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RD 42/03


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

On 19 December we wrote to each company setting down our decisions on its application for capital works projects to include in our early start initiative. Our decisions are summarised in this letter.

Background

Many stakeholders in the industry's capital investment supply chain have drawn our attention to the difficulties caused by the periodic review cycle, particularly in the first year as water companies review their plans in the light of our price limit determinations. In the past this has created a hiatus in capital investment followed by a peak later in the five-year period. This investment roller coaster increases supply chain costs and risks loss of much-needed resources to the sector, both of which inevitably act against customers' long-term interests.

Our early start initiative aims to reduce the investment roller-coaster effect of five year periodic reviews. We will facilitate a prompt start on the next period's investment programmes by giving firm decisions now on a significant number of capital schemes. These will deliver benefits to customers and the environment in the first two years of the next period – 2005-06 and 2006-07. Our decisions involve the approval of schemes and the reasonable level of costs for companies' early start programmes. We will carry forward these costs into price setting next year. These early start initiative schemes add to the investment that will be needed in these years for other reasons. These include completion of the AMP3 period output requirements, routine work needed to maintain asset systems, growth and development, as well as to provide for installing water meters requested by customers. The full investment needs for the AMP4 period – 2005-06 to 2009-10 – will underpin our final determination of price limits in November 2004.

Company draft business plans

We set down our proposals for the early start initiative in 'Setting water and sewerage price limits for 2005-10: framework and approach' (March 2003). We asked each company to identify suitable projects in its draft business plans (August 2003).

Our decision criteria

We have reviewed each company's proposals for candidate schemes in each of our cost categories: capital maintenance/ base, enhanced service levels, supply demand and quality enhancement. We used the following criteria to assess each project.

· There is a clear need.
· There is a definite output.
· The project would be completed by a defined date early in the AMP4 period and no later than March 2007.
· The project is not contentious on the grounds of the balance between costs and benefits.
· Projects associated with drinking water and environmental quality improvements projects were supported by the relevant quality regulator (DWI, EA, EN, CCW).
Following an initial review of each company's proposals in late August and early September we then sought further proposals from each company to increase the proportion of the likely 2005-06 investment programme included in the initiative. Nearly all companies responded positively to our further requests.

Our draft decisions

We sent each company our draft decision on its application in November. These draft decisions used our criteria, as well as assuming that each company would be able to improve its efficiency in line with the reference level assumptions used for reference plans A and B of its draft business plans (see RD28/03). Subsequently our draft decisions were discussed with each company at its draft business plan working level meeting. Universally the companies said that the reference level efficiency assumptions were not feasible and using these would put at risk the whole initiative.

We have been able to take account of updates or revisions companies sent to us up to 15 December, our close down date.

We have sought and obtained the views of regulatory colleagues on each company's proposals and our draft decisions. We have taken account of their comments on the suitability of projects for inclusion in the initiative.

Our final decisions

In the letter we have sent out to each company we included a schedule setting down all the projects, including outputs and the associated delivery dates that we have incorporated into the early start initiative. We have also confirmed the contribution this element will make to the total capital investment and operating costs for each company programme that we will use when setting price limits in November 2004.

We have based these costs on the numbers included in the draft business plans, or on revised information submitted by companies. We have taken account of specific representations made by each company on our draft decision. We have noted the findings of recent research by our consultants on the scope for future efficiencies that supports the case made by the companies.

We want to encourage each company to make a prompt start on this work, and deliver the required outputs by the due dates set down in the schedule.

We have therefore decided to assume less scope for cost reductions than in our draft decisions. For capital investment we have assumed half of the catch-up in the RD28/03 reference assumptions for both capital maintenance and capital enhancement. For operating costs, we have incorporated the same challenge to each year, equivalent to that for one year only. We have not increased it incrementally. This will approximate over the five years to slightly less than half of the reference assumptions. We have not assumed any frontier efficiency movement for this initiative. These assumptions apply only to this initiative. You must not take them as a signal of our likely judgements on the scope for improving efficiency on the balance of costs in each company for the AMP4 period.

Annex 1 provides a summary of the overall early start initiative by projects and assumed investment levels. We have assumed capital costs for the early start initiative of £1090m.

To put this into context, we expect that companies will also continue, on average, with at least the current levels of capital maintenance going forward into 2005-06. Investment will also be needed to support growth in demand, development and meet demands for optional meters. There is also a considerable amount of work to complete the AMP3 programmes set in 1999, both to the end of March 2005, and for a few companies into the first 9 months of AMP4. Companies will also need to carry out other work in 2005-06, that did not meet our criteria for the early start initiative. Finally, there will be investment in 2005-06 to ensure delivery of schemes later in the period.

Next steps

We will be monitoring delivery of the early start project through our normal annual cycle – June returns and the regular progress reports from colleagues in the EA and DWI. If a company fails to deliver any of these projects we would expect this to lead to regulatory enforcement action that would include a full financial reconciliation of the shortfalls or changes in obligations at the next suitable price setting.

If you have any comments or queries on the early start initiative please contact either Rowena Tye (0121 6251364 rowena.tye@ofwat.gsi.gov.uk) or Simon Walster (0121 6251407 simon.walster@ofwat.gsi.gov.uk)

Yours sincerely

BILL EMERY
Director of Costs & Performance
and Chief Engineer

Overall summary

Category of Work	Water service		Sewerage service		Combined service
	Number of schemes	Capex total	Number of schemes	Capex total	Number of schemes	Capex total
	Nr	£m	Nr	£m	Nr	£m	% of total
Capital maintenance	145	170	153	210	298	380	35%
Enhanced service levels	N/A	N/A	409	80	409	80	7%
Supply/Demand balance	23	210	22	20	45	230	21%
Quality enhancement	63	240	222	160	285	400	37%
Total	231	620	806	470	1037	1090	100%