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RD27/03
TO ALL REGULATORY DIRECTORS OF
WATER AND SEWERAGE COMPANIES
AND WATER ONLY COMPANIES 4 July 2003
Dear Regulatory Director
PERIODIC REVIEW 2004 – OVERALL CHECK ON THE LEVEL OF DEPRECIATION
We set out our approach to current cost depreciation (CCD) for the 2004 review in March in 'Setting water and sewerage price limits for 2005-10: Framework and approach'.
We explained briefly the process we will adopt and said that we would set out more details in advance of draft business plans.
This letter:
- Explains the process we will adopt in providing feedback to each company on table B33 of its draft business plan. Table B33 sets out the comparison of CCD charges and maintenance non-infrastructure (MNI) expenditure together with explanations for any differences between the two;
- Provides examples of the explanations which we consider would be valid reasons for any difference between CCD and MNI expenditure (and those which would not); and
- Considers the evidence which companies will need to provide to support their explanations.
1. Feedback
We raised depreciation with each company at the pre draft business plan working level meetings. We saw these meetings as your opportunity to raise any concerns or queries about the completion of table B33 and the commentary to support it. As part of the process we took the opportunity to discuss progress on the comparison of CCD and MNI expenditure and the explanations for any differences, together with the extent and impact of any revaluation of assets which you intend to undertake.
We are offering each company a further working level meeting in November/December 2003 to discuss matters arising from the draft business plan and the company specific feedback. Our feedback will include our views on your comparison of CCD and MNI expenditure contained in your draft business plan.
MNI expenditure projections form the basis of the comparison. Our view is that the level of CCD should be consistent with the level of MNI expenditure. Our views on your MNI expenditure projections will therefore form the first part of our feedback on the comparison of CCD and MNI expenditure. Where our feedback indicates that your draft business plan does not provide sufficient evidence to support the projected level of MNI expenditure, this may have implications for the comparison with CCD.
We will also consider the validity and robustness of any explanations which you have provided for the difference in CCD and MNI expenditure. Where table B33 of your draft business plan indicates that your CCD and MNI expenditure projections are broadly similar we expect that any feedback on this element of your plan will be minimal. This is, of course, subject to any issues raised by your reporter or auditor and additional checks on the consistency of your information such as those identified in section 4 below. We will judge your projections to be broadly similar where line 16 of table B33 is less than our 5% tolerance limit. Where your projections do not meet this test then we expect that you will have provided explanations for the differences.
The analysis set out in table B33 of the draft business plan considers both explanations that we would take into account in making our comparison and those which we would not. Some of the reasons why your CCD and MNI are different may support the need for a different level of depreciation to the one you have projected. We would not therefore take these into account when we make our comparison. However, for us to have confidence in your approach to depreciation, you will need to provide evidence to support all explanations for the difference.
When we set price limits we will form a view on the level of CCD and MNI expenditure which we will use in our overall check on the level of depreciation. Our starting point will be the numbers presented by companies in the business plans. We will look at the explanations provided by companies for any differences. Where we accept an explanation as:
- valid;
- one that should be taken into account; and
- fully supported by the evidence provided by the company;
we will amend the CCD and MNI expenditure which we use to take account of this. (For example where an asset is being depreciated but not replaced during the period we are considering, we would deduct the depreciation on that asset from CCD before we compare this with MNI expenditure.) This will give us a set of adjusted projections on which to base our comparisons.
When we give feedback on your explanations we will categorise these in one of three ways:
- A valid explanation which would result in an adjustment to the CCD/MNI expenditure which we use in our comparison; or
- A valid explanation which would not result in an adjustment to the CCD/MNI expenditure used in our comparison; or
- An explanation which is not a valid reason for the difference.
Table 1 below summarises how we plan to categorise the explanations you provide and the nature of the feedback we would expect to provide on those explanations. Examples of the types of explanations which would fall into each category and the evidence we would require in support are discussed in sections 2 and 3. Section 4 explains some of the additional checks we will undertake to ensure the consistency of information presented in your plan.
Table 1 – Summary of proposed feedback mechanism
 | Category of explanation | Evidence | Nature of feedback |
1
| A valid explanation which would result in an adjustment to the CCD/MNI expenditure used in the comparison | Fully supported by evidence presented in DBPSupported by evidence presented in the DBP but some queries/further information required
Evidence not sufficient to support
No evidence provided | Confirm explanations accepted as valid and robust
Confirm explanation is valid and clarify what additional information is required to support
Confirm explanation is valid but that case presented is not sufficient. Clarify what a robust case would require.
Confirm explanation is valid but request evidence to support. |
| 2 | A valid explanation which would not result in an adjustment to the CCD/MNI expenditure used in the comparison. | Confirm explanation is valid.Explain why we would not adjust CCD/MNI used in the comparison Request further information/clarification if necessary. |
| 3 | Explanation is not valid | Explain why we do not consider the explanation to be valid. Request further information/clarification if necessary. |
We anticipate that discussions on our feedback will begin at the meetings in November/December 2003 and will continue until final business plans are submitted, if necessary.
2. Explanations for the difference
Examples of types of explanation which would fall into the three categories we have identified in table 1 are set out below together with our reasoning behind each one. The list is not exhaustive but gives examples of the reasons for any differences that have been raised in our discussions with companies to date.
a) Valid explanations which would result in an adjustment to the CCD/MNI expenditure projections
i) Assets which are being depreciated but which are not replaced during the period we are considering.This would relate to assets such as buildings and structures that have asset lives in excess of the 28 year period we use for our comparison. The comparison will therefore include depreciation on the existing asset but not reflect MNI expenditure for its replacement. For example where a company has commissioned assets pre 1992-93 to meet new quality standards, but where there is no replacement of these assets in the period from 1992-93 to 2019-20.
We would take this into account by excluding the depreciation on those particular assets from our comparison.
ii) A typical level of MNI expenditure
This is often referred to as 'lumpy' expenditure. We expect that this will be more likely to apply to small water only companies which may have small numbers of major assets such as treatment works.
Generally companies with larger asset portfolios have greater scope to manage their replacement programmes, so that the level of MNI expenditure is relatively stable year on year. For companies with an asset base dominated by one or two large assets this may be more difficult, particularly where the work undertaken includes a major refurbishment in one period but much lower levels of maintenance in other periods. iii) Maintenance expenditure includes replacement of assets purchased since 1992-93
We use the assets existing at 31 March 1993 as the basis of our comparison. The depreciation charges reflected in the comparison will relate entirely to those assets. However, it is likely that the MNI expenditure projected by the company will include expenditure to replace assets constructed or purchased after 1993. This expenditure should therefore be excluded from the comparison.
MNI expenditure for the replacement of assets constructed or purchased since 1993 should therefore be identified separately in table B33 as an explanation for any difference between CCD and MNI expenditure. b) Valid explanations for any difference which would not result in an adjustment
i) The value of an existing asset (on which the CCD projections are based) is higher than the replacement cost of that asset reflected in the MNI expenditure projection.
At previous reviews we have required companies to revalue their assets to reflect the modern equivalent asset value (MEA). In RD22/02 - `Revaluation of assets for the periodic review in 2004', we explained that we do not require companies to carry out an MEA revaluation for the coming review. A number of companies have however indicated that they intend to revalue all or part of their asset base where MEA values have changed significantly since the last review.
If there is no revaluation and there has been a change in the MEA value of a particular asset, there may be a difference between the depreciation charge on the existing asset (based on the previous valuation) and the current or replacement cost of the asset reflected in the MNI expenditure projections.
While we acknowledge that our approach to the overall check on depreciation should not consider the impacts of future efficiency, the depreciation charges reflected in customers' bills should take account of past efficiencies. Where a company identifies an inconsistency between the existing asset value on which the depreciation projections are based and the projected current or replacement value of the asset (assuming like for like replacement), this would indicate that the depreciation projection is too high.
We would not therefore take this into account in making our comparison. The higher level of depreciation would flow through into our comparison resulting in a downward adjustment to the CCD charge allowed in price limits. ii) Asset lives not aligned with operational lives.
In making projections of CCD, we expect companies to consider the serviceability and remaining lives of their assets and the implications this has for the timing of asset replacement. The asset lives assumed for depreciation purposes should match those assumed for operational purposes. This applies equally to the remaining lives for existing assets and to the projected lives for new or replacement assets.
Companies should take the overlap between the quality enhancement and maintenance programmes into account when considering remaining asset lives. Where outputs required under the quality programme also result in early replacement of some assets for maintenance purposes, the companies' projections of remaining asset lives should reflect this.
We said in RD22/02 that we do not require a full asset revaluation for the 2004 review, but we do require each company to consider whether there are any significant changes to the remaining lives of its asset stock since its last assessment in 1998.
Where accounting lives are not aligned with operational lives, this will result in a difference between CCD and MNI expenditure projections. This would result in an incorrect depreciation projection and we would not therefore take this difference into account when making our comparison. The unadjusted level of depreciation projected by the company would flow through into our depreciation comparison and could therefore result in an adjustment to the CCD charge allowed in price limits.
A significant proportion of fully written down assets still in use would indicate that asset lives for depreciation purposes have been too short in the past.
Conversely, assets not fully written off at the time of replacement would indicate that the asset lives assumed for depreciation purposes have been too long.
iii) New assets are different to those they replace.
A number of companies have indicated that there is a trend towards shorter life assets (driven by technology changes). They have argued that the new assets will be different to the ones they are replacing and have shorter lives.
The MEA value of the existing assets of the company should reflect the modern equivalent asset and hence efficiency and technological progress or shift in the types of asset used. The issue of procurement efficiency is dealt with under 2b(i) above. In looking at the comparison of CCD and MNI expenditure, our general assumption will be that the rate of technological progress within the industry in general has been relatively slow. Where you believe this is not the case for certain assets, you should include an explanation in the commentary to table B33.
Assuming that there has not been a significant technological shift, a difference between the asset life on which the projected depreciation charge is based and the life of the replacement asset would indicate that the depreciation charge was incorrect. We would not therefore take this difference into account allowing a higher level of depreciation to flow through to our comparison resulting in a downward adjustment to the CCD allowed in price limits.
c) We have not specifically identified any explanations which would not be valid reasons for any difference in CCD and MNI expenditure projections. The examples set out in a) and b) above show the types of explanations which would explain differences between the two.
If you have identified a reason for any difference which is not covered in this letter, you should set this out clearly in your draft business plan. We will set out our view in our feedback on your plan. If you would like early discussions of such an item, we are happy to do so before you submit your plan.
3. Evidence to support explanations
The evidence you present in your plan will be critical to our consideration of the explanations you put forward to describe any difference between your CCD and MNI expenditure projections. We will also take the quality of evidence into account when forming a view on the overall robustness of your depreciation projections. We will pay particular attention to your reporter's views on the case which you make.
This section sets out in more detail the information which we would require in support of each of the explanations identified in section 2 above. You should note that this covers the basic information we expect to see. As each case will be different, you should consider whether this is sufficient and include such additional evidence as is appropriate.
a) Valid explanations which would result in an adjustment to the CCD/MNI expenditure projections
i) Assets which are depreciated but which are not replaced in the period under consideration.
Your plan should clearly identify:- the assets in question;
- the date they were originally installed/purchased;
- their original cost;
- the depreciation associated with the assets reflected in the projected CCD of 1992/93 assets;
- the current cost value now attributed to them;
- the depreciation life assigned to the asset and assumed in calculating the depreciation charge; and
- the planned replacement date.It should confirm that replacement of the asset has not been reflected in your MNI expenditure projection. You should also demonstrate a clear link with your capital maintenance planning framework to enable us to confirm that this is the case.
Reporters should confirm that the information provided by the company is accurate including confirmation that the MNI expenditure projections do not include replacement of the asset.ii) Atypical level of MNI expenditure
We generally expect that this issue will be restricted to small water only companies.
Your plan should demonstrate that the level of MNI is atypical and not simply a reflection of an ongoing trend. It should clearly identify the reasons for the atypical level of spend, and quantify the difference between this and what you consider to be a normal level of expenditure. Your plan should also identify the CCD associated with these assets.
A robust case will explain how you expect the level of expenditure to move over time showing the point at which an atypically low level of expenditure increases to a higher level (or vice versa). The identification of the ongoing or smoothed level of expenditure and the CCD assuming a smooth level of expenditure is also important.
Reporters should confirm the information presented in the company's plan and give a view on whether the expenditure is truly atypical.
iii) Maintenance expenditure includes replacement of assets purchased since 1992-93
You must demonstrate in your plan that you have considered this issue. Your commentary should set out the level of MNI expenditure relating to assets purchased since 1992-93 and confirm how you have taken this into account in your comparison. Your commentary should confirm what steps you have taken to identify this. Where you believe that the amounts associated with post 1992-93 assets are not significant you should state this explicitly.
Your reporter should confirm his agreement or comment accordingly. b) Valid explanations for any difference which would not result in an adjustment
i) The value of an existing asset (on which the CCD projections are based) is higher than the replacement cost of that asset reflected in the MNI expenditure projection.
For each type of asset where this issue arises, the evidence you should provide to support your explanation should include:- a description of the asset in question;
- the value of the asset on which the CCD charge is based;
- how that value was derived. For example, cost or as part of the 1998 revaluation (and hence the basis of that revalued amount);
- the replacement cost which you have reflected in your MNI expenditure projection and the reasons why the cost has changed.
- the remaining life of the existing asset and associated CCD reflected in the projections.You should also consider the lives of the assets, confirming the life you have assumed for the replacement asset and if this is different to the life of the original asset, why it is different.
The reporter should confirm agreement with the company's commentary and also give a view on whether there may be other similar issues which the company has not identified.ii) Assets lives not aligned with operational lives
In the commentary to table B33 you should identify the asset or group of assets where lives are not aligned and give a comparison of both the accounting and operational life. You should set out any particular reasons for the difference.
This should be linked to your commentary which explains how you have reviewed remaining asset lives as part of your business plan submission. You should also demonstrate the link between the remaining life of the assets, the assumed timing of their replacement and hence the link to the MNI expenditure projection.
The commentary should give the impact on the net MEA value at 31 March 1993 and the CCD projections if the accounting lives were aligned with operational lives.
The reporter should confirm the company's commentary and also provide a view on whether there are any other similar points not identified by the company.
iii) New assets are different to those they replace.
Your plan should identify the assets in question and the reason for the change. This should include a comparison of the cost of new assets with the replacement cost of the existing assets together with their operating lives and the rationale for moving to shorter life assets/different technology. A robust case will also compare the relative proportion of MEA value by asset life with the position at the 1999 review to help demonstrate a shift towards shorter lived assets.
You should quantify the impact on the net MEA value at 31 March 1993 and CCD projections of reflecting the cost and lives of replacement assets in the existing asset base. You should also demonstrate consistency of your assumptions with your projected asset lives for new capital expenditure.
Reporters should confirm their agreement with the companies' assessment.
4. Other checks which we will make
a) Consistency of historic and current cost depreciation chargesThe calculations of historic cost (HC) and current cost (CC) depreciation should be consistent. With the exception of the asset values on which the charge is based, the assumptions which underpin the two calculations should be the same. We would therefore expect the ratio of HC depreciation to CC depreciation to be broadly the same across the industry. We consider the relationship between HC and CC depreciation as a key ratio in our analysis. We will want to explore further the reasons for any outliers with individual companies.
b) Consistency of CCD on assets purchased before 1992-93 and those purchased after that dateOur overall check on depreciation considers the assets at 1992-93. As part of our analysis we will also consider whether the depreciation on assets purchased from 1992-93 to 2002-03 is consistent with the projected depreciation charge on the 1992-93 asset base.
Keith Mason
Director of Regulatory Finance
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