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Letters to Regulatory Directors
RD 31/03 27 August 2003 Dear Regulatory Director NON-HOUSEHOLD TARIFF POLICY ISSUES In RD05/03 we consulted on a number of issues to do with the following types of tariff:
We have taken account of responses from companies and other stakeholders in reaching the conclusions reported below. Standby Charges In RD 05/03 we said that we did not seek to prescribe a single approach to calculating and structuring standby charges. Rather we indicated which approaches we thought were unacceptable and suggested some alternative approaches for companies to consider. Two respondents disagreed with this and suggested that Ofwat gave too much discretion to the companies in setting standby charges. One stated that Ofwat should prescribe a specific method of determining the level of the charge. Companies are responsible for setting individual tariffs. Ofwat's main role in tariffs policy is to ensure that companies comply with Condition E – that is, that they ensure their tariffs are neither unduly preferential nor unduly discriminatory. Where we think that a particular approach would lead to a breach of condition E, then we think it is appropriate for Ofwat to rule out that approach. Condition E Issues In RD 05/03 we suggested that it was acceptable for companies to continue to identify reservation customers according to whether they have an alternative supply. We noted that, whilst possibly being more appropriate, defining reservation customers on the basis of their demand profiles may be difficult to do in practice. The majority of respondents supported this statement. Two companies noted that exceptions could apply. They wanted the flexibility to apply standby charges to customers who did not have alternative supplies, but whose demands were unpredictable and short-lasting. We did not rule this out in RD05/03 and we confirm that this would be acceptable. These two companies also noted that some customers with alternative supplies might have demand profiles that are more predictable and longer lasting. These companies argued that such customers should be charged on the appropriate large user tariff. We agree. In RD05/03 we stated that companies should ensure that their standby charges are consistent with their large/intermediate user tariffs and that we would apply a simple consistency check. In the light of the responses we have received, we propose to check that standby customers who take all of the water they have reserved for the year will pay no more than an equivalent large/intermediate user. That is, we will compare the bill of a standby customer who consumes water every day of the year at its maximum subscription level with that of a standard large/intermediate customer consuming the same volume of water over the year. Accounting for service reliability In RD 05/03 we argued that it may not be very meaningful for companies to offer different levels of service to reservation customers. In particular, we said that companies would not be able to offer a guaranteed supply to reservation customers because the Secretary of State's powers under drought conditions rendered such guarantees meaningless. We also thought it unlikely that reservation customers would accept lower levels of service than those offered to other customers. There was no consensus among respondents on this issue. However, four respondents argued that there may be circumstances where customers may wish to negotiate on the reliability of the standby service provided by the company. We agree that the decision of whether or not to accept lower levels of reliability should be left to the customer, but we suggest that these non standard service arrangements should probably be implemented through special agreements. Meter-based charges In RD 05/03 we proposed that we would not approve meter based charges from 2004-05. We argued that these charges fail to take adequate account of the likely volumetric demand of the reservation customer. Four respondents agreed with our proposal, but two objected. The latter argued that meter size is a good proxy for a customer's maximum (rather than likely) instantaneous demand for standby capacity. If the customer wishes, it can change this maximum to match likely demand by changing the size of the meter. The respondents also claimed that meter based charges are simple to administer and easy for the customer to understand. We consider that reservation charges based on meter size provide the customer with limited flexibility to influence the size of their bill. Usually there are a very limited number of meter-based charges on offer, and changing the meter is an inflexible way of responding to changes in a customer's standby requirements. Customers may not even know the maximum instantaneous volumes that they can take through a meter of a given size, making it difficult to judge what meter size is best for them. Customers cannot easily make (and possibly change) risk based judgements about how much water they should reserve in any given year. Other charging arrangements acknowledge this by providing the customer with the option to take more water than planned, albeit with charges for additional water levied at a penalty rate. This may still be possible with meter-based standby charges if the standby charge is based on a notionally down-sized meter (as happens when customers need larger meters to cope with possible demand for water for fire-fighting purposes), but this will not always be the case. We think that standby charges should be based on the amount of capacity a customer wishes to reserve. We consider that existing meter-based charges provide the customer with limited flexibility to select and possibly change this capacity. Following the consultation, however, we do not currently think that we should withhold approval of meter-based charges. Nevertheless, companies using meter-based charges will have to consider how to reconcile such charges with the condition E test described earlier in this letter. We would, in any case, encourage companies with meter-based charges to explore more customer-friendly alternatives. If companies wish to continue with meter-based standby charges we suggest that they:
Insurance concepts In RD 05/03 we suggested that no claims bonuses/rebates and excess charges could be used to tailor individual charges in order to reflect individual customer characteristics. We did not seek to prescribe the use of such concepts. We highlighted them in order to stimulate debate about alternative ways of making standby charges more cost-reflective. One company supported a no claims rebate for customers who did not take up standby capacity during the peak period in any given charging year. It claimed that this would give some allowance, after the event, for the benefits to the company of having unused standby capacity during the period of peak demand. One company supported a no claims bonus based on historical use of the back up supply. It claimed that this would give a good indication of the robustness of the customer's alternative supply. However, one company argued strongly that insurance concepts such as the no claims bonus and the excess charge are not wholly relevant to an appropriately structured standby charge, such as those based on customer subscription. We still support the no claims rebate but we are less supportive of the no claims bonus and the excess charge. We now consider that these insurance concepts may add unnecessary complexity - especially where the standby charge is structured appropriately. But these are matters of judgement for individual companies. Peak and off-peak rates In RD 05/03 we stated that it may be appropriate for companies to introduce peak and off-peak reservation charges and then to rely on customers subscribing for their likely demands during these periods. Two respondents agreed with our view and none disagreed. We will continue to encourage companies who argue that critical period demands are a key cost driver to develop standby charge structures that reflect the likely timing of customer demand for standby capacity. Special agreements or standard charges In RD 05/03, we said that, despite seeing merit in the transparency of standard charges, we would not object to companies charging for standby via special agreements. There was no consensus among respondents on this issue. One company preferred special agreements whilst another preferred standard charges (with the option of using special agreements where appropriate). We will be flexible on this issue – companies are legally entitled to charge by either standard charges or agreement. Cost basis of the charge In RD 05/03 we said that we would not approve standby charges that are based on the costs of having dedicated back-up capacity for resources and treatment. The majority of respondents agreed that it is not appropriate to set reservation charges on the basis of having dedicated capacity for resources and treatment. Two commented that it might be necessary in exceptional circumstances. For example, companies might have to keep capacity available on a dedicated basis where customers – such as ports and power stations - are large and remote. We confirm our position, but note that exceptions can apply. Companies should deal with exceptions under special agreements. In RD 05/03 we argued that the volume-capacity approach to cost allocation led to excessive standby charges because it failed to account for the potential system diversity benefits provided by reservation customers. We explained that reservation customers could help to reduce the company's costs if they enhance demand-side system diversity. That is, if their demands are more likely to arise outside of the critical period and if they are unlikely to coincide with one another. Similarly, on the supply side, where reservation customers have developed their own resources this can mean that security of supply for other customers is higher than it would have been if the reservation customer's demand had to be met from the company's resources. We thought that supply side system diversity effects were unlikely to be material in practice unless the undertaker had access to the reservation customer's alternative resource. We proposed not to approve standby charges based on the volume-capacity approach but suggested that we would consider sensible modifications to such an approach. The majority of respondents argued that system diversity benefits (demand side and supply side) are negligible. Three respondents stated that as the number of reservation customers is likely to be small the system diversity impact is likely to be negligible. Some respondents questioned the scale of demand side diversity in practice. For example, some questioned the assumption that a number of reservation customers would be on the same supply system and that each would have non-coincident demands. One respondent agreed with our view that supply side diversity is not relevant, because companies do not have access to the standby customers' resources. The effect on costs of greater diversity in customers' demand profiles and/or greater diversity of resources remains uncertain. However, we believe some account needs to taken of this potential benefit - through either the level or the structure of the charge. We will consider this when approving standby charges in the future. Interruptible tariffs A number of companies were supportive of interruptible tariffs. Others were sceptical about their role and relevance. However, as we said in RD14/01, we recognise the use of interruptible tariffs as a supplementary tool to help companies maintain their supply-demand balance. In RD05/03, we said that we would not approve short-term (4-hour) interruptible tariffs for customers who do not use the local distribution network. Some companies disagreed with our position. They argued that there may be circumstances in which the ability to interrupt such customers may have a beneficial impact on the system. We stand by our view that short-term (4 hour) interruptibility impacts on the management of hourly peaks and only affects capacity in the local distribution network. However, we will consider proposals for short-term interruptible tariffs if companies are able to show that reductions in costs associated with their ability to interrupt these customers' supplies could justify lower tariffs. Subscribed demand tariffs We set out in RD 05/03 the views that we expect companies to take into account when they design the structure of their subscribed demand tariffs (SDTs). We have considered the comments from respondents and, consequently, have revised our views as follows. Signalling prices for coincident and non-coincident peak demand Companies size their capacity to balance supply and demand in critical periods. So demands that coincide with the critical period put greater pressure on companies' costs. For this reason, we proposed asking companies to consider reflecting in their SDTs the different costs involved in meeting customers' peak demands when those demands either do or do not coincide with the company's critical period. While we still hold that view, we will not require companies to structure their tariffs to take account of these cost variations. However, where companies propose additional supply/demand expenditure as part of the Periodic Review process, we might not make allowance for such expenditure if appropriate pricing policies would have mitigated the need for it. Companies that decide to signal prices for coincident and non-coincident peak demands may choose to do so in the manner that is appropriate for them. They may decide to set either two separate maximum daily demand (MDD) charges, one each for the summer and winter periods or, as we suggested, only one MDD charge based on maximum daily take in the summer months. Penalty rates We set out two approaches that companies currently use to deter customers from taking more than their subscribed MDDs and asked for views on the relative merits of both approaches. Most respondents said that they preferred companies to apply penalty rates to any demand above the subscribed MDD. The alternative approach is for companies to reset the original subscribed MDD at the new higher daily demand level and raise a higher MDD charge. We do not intend to prescribe a particular approach for companies to follow. It is for companies to devise their own methods. However, we expect any systems that companies devise to be simple. We suggested in RD05/03 that it was not necessary for companies to apply penalty rates/deterrents during their system's off-peak period. We made that suggestion because capacity was less constrained during that period. However, some respondents argued that while that could be the case it did not mean that all companies would have sufficient excess capacity to cope with any potential demand during that period. We accept that argument and, therefore, will accept proposals from companies to apply penalty rates/deterrents in their system's off-peak period. Subscribed demand tariffs as optional tariffs We said that unless companies provided very good reasons, we would not approve optional SDTs from 2004-05. Some respondents said they could see some merit in companies offering SDTs and traditional two-part tariffs at the same time. They reasoned that as more customers with low daily demands opt for SDTs, the average daily demand of the residual customers (ie those remaining on the alternative tariff) would rise resulting in a higher tariff for the residual group. There is some merit in that argument, but it becomes less tenable when one considers the rationale for SDTs, which is to send better price signals so as to help companies manage their supply/demand balance. If companies offered an optional SDT, customers with non-peaky demands are likely to be the only ones who would opt for it. The remaining customers on the alternative tariff will be those with peaky demands. However, the alternative tariff will only give those customers the incentive to reduce their overall demand instead of their peak demands. For Condition E purposes, we would have to check that there is no difference between the bills arising under a SDT and bills arising under an alternative tariff for any given customer. Given the structures of both tariffs it will be difficult for us to devise an appropriate test for that purpose. For these reasons, we confirm that we will not approve optional SDTs from 2004-05, unless companies provide very good reasons. In order to reduce any potential incidence effects from this decision, we will consider proposals from affected companies to withdraw their alternative tariffs gradually. Monitoring daily demands We suggested that it was important for companies to monitor the demand of customers on SDTs on a daily basis. This is because those customers' daily demands drive a significant proportion of their bills. Some respondents did not share our view. They said it was too expensive to monitor daily demands. We accept that companies may find this prohibitively expensive, but they must match their demand monitoring regimes with their cost justifications for the tariff. Therefore, for example, if a company is only able to monitor monthly demands, it should base its SDT on the costs of meeting peak monthly demands. On this basis, the subscription element of the tariff would be significantly smaller, weakening the price signal and so partly undermining the purpose of the tariff. Setting the level of the capacity-based charge It is not our intention to prescribe a set of rules to which companies would have to adhere in setting the level of their capacity based charges. We will scrutinise all proposed levels of capacity-based charges to ensure that they are cost-reflective and consistent with any underlying assumptions that companies make. Implementation issues We said that it was important for companies to give customers at least six months notice of the introduction of a SDT tariff. Some respondents argued that this might not be possible given the charges scheme approval timetable. We set out in RD04/02 a recommended timetable for companies to submit proposals for new or significantly revised non-household tariffs. If companies follow that timetable, there is no reason why they cannot meet our suggested six-month notice period. One other respondent raised the issue of introducing SDTs in phases in order to reduce the incidence effects. We will consider proposals from companies in that respect. Yours sincerely Paul Hope Head of Tariffs  |
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