future dividends would tend to be capitalised in current share prices, resulting in a loss of value in shareholders' UK equity investments. In such circumstances, is it consistent with the Director's duties to customers to pass on to them in price limits the losses specific to shareholders of water companies? Other non-utility sectors of the economy have no such regulatory protection against changes to the tax system. It is, hence, arguable that it would be entirely consistent with the Director's duty to secure that water companies can finance their functions for him to consider shareholders' alternative investment opportunities and to mirror their exposure to the loss of ACT credits. Such a policy would reduce the weighted average cost of capital for water companies by about 0.25-0.5 percentage points.

On the other hand, the chief argument in favour of the Director's passing to customers the impact of this change is that, to be consistent, he should also take account of other changes in the tax system, such as the abolition of the ACT charge itself and the reduction in the corporation tax rate, from which shareholders are currently benefiting and from which customers will also benefit following the Periodic Review.

In order to derive a cost of capital for use in this paper, the Director has assumed that the abolition of ACT credits increased the cost of capital for all equity (both new and existing) and that this is passed on to customers. However, before taking a final decision on the issue he seeks views on whether this is the appropriate treatment.

Appendix C: GLOSSARY OF TERMS AND DEFINITIONS

Appointed business: The business providing water (and sewerage) services. Typically the appointed business is carried out in a subsidiary company known as the Appointed Company, which acts under an Instrument of Appointment (or Licence).

Benchmarking comparison: A method of comparing the performance of different companies where the best performers in a given area are used as a standard or benchmark for the others.

Broad equivalence: The proposal that the capital expenditure to maintain the serviceability of a group of assets should be broadly in line with the current cost depreciation charged on those assets over an appropriate period of time.

Bulk supplies: Supplies of treated or untreated water traded between individual water companies. These supplies are often traded under long-term contracts and on non-standard terms. The Director has power to determine the terms of such supplies if so requested.

Capital asset pricing model (CAPM): An economic model used to provide an estimate of the expected rate of return on a financial investment. One of the cornerstones of modern finance theory.

Capital base: See regulatory capital value.

Capital maintenance: Planned work carried out by companies to replace and repair water and sewerage assets to provide continuing services to customers.

Capital programmes: Planned construction work being carried out by companies to build new assets such as sewage treatment works and water mains.

Comparative analysis: The use of a number of different companies' performance in a given area to assess performance of individual companies.

Comparative efficiency studies: Comparisons of companies' operating costs, taking into account factors outside management control which influence costs. Such factors include the make-up of inherited asset stock (outside short-term control), economies of scale, population density and the nature of the terrain. From these comparisons it is possible to rank or band companies by relative efficiency and to assess relative scope for reducing costs.

Cost of capital: The minimum return that providers of capital require to induce them to invest in or lend to a business, given its risks (see weighted average cost of capital).

Current cost accounting: A method of accounting originally designed to deal with the problem of showing the effect of inflation on business profits. Instead of showing assets at their historic cost (ie their original purchase price), less depreciation where appropriate, the assets are shown at their current cost (replacement cost) at the time of producing the accounts. This method of accounting is used in tandem with Historic Cost Accounting (HCA) in the water industry because of the extensive nature of capital assets and the fact that historic costs do not reflect the asset's true worth.

Demand management: By increasing the efficient use of water by both companies and customers, the need for new water resources to meet increases in demand can be deferred. Demand management strategies, such as selective metering, appropriate tariff structures, leakage reduction and promoting efficiency measures by customers, play an important role in maintaining a company's supply/demand balance.

Demand related tariffs: Tariffs that are structured so that they encourage the efficient use of water by those whose demands impose additional costs of supply, eg garden waterers and other peak users.

Depreciation: Depreciation is a measure of the consumption, use or wearing out of an asset over the period of its useful economic life.

Discharge consent: Under the Water Resources Act 1991, discharges of sewage or trade effluent to controlled waters require consent. The discharge consent is a licence issued by the Environment Agency which sets out the conditions under which the licence holder may make a discharge.

Dividend cover: The number of times a company's dividends to ordinary shareholders could be paid out of net profits after tax in the same period.

Dividend growth model (DGM): A financial model used to provide an estimate of equity returns by reference to the expected growth in dividends.

Business Plans: The submission to the Director in April 1999 which sets out the company Board's view of the price limits needed for the period 2000-05 and its reasons for them.

Economic leakage level: The point at which further leakage control activity would cost more than alternative means to bridge the gap between supply and demand. In determining this, it is important to include consideration of environmental and social costs as well as other costs.

Economic life: The economic life of an asset is the period for which an asset remains useful.

Economies of scale: Economies or savings resulting from the use, management or production of goods in large quantities. A lower cost per unit of output is achieved than would have been the case if smaller quantities were produced.

Enhanced service levels: Permanent, identifiable and measurable improvements in service levels that are above the most recently established company-wide base levels of service and which are additional to improvements resulting from expenditure in other purpose categories.

Equity finance: The risk-sharing part of a company's capital. Usually referred to as ordinary share capital.

Financial indicators: Certain financial ratios specified in Appointed Business Licences, such as gearing, interest cover and dividend cover. These are used to measure the financial performance of a company.

Gearing: A company's net debt expressed as a percentage of its total capital (ie the ratio of net debt to net debt plus equity expressed as a percentage).

Glidepath: At the 1994 Periodic Review, target rates of return were set for water companies. Companies were required to make steady progress from their 1994 rate of return towards their targets over a period of ten years. This progressive decline in rates of return was termed the glidepath.

Historic cost accounting: The traditional form of accounting, in which assets are shown in balance sheets at their cost to the organisation (historic cost), less any appropriate depreciation.

Incentive-based price cap regulation: The current regulatory system operated by the Director. The overall limits to prices that companies are able to charge customers is set by the Director. These are set at such a level as to encourage or incentivise companies to make further savings which can be shared with customers and shareholders.

Indexation: The policy of connecting prices, costs, wages, taxes etc to rises in the general price level, retail prices or other measures of prices (inflation).

Infrastructure assets: Mainly underground assets, such as water mains and sewers and also dams and reservoirs that last for a long time. A distinction is drawn between infrastructure and non-infrastructure assets because of the way in which the assets are managed, operated and maintained by the companies.

Infrastructure charges: Paid by developers and customers in new properties for a first time connection of premises for domestic purposes to a public water supply or a public sewer.

Infrastructure renewals charge: An annual accounting provision for expenditure on the renewal of infrastructure (ie mainly underground) assets charged to the profit and loss account.

Interest cover: The number of times a company's profits before interest and tax cover interest due on all its borrowings.

Interim determination: Condition B of the licence allows the Director to make in any year adjustments to a K factor for certain relevant changes of circumstances, provided these are material. Key variations are: for changes in legal obligations placed on companies; failure to achieve legal requirements allowed for when price limits were set; and to allow for differences between the actual proceeds of surplus land and the proceeds assumed when price limits were last set.

Large users: In general terms, large users are industrial and commercial customers using significant annual amounts of water. Under the Competition and Service (Utilities) Act 1992, inset appointments can be granted to sites using 250 megalitres or more a year.

Levels of service: Specific measures of services to customers.

Licence: The water (and sewerage) companies operate under licences granted by the Secretaries of State for the Environment and for Wales, or by the Director, to provide water and sewerage services in England and Wales. The licences impose conditions on the companies which the Director is required to enforce.

Long run marginal cost (LRMC): Marginal costs can be thought of as the cost imposed on a water or sewerage company in supplying or treating each additional cubic metre of water. LRMC will comprise operating and capital costs.

Net present value: The economic value of a project, at today's prices, calculated by netting off its discounted cash flow from revenues and costs over its full life.

Non-infrastructure assets: Mainly surface assets such as water and sewage treatment works, pumping stations and company laboratories, depots and workshops.

P₀ adjustment: A component of the price limit. For the 1999 review, the permanent percentage reduction in prices from 2000-01, the first year of the five for which price limits will be set. A P₀ adjustment reflects efficiency gains which have been achieved by the company. The term 'P₀' has been used publicly by Ofwat since late 1996 in relation to the 1999 Periodic Review.

Population equivalent: A measurement of organic biodegradable load, and a population equivalent of 1 (1 p.e) is the organic biodegradable load having a five-day biochemical oxygen demand (BOD5) of 60g of oxygen per day.

Quality enhancements: A generic term for work programmes implemented by the companies to improve the quality of drinking water or the environment such as treating wastewater discharges to a higher standard. These enhancements are required to fulfil new legislation or national initiatives approved by Ministers.

Quality regulators: These bodies enforce the relevant quality standards in England and Wales. The DWI, on behalf of Ministers, ensures that the water companies are fulfilling their obligations with regards to quality of drinking water supplies. The EA has a wide range of statutory duties and powers, its principal aim being to discharge its functions so as to protect and enhance the environment.

Quinquennium: A period of five years.

Rate of return: The annual income and capital growth from an investment, expressed as a percentage of the original investment.

Regulatory accounts: Financial statements about the Appointed Business which are required by the Director to enable him to carry out his duties.

Regulatory capital value: The capital base used in setting price limits. The value of the appointed business which earns a return on investment. It represents the initial market value (200 day average), including debt, plus subsequent net new capital expenditure as assumed at the time of initial price setting and including new obligations imposed since 1989. The capital value is calculated using Ofwat's methodology (ie after current cost depreciation and infrastructure renewals accrual).

Reliable water yields: The supply that can be reliably maintained from the water resource system available to a company under drought conditions, as constrained by the company's given level of service and obligations to the EA.

Reporters: Independent engineering consultants who are under a duty to report to the Director on the accuracy of companies' annual returns to Ofwat and whether the returns show progress and performance, particularly in respect of capital investment programmes.

Requisition charges: The charge to a developer and property owner or local authority for requisitioning from the company a new water main or public sewer to be extended to the existing system and to connect into it.

Rights issue: A method by which companies which are quoted on the Stock Exchange raise new equity capital, in exchange for new shares issued by way of rights to its existing shareholders.

Ring fencing: Licence conditions and accounting rules which allow the appointed business to be viewed and treated as a independent company.

Security margin: The difference between the water available to customers for use (including imported water) and demand at any time.

Serviceability: A long run approach which considers the ability of the water and sewerage networks to maintain a standard of services to customers.

Special dividends: Dividends paid by the company which are not part of the usual dividend stream arising in the usual course of business.

Statutory due dates: Dates set out in domestic or European legislation by which certain requirements of the legislation must be met.

Supplementary investment: Investment carried out by companies to provide enhanced levels of service but which has not already been allowed for in price limits.

Supply/demand balance: The balance between the amount of a company's available water resource and the demand for water by customers. Any imbalance between supply and demand can be met via resource enhancement or demand management strategies (eg selective metering and leakage control).

Synergy savings: In the context of the regulation of the water industry, synergy savings are savings resulting from a merger of two companies which could not have arisen without the merger.

Tariff basket: The basket of charges to which the annual regulatory price limits apply comprising: charges for unmeasured water supply; charges for measured supply; charges for unmeasured sewerage services; charges for measured sewerage services and charges for reception, treatment and disposal of trade effluent.

Unit capital costs: The Director makes comparisons between companies so that the best performing companies may be identified and the poorer performers can be encouraged to do better. When comparing how much money companies have spent to replace old or to build new assets, it is important to take account of the fact that larger companies have more assets than smaller ones and so need to spend more money to build and replace them. This is achieved by dividing the amount companies have spent by a suitable measure of the size of the company, such as the number of customers' houses, resulting in a unit cost.

Weighted average cost of capital (WACC): For a company, the average of its cost of debt and cost of equity capital (see Cost of capital), weighted according to the balance of debt and equity which finances the company's assets.

Appendix D: LIST OF CONSULTEES

Other government departments

Department of the Environment, Transport and the Regions

Welsh Office

Water companies

Water and sewerage companies

Water companies

Water UK

Quality regulators/environmentalists

Council for the Protection of Rural England

Council for the Protection of Rural Wales

Countryside Commission

Countryside Council for Wales

Country Landowners' Association

Drinking Water Inspectorate

English Nature

Environment Agency

Friends of the Earth

Institute of Hydrology

National Farmers' Union

Royal Horticultural Society

Royal Society for the Protection of Birds

Surfers Against Sewage

UK Round Table on Sustainable Development

Other regulators

Office of Electricity Regulation

Office of Gas Supply

Office of the Rail Regulator

Office of Telecommunications

Reporters and Auditors

Water companies' Auditors and Reporters

Organisations representing customer interests

Age Concern England

Association of British Chambers of Commerce

Chartered Institute of Purchasing and Supply

Chemical Industries Association Ltd

Child Poverty Action Group

Confederation of British Industry

Confederation of British Industry, Wales

Consumers' Association

Food and Drink Federation

Help the Aged

Institute of Directors

Major Energy Users Council

Money Advice Association

National Association of Citizens Advice Bureaux

National Campaign for Water Justice

National Consumer Council

National Council for one Parent Families

National Federation of Consumer Groups

National Federation of Small Businesses

National Federation of Women's Institutes

Ofwat Customer Service Committees*

Public Utilities Access Forum

Save the Children Fund

Utility Buyers Forum

Waterwatch

Welsh Consumer Council

Trade bodies, suppliers and contractors

British Plastics Federation

British Water

Chartered Institute of Water and Environmental Management

Clay Pipe Development Association

Federation of Master Builders

House Builders Federation

Institute of Plumbing

Sewer Renovation Federation

Society of British Water Industries

Trade unions

TUC

UNISON

Members of Parliament

All Party Water Group

Liberal Democrat Spokesman on the Environment

Shadow Secretary Environment, Transport and the Regions

Local government organisations

Local Government Association

National Association of Local Councils

Welsh Local Government Association

*The Ofwat Customer Service Committees will consult with regional organisations and interested parties in their areas.