In March 1996, I announced a review of the workings of the tariff basket, which is used to calculate the average increase in charges which can be applied each year by a water company. This average is controlled by the K factor which is set, normally at Periodic Reviews, to limit increases or decreases relative to inflation as measured by the Retail Price Index (RPI). But many changes can take place within the basket.

I decided to review the workings of the tariff basket prescribed in the licence because under the current arrangements, particular categories of customer can face unexpected increases which differ substantially from the overall price limit, RPI ± K. Companies have not been successful in explaining these increases to their customers and the Customer Service Committees have had many complaints about them. In writing this consultation paper we have greatly benefitted from discussions in the Ofwat National Customer Council.

The review will be completed so that changes can come into effect on 1 April 2000, the first year of the new price limits to be set in 1999.

Charges to particular classes of customer should be broadly related to the costs they impose on the system. This is both fair and encourages efficiency in the use of water. Each year we check that the average increase in charges proposed by a company does not exceed the price limit for that company and that there is no undue discrimination or undue preference as between classes of customer.

Where changes in costs - or better analysis of costs - point to relative changes in charges, the tariff basket permits a rebalancing of charges between classes of customer. Such changes should be planned in advance and should take place over a considered timescale. They should be both explicit and transparent.

Rebalancing has and is taking place, quite properly, in three main areas.

• All companies have now rebalanced their tariffs to correct the historical imbalance that existed between the bills of customers taking measured and unmeasured supplies. In the past, customers paid too much for measured supplies in comparison with the amount paid by customers for unmeasured supplies. The difference in bills should be no greater than the extra costs of providing a metered supply. As more customers are metered, charges need to be further rebalanced to maintain this differential. Rebalancing is also necessary where demand from customers taking an unmeasured supply grows - again to maintain the differential.
• I am pressing water and sewerage companies to achieve a better balance between charges for water and sewerage. At the last price review, in 1994, I set one overall K factor for each water and sewerage company. I propose to do the same at the 1999 price review. Setting separate formal price limits for water and sewerage would involve unnecessary complexities. At the review I will, however, consider the balance between water and sewerage charges and announce such changes in relativities as are needed to reflect relative costs.
• Several companies have now introduced large user tariffs for water (and waste water) which more accurately reflect the costs involved in supplying those customers who use large quantities of water or discharge large volumes of waste water.

• In particular I am concerned about what happens when a customer changes from an unmeasured to a measured supply. Generally, these customers who opt for a meter do so because they expect to benefit from lower bills. Where they are living in houses with a relatively high rateable value, the tariff basket allows the lost revenue to be recouped by increasing charges to the remaining unmeasured customers (or even raising charges to customers generally). I am considering a change to the arithmetic of the unmeasured basket to remove this effect. This would mean that changes in the average household bill would more closely relate to RPI ± K.
• I also believe that where companies wish to alter large user tariffs further, they should do so without affecting bills for other customers. There is a case for removing charges for large users from the tariff basket because they are part of a more competitive market not requiring the same degree of regulatory protection¹. Removing large users from the tariff basket would also limit the abilities of companies to increase bills for other customers when they reduce tariffs for large users in the same way as when companies make special price agreements with their customers.

This review of the tariff basket is a key step in the next Periodic Review and I welcome views on my proposals.

I C R BYATT

Director General of Water Services

¹ Ofwat,1995, Competition in the water industry.

² See Ofwat MD124, 1997, 1999 Periodic Review and Ofwat consultation paper, 1993, Paying for growth

2. PREFACE

The Director General of Water Services (the Director) believes that there is scope for changing the way the tariff basket works in light of the changes that have taken place within the water industry in the years since privatisation. In particular, the spread of metering and the onset of competition mean that the tariff basket formula that was designed by the Secretaries of State for the Environment and for Wales in the run up to privatisation may no longer be appropriate for dealing with current developments in the water industry.

The Director has put forward the following suggestions for improving the workings of the tariff basket.

• Altering the arithmetic of the unmeasured basket and bringing it into line with the measured basket so that only justified rebalancing is allowed. If the arithmetic of the unmeasured basket is changed this would enable the Director to further simplify the tariff basket formula in the way the weighted average charges increase is calculated.
• Removing large users from the tariff basket given the impact that large user tariffs can have on other customers' bills and the fact that large users are part of a more competitive market not requiring the same degree of regulatory protection.
• Potentially needing to adopt forward looking weights (charge multipliers) in the tariff basket instead of using backward looking weights to aid the sensible introduction of new tariffs.

The Director welcomes your views on all of the issues that are addressed in this paper. Please send them to: Dr A J Ballance, Chief Economist, Office of Water Services, Centre City Tower, 7 Hill Street, Birmingham B5 4UA by 18 July 1997.

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

3. EXECUTIVE SUMMARY

Taken together, the suggestions that the Director has put forward for changes to the tariff basket will enable Ofwat to manage better the rebalancing that takes place within the tariff basket and will mean that changes in customers' bills will move more in line with RPI ± K. There will be less scope for unexpected increases in bills, and the way in which the tariff basket works will be easier to understand.

There are four main areas where tariff rebalancing can take place:

• between unmeasured and measured charges;
• between water and sewerage charges;
• between charges for large users and other groups of customers; and
• as a result of the introduction of new tariffs.

The second reason for rebalancing between unmeasured and measured customers is, however, likely to continue in order to maintain a fair balance between measured and unmeasured charges. The Director expects any difference between measured and unmeasured bills to be no greater than the extra costs of providing a metered service. This measured/unmeasured differential is calculated by applying the company's measured charges to the average amount of water delivered by that company to an unmeasured household and comparing the resulting measured bill with the average unmeasured household bill for that company. Ofwat has calculated the additional costs of metering to be no more than £27 in 1996-97 prices for water and sewerage.

Customers who opt for a meter do so because they believe they will benefit from lower bills. Such customers generally have a higher than average rateable value (and/or a lower than average consumption of water). When high rateable value customers are metered, the average unmeasured bill falls as a consequence. As a result, in order to maintain the measured/unmeasured differential, unmeasured charges need to rise relative to measured charges. This increase is compounded if the customers becoming metered consume less than an average amount of water. This effect could, however, be offset were companies, for example, to selectively meter those customers with higher than average water consumption and lower than average rateable values. Moreover, rebalancing will also continue to occur (with unmeasured charges needing to increase relative to measured charges) due to growth in demand from unmeasured customers given the need to maintain the measured/unmeasured tariff differential.

The third reason for rebalancing between unmeasured and measured charges is due to an additional effect arising from the movement of customers from the unmeasured basket to the measured basket. When a customer becomes metered, the tariff basket works in such a way that the company loses only the equivalent of an average unmeasured bill from its revenue stream and not the unmeasured bill associated with that particular customer. The current arithmetic of the unmeasured basket allows companies to recoup the lost revenue where this customer is paying a higher than average annual bill (ie they are in a higher than average rateable value property) by raising charges to the remaining unmeasured customers (or even raising charges to customers generally). This effect means that average charges and bills have generally increased by more than RPI ± K, particularly where metering is not uncommon. The Director believes therefore that there may be a case for changing the arithmetic of the unmeasured basket and thus removing this hidden effect. This would allow the tariff basket formula to be further simplified. The charges increase would be calculated as the ratio of the total weighting year revenues for the charging year and the prior year, and the need to calculate year-on-year increases for each basket item would be removed.

Rebalancing has also occurred between water and sewerage charges, mainly to reflect the cost of complying with the EC Urban Waste Water Treatment Directive. As a result, sewerage charges have needed to increase more rapidly than water charges. At the last Periodic Review in 1994, the Director determined one overall K factor for water and sewerage companies but set out how the K factor disaggregated into separate water and sewerage elements. It has been suggested that the Director set separate formal K factors for water and sewerage at the next Periodic Review. He does not believe that such a step is necessary, as companies already broadly follow the Ofwat approach in setting the respective levels of their water and sewerage charges. In addition, companies are subject to Licence Condition E, enforceable by the Director, which prohibits undue discrimination and undue preference. Setting formal separate K factors may also complicate the price setting approach at the Periodic Review, and may add to the complexity of the tariff basket. The Director therefore is minded to continue to set one formal K factor for each company, but to announce at the Periodic Review any changes in relative prices for water and sewerage necessary to reflect relative costs.

This review also considers whether competition for large users enables their charges to be removed from the tariff basket, because they are part of a more competitive market not requiring the same degree of regulatory protection. Several companies have already introduced large user tariffs for water (and waste water) which more accurately reflect the costs involved in supplying those customers who use large volumes of water (or discharge large volumes of waste water). It is possible that companies may wish to further alter large user tariffs, which under the current arrangements could mean higher bills for other groups of customers. The Director is concerned that this may lead to difficulties in the interpretation of Condition E. The Director would like to see companies reflecting the continuing costs of augmenting supply (ie long run marginal cost) in their tariffs for large users. He recently published a paper on this subject by London Economics entitled Water pricing: The importance of long run marginal costs. If companies wish to make changes to tariffs for large users, they should do this without affecting bills for other customers. To this end, the Director is minded to remove large users from the tariff basket.

The tariff basket should be able to accommodate new tariffs in a sensible way. Companies should gain revenue when demand rises but, if demand is less than expected, companies should not be able to gain revenue through rebalancing onto other groups of customers. The measured basket already operates in this way in that customers pay for the water they use and, if demand increases, companies receive greater revenues. Conversely, if demand falls (as it has in the past for some companies) revenue falls. Expenditure to meet imbalances in supply and demand should, as far as is practicable, be met by those whose demand is increasing and should largely be paid for by changes in their bills rather than by the generality of customers through higher K factors. The Department of the Environment and Welsh Office publication, Water resources and supply: Agenda for action, states that water companies should develop more sophisticated tariff structures. The Director wishes to ensure that companies are able to introduce any new tariffs (for example, more sophisticated demand-related tariffs) into the tariff basket in a sensible way. There may, therefore, be a case for adopting forward looking weights (charge multipliers) in the tariff basket formula instead of using prior year weights.

Each of these issues is addressed in more detail in the main body and Appendices of the paper.

4. CONCLUSIONS AND PRACTICAL ISSUES

The Director has put forward a number of suggestions for dealing with the current difficulties experienced with the workings of the tariff basket. These are as follows.

1. Changing the way in which the unmeasured basket calculates increases in charges, bringing it into line with the measured basket. This would allow the tariff basket formula to be further simplified such that the charges increase is simply the ratio of the total weighting year revenues for the charging year and the prior year, and would remove the need to calculate year-on-year increases for each basket item.
2. Retaining the system of setting one formal K factor for each water and sewerage undertaker.
3. Removing large users from the tariff basket, given the impact that large user tariffs can have on other customers' bills and the fact that large users are part of a more competitive market not requiring the same degree of regulatory protection.
4. Continuing to use a system of dynamic weights (charge multipliers) in the tariff basket, as is currently used in the measured basket. To facilitate the introduction of new tariffs there may, however, be a case for adopting forward looking weights (charge multipliers) instead of using backward looking weights.

Timing

This paper should be seen as part of the structured approach to the next Periodic Review, and as such, changes to the tariff basket arising from the consultation process will need to be incorporated by 1 April 2000, the first year of the new price limits.

Practical issues for water companies

Principal Statement

If the changes that are suggested in this consultation paper are adopted then the Principal Statement will need to be changed. First, if the arithmetic of the unmeasured basket is brought into line with that of the measured basket, then the format of the unmeasured basket entries will need to change such that there is one charge multiplier for each charge in the tariff basket. The Principal Statement will then calculate the weighting year revenue for the charging year and the prior year for each basket item and in total. The ratio of the total weighting year revenues could then determine the weighted average increase in charges.

Secondly, large users will have to be removed from the measured basket. Information regarding large users would continue to be collected at the same time as the Principal Statements, but this would be done using an alternative capture system.

Condition B

Condition B of a company's licence sets out the tariff basket formula. Any changes to the tariff basket will therefore require Condition B to be amended.

Consultation

The Director welcomes your views on all of the issues that have been addressed in this paper. Please send them to Dr A J Ballance, Chief Economist, Office of Water Services, Centre City Tower, 7 Hill Street, Birmingham B5 4UA by 18 July 1997.

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

The Director intends to arrange seminars with a number of interest groups later in 1997 to discuss the issues raised in the consultation process. Seminars will be held for the water industry and for interested customer groups such as the Ofwat Customer Service Committees, the Consumers Association and the Confederation of British Industry (CBI).

Copies of the paper are available free of charge from the Ofwat Library.

Orders can be placed by e-mail: puborders@ofwat.gsi.gov.uk Please include postal address.

or by contacting the Ofwat Library.