CONTENTS

1. Foreword

2. Summary

3. The framework for setting price limits

4. The business planning process

5. Taking account of the views of interested parties

6. Key issues in the approach to setting price limits

7. Information to support price setting

Appendices

Respondents to the proposed framework and approach to the 1999 Periodic Review

Respondents to the Business planning process, customer consultation and information requirements for the 1999 Periodic Review

National customer surveys in 1998

Serviceability of water and sewerage assets in England and Wales

The principles of broad equivalence

A résumé of responses on the proposed information submissions

The proposed content of the draft Business Plan

Glossary

Last summer, I published two consultation papers: The proposed framework and approach to the 1999 Periodic Review and The business planning process, customer consultation and information requirements for the 1999 Periodic Review.

This paper summarises the responses I received and, in the light of these, sets out my decisions, together with my reasoning.

I received a substantial number of responses to each paper. On some issues, the responses showed a marked diversity of views. This is perhaps to be expected from the widely-differing parties interested in the water industry. In framing my decisions, I have considered carefully all the responses in order to achieve a reasonable balance between two overarching objectives. First, a regulatory regime which preserves incentives for companies to act efficiently. Secondly, to ensure that customers benefit, and are seen to benefit, as soon as possible from efficiencies which the industry has already achieved.

In many instances, the consultation has reinforced the thinking I set out in my earlier papers. In a few important areas, such as the effect which the proposed treatment of capital efficiencies would have had on incentives and the burden imposed on companies by the proposed Periodic Review timetable, I have changed my proposals.

The consultation papers were issued before the Government's Review of Utility Regulation was announced. The results of the Government's review will be announced in a Green Paper to be published shortly. In my submission to the Government, I argued for changes in the regime to strengthen the protection of customers.

My consultation papers and this paper have been written on the basis that the RPI-X price-cap regime would continue and would not be replaced or complemented by any form of formal profit sharing scheme. The responses which I received uniformly supported my approach. Changes resulting from the Government's review could affect the balance between incentives to efficiency and early benefits to customers.

The next stage of the price review will be to publish, at the end of April, an open letter to the Deputy Prime Minister and the Secretary of State for Wales. This will make clear how much customers are already paying in their bills to allow the companies to meet quality obligations. It will also estimate how much they may expect to pay in future should various proposals, originating from European Community Directives or from the Environment Agency's National Environmental Programme, be implemented in UK law.

I then intend to publish, in October, a consultation paper for the Periodic Review, Prospects for prices, strategic options and issues. This will set out, for the first time, ranges of possible price limits for each company for the period 2000–05. It will allow all interested parties to see the possible impact on customers' bills of the potential environmental obligations which companies may face, taking into account levels of service to customers and expected improvements in efficiency. This paper should foster debate about customers' priorities and their willingness to continue to pay for improvements to the environment and for customer service. I will expect companies to prepare their draft Business Plans, due for submission to me in April 1999, taking into account the responses to that consultation paper.

There are many stakeholders in this price review. They all need opportunities to put forward their points of view. My starting position, as economic regulator, is that, at the start of the new price limits, companies should not earn more than is necessary to finance their functions.

I C R BYATT

Director General of Water Services

2. SUMMARY

On 15 October 1996, the Director General of Water Services (the Director) announced that in 1999 he would be determining price limits for water companies from 1 April 2000. On 11 February 1997, he set out his proposed timetable for the Periodic Review (the review) in MD124, a letter to the Managing Directors.

Throughout the review, the Director intends to conduct an open and transparent process and to consult widely. He published two consultation papers in the summer of 1997 seeking the views of interested parties on various aspects of it.

The proposed framework and approach to the 1999 Periodic Review (June 1997) (the Framework paper) sought views on the Director's approach to the methodology of setting price limits. The business planning process, customer consultation and information requirements for the 1999 Periodic Review (July 1997) (the Business planning paper) considered other aspects of the review. The respondents to these two papers are listed in Appendices 1 and 2 respectively. Copies of the responses are available from the Ofwat Library.

In light of the responses received, this paper sets out the approach the Director intends to adopt in setting prices, together with the business planning process and information requirements needed to do so.

2.1 Significant changes to the methodology

Following the consultation, the Director has proposed two significant changes to the way he will set prices.

First, the Director has concluded that the proposed approach to paying for quality obligations only after the companies had delivered the planned outputs should not be followed. He noted concerns that this approach would entail significant risk for companies and so lead to a higher cost of capital. He considers that the benefits of transparency to customers do not outweigh the possibility that customers' bills may ultimately be higher. There are also considerable practical complexities entailed in this approach, including the possible requirement for licence amendments. There are other ways of ensuring timely compliance with new quality obligations.

The Director will, therefore, continue to set prices so that customers pay for quality improvements through bills, which cover the financing costs of the relevant capital expenditure, while work is being carried out. The approach will be developed to achieve greater transparency in the monitoring and the delivery of the programmes. This is discussed in more detail in Section 6.2.2.4.

Secondly, the Director has re-examined his proposals for transfering the benefit of capital efficiencies to customers through the regulatory capital value and the impact of this upon incentives. He now proposes that companies retain capital efficiencies for five years and, consequently, adjustments will be made to the regulatory capital value on a rolling basis. The Director believes that five years is an appropriate period to provide companies with adequate incentives to make efficiencies but for customers to realise the benefit of them as quickly as possible. This is discussed in more detail in Section 6.5.1.

2.2 The framework for setting prices

In response to the suggestions made in his Framework paper, the Director intends to conduct the 1999 Periodic Review, subject to any legislative changes resulting from the Government's Review of Utility Regulation, in the following manner:

• The Director believes the system of regulation and the setting of price limits should provide incentives for water companies to become more efficient and to improve their services to customers. Of the various alternatives, he believes the current method of setting fixed price limits for a number of years is the best way of achieving this. This system allows savings made by companies to be transferred to customers at price reviews.
• He proposes to set new price limits every five years. This will require companies' licences to be changed. The existing licence terms which allow for price limits to be adjusted within the five year period following specified changes in circumstances and, in particular, the imposition of new environmental obligations, will be retained.
• In the first year of the new price limits, 2000–01, the Director will reduce prices and profits (through the so called P_o adjustment). This price reduction, which will vary from company to company, will reflect the fact that companies have been able to provide their services at lower costs than the Director expected. It will allow customers to benefit from this greater efficiency. This approach was endorsed by the Committee of Public Accounts.
• Following the first year's price reduction, the Director will set prices for the remaining four years after examining the amount of investment which companies will need to make in order to provide the necessary services to customers. He will also examine the scope for them to make further improvements in efficiency. At this stage in the review, it is too early to know whether these future efficiency savings will be great enough to allow the companies to meet their investment obligations without prices having to rise.
• The Ofwat National Customer Council (ONCC) has said it would not like to see prices rising by more than the level of inflation after the first year. The Director is sympathetic to this view. Whether this is possible will depend on the preferences expressed by customers, following consultation with them by the companies and the Ofwat Customer Service Committees (CSCs), and the views of the Deputy Prime Minster and the Secretary of State for Wales (the Secretaries of State) on the size of the future environmental and drinking water improvement programmes.
• The Director will maintain incentives for companies to become more efficient and produce better services for customers by:
  Setting efficiency targets for each company for the five years of the new price limits. He will assess each company's current efficiency by comparing it with other companies. He will compare the quality of the service provided by the companies as well as the costs of providing it. In looking at costs, he will consider operating costs and capital expenditure costs separately, but will also look at how these affect each other.

  Ensuring that those companies that are currently less efficient are set tougher targets. The Director will consider how quickly the less efficient companies may be expected to catch up with the most efficient. Companies that have made good progress and are at the forefront of efficiency will be expected to make only modest improvements over the five year period.

  Taking into account, when setting the level of the first year price reduction, that some companies have already shared efficiency savings with customers through cash rebates, by increasing prices by less than they were allowed to or by carrying out supplementary investment.

  Making adjustments to the first year price reduction to reflect the quality of the overall level of service provided to customers. Although this is subject to further assessment, the Director believes that adjusting prices within a range of, say, +0.5% for the best performing companies and –0.5% for the worst would be appropriate.

  Passing to customers the benefits of efficiency savings on capital investment programmes in a way which provides incentives for the companies to make such efficiencies. He believes this would be achieved by allowing companies to retain any savings for a period of five years. To achieve this, adjustments would be made, on a rolling basis, to the companies' regulatory capital values. Where companies have made supplementary investment from any savings achieved in their capital investment programmes, companies will earn a reasonable return on that investment, providing that it is in accordance with the preferences of and benefits customers.

• The Director will scrutinise each company's requirements for investment. He will look at the investment needed to maintain the existing network of water mains and sewers. His first concern will be to examine whether these networks are maintaining the quality of service to customers. Provided they are, he will require well argued justification before he will allow in price limits for more money to be spent on maintenance or improvement. It is for companies to consider age and condition when deciding their priorities for maintenance work. In some cases, where the networks are maintaining the quality of service, the Director may assume, when setting price limits, that a company could be more efficient in its expenditure on maintenance.
• The Director would like to achieve a fair balance between present and future generations of customers in terms of the amounts paid in their bills for maintaining companies' assets, both above and below ground. He will do this by bringing the allowance made in price limits for depreciation and infrastructure renewal charges into line with the levels of expenditure to maintain services to customers. The Director proposes to assess such expenditure over 15 years for underground assets and 23 years for surface assets.
• He will also look at each company's past record in meeting its statutory environmental obligations and obligations to improve the quality of drinking water. If companies fail to meet them, they risk enforcement action being taken by the Environment Agency (EA) and the Drinking Water Inspectorate (DWI) to make them do so. The Director would also make a financial adjustment to the company's regulatory capital value to ensure it did not gain financially from any such failures.
• The Director will allow in price limits for future investment, provided it is necessary to meet new obligations, there is a set timescale for its completion and it is clear how it can be achieved. The Director will ask the Secretaries of State to guide him and the companies on the types of projects and schemes which are likely to fall into these categories. Such schemes may result from European Directives, UK legislation or national initiatives.
• Customers will, however, continue to pay for such investment projects in a way similar to a repayment mortgage, ie over the life of the assets created, rather than pound for pound as capital is spent.
• The Director will want to ensure that customers' reasonable demands for water are met in the most cost effective way:
  The balance of evidence shows there is no need for the amount of water delivered to each household for domestic purposes to increase. If there is increased demand for garden watering or commercial water use, such uses should be selectively metered. This would ensure that only those customers who are using more water than they did before, pay extra for it. The Director intends to encourage companies to introduce charging systems which encourage the efficient and economical use of water.

  Some companies have argued that they need to develop new water resources. The Director will ask companies to justify why this is necessary and to demonstrate that they have looked at alternatives, such as reducing leakage and increasing metering. The Director will not allow companies to pass on to customers the costs of developing new resources, such as reservoirs, when it would be cheaper for them to reduce their levels of leakage.

  Infrastructure charges for water and sewerage should remain at their existing levels, indexed for general inflation.

  It may be necessary, because of changes to the climate or the need, for example, to abstract less water from certain rivers, to allow some companies to increase charges to customers generally to pay for any required investment. However, some companies argue that they need to invest in new water resources to provide a greater safety margin to cater for possible future droughts. These companies will be expected to demonstrate that their customers are prepared to pay higher bills for what amounts to an increased level of service.

  All companies will be set targets for reducing leakage. Failure to meet these targets will result in enforcement action by the Director.

• The Director believes the water industry remains relatively low risk compared with other industries, and indeed with many other utilities. Any uncertainty created by the regulatory system itself may be better assessed once the Government has set out its proposals for changes to utility regulation. In setting price limits, he will assume that companies choose the cheapest form of finance available at that time, which will, in some cases, mean a continuation of the trend towards higher borrowings. He will also assume that the companies can choose from a broad range of financing options, including issuing new shares. The cost of capital for water and sewerage companies seems unlikely to have altered substantially, ignoring taxes, from its level in 1994. However, the Director will take account of significant changes to the tax system announced since then.

There was broad support from respondents for the Director's objectives for the review process, which were:

• to operate an open and transparent process
• to operate an effective process
• to ensure efficient use of data.

The first phase will be to develop the framework and expose issues (February 1997 to October 1998).

• The Director will publish in April 1998 an open letter to the Secretaries of State on the implications for customers of potential environmental and drinking water quality improvements.
• Phase one finishes with the publication of the Director's paper Prospects for prices: strategic options and issues in October 1998. This paper is central to his approach to the review. It will pull together all the relevant issues at both a national and local level. It will set out for the first time ranges of possible price limits for each company for the period 2000–05. It will consider the likely impact on customers' bills of the options for environmental improvements, as well as options for improvements to other services and assess the results of the consultation with customers on their priorities. This paper will take account of the EA's prioritised programme for environmental obligations which will be published shortly after. The Director and the EA will co-ordinate the preparation of their respective publications.

• Following Prospects for prices and the guidance provided by the Secretaries of State, EA and DWI on quality improvements, the companies will submit their views on price limits in their draft Business Plans in April 1999. The companies will be required to publish public summaries of their plans. The Director will issue his draft determinations of price limits in July 1999 and, following representations on these from companies, issue his final determinations in November 1999.

• Companies will publish their monitoring plans for the next five years in March 2000 and implement the price limits from April 2000 onwards.

Most interested parties accepted, with some misgivings, the lengthy programme for the review outlined in MD124 (February 1997) and explained in the Business planning paper. All saw the need for the clear timetable and for a common understanding about when contributions to the debates and discussions would be most productive. Chapter 4 of this paper confirms the timetable.

The Director recognises the importance of good consultation with customers at regional and local levels. In line with his own practice, he suggests that companies, CSCs and the EA regions set down how they intend to assess the views and priorities of both household and business customers. He encourages companies and others to publish their research so that all can understand the basis of the findings and the conclusions drawn from them.

The Director believes it will be sensible to evaluate the results of the work done by others before deciding whether he needs to carry out any further research.

The EA's consultation paper Outlook for the Environment (January 1998) sets out how its consultation on the key environmental issues will be carried out. Decisions on these matters rest with Government ministers.

2.5 Information requirements for price setting

It is important for Ofwat to receive early information from companies so that a debate on the issues can take place. The Business planning paper proposed a series of separate early information returns that would be required from the companies and which would inform the analysis to be included in the Prospects for prices paper. These returns are in addition to the companies' draft Business Plans required in April 1999 and the Monitoring Plans (AMP3) required after price limits have been set.

Overall, the Director's information strategy was well received and accepted. All recognised the need for the separate early returns, although several companies pointed out the implications of the timetable on the quality of data in the earlier (phase one) returns.

The Director recognises the companies' concern about the amount of information required for the review. Ofwat is reviewing the scope of the phase one submissions following recent consultation on the draft reporting requirements and will streamline the information requirements wherever feasible. However, the timetable set out in this paper must be adhered to and good quality data must be provided, given the importance of the Prospects for prices paper.

Further information on the data required in phases two and three of the process is outlined in this paper. In particular, a description of the proposed content of the draft Business Plan is provided in Appendix 7. These plans will be shorter and more focused than the 1994 Strategic Business Plans. There will need to be a clear linkage between the earlier information submissions and the draft Business Plan. The exposure and challenge of issues and assumptions is likely to result in changes to the information submitted in earlier returns. Hence, the draft Business Plan will need to restate material elements of the data submitted earlier so that the latest positions can be assessed.

The Director recognises the problems that external readers will have in locating the relevant information. He will produce one page summaries to explain the nature of submissions required by Ofwat and ask companies to produce one page summaries of their submissions which will be placed in the Ofwat library.

The Director will publish in July 1998 a detailed specification of the rules and calculations used in the modelling of financial projections. This will be independently audited.

The Director confirms his general presumption that the company information returns will be non-confidential. He will only respect information submitted as confidential provided it is clear that those requesting confidentiality have properly addressed the 'substantial harm' test outlined in the Freedom of Information White Paper. In this case, he will publish the reasons given by those requiring information to be treated confidentially.

3. THE FRAMEWORK FOR SETTING PRICE LIMITS

3.1 The approach

The Director has a statutory duty to act in the manner which he considers best calculated to secure that the functions of water and sewerage undertakers are properly carried out and that those companies are able to finance the proper carrying out of their functions.

In setting price limits, he interprets this to mean that prices may be set in such a way that passes on to customers the benefits of companies' increasing efficiency, while providing finance for companies to meet their legal obligations, maintain an adequate service and provide a reasonable return for shareholders.

The Framework paper maintained that the RPI+K regime provides powerful incentives for companies to become more efficient. Respondents to the consultation paper generally agreed that this framework was appropriate and should be retained. It was preferred to mandatory forms of profit sharing or sliding scale mechanisms.

The Director recognises that it is desirable to apply the regime in such a way that maintains sufficient incentives for companies to improve their operating and capital efficiencies but also increases the benefits to customers. Many respondents to the Framework paper commented on the balance and judgements necessary in this area. These are discussed further in the following sections.

3.2 Framework

The Framework paper identified key constituents of K which are considered to influence price limits.

K Þ - P_o – X + Q + V + S

The constituents are to take account of :

P_o - Past outperformance

X - Future efficiency gains

Q - Quality standards

V - Enhancements to the security of supply

S - Enhanced service levels

Not all of the factors apply to all companies and, in addition, some of the elements interact. The Director does not, therefore, intend to publish separate values for all of these elements of K when he determines final price limits. Separate K factors will not be set for water and sewerage. He will, however, indicate which are the chief factors driving the trend in customers' bills and set out indicative Ks for water and sewerage services.

3.3 Outperformance and P_o

In the Framework paper, the Director asked how benefits should be passed to customers and, in particular, whether prices should fall in real terms across the industry for the first time – the P_o adjustment.

Many respondents agreed that the current regulatory regime creates strong incentives for companies to minimise their costs within their price limits. Customers benefit from these incentives at reviews when the Director resets price limits and takes account of the companies' achievements.

The Director proposed that past outperformance should be transferred rapidly to customers through an initial adjustment to prices. The initial adjustment would be represented by the P_o element of K in the first year of the new price limits. The Director considered that this would produce earlier and greater benefits for customers without materially reducing incentives.

Responses from customers and customer groups supported such an approach and welcomed a reduction in prices. The ONCC wanted prices in the years 2001–05 to remain below the rate of inflation. Environmental groups supported the rapid transfer of benefits, but argued that efficiency gains should be used to finance environmentally beneficial schemes rather than reducing prices.

The Director has also noted the comments of the Committee of Public Accounts (PAC) both in its review of the work of the Directors General of utilities and more recently. The PAC was concerned that profits should be no more than sufficient to provide the return required to attract the necessary funds for future investment.

The Director proposed that a company-specific package of P_o and X factors (for future efficiency) would provide greater incentives than a uniform industry wide P_o adjustment. This was broadly agreed by all respondents, although a small number of companies argued for the uniform P_o approach.

More generally, companies suggested that a P_o adjustment would erode incentives to achieve further efficiencies. They argued that the balance between investors and customers in the sharing of any efficiencies would be too heavily weighted towards customers. The more efficient companies also considered that they would be penalised by the approach relative to the more inefficient companies. Companies, generally, favoured the retention of a `glidepath', similar to that in the 1994 price limits, whereby the benefits arising from efficiency savings are gradually transferred to customers over a period.

The Director considers that without a P_o adjustment the rates of return earned by the companies will remain above the cost of capital for some time. The length of this period will depend on the profile of the K factors. This glidepath would result in higher profitability for companies than is necessary to finance their functions.

The Director remains of the view that P_o adjustments should be made unless further research and consultation with customers demonstrates strongly that this is not their preference. The Director considers that incentives to companies can be maintained, particularly through the interaction between a P_o adjustment, which captures past efficiencies, and the X factors for future efficiency.

Companies that have achieved greater efficiencies than was anticipated at the last review will have relatively higher P_o adjustments than those which did not. However, the future targets for efficiency will be set relative to the achievements of the most efficient companies. This implies that the future X factors will be commensurately higher for the relatively inefficient companies than for the efficient ones.

The phasing of future efficiencies is of critical importance and is discussed further in Section 6.1.3.

The Director hopes that the K factors in the four years after the P_o adjustment can be zero, or possibly negative, but this will depend principally on the scope for future efficiency and the size of the quality programme for each company.

3.4 Formal profit sharing mechanisms

There was little support from respondents for a formal profit sharing or sliding scale mechanism to be incorporated within the regulatory framework, particularly in the light of the proposal for a P_o adjustment.

The adverse impact on incentives was clearly recognised. Companies would be likely to find rather fewer cost savings, to the ultimate detriment of customers' bills. Profit sharing mechanisms were also considered to be less relevant if there were to be shorter periods between reviews.

3.5 Voluntary sharing mechanisms

The Director has encouraged companies to share benefits voluntarily with customers between reviews. These have been in the form of cash rebates, deferral of K factors or supplementary investment.

Respondents welcomed the continuation of voluntary benefit sharing of outperformance. The Director will take account of rebates or deferrals of K resulting from outperformance. This will take the form of an equivalent credit for amounts paid under such schemes on a rolling basis. This should ensure that companies that have shared outperformance with customers are not disadvantaged compared with companies which have not done so. This is set out further in Section 6.5.1 on regulatory capital values. Supplementary investment will be treated similarly and this is discussed further in Section 6.4.2 on service performance and Section 6.5.1.

3.6 The period between price reviews

The Director proposed in the Framework paper that Periodic Reviews take place every five years and that companies' licences should be amended to reflect this.

Currently, the Director sets prices for a period of ten years with an option to re-determine them after five years if he or the companies wish.

The Framework paper and the public letter to companies (MD124) discussed the optimum period between reviews. The Director suggested that a five year period adequately balances the need to maintain a stable long-term framework that gives incentives to companies with the speed with which the benefits of efficiencies are transferred to customers. The Director also recognised that the effect of a P_o adjustment is also relevant to this balance.

The majority of respondents accepted that five years is an appropriate period and the Director concurs with this. Certain companies questioned whether this needs to be formalised by a licence amendment, but the Director believes an amendment would remove any doubt about the timing of reviews.

4. THE BUSINESS PLANNING PROCESS

4.1 Responses to the Business planning paper

The Business planning paper set out the Director's objectives for the review process. These were:

• to operate an open and transparent process
• to operate an effective process
• to ensure efficient use of data.

Phase one: Developing the framework and exposure of the issues (February 1997 to October 1998)

Phase two: Decisions and determinations (October 1998 to November 1999)

Phase three: Implementation (December 1999 onwards).

 

Respondents gave near universal endorsement to the proposed phased process and objectives underpinning it. Most respondents accepted that interested parties would require time to reflect on the emerging issues and so supported the lengthy process set down by the Director. The importance of the first phase in the success of the review was highlighted by many respondents.

Many respondents wanted greater clarity on how consultation with customers (and their representative bodies) is to proceed during the phases of the review. There were concerns expressed as to the closed nature of the proposed quadripartite process. Some respondents also made strong pleas for more accessible and understandable explanations of issues and assessments made by companies and regulators. Companies requested more explicit feedback mechanisms following the Director's assessment of their submissions. Some respondents wanted greater clarity on the integration of decisions on quality obligations into the process. These concerns are discussed further in Chapters Five and Seven.

4.2 The phases and milestones of the review

In the light of these supportive comments, the Director confirms the business planning process as set down in the Business planning paper. The milestones in each phase have been expanded to include the steps and timetable set out by the EA in its recent consultation paper Outlook for the Environment (January 1998) and also the involvement of the Department of the Environment, Transport and the Regions (DETR). The three phases and their respective milestones are described below.

4.2.1 Phase one: Developing the framework and exposure of issues

The milestones, key dates and lead parties for phase one, leading to the publication of Prospects for prices, are set out in the table below.

Lead party	Milestones	Key dates
Ofwat	Consultation on MD124 —1999 Periodic Review	February to May 1997
Ofwat	Consultation on The proposed framework and approach to the 1999 Periodic Review	June to October 1997
Ofwat	Consultation on The business planning process, customer consultation and information requirements for the 1999 Periodic Review	July to mid November 1997
Ofwat	The Director's paper The framework and business planning process for the 1999 Periodic Review	February 1998
Environment Agency	Consultation on Outlook for the Environment setting down the broad priorities, principles and benefits which should be sought from the environment programmes for water companies after 2000.	January 1998 until 21 February 1998
Ofwat	The Director's open letter to the Secretaries of State exposing the implications for customers of the potential environmental and drinking water improvements and the possible scope for efficiency	April 1998
Environment Agency	The EA publishes advice to Secretaries of State on broad priorities and benefits of environmental improvements.	May 1998
DETR and Welsh Office	DETR and Welsh Office open to representation from interested parties on priorities for environment improvements.	May to June 1998
Companies and CSCs	Companies and CSCs summarise their customer consultation results and the implications for future service	Early August 1998
Ofwat	The Director's paper Prospects for prices: strategic options and issues	October 1998 Consultation closes early January 1999

The Director has set out his conclusions and decisions on the information requirements to support price setting and the approach he will take in this paper.

In late April 1998, the Director will advise the Secretaries of State, in an open letter, of the indicative costs of the possible environmental and drinking water programmes. The Director will be seeking initial policy guidance from the Secretaries of State on the scale and timing of such obligations. The Director is seeking this guidance by late July 1998 to enable the EA and the DWI to advise on quality requirements in the early autumn of 1998.

In early August 1998, companies will summarise the results of their customer consultation and set out their preferred option for the balance between service levels and customer charges. The CSCs will also report to the Director on the customer consultation process and the companies' submissions.

4.2.2 Prospects for prices: strategic options and issues

Phase one of the business planning process closes with the critically important paper, Prospects for prices: strategic options and issues, which will be published in October 1998. The Director intends to bring together the results and views of interested parties. The paper will identify strategic issues on balancing needs and priorities within prices acceptable to customers. It will identify critical issues for individual regions while focusing generally on the national picture. To achieve these objectives, the Director anticipates that his paper will draw on, and bring together, the position reached on:

• consultation with customers on their priorities;
• the likely impact of statutory environmental and drinking water obligations, especially for the period 2000–05, on the basis of the policy guidance received from the Secretaries of State;
• the drinking water quality requirements as specified in the new Drinking Water Directive;
• work by the EA, other statutory environmental bodies, environmental interest groups and the CSCs on the priorities for the environment in the light of their costs together with the guidance from the Secretaries of State. This will include the implications of the EA's prioritised programme of environmental improvements to be published in November 1998.
• the most cost effective way of balancing supply and demand in the light of guidance from the EA and Secretaries of State; and
• Ofwat's work on the possible scope for the size of an initial downward adjustment to prices and expectations about future efficiency and other factors influencing price limits. This would build on the comparative efficiency work following the July Return 1998 submissions from companies.

The milestones, key dates and lead parties for phase two are set out in the table below:

Lead party	Milestones	Key dates
DETR and Welsh Office	Guidance issued by Secretaries of State on priorities for water quality improvements and the environment, including views on the scope for environmental improvements for each water company	July 1998
Environment Agency	In the light of guidance from Secretaries of State, interested parties invited to put forward their priorities for environmental improvements to the EA together with an assessment of the associated benefits	August to October 1998
Environment Agency	EA publishes prioritised programme of environmental improvements for approval by Secretaries of State	November 1998
Ofwat and companies	A series of formal meetings between the Director and the individual companies	January and February 1999
DETR and the Welsh Office	DETR and Welsh Office make decisions on environmental objectives for each water company for the period (2000–05)	Early March 1999
Companies	Companies submit draft Business Plans to support their proposals for price limits	By 9 April 1999
Ofwat	The Director's draft determinations of price limits published for consultation	End July 1999
Companies	Representations on the draft determinations	September and October 1999
Ofwat	The Director's final determinations of price limits published	End November 1999

The Prospects for prices paper will need to take account of the EA's prioritised programme for environmental improvements to be published a few days later. The Director and the EA will co-ordinate the preparation of their respective publications at that stage. These publications will provide the basis for discussions between the Director and individual companies early in 1999, as well as enabling other interested parties to express views on the emerging strategic options and issues.

During January and February 1999, the Director will hold a formal meeting with each company to discuss the issues raised in the Prospects for prices paper and how the company intends to deal with them in its draft Business Plan to be submitted to the Director in April 1999.

These meetings provide the final opportunity for companies to discuss matters with the Director prior to the submission of their plans. Earlier in the business planning process, there will have been several opportunities for dialogue between Ofwat and the companies on their key issues.

Each company's plan will incorporate its proposals for 2000–01 to 2004–05, explaining the basis of the price limits requested and its reasons for them. The submission would include the companies' forecast outturns for 1998–99. Companies will be required to publish public summaries of their plans.

The Director will prepare his draft determinations in the period from early April to late July 1999. The Director will publish, in late July 1999, the draft determinations in a report setting out the individual company K factors, infrastructure charge limits and the outputs required during the next price limit period. The report will provide broad justifications for the Director's decisions and set out an account of the consultations which have taken place.

At the same time, the Director will write to each company with an explanation of the factors underlying the draft determination specific to the company and not included in the formal publication.

A longer period than that allowed at the 1994 review will be required between receipt of the companies' draft Business Plans and final determinations, in order to allow for external consultation and comment on the draft determinations.

There will then be a series of formal meetings between the Director and each company during September and October 1999. These meetings will provide each company with the opportunity to make representations on the draft determination before the Director makes his final determination. The Director proposes to announce his final determinations in November 1999.

4.2.4 Phase three: Implementation

The milestones, key dates and lead parties for the implementation of price limits and subsequent monitoring regime are set out below:

Lead party	Milestone	Key dates
Companies	The monitoring plan (AMP3) published by each company, setting down its service, quality and environmental improvement plans together with how these will be achieved and the prices to be charged.	31 March 2000
Ofwat	New price limits in force	April 2000
Ofwat, EA and DWI	Active annual monitoring of company performance — July Return 2000, July Return 2001 etc.	July each year

Each company will prepare and publish a Monitoring Plan (AMP3) identifying the outputs that it is required to deliver year by year through the next price limit period. The plan will also indicate the expected expenditure levels and key activity profiles as set down in the final determination. The implications for customers' bills will be set down in accordance with the Director's final determination.

The Monitoring Plan (AMP3) will be reviewed by the Director, the EA and the DWI to confirm that the output profiles are correct.

The plan will be used by the Director, the EA, DWI and other interested parties to assess the performance of the company year by year throughout the price limit period.

4.3 Modelling of the financial projections

The Director recognises that companies and other interested parties want to understand how the detailed methodology and information submissions are incorporated in the financial projections which underpin price limits.

He considers that this can be achieved by the publication of a detailed specification of the rules and calculations used in the modelling of financial projections. This specification will be published in July 1998.

The financial model and the specification will be independently audited to provide external certification that the published specification corresponds to the working of the model.

4.4 Improved arrangements for Reporters and Auditors

The Business planning paper explained how the Director intends to use Reporters and Auditors. He made proposals in MD126 (March 1997) to strengthen the appointment of Reporters.

Many company respondents were concerned that it would be very disruptive to adopt the appointment procedures set out in MD126, but agreed there was a need to resolve the requirements for reporting on companies' submissions.

Some respondents considered that the Reporter's role was suspect and flawed. These respondents saw a need for Ofwat to adopt a more conventional approach, which would require Ofwat to appoint and pay for the Reporters.

The Director issued a new protocol for Reporters in November 1997 (MD130). This addressed the main points made by respondents. The Director considers that, at this time, it is not necessary for him to employ the Reporters directly.

4.5 Other issues raised by respondents

A number of customer representatives commented on the use of jargon and difficulties they had in understanding Ofwat papers. Some respondents wished to see simpler and more explicit information in the public domain. One respondent suggested it would be more helpful to use proportions of customer bills rather than annual movements in bills. They saw this as a more transparent way of exposing the impact of quality obligations.

These points have been noted. Ofwat will make every effort to produce reports and papers that are more easily understandable to a lay audience. Where it is necessary to use complex terms, Ofwat will provide a simple summary of the key points and also a glossary.

5. TAKING ACCOUNT OF THE VIEWS OF INTERESTED PARTIES

The Business planning paper explained how the Director proposed to involve the major interested parties in the review. These are:

• customers

• the EA and environmental interest groups

• investors and lenders.

5.1 Customers

Respondents generally welcomed and supported the commitment to customer consultation, without commenting on the detail of the proposed arrangements. There was broad support for the proposed co-operation between companies, Ofwat, CSCs and the EA to understand customers' views at the regional level. A number wanted more account to be taken of customers' views than was apparent to them in the 1994 review. Some were concerned that the Director had prejudged what customers want. Most comments on the arrangements were made by customer groups, principally the CSCs, the Consumers' Association (CA) and the National Consumer Council (NCC).

CSCs agreed that the focus of consultation should be at the regional level, involving themselves, the companies, the EA and other regional customer and environmental organisations. On the other hand, the NCC and the CA, while recognising that this is important, thought the Director should not rely solely on company market research but that Ofwat should carry out its own. CA argued that this research would only be a true indication of customers' views and priorities if it was done independently and in a consistent fashion. On a related point, CA and NCC queried whether the CSCs had sufficient expertise in, and resources for, market research to provide the Director with advice on the conclusions to be drawn from the customer consultation. One respondent representing business customers felt that the CSCs, and the ONCC, were more concerned with the interests of household customers, to the possible detriment of other customers.

Some national customer organisations wanted to be able to raise issues direct with the Director during the period of the review. They have urged the Director to continue to make use of seminars to discuss specific issues.

Since publication of the Business planning paper, discussions have taken place at a regional level between companies, CSCs and the regional offices of the EA to formulate plans for consultation. CSCs generally report effective working relationships with the companies, including involvement in the design of questionnaires and observation of focus group discussions.

At a national level, a number of organisations have decided to commission market research. These are DETR, The Water Services Association (WSA), The Water Companies Association (WCA), the EA and the CA. Ofwat has been fully involved in the work of the WSA/WCA. The ONCC will commission national research to provide a framework within which the CSCs can consider the results from individual companies. Appendix 3 to this paper provides more detail of the objectives and timing of the work to be done at a national level.

In the light of this, the Director believes it is sensible to evaluate the results of work done by others, both at a regional and national level, before deciding whether any further research is necessary to clarify issues or address omissions.

Nevertheless, it is important that the regional consultation is conducted in an objective and professional manner and that all interested parties are satisfied that conclusions drawn are soundly based. Ofwat will monitor companies' approaches and support the CSCs in assessing whether consultation work addresses the central issues and is representative of the whole range of the customer base. The Director has proposed to companies that details of their market research should be made public. Similarly, he expects that work done at a national level by other organisations will also be made public.

He also expects that each CSC, water company and EA region will state publicly how they intend to identify household and business customers' views and priorities within their areas.

Finally, the Director will invite the key customer groups to seminars to discuss the views of customers. These will need to coincide with early market research work in this area.

5.2 Environment Agency and environmental interest groups

Both consultation papers drew attention to the importance of decisions on the size and timing of future environmental improvements. Decisions on these matters will be made by the Secretaries of State. DETR has established a quadripartite process to help expose the quality issues. Respondents' concerns as to the transparency of the quadripartite process have been relayed to DETR. The quadripartite process will not itself make decisions; it is a mechanism to assist in the orderly and timely collection of information to support public debate and the decisions to be taken by the Secretaries of State.

The EA plays a central role in advising the Secretaries of State. Respondents to the Director's consultation paper sought greater clarity about the process to be followed by the EA in advising Ministers on environmental priorities. Other statutory environmental bodies and environmental interest groups wanted to ensure their views would not be diluted in the EA's advice. The EA has recently set down its proposals as to how it will consult on the priorities for environmental improvements within the context of the review — Outlook for the Environment (January 1998). These concerns have been addressed by the EA in its consultation paper. This greater clarity provides the basis for interested parties to make their views known to the EA, the Director and to DETR at the appropriate times.

The Director held a seminar with the EA, statutory environmental bodies and other environmental interest groups in September 1997 to explain the process and to gain feedback on his proposals. He also wanted to understand their environmental priorities. Further seminars will be held as the review proceeds.

The Director and the EA will co-ordinate the preparation of their respective publications, particularly Prospects for Prices in October 1998 and the EA's prioritised programme of environmental improvements which will be published very shortly after.

5.3 Investors and lenders

Ofwat has held meetings with a number of investors and lenders to obtain their views. Nothing has arisen in these discussions that would require the procedures established to be revised to take account of their views.

6 KEY ISSUES IN THE APPROACH TO SETTING PRICE LIMITS

The following sections set out in more detail the approach to be taken in setting price limits. The views of respondents to each of the key issues raised in the Framework paper are also summarised.

6.1 Efficiency past and future

6.1.1 Incentive regulation and efficiency

In a competitive market, companies become successful by anticipating their customers' requirements, improving performance and reducing costs. They, therefore, improve value for money, profitability and market share. It is competitive pressure that causes companies to become more efficient. In the absence of competition in the water industry, the RPI+K regime provides incentives to reduce costs. The benefit of reduced costs is passed on to customers through the setting of price limits by the Director.

Respondents to the consultation paper agreed that the RPI+K regime was working well. Companies are making considerable efficiency gains and, as a consequence, shareholders have benefited substantially. The Director wishes to measure improvements in efficiency so that prices from 2000 properly reflect the cost savings that companies have achieved. This will be passed to customers through the initial reduction in prices ( P_o).

The Director intends to set targets for future efficiency beyond 2000 (X factors), specific to each company. The relationship between P_o and X has been discussed in Section 3.3. In order to assess the X factors, the Director will use a similar approach to that taken at the last review, using comparative efficiency studies and by considering efficiency improvements achieved in the wider economy.

The proposed methodology for the assessment of both past and future efficiencies and the views of respondents to the issues raised in the Framework paper are discussed in the following sections.

6.1.2 Measuring past efficiency gains

6.1.2.1 Operating cost assessments and past operating efficiency

The Director's approach to assessing past operating efficiency was set out in the Framework paper. It is intended that operating cost efficiencies will be incorporated in the first year of new price limits and will be based on the level of operating costs in 1997–98, excluding short-term atypical costs. This will be constrained by the operating costs assumed in current price limits and adjusted on receipt of the 1998–99 operating cost data. The Director does not now intend to take account of assumed efficiency savings in 1999–2000 in his assessment of P_o. Such savings will, however, be included in his assessment of future efficiency as set out in Section 6.1.3.2.

His assessment will examine material non-recurring operating costs, for example drought costs that are not part of operating costs in a typical year.

In the Framework paper, the Director asked what categories of operating costs may be considered atypical in any one year.

There was little consensus on this except for those costs associated with extreme climatic conditions. Companies argued that atypical costs were a legitimate part of base costs and the same levels of cost should be used for both assessing efficiency and setting base costs. They stated that, otherwise, this would imply an inconsistent treatment. They also argued that the exclusion of some occasional costs, such as drought costs, would not recognise business risk. The EA asked to be consulted where companies put forward proposals regarding atypical operating costs relating to environmental matters.

In assessing companies past efficiencies, the Director will wish to consider all their actual expenditure, ie including atypical costs. Where a company has incurred extra costs because of particular weather conditions, for example, drought or a severe winter, these costs are part of the money spent to maintain a service to customers. When a company makes short-term savings, for example local authority rates rebates, the benefits of this should be shared with customers.

These variations in costs from year to year are, however, unusual and not part of the normal costs of the company. They should, therefore, usually be excluded in assessing future base costs and the scope for future efficiency savings. However, where a company has a long period of, for example, low pension contributions, this could be viewed as part of normal costs. Companies reporting unusual pension contributions in 1997–98 should indicate this in their July Return together with their expected scale and duration.

Leakage expenditure may be a special case. Following the Water Summit, many companies may need to increase their expenditure in 1997–98 and 1998–99 to reach their leakage targets. However, while targets are believed to be above economic levels, this expenditure should be no greater than that which might have been expected over the full quinquennium had companies given sufficient priority to leakage control. The Director will ask companies to detail and justify any extra operating or capital maintenance costs attributable to leakage for 1997–98 and 1998–99. He may reprofile the operating costs across the current quinquennium when assessing base costs for the next five years. Capital maintenance costs will be treated as for other infrastructure renewals expenditure.

6.1.2.1 Past capital efficiency

Capital efficiencies achieved in the current price limit period will be transferred to customers, over time, through an adjustment to the regulatory capital value. This is set out in further detail in Section 6.5.1

In addition, the Director will expect companies' estimates of the costs of meeting future obligations to have taken into account their achievements in the current price limit period. In particular, the Director will wish to revisit his 1994 assumptions in respect of the period after 2000 to ensure this is the case.

The submission of standard costs by companies in the Cost Base Submission G will be structured to allow a comparison against those provided for the 1994 review. This will inform the extent to which a new lower level of unit capital cost after 2000 should be assumed.

Companies will be required to provide strong justification for any cost estimates for current and new quality obligations which imply higher unit costs than in the past. Reporters will be asked to identify and review such cases in detail. Following the review in 1999, the Director, through the Reporters, will monitor the actual cost of achieving quality obligations against the amounts assumed in price limits.

6.1.3 Estimating future efficiency – X

The X factor of price limits is the mechanism by which the Director's expectations of future efficiency gains are passed to customers. Customers will benefit whether or not those expectations are actually met. There is, therefore, a strong incentive on companies to meet and exceed efficiency targets in order to produce higher returns for shareholders.

There is a strong relationship between past achieved efficiencies (and hence P_o) and future efficiencies. This has been discussed in Section 3.3.

In the Framework paper, the Director questioned whether there is more or less scope for efficiency savings (both operating and capital) in the water industry than in other utilities or other industries.

The companies were clear in their view that there is less scope for efficiency savings in the water industry than in other utilities or other industry sectors. Other respondents disagreed. Many respondents did not address this issue.

A number of companies, however, have already demonstrated, through substantial reductions in operating expenditure, that there is scope for large efficiency savings in the less efficient companies. On the other hand, the scope for the most efficient companies may be less. The Director believes that there is scope for efficiency savings in any industry that is undertaking large scale improvements to its capital assets. When assets are reconfigured as a consequence of capital programmes, existing sub-optimal arrangements will be replaced with more efficient ones. These new assets may then be maintained more efficiently than those they have replaced.

Efficiency savings also arise from capital programmes where projects are combined so that more than one problem can be solved with a single capital solution. There is also greater potential for companies to procure at lower prices.

6.1.3.1 The interaction of operating and capital efficiencies

In the Framework paper, the Director stated that he wished to capture both operating and capital efficiencies for customers. He proposes to treat these separately but cumulatively. The comparative efficiency studies will examine both operating and capital maintenance expenditure and, therefore, will inform the Director's judgement on the potential for efficiency.

The Director asked for views as to how far the proposals to consider such efficiencies separately provide an adequate treatment of efficiency.

There were several comments on this, principally from the companies. There was a general view that total efficiency needed to be considered, or at least the interaction between operating and capital efficiencies examined. It was further argued that treating them separately may provide incentives which do not result in the most efficient option overall.

The EA would like to see companies achieving an efficient balance between operating costs and capital expenditure in areas relating to its statutory duties. Customer respondents requested greater transparency in the assessment of efficiency and asked for it to be measured in a more comprehensible way.

Ofwat commissioned research into the feasibility of one way of assessing total efficiency, through production functions, following the 1994 Periodic Review. This concluded that capital costs should be considered in assessing efficiency, but that defining appropriate inputs and outputs for the industry was problematic and that defining data requirements and collecting such data was very difficult. There are a considerable number of factors beyond management control, for example geographic areas and the inherited capital stock, that would need to be adjusted for.

Although the research concluded that some data envelopment analysis might be possible, there are practical difficulties in collecting sufficient sound data to an appropriate degree of detail. This leads the Director to conclude that separate efficiency comparisons using operating costs and capital maintenance costs are likely to lead to more robust conclusions than analysis undermined by patchy and unreliable data. He will, therefore, assess these separately but cumulatively.

Furthermore, having considered these comments and the research, the Director considers that the best way to identify any interaction of capital maintenance and operating efficiencies is to assess comparative efficiency in both areas using similar econometric techniques. The relationship between the two assessments will then be reviewed and an allowance for any significant interaction, where it can be identified, would be made when future efficiency targets are set.

The Director will issue a technical paper in April explaining in more detail how he will assess these efficiencies and their possible interaction. Ofwat has been developing capital maintenance econometric models and the results of this modelling work, together with its relationship to the comparative operating cost efficiency of companies, will also be included in that paper.

6.1.3.2 Future operating efficiency

At the last Periodic Review in 1994, the Director examined the scope for future savings in operating costs. He considered that the industry as a whole could make real savings on average of about 2% a year from 1995–96 to 2000–01 and 1% a year thereafter. The Director will now revisit his assumptions for the period after 2000–01 based on companies' achievements since the last review, evidence from the wider economy, other industries and utilities and, where possible, comparison with the water industry outside England and Wales. He will also take into account likely gains in efficiency between 1998–99 and the first year of new price limits, 2000–01.

The Director has recruited a panel of senior industrialists to advise him on these and other issues.

Within the framework of his assessment of the scope for savings in operating costs at an industry level, the Director will need to make judgements about the comparative efficiency of each company. As in 1994, companies that are relatively less efficient can expect commensurately tougher targets.

The Director will revisit his 1994 assumptions about how quickly less efficient companies may be expected to improve. At the last Periodic Review, the Director assumed that less efficient companies could make sufficient operating cost savings over a five-year period to reduce substantially the margin between their costs and those of more efficient companies. For the coming review the Director wishes to strengthen this approach. He will consider the savings expected and the position reached by those companies that are expected to be at the forefront of efficiency in 2005–06. He will expect other companies to move substantially towards this target over the period of the new price limits.

In the Framework paper, the Director requested views on how quickly companies might be expected to make such efficiency savings to catch up with or overtake their most efficient peers.

In general, all respondents agreed that the more inefficient companies should catch up with their most efficient peers — one suggesting as quickly as two years, others proposing a five year period.

Since the last Periodic Review, companies have consistently outperformed the targets for operating costs. Those companies who were least efficient have tended to make the biggest changes as shown in the 1996–97 Report on water and sewerage service operating costs and efficiency (December 1997). The Director wants to ensure that customers benefit from these savings when they occur, but he also wishes to maintain incentives for companies to operate efficiently. He will need to consider the relative range of efficiencies and the scope for the least efficient to catch up with the most efficient in a five year period.

The Director also requested comments on how cost savings should be phased over the review period.

The majority of companies favoured even phasing but there was some support for a swift catch up in the early years for the least efficient. Customer groups also preferred efficiency targets to be greater in the early years of a review period. The Director concurs with this latter view and, therefore, is likely to assume a phasing of savings so that the benefits are gained by customers sooner rather than later.

6.1.3.3 Future capital efficiency

At the last Periodic Review, the Director examined the scope for further savings in capital costs from the prevailing levels. Both industry wide and comparative tools were used. The industry as a whole was expected to achieve continuing capital efficiency gains of 1% per annum over the price review period. On top of this, the comparative costs from the cost base exercise were used to derive company specific capital efficiency targets.

Since the review, some companies have stated, and indeed demonstrated, that they have been able to achieve larger capital efficiency gains and deliver these more quickly than those assumed when price limits were set. The Director will, therefore, revisit the industry capital efficiency assumptions for the next price review period.

The scope for additional company specific capital efficiency targets will again be judged by the comparative analysis of standard capital unit costs. As indicated in MD127, Capital unit costs in the water industry (March 1997), consideration will be given to increasing both the extent to which the less efficient companies can improve their capital efficiency and the rate at which this may be expected to occur. In particular, the Director will receive advice from Reporters on the appropriateness of companies' proposed capital solutions. He will expect companies to be able to achieve costs appropriate to capital solutions that would be adopted by an ordinarily efficient company. Ofwat has also been developing econometric models of capital maintenance and these will also be used to assess the scope for improvements in capital efficiencies.

6.2 Capital investment

The water industry is capital intensive, with significant requirements for investment to maintain and improve its network of assets. Judgements on capital investment are central to both company and regulatory decisions. Comparisons between companies at Periodic Reviews enable the performance and efficiency of the best companies to be reflected in price limits.

6.2.1 Capital maintenance

The maintenance of a company's capital assets is crucial in ensuring continuing delivery of services to its current and future customers. The Director, as set out in the Framework paper, intends to assess companies' plans for future maintenance of water and sewerage assets principally through an examination of trends in serviceability to customers and levels of past maintenance expenditure.

Companies will also be submitting summaries of their asset stock resulting from surveys of their assets. The Director will review these against the summaries submitted by companies for the last Periodic Review. For regulatory purposes, however, the Director considers that an approach starting with serviceability to customers is appropriate. Asset age and condition are matters for the management of companies to consider in prioritising their capital maintenance programmes.

Levels of capital maintenance expenditure included in price limits will also take account of judgements arising from the comparative analysis of companies' capital costs and the scope for improvements in capital efficiency.

6.2.1.1 Measuring serviceability to customers

The Director believes that the most appropriate way to assess the future capital maintenance needs of the industry is through an examination of serviceability to customers and its long run trends. Serviceability is a measure of the ability of company assets to provide the service required by customers. Old assets may be as serviceable as new ones. This concept of serviceability to customers was generally accepted by respondents. The indicators of serviceability to be examined by the Director are set out in more detail in Appendix 4.

Many respondents, principally companies, stated that they considered the proposed indicators of serviceability to customers were not the only indicators that should be used. However, there were no suggestions from companies as to any additional ones that would be desirable to include in the Director's assessment.

There were also concerns that serviceability to customers is a short-term approach. In assessing this at the review, the Director will look at objective measures of the performance of the overall asset networks, such as the numbers of burst mains and sewer collapses, over the last 20 years. Generally, the trend of serviceability to customers has improved, suggesting that the corresponding levels of capital maintenance expenditure are adequate.

6.2.1.2 Interaction between quality and maintenance programmes

There continues to be a high level of capital investment on quality programmes in both the water and the sewerage services. There are a number of areas where these quality programmes may affect the level and timing of future maintenance expenditure compared to current levels.

First, the same expenditure may fulfill both quality and maintenance purposes. Companies' allocation practices vary and adjustments may be necessary to ensure consistent treatment. This is particularly the case for water distribution which is considered in more detail below.

Secondly, the quality programmes have had the effect of advancing some capital maintenance programmes since the renewal and refurbishment work to maintain existing standards is often carried out before it would otherwise have been necessary.

Quality enhancement programmes may also have an effect on future capital maintenance requirements by improving the general condition of the asset stock. Customers should not pay twice for maintenance of the same assets.

In the Framework paper, the Director asked how the interaction between quality enhancement and capital maintenance programmes should be assessed.

This question was not addressed directly by any of the respondents to the consultation paper. Most responses centred around the possibility that an increased asset base would require a rise in maintenance expenditure, although some companies did acknowledge that a significant increase would not become necessary in the short term.

The key area where the two types of expenditure may overlap is in the water distribution system, where investment is required to deal with deficiencies present in 1989. Most companies were required to give undertakings to the Secretaries of State to carry out work on the distribution system to comply with the Water Quality Regulations.

At the last Periodic Review, expenditure on replacing and relining water distribution mains required to fulfil quality obligations was treated as quality enhancement. The Director plans to continue with this approach and aim to achieve greater consistency in this area taking into account differing company policies.

Maintenance of other parts of the network since 1989 has been dealt with as infrastructure renewals. Judgements will be made on the appropriate levels of infrastructure renewals expenditure when setting price limits, using the serviceability assessments. The Director will also take into account the proportion of the distribution system requiring renovation, the general level of maintenance expenditure on the system and company progress since 1989 in demonstrating quality improvements and fulfilling undertakings.

Capital investment on quality enhancements for surface assets has resulted mainly in the construction of new assets. These represent only a small proportion of the underlying asset base and, consequently, the current levels of capital maintenance required have been largely unaffected.

For new assets acquired for the quality enhancement programme, there will not be a significant effect on future capital maintenance requirements in the period of the next price limits. These new assets will not need to be renewed until towards the end of their economic lives, which will be well into the future.

There are occasions when capital investment needed to achieve quality enhancements has been undertaken on existing assets. In addition, companies have often taken the opportunity to carry out capital maintenance on existing assets at the same time as quality schemes at the same site. In both cases, companies use straightforward methods of proportional allocation to distinguish quality enhancement from capital maintenance expenditure.

The Director is, therefore, of the view that expenditure totals recorded for the maintenance of surface assets can be assumed to reflect the amount of work that has been carried out on the underlying asset base for the purpose of maintaining serviceability to customers. There is no evidence of a general deterioration in serviceability to customers.

The relationship between maintenance expenditure and depreciation and their broad equivalence over a period is discussed further in Section 6.5.5.

6.2.2 Quality standards

6.2.2.1 Maintaining quality standards

Companies are required to meet the legal obligations set out in regulations and enforced by the DWI or the EA.

Each year, these regulators report to the Director on companies' performance as set out in MD109, Compliance with quality obligations — monitoring company performance (August 1995). The analysis of these reports allows company performance on quality aspects to be monitored.

If companies are required to regain compliance with current standards, or suffer enforcement action from the DWI or EA because of failures, no additional allowance will be made in price limits. Customers will have already paid for this service and companies will be expected to rectify problems within the current price limits.

The Director asked whether implementing financial rebates to customers would be desirable if companies do not continue to comply with existing quality standards and obligations required by law.

There was a divergence of views between the companies and other respondents.

Organisations representing business users generally supported the idea that there should be financial penalties on companies for failure to meet their legal quality obligations. Some felt that rebates should go to customers, perhaps automatically, and some thought they should go only to those customers affected by the failure. The response of environmental groups varied. Some believe that the introduction of a financial penalty in addition to fines is not necessary, while others believe that there should be a rebate, at least part of which should be invested for environmental improvements.

The companies believed that the introduction of financial penalties would add to the risk in their business and they would need higher investment levels in maintenance to reduce the risk of incurring penalties. They were also opposed to 'paying twice' for non-compliance, through prosecution and the associated fines as well as through rebates to customers.

The Director has considered all these views. Maintaining compliance with quality standards is an important aspect of company performance and service to customers. If there has been a significant failure by companies to maintain the expected standards, then they may already have had enforcement action taken against them by the quality regulators. They may have been prosecuted or required to give undertakings and the shortcomings would have to be remedied within the prevailing price limits. When deciding whether further financial penalties are appropriate, the Director has considered the potential practical and administrative issues involved in identifying customers and deciding the level of rebates. He has concluded that a more general approach linked to overall service performance would be more appropriate.

It is intended that the performance of a company in maintaining compliance with the quality standards prevailing from time to time should be included in the assessment of good or poor service for which companies are rewarded or penalised. This is described further in Section 6.4.1. Further discussions with DWI and the EA are necessary to consider the most suitable indicators to use in the assessment of performance in the quality area. The nature of the measures used will be consulted on further in a technical paper to be issued in March 1998.

6.2.2.2 Quality enhancement programmes

At the review, the Director will be considering two types of financial adjustment: downward, when companies have not delivered improvements which customers are paying for in their bills, and upward, to finance any new legal obligations placed on them. The Director is considering making these adjustments to bring the financial position of a company in the first year of the new price limits, 2000–01, into line with its performance.

The Director proposed the adoption of a materiality threshold for claims from companies for an adjustment of price levels to meet additional obligations ('logging up') at this review. He also proposed that a similar threshold also be applied to the valuation of any shortcomings in company performance in delivering the expected quality enhancements.

This question was commented on mainly by the companies. The companies supported the concept that their expenditure to meet additional new obligations should be taken into account when setting price limits at the review. There was some concern over the application of thresholds or triviality considerations. Some companies wished to receive an assurance that the Director would aggregate the obligations and not apply the threshold to individual pieces of work.

The Director proposes to retain the concept of a threshold when considering claims for additional expenditure to meet new quality obligations. This will be applied at an obligation and not a scheme level. The total work required to deal with new standards arising from a new policy or a new or revised set of regulations will be considered. At present, the Director considers that 1% of turnover (as was used in the 1994 Price Review) is a suitable threshold.

The EA and the DWI will inform the Director of company failures to meet the outputs funded in price limits. These shortfalls will be valued and, if significant, corresponding financial adjustments will be made to the regulatory capital value. Companies should not gain financially for their failure to deliver quality improvements paid for by customers.

6.2.2.3 Framework for new quality obligations

There will be, as at the last review, uncertainty about the timescale and extent of any new quality obligations to be placed on companies. Before prices are set, it will be necessary to ascertain both the extent of any new obligations and how much companies estimate it will cost them to deal with any tightening of standards.

This process has already started, following the timetable proposed in MD124, involving the Secretaries of State and the quality regulators as well as the Director. The Director asked companies in November 1997 (RD20/97) for a detailed estimate of the extent of any asset improvements required to comply with a number of possible options for new quality standards. Companies were asked to estimate how much it would cost to carry out this upgrading within likely timescales.

These cost estimates will be used when the Director asks the Secretaries of State in April 1998 for their perspective on future policies for drinking water and environmental quality improvements. The Director will provide estimates of the effect on customers' bills of possible improvements. This will be complemented by assessments from the EA and the DWI on the likely quality benefits of such improvements and the levels of support among customers. When considering these issues, the Secretaries of State will have information available on the possible impact of their policies on customers' bills as well as the benefits which could accrue.

It is not yet possible to predict accurately the extent of any additional quality obligations required to implement any new or revised European Commission Directives, currently at the draft stage. However, there will be greater certainty about the period 2000–05 at the time of the review. The uncertainty in the period from 2005–10 should be less of problematic, since the Director proposes that licences be amended to require price limits to be determined every five years.

The timescale for completion of those improvements which are confirmed as required, must be set out by the DWI or the EA. If it is not possible to define the outputs or delivery dates, such work will be considered at a later date when the critical information is available. This could be at the next Periodic Review or, possibly, if the costs are material, at an interim determination.

6.2.2.4 Costs to be allowed and the funding of quality obligations

In judging the capital costs to be allowed for quality improvements, the Director will follow the approach applied to capital efficiency set out in Section 6.1.3.3.

Where companies have replaced or modified existing works to meet tighter requirements, they will be expected to deal with the associated operating costs as part of the efficiency that may be expected to arise from rationalising and optimising existing installations.

The costs of operating the refurbished works will normally be expected to be the same or lower than before. Companies will continue to have to justify claims for additional operating expenditure when new works are required to comply with tighter standards. Company claims will be compared with those submitted by other companies and will be subject to comparative efficiency analysis.

Currently customers are paying for quality improvements through bills while the work is being carried out and before the improvements have been completed. This is contrary to normal commercial practice, where suppliers of new services only charge once the service is provided.

This, together with experience of the companies' rephasing of their capital programmes since the last Periodic Review, led the Director to consult on a new approach to the funding of quality obligations.

The Director proposed that it would be in the public interest to introduce a new approach to making allowance for quality improvements in price limits only after the expected completion date.

This approach was based on the principle that customers should not be expected to pay for an improvement until after it has been completed. There was an extensive response to this proposal.

The Director particularly noted concerns that the cost of raising capital for relevant construction projects would rise. There would be an increase in business risk if the future means of providing a return on such capital were uncertain and subject to future regulatory scrutiny.

The practicalities of such an approach (for quality and economic regulators as well as companies) were also raised, including the possible requirement for licence amendments. However, some business organisations did agree that it was normal business practice for companies only to be paid for innovations and new products after the customer had received them and felt this should be the case in the water industry.

The Director accepts there is a fine balance to be struck between retaining incentives for the companies and the way customers pay for new quality obligations. However, he believes that the benefits to customers of only paying for new works after completion would be outweighed by the higher costs which might arise, particularly an increased cost of capital. The benefits of transparency to customers would not be strong enough to warrant the risk that customers' bills might be higher, however attractive the proposal might be in other ways. Consequently, he has decided not to proceed with the proposal, but will develop further the current methodology. Price limits will continue to assume that capital investment will attract a return when it is incurred to deliver improvements.

The current methodology will be developed to ensure that customers are fully aware of the improvements that are included in bills. Allowance will only be made in bills when definite, measurable improvements are required with a firm completion/delivery date. For large investment programmes taking several years to complete, companies will be required to meet milestones during construction. They will be required to set out their programme of work before price limits are finalised and progress against this programme will be monitored annually. There should be fully auditable work programmes for construction projects. Companies will still have the incentive to complete the schemes on time in an efficient way. The development of the current process will also maintain the strong incentives on companies to both comply by the statutory dates and also to introduce innovative solutions.

6.3 The supply/demand balance

Many respondents to the Framework paper identified the supply demand balance as a key issue for the next review of price limits. This view was expressed by respondents representing a wide range of interests, including companies, customers and environmental groups. The Director believes that this reinforces the need to have a framework at the review which results in the best use of existing resources and the future provision of sustainable water supplies. This should be consistent with the approach set out by the Government in Water Resources and Supply: Agenda for Action (October 1996).

There are several reasons why companies may seek allowances in price limits for expenditure to ensure a balance between supply and demand. These include:

• meeting growth in demand from customers;
• restoring the security of supply to customers because of, for example, a contraction in reliable yields or climate change;
• enhancing the security of supply to enable higher levels of service, such as no hosepipe bans; and
• a need (for example identified by the EA) to leave more water in the environment.

6.3.1 Growth in demand

Expenditure by companies related to growth in demand arises from servicing new development and from meeting increases in the volumes of water delivered and sewage collected from both new and existing customers.

6.3.1.1 New development

The Framework paper proposed that the approach taken at the 1994 Periodic Review to the costs associated with expanding the local water (or sewerage) distribution system remains valid. This view was not challenged in the majority of responses. The Director believes, therefore, that the costs of new development should not be financed through an increase in price limits but instead by receipts from infrastructure charges, a proportion of the annual bill from newly connected properties (which are generally metered) and requisition charges, where justified.

A number of respondents did, however, question whether the present limit on infrastructure charges (ie £200 per property for each service) was cost-reflective for all companies. This issue appears to be most relevant in circumstances where water resources may be considered tight. It is important to signal to developers that water resources in a particular area may be scarce, but the Director is of the view that such messages are more appropriately conveyed through general charging policies which reflect the continuing costs of supply. The Director will, therefore, maintain infrastructure charges for water and sewerage at their existing levels, indexed for general inflation.

6.3.1.2 Growth in water delivered (and sewage collected)

In the Framework paper, the Director set out the principle that the costs of increasing demand should in general be recovered from revenues generated by those demands.

He asked whether customers whose demand is increasing should pay for any resource development to meet that demand and, if so, how could this be achieved?

Companies almost universally agreed with the principle, but questioned the feasibility of implementing such an approach because of the relatively low penetration of household meters. As a consequence, companies generally argued that allowances for growth in demand would still need to be made in price limits. Consumer and environmental groups were generally supportive of the principle, but expressed reservations about the potential social impacts of increased metering and the extent to which measured tariffs would take account of environmental costs.

The argument that low levels of metering represent a practical obstacle reinforces the case for companies to progress metering where it is sensible and economic to do so. The Director believes this is best done on a selective basis. Companies are expected to identify those groups of customers where the benefits from metering in managing demand are greatest.

The arguments presented by companies also presuppose that significant growth in demand will come from customers who are not metered. The Director believes that this is open to challenge. Indeed, there are good reasons to suggest that growth in water delivered for domestic purposes (or sewage collected) to unmeasured households should not be material to price-setting. This view is based on national and international evidence of static or even falling domestic use and on a range of off setting factors. These include:

• the impact of free supply pipe repairs;
• declining household size;
• the impact of companies' metering policies, particularly the selective metering of unmeasured households with high non-domestic usage;
• improvements in the water efficiency of white goods (eg washing machines and dishwashers); and
• the impact of companies' water efficiency plans.

The Director will set out, in a RD letter to the companies in early April 1998, the methodology which he intends to employ for assessing companies' plans for supply/demand expenditure. This methodology will incorporate the principle that, as far as practicable, expenditure related to growth in demand will be met by additional revenues generated by companies and not through an allowance in price limits.

6.3.2 Security of supply

Some companies have indicated that they expect supply/demand expenditure to increase because of several factors. These are downward revisions in reliable yields, the uncertainties associated with climate change, environmental improvements requiring more water to be left in the environment and changing customer expectations about security of supply. Companies also believe that such expenditure should be recovered from the generality of customers through price limits.

The Director understands that companies have been considering various proposals to increase the margin between water available for supply and the demand from customers compared with the standards adopted in 1994. However, he believes it is important to ensure that the factors contributing to this are kept distinct. Each company will be expected to identify the total additional costs incurred by increasing the margin and to justify these by analysing them between, for example:

• supply/demand balance — including yield assessment, the impact of climate change, resource planning margins (headroom and outage allowances);
• quality enhancements — including new environmental obligations restricting abstractions from low flow rivers and conservation sites; and
• enhanced levels of service — including no hosepipe or sprinkler bans. (This is discussed further in Section 6.3.3 below)

The Director believes that such a reconciliation is best achieved by making an allowance in price limits for:

• expenditure on prudent feasibility studies into resource development; and/or
• trials with emerging technologies, such as desalination plants and grey water systems; and
• the further extension of metering and the development of demand related tariffs.

Where companies can demonstrate that there is a longer term imbalance between supply and demand, allowance may be made in price limits for a higher level of security of supply which involves a wider set of options than those above (for example, through the expansion of water resources). Companies, in any event, should look at the full range of alternatives when considering how to balance supply and demand through the least-cost means.

6.3.3 Enhanced security of supply

Issues genuinely affecting the amount of water available for supply, and therefore margins, need to be distinguished from companies' claims about changing customer expectations. The latter are more properly part of enhancing levels of service. The Director believes that companies should demonstrate customer willingness to pay for enhanced levels of service and introduce the tariffs necessary to pay for such improvements.

The Director also intends to use comparative analysis of company performance across a range of indicators (for example, water efficiency, metering and leakage policies) to assess the need to increase the supply-demand margin so as to meet demands for higher levels of service.

6.3.4 Leakage

Many respondents representing customer and environmental interests endorsed the Director's position that no allowance would be made in price limits for new resources while leakage remains above its economic level. Companies generally acknowledged the importance of ensuring leakage was close to economic levels. This contributes to the best use of existing water resources and, as such, is of benefit to customers and companies alike.

A number of companies queried whether price-setting would take account of the costs associated with reducing leakage towards economic levels. In principle, convergence to economic levels should imply benefits that offset costs to companies. The Director will take into account allowances made at previous price reviews for expenditure on leakage. Where mandatory leakage targets have caused companies to spend more on leakage later in the quinquennium, this may be profiled for the purposes of assessing base costs and capital maintenance as set out in Section 6.1.2.1.

Changes in environmental objectives and constraints, for example if assessments of reliable yields are reduced by the EA, may justify an allowance for associated extra leakage expenditure to achieve a lower economic level of leakage.

The Director recognises the importance of ensuring that alternative ways of balancing supply and demand are treated equitably. For this reason, and in contrast to the approach at the 1994 Periodic Review, the Director intends to assess supply/demand balance costs by unit of water delivered rather than by that put into supply. This should ensure even-handed treatment for those companies that increase their water delivered to customers through leakage control.

6.3.5 Tariff structures and the tariff basket

In MD131 Tariff rebalancing and the tariff basket (November 1997), the Director announced his intention to revise the current tariff basket arrangements. This means that price limits for the period 2000–01 to 2004–05 will be determined on the basis of a revised Licence Condition B; specifically there will be a simpler formula for calculating the average increase or decrease in charges and large users, whose consumption is or exceeds 250 megalitres per annum, will be excluded from the tariff basket.

In their responses to MD131, companies questioned how, with the new tariff basket arrangement, price limits would be determined from companies' revenue requirements and whether this would be transparent. The Director recognises that his determinations on price limits need to make allowance for the workings of the new tariff basket. This has been reflected in the proposed tariff basket calculation set out in the consultation document The Supply/Demand Balance Submission: (PR99 Information Requirement E), issued in November 1997.

Respondents to MD131 have also sought further guidance on how account will be taken of revenues associated with large users that have been removed from the tariff basket. The Director intends to set price limits on the basis of the revenue required after taking account of forecast revenues from large users which are outside the tariff basket. Companies who believe there is a cost justification for tariff rebalancing between large users and other customers will need to make their case; the Director will expect any cost justification to be on the basis of robust estimates of long run marginal cost. The Director's approach to the treatment of the revenue and costs of large users will be set out in The supply/demand submission (PR99 information requirement E) to be issued on 27 February 1998.

In tandem with this announcement on the revision of the tariff basket, the Director issued, in December 1997 (RD 27/97), revised guidance for the introduction of new tariffs. This was particularly focused on the potential introduction of more sophisticated measured tariffs, for example seasonal tariffs. The Director wants companies to develop their tariff structures in a way which enhances incentives for customers to conserve water resources.

6.3.6 Legal powers and charging

In the Framework paper, the Director suggested a number of legislative changes of relevance to the supply/demand balance. Views were specifically invited on whether the water (and sewerage) companies should have a statutory duty to use their charging powers to promote economy in the use of water resources; and whether legislation should be clarified to allow water (and sewerage) companies to differentiate between measured and unmeasured customers when imposing hosepipe bans.

The majority view of companies was that such a new statutory duty was unnecessary given their existing duty to promote the efficient use of water by customers. However, environmental groups, notably the EA, expressed strong support for the proposal. The Director continues to believe that such a new statutory duty would provide an effective mechanism for promoting the efficient use of water and would be complementary to existing duties. This is a matter requiring legislative changes and is not of direct relevance to price-setting. As a consequence, the Director is pursuing this with the Government as part of its review of charging.

With respect to differential hosepipe bans, respondents in general questioned whether the proposal could be implemented in practical terms and whether customers would accept differentiation. The consultation paper suggested that, as an initial step, the Director would seek clarification on whether existing legislation permits differentiation between customers as well as geographical regions. The real issue for companies would appear to be whether, as a matter of policy, they choose to make use of any such provision. Ultimately, it will be for companies to test the law on this matter. In the light of this, and the clear expressions of support from some respondents, the Director is, similarly, pursuing this with the Government as part of its review of charging.

Two further points are of relevance to this issue. First, the need for differential hosepipe bans is lessened if customers with hosepipes, as well as sprinkler users, are predominantly metered. Companies which oppose differential hosepipe bans will be expected, therefore, to address this issue through metering and tariff structures. Secondly, the Director recognises that it is important for companies to retain the option to impose hosepipe bans, in exceptional circumstances, on all customers given their statutory duty to provide an uninterrupted supply of water for essential domestic purposes.

The Framework paper also sets out the Director's view that he should have legislative powers to determine disputes over the correct level of requisition charges for a new customer connected to the water distribution or sewerage network. The Director intends to pursue this proposal to strengthen his legal powers in this area.

6.4. Levels of service

In setting price limits in 1994, the Director made specific allowance for improvements to service levels for only a few companies.

Levels of service have generally improved across the industry as companies have carried out capital maintenance or invested in statutory environmental or drinking water quality schemes. In some cases, companies have also chosen to share the benefits of outperformance through specific supplementary investment (ie not already allowed for in price limits) intended to enhance particular aspects of service. The Director has welcomed this.

6.4.1 Improvements to levels of service

In setting price limits, it is important to maintain incentives for companies to improve their service to customers. The Framework paper asked for comments on the suggestion that price limits be adjusted up or down for those companies which have offered good or poor service to customers in the past. The Director also asked what differential between the better and poorer performing companies would provide an appropriate incentive to improve services.

Responses to this proposal were mixed. The objective underlying the proposals was the need to provide incentives for companies to continue to improve their service to customers in the context of increasingly tight price limits and reduced scope for outperformance. Respondents to the consultation generally supported this objective. However, views differed as to the most appropriate way to achieve this. Those representing customers generally supported various forms of penalties for poor performance, but coupled this with a requirement to improve the inadequate service. There was little support for the notion that good service should be rewarded with higher prices.

Conversely, and perhaps unsurprisingly, the companies generally believed that the current system was adequate and would prefer positive incentives, although a few supported additional penalties for poor performance. Others, however, suggested that it is unfair to penalise poor performance whilst also refusing to finance service improvements through price limits.

Very few respondents commented upon the scale of appropriate adjustments. A number of companies said that if prices were to be adjusted to reflect past performance, there should be more clarity about what is expected of them over the period ahead.

The Director has considered the responses. As part of the overall package of incentives on companies to perform efficiently and to provide good and improving services, he feels it is appropriate to make an explicit adjustment in price limits to reflect the service which customers have experienced during the current period. This adjustment should be based on a broad assessment of the water supply, sewerage and other customer services provided and could also include elements to reflect environmental and drinking water quality. The Director will invite comments on a proposed method for assessing overall performance in a technical paper to be issued in March 1998.

All companies have been funded to provide a reasonable level of service. It is, therefore, not unreasonable to impose a financial penalty on those which have failed to do so. Even if they have been required to address service failures at their own expense, eg as a result of regulatory action, customers will, in the meantime, have been receiving inadequate service. However, in order to maintain adequate overall incentives on companies, the Director believes it is appropriate for any adjustments to be symmetrical and that companies which are operating most efficiently and provide particularly good service should derive some benefit from doing so, as they would in a competitive market.

In the last price review, an adjustment to reflect levels of service was included as one of the non-econometric elements underlying assumptions about companies' future operating efficiency. The Director believes that, for this Review, any adjustment might be better included as part of his assessment of P_o. This would result in a clearer linkage with past efficiency savings and emphasise that such savings should not be made at the expense of a reduced level of service to customers. To ensure that customers are not paying more than they should for good service, the Director proposes only to consider rewarding such companies where his analysis of comparative unit costs also shows that they are operating efficiently.

The Director will need to judge what level of adjustment would provide an appropriate weight of incentive for such behaviour compared with other elements of the price formula. The consultation process yielded little comment on the proposed range of 0.5 to 2.5% over five years. The Director will consider this issue further but an appropriate adjustment to P_o could be within a range of plus or minus 0.5% for the best and worst performing companies.

6.4.2 Past supplementary investment

Responses to the Framework paper generally accepted that it was appropriate that past investment by companies to enhance levels of service, which had been financed from efficiency savings, should be reflected in future regulatory capital values. This is dealt with in greater detail in Section 6.5.1. The Director will not, in the majority of cases, make allowance for supplementary investment which takes a company's capital expenditure beyond that assumed in current price limits plus 'logging up'. To do so would provide incentives for companies to over-invest and would undermine the decisions taken in 1994. The Director will apply very stringent criteria before accepting that any such investment should be allowed for in price limits. He would expect to see clear and uncontrovertible evidence that customers had been consulted, that the intended improvement in service was regarded as a high priority and also one for which customers would be prepared to pay higher bills.

In considering these issues, the Director will take account of the quality of the entire service provided as it would not be appropriate to reward a company for claimed supplementary investment aimed at one specific service improvement if that company was failing to provide an adequate service elsewhere.

6.4.3 Future supplementary investment

As explained in MD124, the Director proposes to adopt a similar approach to future enhancements of service levels as at the last Periodic Review. Experience since 1994 has shown that companies are able to improve the service they offer to customers without a specific allowance being made in price limits. Improvements will arise as an indirect consequence of investment to meet existing or new quality obligations; other improvements can be achieved through efficient targeting of capital maintenance expenditure or through changes in operational procedures which involve no extra cost. The Director considers that companies should be expected to continue to achieve service improvements by such means.

However, where it is clearly demonstrated that customers are prepared to pay more for specific service improvements that are unlikely to be achievable within the scope identified above, the Director will take account of this in reaching his decisions on future price limits.

6.5 Financial issues

6.5.1 Regulatory capital values

The proposal to continue with the same broad principles underlying the regulatory capital value as at the last review of price limits in 1994 was welcomed by the majority of respondents. The broad principles are that the regulatory capital value starts with a direct measure of the value placed on each company's capital and debt by the financial markets following privatisation (or a broadly similar measure for water only companies which were not floated). This is then adjusted to take account of the new capital expenditure net (ie after allowing for current cost depreciation).

The regulatory capital value should reflect past capital efficiencies and hence transfer the benefit of these efficiencies to customers through lower prices. This should be done in a way that preserves sufficient incentives for companies to achieve these efficiencies. In the Framework paper, the Director asked whether the proposed approach to adjust the regulatory capital value for such capital efficiencies from 1990 to 1997–98 retained adequate incentives.

Companies argued that this was not the case and would be to the customers' ultimate detriment. It was also argued that the proposal would introduce an inconvenient boundary in a review period, ie 1997–98, which would limit the flexibility of companies to manage their capital programmes.

On the whole, companies believed that a more appropriate methodology would be the one outlined in MD104 (April 1995) whereby the regulatory capital value is adjusted for efficiencies occurring in the period prior to the start of the previous price limit period. For example, the regulatory capital value at 2000 would be adjusted only for the actual change in net new investment compared with expectation for the period 1990–95. This approach, however, would not deal equitably with companies that have accelerated benefits to customers through a supplementary investment programme and those companies that have made cash rebates. It would also allow ten years — ie to 2005 — before customers saw any benefit from the significant differences between actual and forecast capital expenditure from 1995–96 onwards.

The Director has considered these arguments and, in particular, the level of incentives which companies require to achieve efficiencies. He proposes that adequate incentives would be provided if companies retained the benefit of capital efficiencies for a fixed period before they are transferred to customers. In that way, the level of retention of efficiency benefits would be independent of when efficiencies were achieved. This implies that a rolling adjustment to the regulatory capital value would be appropriate.

The Director considers that the retention of capital efficiencies by companies for five years is sufficient to maintain incentives. This means that efficiencies achieved in 1995–96 would be retained until 2000–01, those in 1996–97 until 2001–02 and so on. This approach also has the advantage of eliminating boundary problems. It allows companies to retain a larger share of benefits than under the consultation paper proposal, although less than under the MD104 method.

In practice, the approach will be to compare net actual expenditure and depreciation in the year with net projected expenditure and depreciation. No adjustment to the regulatory capital value will be made if the cumulative net actual expenditure exceeds that projected at previous price reviews.

An appropriate credit for cash rebates paid out of efficiencies will be made on a similar rolling basis. This will provide an equitable treatment compared with those companies that have carried out supplementary investment programmes.

Although remuneration of supplementary investment through price limits was widely welcomed, certain companies further argued that all investment which yielded benefits to customers or was approved by them should be allowed in prices, even if this had not been financed through efficiencies. The Director remains of the view that supplementary investment over and above the projected levels of investment (including logging up) will need a particularly high level of justification. Such investment will need to have a clear priority for customers for which they would be prepared to pay higher bills. He would expect to see clear and uncontrovertible evidence that customers had been consulted.

6.5.2 Cost of capital

In the Framework paper, the Director requested views on whether the risks faced by the water industry were materially different from those in 1994 and whether they warrant a different cost of capital.

6.5.2.1 Risk

A variety of views were put forward by respondents (primarily companies, institutional investors and investment analysts) on the risks faced by the water industry and how these have changed since 1994.

It is generally accepted that the water industry has many characteristics which make it materially lower risk than other equity investments: inflation-proof income which is predominantly unrelated to volumes sold, a non-cyclical business, little risk of insolvency, and very limited competition. In addition, the Director has a duty to ensure that companies can finance their functions. However, some respondents (particularly the companies and the WSA) argued that some of these characteristics have been offset by the increase in other risks, particularly regulatory risk and revenue risk, since the last Periodic Review. They argue that this is borne out by the objective evidence that is available.

These risks can be split between those that are systematic to the utility sector and those that are specific to individual water companies. Systematic risks can be summarised as regulatory, political and climatic.

• A case has been made that regulatory risk is the most significant element of risk in the sector and that it has increased significantly since the last Periodic Review. The most often cited symptoms of this are mandatory leakage targets and the potential for a P₀ adjustment. However, regulation is a substitute for competition and it would be naïve to expect it to be static. Competition is a dynamic process as is regulation. In addition, regulation is still relatively young and can be expected to evolve into a more predictable standard model. Effective communication and the open and transparent process which the Director has espoused are seen by many as the most effective means of minimising regulatory risk.
• Political risk derives from the ability of government to make changes to the sector driven by political and not economic considerations. This is considered to be less predictable than competitive forces. Following the election of a Labour Government, the general City view is that such political risk has declined. For example, the new Government has given assurances that the windfall tax is a one-off tax.
• The Government is currently undertaking a review of utility regulation. When that review is complete, one present reason for uncertainty will be removed. The Director would be concerned if any elements of that review increased regulatory uncertainty.
• Some view long-term climate change as creating a new risk outside the control of companies. The counter view is that such risk will not arise in the short term providing that the economic and environmental regulators adopt a transparent and consistent approach to climate change.

• The argument was put that because of the long-term nature of the industry, individual companies were more vulnerable to construction inflation and changes in regulatory rules on capital expenditure. There seems little evidence that this risk has increased since the last review
• The general view is that revenue risk, ie the volatility of revenue flows, has increased since the last review and will continue to do so as a result of further metering and changes to the tariff basket. However, in the long term, metering does provide some protection from imbalances in supply and demand. At the present time, except for a few companies, the proportion of revenue at risk is still relatively small because of the low level of metered customers.
• Many companies have pointed to greater competition as increasing risk. This is difficult to substantiate when all companies still have an effective monopoly. All outstanding inset applications are broker type arrangements rather than the result of direct competitive entry.

The Director is unconvinced by these arguments. On the question of headroom, it would seem perverse to add a premium to the cost of capital, merely because in future companies will be expected to operate much closer to that cost of capital. In a transparent regulatory review, such as this, investors can make their own assessment of the risks of the industry, including regulatory risk, and this will be reflected in the cost of capital they demand. To cushion companies' returns would run counter to the Director's duties to customers.

The issue of asymmetry is more complex. In essence, however, the assertion is that various asymmetries peculiar to the regulatory system itself require a premium to be included in the cost of capital which would not otherwise be captured in the beta factor of CAPM. The asymmetries cited include: changes in the competitive environment; the difficulties of passing through price increases if growth in demand expectations are not met; and the character of the regulatory or political 'tightening of the screw'.

The Director's response is two-fold. First, if there are asymmetries of returns in the water industry, they are certainly also prevalent in others. The forces of competition are not symmetric. Consequently, an adjustment relative to returns in other industries would be inappropriate. Secondly, if there are asymmetries in the regulatory system which tend to reduce returns, there are equally many asymmetries which tend to increase them. For example, only companies have the ability to appeal to the Monopoly and Mergers Commission (MMC) over a price determination, customers do not. Furthermore, access to information in a Periodic Review is asymmetric. Tightening of the regulatory screw, if it occurs, does so in order to check the asymmetries which operate in favour of companies and their shareholders. Any regulatory asymmetries, therefore, are in his view merely redressing the balance and not adding further to risk.

The Director does not consider it necessary to make any adjustments to the cost of capital in respect of either of these issues.

An empirical backward-looking measure of non-diversifiable risk (within a portfolio of assets) is the beta factor. This, calculated on an ungeared basis, has increased for the water and sewerage companies since the last Periodic Review (although it has fallen for many water only companies). Various issues may have contributed to this rise, including a perceived increase in regulatory risk, political uncertainty and the increased diversification (including multi-utility mergers) into higher risk activities. Ofwat will continue to consider the appropriate beta as the 1999 review approaches and to assess the forward-looking risk perceived by potential investors in the industry.

6.5.2.2 Equity risk premium

The equity risk premium is a key component of the cost of capital and probably the most controversial. A widely considered but unresolved issue is the reason why there is such a high degree of investor risk aversion implied by the historic premium earned from equity investments over and above the risk free rate when compared to ex-ante assessments of investors' expectations — the so called equity risk premium 'puzzle'.

One conclusion from many detailed academic studies is that investors' expectations about gilt returns have been substantially above the actual out-turn. In addition, some argue that structural and economic changes mean that the equity risk premium will be substantially lower than in the past. Various economists and City investment analysts have estimated the ex-ante investor expectations at between 1–5%. Despite a continuing debate about the reasons why this is lower than the historic premium, there is a growing consensus among investors and City analysts to this effect.

Few companies quantified their arguments. However, three water groups in their responses to the consultation paper suggested a figure of 3.5–5%. The WSA/WCA has suggested that the premium lies at the upper end of a range between 4.5–9%. The higher estimates were based on an arithmetic mean of ex post returns over a very long period. The MMC, in the Northern Ireland Electricity case, rejected such approaches and considered the range 3.5–5% to be appropriate. This was compared with 3.5–4.5% used by it for Hydro-Electric and 4–5% for BAA. In its survey of fund managers, (MMC Report on British Gas plc in 1993) the MMC used an implied range of 2.5–4.5%.

Ofwat sees no current evidence to justify increasing its estimate of the equity risk premium from that used at the last Periodic Review, and also implied by the MMC (in its determination of price limits for South West Water Services) ie a premium of 3–4%. Furthermore, there is some evidence that a figure towards the lower end of this range would be appropriate.

6.5.2.3 Cost of debt

The cost of debt can be determined empirically (particularly in terms of the spreads over index-linked gilts) and will be evaluated closer to the review. To date, however, evidence does not support an increase on that used at the last review.

The Director will take account of the tax shield provided by debt finance and the effect of the loss of advance corporation tax credits on the relative costs of debt and equity. The relative cost of debt for small companies compared with larger ones will be considered. The Director will also look at how debt costs may be expected to vary with credit ratings, particularly at the point where ratings move below 'investment grade' quality.

6.5.2.4 Overall position

The Director still believes that there is no single satisfactory approach to determining the cost of capital and will continue to assess evidence using both the CAPM and the DGM.

The cost of capital will need to reflect changes in the capital structure of many companies through, for example, share buy-backs and the general increase in gearing occurring in the industry. This has resulted in a shift to cheaper debt finance. The Director will assume that companies will operate, as far as possible, with the most efficient capital structures, taking account of the impact of financial risk on credit ratings and debt costs. That is, he will assume that companies will continue to use debt finance (and hence gear up their balance sheets) as long as such a policy tends to reduce the weighted average cost of capital. The position of small companies and their access to capital markets will also be considered.

There are arguments that the balance of risks has changed and, possibly, overall risk has increased but this is offset by growing acceptance of a lower equity risk premium and evidence, since the last review, that gearing can be higher. Overall the Director remains of the view that the weighted average cost of capital, for the water and sewerage companies, would be unlikely to deviate substantially from the 5–6% after business taxes that was used in 1994.

6.5.3 Taxation

The Director is required to set price limits which enable companies to secure a reasonable return on capital. Theoretically, this should be returns to investors after all taxation, ie both personal and corporate, although, in practice, only corporate taxes are considered unless there is knowledge of the personal tax positions of all investors.

Although the Director set price limits by reference to a return on capital after business taxes in the 1994 Periodic Review, other regulators and the MMC have considered primarily pre-tax returns in price reviews carried out since that time. The Director, therefore, consulted upon whether the cost of capital for the review should be set on a pre-tax basis.

Most respondents did not express a strong preference, providing allowance is made for company specific tax positions, although some City commentators favoured a post-tax basis.

The corporate tax positions of the water and sewerage companies up to 2000 and in the period covered by the review will change significantly compared with the early years following privatisation. The special circumstances of the water industry since privatisation have diminished and recent changes to general corporate taxation, notably with respect to capital allowances, have accelerated the transition towards a full tax paying position for many of the companies. However, this will not be reached in the short term, despite the proposed abolition of advanced corporation tax from April 1999. The tax positions of companies are unlikely, therefore, to be similar.

The Director proposes to set price limits by reference to a post-tax cost of capital but recognises that he will need to consider the specific tax positions of each of the companies — the so called tax wedge. The actual tax charges projected for each company may need to be adjusted to take account of the capital structure assumed for the purposes of calculating the weighted average cost of capital. This may mean adjusting the 'tax shield' on debt finance.

The Government introduced a one-off windfall levy in July 1997 on certain privatised utilities, including the water companies. The levy was specifically made on the listed company and the size of the levy was calculated by reference to group profitability in the first four years after privatisation. The Director, therefore, considers that this levy is properly borne by shareholders and not by customers of the water utility.

6.5.4 Financial indicators

The Director proposed that financial indicators would play a less significant role in the review than in 1994 or, particularly, at privatisation. Nevertheless, the trend of financial indicators will inform the Director's judgements in determining the revenue needed by companies to cover costs and provide an appropriate return on capital.

In the Framework paper, the Director asked what are the appropriate levels of financial indicators and over what period, taking into account the availability of equity capital.

Respondents generally agreed that the key financial indicators, in addition to the return on capital, are historic cost interest cover, gearing and both historic cost and current cost dividend covers. Of these, interest cover is the most important. There was little response to what the appropriate levels of financial indicators may be, but many respondents believe gearing levels could be higher. One company suggested that gearing of up to 50% (ie debt to debt plus equity) would be appropriate. City analysts and financial commentators have been making similar points for some while and there is evidence from mergers since 1994 that higher levels of gearing are sustainable.

Companies drew attention to the need to operate within banking covenants and the higher costs of debt and equity which might result from gearing as high as, say, 75%. Rating agencies suggested that in order to maintain 'investment grade' type debt ratings, interest covers should be between two to three times. The Director considers that the cost of debt and appropriate financial indicators need to be considered together, as the weighted average cost of capital is, at least at the extremes, affected by levels of financial indicators.

At the 1994 review, adjustments were made to the balance sheets of companies, as reported in regulatory accounts, in order to reflect the appointed business as a free-standing plc, rather than as a member of a group. The water companies argued that the Director should consider only the actual financial indicators of the company. In setting price limits, the Director is concerned only with the appointed business and hence adjustments may be necessary. For example, he may make his own assumptions about past and future dividend growth rates —consistent with the cost of equity capital. The Director will discuss any necessary adjustments with individual companies.

The Director will need to collect and consider empirical evidence up to the review. He will take further advice from his City advisers on the influence which levels of financial indicators may have on the availability and cost of debt, together with companies' abilities to raise equity capital.

6.5.5 Current cost depreciation

In the Framework paper, the Director proposed that if the service capability of a pool of non-infrastructure assets is in a steady state and the accounting life of assets is equivalent to their service life, then there should be broad equivalence in the long run between capital maintenance expenditure and the current cost depreciation charge.

The Director asked for views on whether such an approach to non-infrastructure assets was valid which, for the purposes of price setting, reduces current cost depreciation charges by reference to actual expenditure and, if so, over what period should equivalence be determined.

Responses to this proposal came from companies only. They agreed in principle with this approach, but suggested that a five year period is too short a time to consider current cost depreciation to be broadly equivalent to capital maintenance expenditure. Suggested time periods ranged from the life of the asset, to 20 to 30 years, or the rather less specific 'long' or even 'very long' term.

Having considered these arguments, the Director proposes that current cost depreciation will continue to be remunerated through price limits. It is proposed that the time period over which broad equivalence should be considered is the longest for which data is available ie 23 years from 1992–93 to 2014–15. The net present value of current cost depreciation charges over the period will be compared with the net present value of capital maintenance expenditure over the same period. It is anticipated that this is a sufficiently long period in order to demonstrate broad equivalence.

If broad equivalence is not demonstrated and there are no clear explanatory factors, the Director will assume that the base current cost depreciation used for setting price limits should be adjusted to be broadly similar to the amount of capital maintenance expenditure. `Broadly similar' will be judged by reference to a percentage of turnover. That is, the current cost depreciation will be broadly equivalent, in present value terms, to capital maintenance expenditure over the 23 year period. The 23 year period will be a rolling period to ensure consistency between price reviews.

Appendix 5 sets out in greater detail the technical background underpinning broad equivalence.

6.5.6 Infrastructure renewals charges

Infrastructure renewals accounting is used in the water industry for the largely underground system of assets. A charge is made each year against profits (the infrastructure renewals charge). This charge is an average of projected infrastructure renewals expenditure over several years. This smooths the profile of expenditure, which may vary from year to year.

The difference between the charge against profits and expenditure in a given year will give rise to an accrual or prepayment in the balance sheet, rather than influencing reported profits. The Director proposes that the infrastructure renewals charge allowed for in financial projections should be equal to the average level of expenditure over the 15 year period from 1995–2010.

At the last review, no adjustment was made to future renewals charges in respect of accruals which had built up since privatisation for certain companies. These accruals could, therefore, be used either to absorb additional infrastructure renewals expenditure or, if not thus utilised, reduce price limits without affecting profits.

If the serviceability analysis for underground assets indicates that infrastructure renewals expenditure is likely to be stable for the foreseeable future, then the infrastructure renewals charge would be at a broadly similar level and, therefore, no further material accruals would be created.

This would also provide evidence that current accruals are no longer required and the Director would be minded to assume that the unutilised accrual at the last review could be eliminated over the five year period to 2005. This would reduce the infrastructure renewals charge allowed within price limits for those companies concerned and would result in lower bills.

The Business planning paper set down the four criteria used by the Director to develop his proposed information requirements: These are:

• materiality — the level of data needed to set realistic price limits and to specify the required outputs;

• sensitivity —the data needed to involve interested parties in the key areas of consultation;

• performance — the data needed to assess company performance, particularly in areas of concern; and

• competition — the data needed to ensure that effective comparative competition exists across all regulated activities given that the Director is acting as proxy for a competitive market.

The Business planning paper also considered a number of related issues: the confidentiality of company submissions; time horizons for data; improved arrangements for Reporters and Auditors; and the handling of multi-utilities, companies in common ownership and small companies. The exposure of the rules and calculations underlying the financial projections, which are based on the information provided, has also been considered by the Director.

7.1 Responses on the need for the information submissions

Overall, respondents recognised the need for the individual submissions. Difficulties for companies and, to a lesser extent, Reporters arose from the concentration of submissions in the summer of 1998. These difficulties were exacerbated by later proposals to bring forward some dates (RD19/97 November 1997). Many companies thought there would be scope to streamline some of the proposed information submissions, although few suggestions were made. One respondent drew attention to the risks of information overload confusing rather than helping decision making. A résumé of the responses on the information submissions is given in Appendix 6.

The Director is sympathetic to the views expressed and recognises the companies' concern about the amount of information required for the review. He will continue to minimise the information requirements for each submission, based on the current consultations on each of these. The date now proposed for the Asset Inventory Submission (14 August 1998) reflects the Director's desire to spread the workload and to give companies as much time as possible to collate accurate information. However, the timetable set out in this paper must be adhered to if sufficient attention is to be given to the issues relevant to the review and, in particular, the publication of Prospects for prices.

The dates proposed below are consistent with those proposed in the Business planning paper.

INFORMATION RETURNS FROM COMPANIES
		Reporting requirements issued	Information submission
A	Initial quality costing to identify the scale of potential new quality obligations	10 April 1997	30 May 1997
B	July Return and Regulatory Accounts 1996–97 — annual return and additional data for comparative efficiency studies	31 January 1997	1 July 1997
C	Capital maintenance — to extend the pilot work by seven companies to an industry wide database	22 August 1997	14 November 1997
D	Main quality costing — to quantify the cost implications of potential environmental and drinking water obligations and summarise initial views of customers and interested parties	14 November 1997	20 February 1998
E	Supply/demand balance — to set down proposals for matching supply and demand in the light of a full supply/demand appraisal, economic level of leakage, tariffs etc	27 February 1998	1 June 1998
F	July Return and Regulatory Accounts 1997–98 —annual return and additional data for comparative efficiency studies, logging up quality expenditure and key financial information.	30 January 1998 (standard return) 27 February 1998 (additional data)	1 July 1998 (standard and additional)
G	Cost base — to inform comparative capital works costs across the companies	6 March 1998	5 June 1998
H	Asset inventory and system performance — to report on the audit of the current asset stock, its value, condition and age profile with particular reference to the changes since 1992–93.	27 March 1998	14 August 1998
I	Customer consultation and strategic option — to report on the results of customer consultation and set out proposals on the preferred business strategy.	24 April 1998	3 August 1998
J	Update of quality costing — to refine the costs of environmental and drinking water obligations in the light of Secretaries of State guidance	18 September 1998	December 1998
K	Draft Business Plan — to support the company's application for price limits	Late July 1998	9 April 1999
L	July Return and Regulatory Accounts 1998–99 — annual return	29 January 1999	7 June 1999
M	Company representations on the draft determination	Not applicable	September/ October 1999
N	Monitoring plan (AMP3) — to set down the business plan for the period of new price limits – outputs, activities, expenditure etc.	November 1998	31 March 2000

In their comments on the detailed requirements for Submission I: Customer and strategic options return, many companies expressed concern that it would be difficult for them to set out a preferred investment strategy in the absence of clear guidance from the Government on the required improvements to drinking water quality and the environment. The Director fully accepts that there is likely to be further refinement of the quality requirements between the submission of companies' strategic option returns and their final business plans. This does not, however, prevent companies from setting out what they consider to be the most appropriate strategy for future investment in the light of their understanding of their customers' views. Indeed, it is important that they do so in order to inform the debate on decisions which have yet to be made. Where companies consider that this overall strategy would be significantly affected by the further refinement of quality requirements, they should suggest how their proposals might need to change.

The Director recognises the problems that external readers will have in locating the relevant information upon which they want to focus. He will produce one page summaries to explain the nature of submissions required by Ofwat. He will also require companies to produce single page summaries of their submissions to be available when the submissions are placed in the Ofwat Library.

7.2 Information submissions — phase one

Draft reporting requirements for each of the phase one information submissions yet to be received (E, F, G, H and I) were issued for consultation. Close attention has been given to the scope and content of the individual submissions in the light of the comments made. Final reporting requirements have been issued or will be issued shortly. The final timetable for these submissions is set out in the table above.

The relationship of the phase one submissions to the business planning process is set out briefly below but in each case a greater level of detail is provided in the relevant reporting requirements document. The submissions are not independent and need to be considered and analysed in conjunction with each other.

• Main quality costing (submission D)

• Supply/demand balance (submission E)

— a report in which companies will set out their forecasts of demand and supply;

— a supply/demand balance appraisal in which companies will examine the alternatives for achieving a balance between supply and demand at lowest cost and a leakage appraisal setting out an action plan for moving towards the long term level of leakage; and

— a tariff action plan in which companies will set out their proposed charging policies.

• Supplements to July Return 1998 (submission F)

• Cost base (submission G)

• Asset inventory and system performance (submission H)

The Director intends to assess the future capital maintenance needs of companies through an examination of the long run trends in serviceability to customers. Comparison of the assessed condition of assets between 1992–93 and 1997–98 will also indicate the adequacy of capital maintenance in that period.

The Director needs to be assured that companies have met their general obligation to maintain their assets before publishing views on future price limits in the Prospects for prices paper.

• Customer consultation and strategic option (submission I)

7.3 Information submissions — phase two

The relationship of the phase two information submissions to the business planning process is set out briefly below.

• Update to quality costing (submission J)

• Draft Business Plan (submission K)

The draft Business Plan sets down the company board's view of the price limits sought for the period 2000–01 to 2004–05 and their justification for this. As such, the plan represents a drawing together and refinement of the various strands exposed in phase one of the review.

In their draft Business Plans, companies will need to explain the linkage between their latest assumptions/data and their earlier information submissions where these are material to the price limit determinations. It is expected that the exposure and challenge of company issues and assumptions during 1998 and early 1999 is likely to result in changes in some of the information submitted in earlier returns as was the case in the 1994 Periodic Review. For example, feedback to companies on their Cost Base submissions (October 1993) led them to revise and reduce their standard capital costs by around 10% in their strategic business plans (March 1994). Some of these changes would have fed through into company unit costs and so into reduced capital expenditure projections.

The draft Business Plan will need to provide, therefore, for a restatement of the material elements of the data submitted earlier in the process. This will enable the latest positions to be assessed and for the determinations in 1999 to be based on the most up to date information from companies.

As the data required in the draft Business Plan to support the price limits sought will be based on the earlier information submissions which have been consulted upon, there would be little benefit from a further extensive consultation exercise. Ofwat will issue, therefore, the draft Business Plan manual (including a complete PR99 Information Requirements Definitions manual in electronic format) in late July 1998. The manual will be updated from time to time as points of clarification are found to be necessary. Ofwat expects the last revisions to the manual will be issued in November 1998.

The company is required to submit its draft Business Plan by 9 April 1999. Companies will be required to publish public summaries of their plans and copies will be placed in the Ofwat Library upon receipt. The Director proposes to place the non-confidential elements of the draft Business Plans in the Ofwat library on completion of the review, ie generally April 2000 or after re-determinations by the MMC for any companies which appeal against the Director's determination.

• July Return 1999 (submission L)

7.4 Information submission — phase three

Each company will be required to submit by 31 March 2000 its Monitoring Plan (AMP3), setting out its Business Plan for the five years of price limits, in the light of the Director's final determination. Ofwat will consult with companies on the scope and detailed content of this submission. The intention is that sufficient detail on projected outputs, activities, expenditure, customer bills and other initiatives should be provided to enable the Director to monitor performance on each of these in the regular July Returns (2000–01 to 2004–05).

7.5 Confidentiality of company information

The views of respondents on the confidentiality of company submissions varied considerably. Companies maintained that some of the submissions, or elements of them, will need to be confidential and that this should be recognised and respected. Some companies wanted the burden of proof to lie with those who required disclosure. One company drew attention to Stock Exchange rules stating that these would preclude disclosure. A number of companies thought that the Reporters' reports should be confidential. In comments on draft information requirements, companies have also suggested that their reasons for requesting confidentiality should also be confidential.

Other respondents took the view that no information should be confidential as the water companies were in very privileged positions as monopolies.

In the light of these comments, the Director confirms his original proposal to adopt a general presumption of non-confidentiality for all information submissions. The burden of proof will be on those requiring a confidentiality restriction to justify this. The justification will need to address the appropriate 'substantial harm' test outlined in the Government's Freedom of Information White Paper. The Director will publish the reasons given for any information which is treated confidentially.

Some respondents commented on the complexity of some of the submissions. In their view, information put in the public domain should help the public understand what was going on rather than potentially to confuse the issues. One respondent suggested that single page summaries of all reports and information submissions should be required from both Ofwat and the companies to enable external readers to gauge whether they needed to look at the full reports or submissions. As noted in Section 7.1, the Director will adopt this suggestion.

7.6 Time horizons for data

The Business planning paper discussed the time horizons for data collection, proposing for example, an 18 year period up to 2014–15 with some projections stopping earlier (for example operating expenditure, financial indicators and service performance indicators). Some would be extended further where there was a need to plan ahead for major new resources.

All company respondents took the view that a general horizon of 18 years was too long. The general consensus was to limit the data to the period up to 2009–10. Some respondents suggested the period for 2010–11 to 2014–15 could be identified as an annual average figure. Many companies saw the merit of longer term projections in the supply/demand area.

In the light of these comments, the Director proposes to adopt a 13 year general rule for projections (ie to 2009–10). Longer term projections will be required in certain areas, such as the supply/demand area, and to demonstrate broad equivalence between capital maintenance charges and expenditure levels.

7.7 Multi utilities, companies in common ownership and small companies

The proposals to increase the scrutiny of the information returns from multi-utilities to minimise the risks of cross subsidy were welcomed by respondents.

Respondents (particularly those from the larger companies) were less favourably inclined to support the Director's proposals to limit the information load on the smaller companies (those serving less than 500,000 people). Many thought the threshold was set too high and thought exemptions should only apply to very small companies (<20,000 people (ie Cholderton).

The Director has noted the points made. He intends to continue to exempt small companies from certain requirements within each information submission. Small companies will be defined as those serving populations of less than 350,000. This is consistent with the definition used for exemptions from certain July Return Reporting Requirements.

APPENDIX 1: RESPONDENTS TO THE PROPOSED FRAMEWORK AND APPROACH TO THE 1999 PERIODIC REVIEW

Company

Anglian Water Services Ltd

Bournemouth & West Hampshire Water plc

Bristol Water plc

Dwr Cymru Cyfyngedig

Essex & Suffolk Water plc

Folkestone & Dover Water Services Ltd

Mid Kent Water plc

Northumbrian Water Group

North Surrey Water Ltd

North West Water Ltd

Severn Trent Water Ltd

South Staffordshire Water plc

South West Water Services Ltd

Southern Water Services Ltd

Thames Water Utility Ltd

Tendring Hundred Water Services Ltd

Three Valleys Water plc

Water Companies Association

Water Services Association

Wessex Water Services Ltd

Yorkshire Water Services Ltd

Customer

CBI

Central CSC

Chartered Institute of Purchasing and Supply

Chemical Industries Association

Consumers' Association

Eastern CSC

Federation of Small Businesses

Major Energy Users' Council

Matthew Taylor MP

National Campaign for Water Justice

National Consumer Council

North West CSC

Northumbria CSC

Ofwat National Customer Council

The Confederation of British Wool Textiles Ltd

Utility Buyers' Forum

Wessex CSC

Environment

Chartered Institution of Water & Environmental Management

Country Landowners Association

English Nature

Environment Agency

Friends of the Earth

Marine Conservation Society

North Yorkshire County Council

National Federation of Anglers

The Royal Society for the Protection of Birds

Staffordshire Wildlife Trust

Surfers against Sewage

The Wild Life Trusts

UK Round Table on Sustainable Development

Other

CRI

British Plastics Federation

GHK Economics & Management

Sir William Halcrow & Partners Ltd

Institute of Plumbing

The Royal Town Planning Institute

Yogi Dutta

APPENDIX 2: RESPONDENTS TO THE BUSINESS PLANNING PROCESS,CUSTOMERS CONSULTATION AND INFORMATION REQUIREMENTS FOR THE 1999 PERIODIC REVIEW

Company

Anglian Water Services

Bournemouth & West Hampshire

Bristol Water

Dee Valley Group plc

Essex & Suffolk Water

Folkestone & Dover Water

Mid Kent Water

North Surrey Water

North West Water

Northumbrian Water

Severn Trent Water

South Staffordshire Water

South West Water Services

Southern Water Services

Thames Water Utility

Tendring Hundred Water

Three Valleys Water

Water Companies Association

Water Service Association

Welsh Water

Wessex Water Services

Yorkshire Water Services

Customer

Chartered Institute of Purchasing & Supply

Consumers' Association

Customers in Europe Group

Eastern CSC

Federation of Small Businesses

Major Energy Users Council

National Campaign for Water Justice

National Consumer Council

North West CSC

Northumbrian CSC

The Metal Finishing Association

Utility Buyers Forum

Wessex CSC

Environment

Surfers against Sewage

Other

Alton Town Council

Halcrow Management Sciences Ltd

Institute of Directors

Unison

WS Atkins

Scope: To provide the Deputy Prime Minister with independent advice on customers' views about broad environmental priorities.

Timetable: Final report planned for March 1998.

Water Services Association and Water Companies' Association

Scope: To identify customers' views on first, priorities for future customer services and contributions by the companies to environmental quality and secondly, the balance between improvements and prices.

Timetable: Final report planned for May 1998.

Drinking Water Inspectorate

Scope: To explore customers' views on drinking water and the nature and extent of any concerns they may have.

To explore customers' views on relative priority of drinking water quality and other issues, including prices.

Timetable: Final report planned for March 1998.

Environment Agency

Scope: To identify customers' views on environmental priorities and the financing of improvements.

Timetable: Report published December 1997.

ONCC

Scope: Qualitative work to explore the views of low income customers on affordability and the balance between service improvements and price.

Timetable: Final report planned for March/April 1998.

In addition, there may be possible quantitative work during 1998 to explore customers' understanding and views on priorities for environmental and other services and the financing of improvements.

Consumers' Association

Scope: To investigate consumer priorities for assessment of value for money and attitudes to water.

Timetable: Final report in early Summer 1998.

APPENDIX 4: SERVICEABILITY OF WATER AND SEWERAGE ASSETS IN ENGLAND AND WALES

1. Approach to serviceability to customers

In 1994, Ofwat assessed the companies' plans for the future management and capital maintenance of the underground systems using the concept of serviceability to customers. This is a long run approach which considers the ability of the water and sewerage networks to maintain a standard of services to customers. As set out in Section 6.2.1 of this paper, the Director intends to use a similar approach to assessing capital maintenance requirements for both underground and some of the components of surface assets at the 1999 Periodic Review. The aim is to assess whether expenditure on capital maintenance has been sufficient to avoid a deterioration in serviceability.

In the water industry, the serviceability approach has a number of advantages over an assessment based on, for example, asset age. The economic life of many water industry assets is uncertain and old assets may be as serviceable as new ones. With the historical serviceability approach, the need for future capital expenditure is assessed directly against the service provided to customers and to the environment. The indicators used in the serviceability approach are objective measures which are not influenced by elements of judgement or interpretation which may vary between companies or over time.

The approach examines trends in historical data for serviceability and expenditure over all the years for which data is available. This was used in 1994 to establish the validity of the approach and was also supported by an analysis which spanned 40 individual service examples. For the 1999 Periodic Review, if it is found that there is no evidence of a deteriorating trend in serviceability over the most recent five year period, the Director will assume that the average level of maintenance expenditure in that period will be sufficient in the future – on a company wide basis – to avoid deterioration in the period covered by the new price limits.

Companies will be submitting summaries of their asset stock arising from surveys of the condition and performance of their assets in Periodic Review Information Requirement H: Asset Inventory and System Performance.

Comparison of the assessed condition of assets between 1992–93 and 1997–98 will also indicate the adequacy of capital maintenance in that period. The inventory of age and condition should guide the priorities of companies when deciding on their detailed maintenance requirements to ensure continued serviceability. For regulatory purposes, however, the Director considers that an approach starting with serviceability to customers is appropriate.

Assessments of future capital maintenance expenditure derived from the serviceability analysis will be adjusted to take account of judgements arising from comparative analyses of companies' capital costs and the scope for improvements in capital efficiency.

2. Measures of serviceability

The infrastructure indicators are identical to those used in 1994 since respondents suggested no additional ones. For treatment works, the Director is discussing with the quality regulators additional indicators and measures to those given below.

The measures of serviceability of treatment works can be influenced by the effects of operating expenditure. If a treatment works is nominally capable of meeting the required standards of output, failure to do so will be due either to operational deficiencies or to deteriorating plant.

Nevertheless, since it is in the interests of a company to solve non-compliance with output standards as quickly as possible, it is reasonable to assume that short-term problems which lead to non-compliance are dealt with through actions recorded as operating costs. It follows that problems which cannot be dealt with in this way, and which lead to more persistent failures, will need some degree of asset renewal.

It is, of course, possible for a company to delay the need for asset renewal by increasing expenditure on operations, but this is likely only in the short-term. As a check on this conclusion, the corresponding trend of operating expenditure has been examined. In the majority of cases operating expenditure is falling which suggests companies are not attempting to correct problems through this means.

Therefore, where a long-term trend of steady or improved performance is observed, this is taken to show that expenditure on plant renewals has been adequate. As with the analysis of infrastructure renewals, this interpretation of the performance of any one company is supported by the same analysis for all other companies.

2.1 National trends

As a method for assessing capital maintenance needs, the historical perspective approach is essentially company specific. However, it is of interest to examine national trends in the parameters listed below. In all cases — water distribution, sewerage, water treatment and sewage treatment — there is a clear indication of no deterioration in serviceability to customers or to the environment in recent years. Indeed, there is much evidence of improvement. There are, nevertheless, some company services where the trend of serviceability is not satisfactory and companies will be required to provide an explanation for this.

3. Indicators of serviceability to customers

The indication of serviceability to customers to be used are set out below by asset and service category.

3.1 Water distribution

• Extent of low-pressure problems (DG2)
• Number of burst mains
• Properties suffering an interruption of supply for more than 12 hours to customers (DG3)

• Properties flooded from sewers due to hydraulic inadequacy (DG5)
• Number of sewer collapses
• Length of sewers in categories 4 and 5

The data assessed is for current performance against current standards.

• Enforcement action considered in respect of contraventions of microbiological standards.

3.4 Sewage treatment works

The key element of performance for sewage treatment works is their compliance with the discharge consent conditions set by the EA. Some relevant data is published in the Digest of Environmental Statistics and, of these, the following have been used. The data assessed is for current performance against current standards.

• Number of sewage treatment works compliant against all sanitary consent criteria.
• Population equivalent of works compliant with 95-percentile sanitary consent criteria

APPENDIX 5: THE PRINCIPLES OF BROAD EQUIVALENCE

1. Current cost depreciation and broad equivalence

Capital expenditure in the water industry can be considered in two parts: capital expenditure on maintenance, renewal or replacement of the pool of base service assets and additions or enhancements which occur as a result of, for example, quality programmes which companies have undertaken. In order to maintain the serviceability to customers, capital maintenance expenditure is incurred to renew or replace base service assets when they reach the end of their useful lives, so that the pool of assets is maintained.

At present the cost of replacing or renewing assets is included in prices via the current cost depreciation (CCD) charged on the base service assets.

Current cost depreciation may have any number of profiles. This is acceptable provided that the profile adopted is matched by changes to the regulatory capital value. Since most of this depreciation charge relates to the base service assets, one sensible method of determining a suitable depreciation profile is to assume that, over an appropriate period, the capital expenditure to maintain the serviceability of the base service assets at that date should be broadly equivalent to the CCD charged on those assets. Thus the amount that is included in customers' bills should approximate to the amount which companies spend in maintaining their assets over an appropriate period.

2. Comparison of CCD and capital maintenance expenditure to date

When the total CCD at 31 March 1993 and average capital maintenance expenditure over the period 1992–93 to 1996–97 are compared, at an industry level, CCD is broadly equivalent with the average capital maintenance expenditure. However, the individual company results underlying this trend show a wide variation. Comparisons range from significant deficits in capital expenditure when compared to CCD (up to 14% of turnover) to large excesses (up to 10% of turnover). The comparison has been made over this period since this is the period for which information is available. Using 1992–93 CCD excludes the effect of any depreciation on any enhancements to, or growth in, the asset base since that date ie the comparison assumes a steady state for the asset base.

The above comparison raises two issues regarding broad equivalence:

• the time period required for broad equivalence; and
• the assumption of a steady state in the asset base.

3.1 The appropriate period

The broad equivalence principle is expected to apply over an appropriate period of time. The use of simple examples with a limited number of assets shows that CCD will exactly equal capital maintenance expenditure over a period which equates to the lowest common multiple of the asset lives. If the two are expected to be broadly, rather than exactly, equivalent then using the period of the longest asset life gives acceptable results. In the water industry, the weighted average life of non-infrastructure assets additions, as reported in July Returns, ranged from 30 to 34 years. The life attributed to long life assets by companies ranges from 40 to 100 years.

Responses to the consultation paper in this area were from companies only. All who agreed with the principle of broad equivalence stated that a comparison over a five year period is too short. In three cases respondents propose that the appropriate period is the life of the asset. In other responses the time period proposed refers to 'the long term' or 'very long term'. Where a specific time period was suggested, this was in the range of 20–30 years. One response suggested a period greater than 30 years.

3.2 The timing of cash flows

Because the comparison of CCD with capital maintenance for broad equivalence purposes occurs over a period of time, it is necessary to consider the effects of the timing of the implied cash flows arising from CCD and capital maintenance. For example over a period of 23 years (from 1992 to 2015), the total CCD and capital maintenance expenditure may be equal but, if all the capital maintenance expenditure were to occur at the end of the period, in present value terms, the total CCD and capital maintenance expenditure would be very different.

Any differences between the timing of CCD and capital maintenance expenditure are offset by the corresponding effect on the regulatory capital value.

The overall net present values of CCD, capital maintenance expenditure and the resulting change in the regulatory capital value are not material when considered over the 23 year period.

4. Steady state asset base

In order for the principle of broad equivalence to apply the asset base must be in a steady state ie neither growing nor contracting. Due to the recent quality programmes which companies have been required to undertake, in the majority of cases the asset base has been growing.

The comparison of CCD and capital maintenance expenditure for the period 1992–93 to 1996–97 uses 1992–93 CCD to exclude the effect of enhancement expenditure. This assumes that the 1992–93 CCD is representative of the CCD on base service assets.

Both comparisons assume that enhancements do not attract any capital maintenance expenditure within the five year period. If a longer period were taken into account, consideration would need to be given to additional maintenance requirements for enhancements.

5. Current cost depreciation profile and its relationship with the regulatory capital value

It is proposed that the current cost depreciation profile be determined by reference to the capital expenditure incurred by companies to maintain their assets. The same current cost depreciation charge included in prices charged to customers will be deducted from the regulatory capital value upon which companies earn a rate of return. This ensures that there is symmetry between the depreciation which is charged in the regulatory profit and loss account and that which is deducted from the regulatory capital value.

6. Approaches to depreciation adopted by different regulators and approaches by the MMC

6.1 Other utility regulators

The regulated utilities generally have regulatory capital values which are less than the replacement cost of the assets. The ratio of the regulatory value to the replacement cost is known as the Market to Asset Ratio (MAR).

When setting price limits, regulators have adopted two separate approaches in the treatment of the CCD charge and interaction with regulatory asset values. They are:

• allowing full CCD charge on replacement assets which result in a steady state as CCD is assumed to equal investment maintaining a constant regulatory asset value ie broad equivalence is assumed to exist.
• reducing the CCD charge by the MAR resulting in a lower initial revenue requirement but allowing the regulatory asset value to increase over time to equal replacement value.

6.2 The MMC's views of broad equivalence

The MMC has not made any specific reference to the broad equivalence principle in its reports on South West Water, Transco or Northern Ireland Electricity. In its report on Transco, however, the MMC concluded that an allowance based on actual expenditure may be appropriate for certain types of asset in certain utilities. However, for British Gas, there would be difficulty in determining a smoothed level for such a charge and in distinguishing between replacement and new assets.

APPENDIX 6: A RÉSUMÉ OF RESPONSES ON THE PROPOSED INFORMATION SUBMISSIONS

(A) Main quality costing

Many companies expressed concerns about the level of detail in this return and whether the timetable was achievable.

(B) Supply/demand submission

Most respondents were concerned that decisions from the EA and DETR would make it impossible to satisfactorily deliver this submission in June 1998. Most suggestions were to delay this until October 1998.

(C) July Return 1998

Companies suggested limited or no new changes to the current requirement and some suggested the separation of the additional data from the core return.

(D) Customer consultation and strategic options

Respondents agreed that this was an important submission. However, they stressed that significant elements were outside the direct control of the companies. Many suggested delaying this submission until the end of August 1998.

(E) Update of quality costings

A number of companies suggested this should be the first time that the summary of forecast expenditure by purpose is submitted

(F) Draft Business Plan

No significant adverse comments were received on the structure of the draft Business Plan. One or two respondents welcomed it as an improvement on the 1994 strategic business plan.

Companies made the point that this would be the definitive data set, drawing attention to the 'without prejudice' numbers submitted earlier.

(G) July Return 1999

Many companies reiterated the difficulties of bringing forward the full return to early June 1999, stressing the need for audit and stock exchange rules. Some suggested splitting the return to provide the less important data in August 1999.

(H) Monitoring Plan

Where commented upon by respondents, they stressed the need for this to focus on output delivery programmes, to be in a common format and to be submitted by April 2000. Early definition of the scope of this plan would be welcomed.

APPENDIX 7: THE PROPOSED CONTENT OF THE DRAFT BUSINESS PLAN

1 Objective

The draft Business Plan will set down the company board's view of the price limits needed for the period 2000–01 to 2004–05 and its reasons, so that the Director can take proper account of the company's views in his determination of price limits. These plans should be shorter and more focussed that the 1994 Strategic Business Plans. They should explain the linkages to previous data submissions and any material changes to assumptions or data.

2 Outline

The draft Business Plan will provide the justification for the company's view of the price limits needed. Each company will submit information to the Director under four main headings:

• what it considers constitutes the proper carrying out of its functions over the five year period 2000–05 and how it will ensure that these can continue to be delivered into the future;
• the service performance in recent years and the state of its assets in 1997–98;
• the investment needs and priorities to maintain long-term serviceability to customers, to improve service where considered necessary, to meet new legal obligations and to ensure an adequate balance between supply and demand in the provision of water and sewerage services for customers; and
• the price limits for the five year period 2000–05 which it considers are necessary for it to be able to finance the proper carrying out of its functions;

3 Proposed content and format

The draft Business Plan will be in three parts: an overview, the main submission and a public summary. Reports from the Reporter and Auditor will be separate, sent by them to the Director and copied to the company. The scope and content of each part is summarised below.

3.1 Overview

The overview will be a freestanding summary of the company's plan which should be succinct and comprehensive. The overview must have been endorsed by the company's board (or plc board where appropriate). The overview will receive the personal attention of the Director. The overview will:

• set out the price limits sought by the company's board for the period 2000–01 to 2004–05;
• set down in outline the company's view of the key functions it proposes to carry out over the period;
• outline how the company has taken into account the interests of customers;
• include a series of summary tables covering the overall strategy, financial projections, asset values, serviceability and maintenance data, service quality and environmental outputs, efficiency targets and expenditure by purpose for the price limit period; and
• state how the company proposes to finance its functions.

The main submission will draw together the various issues in an integrated way and provide justification for the top level plan identified in the Overview. The submission shall have the following sections:

• The company: A statement of what the company considers constitutes the proper carrying out of functions (statutory quality obligations, assumptions, targets etc). It will summarise the state of the company's assets in 1997-98 and the company's policies with respect to the supply/demand balance, charging for services and its key forecasts over the plan period.
• Efficiency: It will set out the company's assumptions on the scope for future efficiency savings that have been incorporated into its projections (both operating and capital expenditure). This section shall include the final standard costs revised, if appropriate, in the light of feedback on the information submitted in June 1998 (Submission G).
• Maintaining base service levels & serviceability for customers: It will set out the year by year delivery of outputs over the plan period to maintain base service levels and serviceability for both current and future customers. These will cover quality compliance, levels of service indicators and other serviceability and performance measures. The proposed leakage targets, linked to updated assessments of the economic level of leakage will need to be set down. It should include the planned activity levels for work on the assets and justify the projected operating and capital expenditure needed to maintain serviceability to customers.
• Quality enhancements: This section should set out a full description of the year by year delivery of quality enhancement outputs over the plan period. These will cover the phased delivery of the quality enhancements at both major project and programme level. For major projects, milestone dates will be required. It will set out the planned activity levels for quality enhancement work and justify the projected quality enhancement operating and capital expenditure needs. The information provided should be consistent with that submitted in February 1998 and updated in December 1998 (Submissions D and J). Provision will be made for companies to include material changes to their logging up submission included in the 1998 July Return (Submission F).
• Maintaining the supply/demand balance. It will set out a full description of the year by year delivery of outputs, leakage levels, tariffs and revenue projections necessary to maintain the supply/demand balance over the plan period. Assumptions on the headroom in water resource provision will need to be exposed and justified. The implications of the projections for the economic level of leakage will need to be explained, taking due account of feedback on Submission E and leakage targets set or to be set by the Director. It will set out and justify projected supply/demand balance operating and capital expenditure needs. Key and material information collected in the supply/demand balance submission E will be required to be included in the draft Business Plan.
• Service enhancements: This sets out a full description of the year by year delivery of other service enhancement outputs over the plan period. It will set out and justify the projected service enhancements operating and capital expenditure needs.
• Financial projections. This should set out the key financial information and assumptions underpinning company financial projections, including return on capital, taxation, dividends and dividend growth and any financial ratio constraints assumed. It should include the financing plan for the period. It will also set out and justify the company's approach to accounting charges (IRC, CCD (base), CCD (enhancements) and broad equivalence tests). The financial information required in the draft Business Plan will match the format of that required in the financial supplement to the 1998 July Return (Submission F).
• Risks and uncertainties. This section should set out and quantify the risks and uncertainties involved in all the elements of the plan, perhaps in the form of scenarios, and to justify the robustness of the plans to changing circumstances. It will examine the implications for a range of different price limits in terms of output delivery, efficiency improvements and financial returns.

A freestanding public summary of the company's plan will be required. This should be in plain English and written with the customer, CSC, EA and informed observer audience in mind to enable them to understand the company's plan. The summary will:

• set out what the company intends to deliver over the plan period in terms of quality enhancements and service delivery, together with its request for price limits;
• set out the implications of major enhancement programmes in terms of benefits to customers or the public at large;
• explain the impact of the requested prices for customer bills, distinguishing between measured and unmeasured customers; and
• identify the main components of the proposed charges in terms of:
  past and future efficiency improvements (Po & X),

  water quality and environmental improvements (Qw & Qs),

  maintaining the supply/demand balance (V), and

  other aspects – service improvements, charging policies etc (S).

Ofwat will issue the draft Business Plan manual (including a complete PR99 Information Requirements Definitions manual in electronic format) in late July 1998. The manual will be updated from time to time as points of clarification are found to be necessary. Ofwat expects the last revisions to the manual in November 1998.

The company is required to submit its draft Business Plan by 9 April 1999 and to publish its public summary. The public summary will also be placed in the Ofwat library upon receipt. The non-confidential elements of the draft Business Plans will be placed in the Ofwat library on completion of the review ie generally April 2000 or after re-determinations by the MMC for any companies which appeal against the Director's determination.

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.

Beta factor: This is a coefficient (ie a number) which measures the riskiness of equity capital. Individual equity shares tend to be more or less risky than the overall equity market. The riskiness of a stock, as measured by beta, is the volatility of its return in relation to that of a market portfolio. The beta factor is a component of the Capital Asset Pricing Model (qv) which is used to estimate the cost of equity capital.

Broad equivalence: The principle 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 (see Appendix 5).

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 that 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).

Cost reflective tariffs: Tariffs that are structured so that differences in costs of supply or service imposed by different classes of customers are reflected in the tariffs they pay. The implication is that one group of customers should not cross-subsidise another.

Current cost accounting: A method of accounting originally designed to deal with the problem of showing the effect of inflation on business profits. For example, 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 and depreciation charged on that value. This method of accounting is used in tandem with Historic Cost Accounting (HCA) in the water industry because of the extensive nature and long life of capital assets and the fact that historic costs do not reflect the assets' true worth.

Data Envelopment Analysis: One of the mathematical methods for assessing productive efficiency. It can be used to estimate the potential in each water company for savings through improved efficiency. It estimates the potential for reducing inputs to achieve a given level of outputs or to increase the output for a given level of input.

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 they encourage the efficient use of water by those whose demands impose additional costs of supply, eg garden waterers and other peak users. Application of such tariffs is an essential part of demand management policies.

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.

Draft Business Plans: See Appendix 7.

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.

Equity risk capital: Equity shares carry more risk for investors than other investments where there is little or no risk of losing the capital invested, for example, government securities. This additional risk is reflected in the expected return that will induce investors to buy a company's shares. The additional return, ie that over the 'risk free' rate, is called the equity risk premium. It is difficult to measure precisely. Some methods estimate it using historic data (ex post approaches) while other consider forward-looking returns (ex ante approaches).

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, the rates of return earned by water companies were greater than the cost of capital. Price limits were set on the basis that the return declined to the cost of capital over a period of ten years. This progressive decline in rates of return was termed the glidepath.

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

Historic cost accounting: The traditional form of accounting, in which assets are shown in balance sheets at their purchased cost to the business.

Indexation: The policy of linking 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 (qv) 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 either 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 annual profits before interest and tax cover the 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 (eg greater than 25-50 megalitres a year). Under the Competition and Service (Utilities) Act 1992, large users are defined as those customers 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 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.

Market mechanisms: The forces of supply and demand, that, in a free market determine the quantity available of a particular product or service and the price at which it is offered. In general, a rise in demand will cause both supply and price to increase, while a rise in supply will cause both a fall in price and a drop in demand. Many markets have individual features that modify this simple analysis; such is the case with the water industry where monopoly supply is predominant.

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. The revenues and costs will have been discounted (using an appropriate discount rate) so that cash flows at different times can be properly compared.

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

Outage: A temporary interruption of water supply due to planned or unplanned events. Planned events are those such as maintenance of sourceworks; unplanned events are exclusively pollution, turbidity, nitrate, algae, power failure and system failure.

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.

Price cap regulation: The Director sets prices which allow the companies to finance their functions. He does not control profits or dividends. Regulation by price cap gives companies incentives for greater efficiency which can be shared with customers and shareholders.

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 Drinking Water Inspectorate, on behalf of the Secretaries of State, ensures that the water companies are fulfilling their obligations with regards to quality of drinking water supplies. The Environment Agency 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 Environment Agency.

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 and safeguard the assets and resources of the appointed business.

Serviceability: See Appendix 4.

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 commonly be met via demand management strategies such as selective metering and leakage control.

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.