Anglian Water PR19 Part G: Reply to Ofwat's Response on Cost Issues
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Anglian Water PR19 Part G: Reply to Ofwat's Response on Cost issues (re-issue 4 June 2020) i Part G: Reply to Ofwat’s Response on Cost issues Table of Contents Contents Page Part G.1: Reply on Uplift in totex from AMP6 to AMP7 and previous outperformance 1 1 Expenditure uplift 1 2 Outperformance 4 Part G.2: Reply on Capital Maintenance 12 1 Overview 12 2 Ofwat has no established framework to monitor companies’ serviceability 14 3 Anglian is forecasting higher capital expenditure than historical levels 16 4 Ofwat incorrectly assumes that companies' long-term capital maintenance requirements are constant over time 17 5 Ofwat misrepresents the evidence Anglian provided in support of its base cost requirements 27 6 Ofwat fails to engage with the evidence provided on the impact on resilience 28 Appendix 1 29 Part G.3: Reply to Ofwat's response on facilitating sustainable economic and housing growth 34 1 Overview 34 2 Introduction 34 3 Updated expenditure requirements 35 4 Anglian's proposed investment costs are efficient and have not been assessed properly by Ofwat 36 5 Growth-related costs are not appropriately captured by Ofwat's base cost models 37 6 Ofwat incorrectly asserts that its Developer Services Revenue Adjustment ("DSRA") offers "considerable" protection against the risk of higher growth 38 7 Anglian's proposed true-up mechanism 38 Part G.4: Reply on Enhancement cost efficiency 40 1 Overview 40 2 Introduction 41 3 Lack of evidence provided by Ofwat in relation to each of its efficiency arguments 42 ii Part G: Reply to Ofwat’s Response on Cost issues 4 How Anglian has developed its view of appropriate costs for delivery of its AMP7 Enhancement 45 5 Information asymmetry 49 6 Impact of Ofwat's FD on Anglian's Enhancement programme 49 Part G.5: WRMP Supply-side decision-making process 50 1 Overview 50 2 Introduction 50 3 Development of WRMP supply-side options for Anglian's Plan 51 4 Full engagement with Ofwat 55 5 Best available guidance taken into account when preparing Anglian's Plan 56 6 Concluding remarks 57 Part G.6: Reply on Frontier shift 59 Part G.7: Reply on Opex/Capex Misallocation 62 1 Overview 62 2 Ofwat does not contest that it has misallocated opex as capex 62 3 Ofwat's allocation is not consistent with Anglian's business plan approach 63 4 Ofwat's FD does not provide sufficient justification for why base and growth costs should be considered together for cost recovery 64 5 Furthermore, Ofwat does not engage with the impact of the misallocation 65 Amendment Date Para 15 replaced £157m with £86M 4 June 2020 Para 71 addition of text to end of sentence. 4 June 2020 Table 6 – restated table to reflect IFRS changes introduced from 2015/16. iii Part G: Reply to Ofwat’s Response on Cost issues Part G.1: Reply on Uplift in totex from AMP6 to AMP7 and previous outperformance 1 Expenditure uplift1 (i) Ofwat has misrepresented the variance between Anglian's Botex expenditure in AMP6 and AMP7 by reinstating the error it made at IAP and subsequently corrected at DD, of including enhancement opex in base costs. (ii) Anglian previously noted a 1.9% uplift on base costs for its plan versus AMP6. However, adopting Ofwat's treatment of the costs of transferred sewers and pumping stations, Anglian's plan for Botex in fact shows no material uplift from its expenditure in AMP6. Botex for AMP7 is essentially the same as Botex for AMP6. (iii) The uplift in Anglian's expenditure proposals compared to AMP6 is almost entirely in its enhancement programme and results from the materially increased scope of that programme relative to AMP6. Ofwat has consistently failed to acknowledge this when presenting totex comparisons. (1) Ofwat repeatedly states that Anglian requested a larger increase in its totex allowances, relative to PR14 levels than any other company.2 Anglian does not dispute this.3 Ofwat also says that any company should be able to provide convincing evidence to support the claims it is making.4 Anglian does not dispute this either. Ofwat's implicit suggestion is that this increase in totex means Anglian's costs are inefficient and that the Company is therefore subject to a high evidential bar to justify any of its expenditure needs.5 And the suggestion of inefficiency is something Anglian does dispute. (2) In order to understand the increase in Anglian's proposed expenditure compared to AMP6 two things are necessary. Firstly, it is necessary to decompose the overall expenditure plan into smaller parts. The variance from past expenditure will differ from one area of the programme to another, and the explanations for those variances are also area-specific. Totex-level comparisons are not informative without this context, and an understanding of what is being offered for the expenditure proposed. Secondly, it is necessary for those variances to be assessed on a truly like-for-like basis to enable a meaningful comparison. (3) Throughout the PR19 process Ofwat has resisted Anglian's attempts to explain its Plan through decomposition and comparability. It has preferred to engage in simplistic, high-level terms, implicitly inviting stakeholders to form the view that a large uplift must equate to gaming and inefficiency. This is both misleading and a weak and inadequate response to the shortcomings which Anglian and others have highlighted in Ofwat's models. It certainly does not support the output of Ofwat's flawed models. (4) Where Ofwat has decomposed the variance, it has done so in a highly misleading way, and repeats this in its Response to Anglian's SOC. Regrettably, other stakeholders have then relied on Ofwat's flawed 1 Note – all analysis in this paper makes use of the forecast expenditure for 2019-20 that Anglian submitted in its DD Representation (SOC168) in August 2019. The audited outturn figure for 2019-20 expenditure will become available during the course of the re- determination, which will allow Anglian to update its analysis. Anglian does not expect the difference between its August 2019 forecast and audited outturn figure to make a material difference to the key messages of this paper. 2 See for example Response to Anglian, para. 1.15. 3 Para. 1.7. 4 Ibidem. 5 Ibidem. 1 Part G: Reply to Ofwat’s Response on Cost issues presentation to shape their views.6 This Reply provides the correct presentation, which the CMA is invited to consider in its redetermination. (5) Anglian decomposed the uplift in its plan for AMP7 between enhancement costs and base costs, and explained this in its SOC.7 For this purpose, Anglian defined "base costs" in the normal sense of the term (that is, opex plus capital maintenance, or "Botex") rather than the new concept of "Botex Plus" which Ofwat switched to during the PR19 process. "Botex Plus" incorporates components of expenditure which Ofwat (and companies) have always in previous price controls regarded as enhancement expenditure. These components mainly relate to growth, but also include low pressure, sewer flooding and transferred sewers. (6) Anglian stripped out these added components in its Botex uplift analysis to allow for a like-for-like comparison between AMP6 Botex expenditure (where these elements were previously treated as enhancement) and its planned AMP7 Botex expenditure. (7) The reason these elements were previously treated as enhancement expenditure is because growth is subject to cyclical variation, relating primarily to economic forces, and the scale of expenditure on sewer flooding and low pressure depends on the views of a company's customers about the extent to which it should prioritise these service improvements. In other words, the scope of a company's enhancement programme (and hence its cost) can vary significantly from one period to another according to the obligations it is required to deliver. In its SOC, Anglian explained how its AMP7 enhancement programme differed from its AMP6 enhancement programme because of, for example, significant increases in the size of its WINEP programme and the scale of its WRMP.8 (8) Because of this inter-period variance in the scope and drivers of enhancement programmes, it is highly misleading to draw conclusions about a company's overall efficiency on the basis of the relative scale of expenditure between periods. For the same reason, one company's enhancement programme can be very different from another's in the same period and so inter-company comparisons are equally misleading. To illustrate this, in its SoC Anglian explained how its AMP7 WINEP programme included 19% of the total national obligations and more than any other company.9 (9) Similarly, historical expenditure on Botex (representing the combined base opex and capital maintenance required to maintain the asset base to the historical service standards achieved) provides only one component of any benchmark for assessing the efficiency of any future Botex costs. Account also needs to be taken of the general upward pressures on capital maintenance that result from an ageing and growing asset base and additional service obligations, as well as any efficiency challenges applied by the company to offset these increasing costs. (10) Anglian showed in Table 1 of its SOC10 95% of its variance between AMP6 and AMP7 related to enhancement expenditure. Below is a summary of Table 2 to illustrate this: 6 For example, CCW's submission to the CMA about Anglian's SOC, para. 6.3, available at: https://assets.publishing.service.gov.uk/media/5ebebe3986650c27955a89bb/The_Consumer_Council_for_Water__Anglian__submissi on_redacted_.pdf. 7 Anglian's SOC, Chapter B.3: Anglian's Plan and how it was built, Section 2.1, paras. 292 to 304.