FINAL DETERMINATIONS Future water and sewerage charges 2000–05 Office of Water Services Centre City Tower 7 Hill Street Birmingham B5 4UA CONTENTS Foreword 5 Section I 1. Summary of the determinations 9 Part 1: The determination of price limits 9 Part 2: The framework and context of the determinations 21 2. Representations on the draft determinations 37 3. Individual company summaries 39 Section II 4. Customers’ priorities and the outputs to be delivered 67 4.1 Customers’ priorities 67 4.2 CSCs’ views on companies’ Business Plans 68 4.3 The outputs to be delivered by companies 69 4.4 Metering 72 4.5 Security of supply 72 4.6 Levels of service 73 4.7 Capital and operating expenditure included in the determinations 74 5. The profile of prices and bills 76 5.1 Overall position 76 5.2 The initial reduction in bills in 2000–01 78 5.3 The links between price limits and bills 78 5.4 Charges for water and sewerage services 84 5.5 Profitability and price profiles 86 6. Efficiency and incentives 89 6.1 Summary of the efficiency improvements assumed in price limits for 2000–05 89 6.2 Cost trends since 1989 90 6.3 Incentives 91 6.4 Relative efficiency of water companies 91 6.5 The scope for efficiency in operating expenditure 92 6.6 The scope for efficiency in capital maintenance expenditure 95 6.7 The scope for efficiency in capital enhancement expenditure 97 6.8 Service performance adjustment 99 7. Maintaining service to customers 102 7.1 Trends in service to customers and expectations for 2000–05 103 7.2 Operating expenditure 103 7.3 Capital maintenance expenditure and charges 104 8. Quality programme and other enhancements 109 8.1 Drinking water quality and environmental improvements 109 8.2 Other enhancements 118 9. Maintaining the balance between supply and demand 121 9.1 Demand and revenues 122 9.2 Costs of maintaining the balance between supply and demand 124 9.3 Enhanced security of supply 126 9.4 Water resources in the South East of England 127 9.5 The economic level of leakage and leakage targets 127 2 10. Financial issues 128 10.1 The framework for the financial projections 128 10.2 Regulatory capital values 128 10.3 The cost of capital 129 10.4 Financial projections and bankability 134 10.5 Taxation 134 11. The review process 136 11.1 Establishing the framework and exposing the issues 136 11.2 Decisions and determinations 137 11.3 Monitoring and assessment of company performance 138 Appendices: A Respondents to ‘Future water and sewerage charges 2000–05: Draft determinations’ 139 B Summary of the representations on the draft determinations 143 C The cost of capital 151 D Capital works unit costs: the cost base approach 158 E Protocol for changes in companies’ obligations and consents after the final determinations 161 Glossary of terms and definitions 165 FIGURES 1. Average household bills 1989–2004 24 2. Components of the average household bill 1991–2004 25 3. Capital investment 1981–2005 26 4. Comparison of actual and projected total operating expenditure 27 5. Comparison of actual and projected capital charges 28 6. Total capital maintenance expenditure 29 7. Regulatory capital value 1990–2005 30 8. Post-tax rates of return 1991–2005 31 9. Actual and projected capital investment 1981–2005 69 10. Actual and projected average household bills 1990–2004 76 11. Comparison of average household bills in the final determinations and the Business Plans 77 12. Comparison of unmeasured and average household bills 79 13. Impact of optional metering on unmeasured and average household bills 84 14. Current cost depreciation charges for base and total assets 87 15. Post-tax rates of return 88 16. Comparison of actual and projected total operating expenditure (as Figure 4) 90 17. Performance scores for water and sewerage companies 1996–99 100 18. Performance scores for water only companies 1996–99 100 19. Total capital maintenance expenditure 102 20. Cost of quality enhancements in the water service included in the price limits for each company 117 21. Cost of quality enhancements in the sewerage service included in the price limits for each company 118 3 TABLES 1. Price limits for 2000–01 to 2004–05 11 2. Comparison of price limits: final determinations compared with companies’ Business Plans 13 3. Comparison of price limits: final determinations compared with draft determinations 15 4. Average expected household bills 18 5. The drivers of changes in average expected household bills 23 6. Assumed range for total efficiency savings for water and sewerage 34 7. Projections of expenditure 2000–05 74 8. Capital expenditure by company 75 9. Changes in measured and unmeasured household bills 81 10. Rates of take up of optional metering 82 11. Indicative changes in water and sewerage charges 2000–01 to 2004–05 85 12. Financial projections 86 13. Assessments of relative efficiency at November 1999 — water service 93 14. Assessments of relative efficiency at November 1999 — sewerage service 94 15. Operating costs efficiency assumptions 2000–01 to 2004–05 95 16. Capital maintenance efficiency assumptions 2000–01 to 2004–05 96 17. Enhancement expenditure efficiency assumptions 2000–01 to 2004–05 98 18. Service performance adjustments by company 101 19. The assessment of capital maintenance expenditure allowed for in the determinations for 2000–01 to 2004–05 105 20. Cost estimates for quality enhancements 110 21a. Assessing the likely costs of the quality enhancement programme 2000–05 — water service 113 21b. Assessing the likely costs of the quality enhancement programme 2000–05 — sewerage service 114 22a. Outputs expected from companies for the period 2000–05 — water service 115 22b. Outputs expected from companies for the period 2000–05 — sewerage service 116 23. Projected changes in water delivered to customers 122 24. Industry revenues 123 25. Expenditure to maintain the balance between supply and demand 124 26. Movement in the industry aggregate regulatory capital value from 2000 to 2005 129 27. Components of the weighted average cost of capital 130 28. Ranges for critical financial indicators 151 29. Summary of the catch-up improvements arising from the cost base assumed in the final determinations for capital maintenance and enhancement efficiency 160 4 FOREWORD Price limits for 2000–05 Customers will now benefit from lower bills for the first time since the industry was privatised in 1989. They can look forward to a higher quality water service and an improved environment within a framework of falling prices, thanks to the growing efficiency of the water companies. My determinations of price limits for water companies in England and Wales, for the years 2000–01 to 2004–05, are set out in this publication. The price limits vary from company to company and from year to year. These variations result from a fair and consistent application of the policies I have established over recent years, taking account, where appropriate, of each company’s circumstances. I have listened carefully to all stakeholders’ views and taken account of ministerial guidance and the latest available information. As a consequence, I have made some changes to my draft price limits for individual companies. In particular, there are changes to the price limits for North West Water arising from ministerial guidance. Companies will now draw up their charges schemes which will govern the bills sent to individual customers for the year beginning 1 April 2000. Under the Water Industry Act 1999, charges schemes must be approved by me. I consulted and then published my conclusions (MD152, September 1999) on the criteria which I will use to assess them, paying regard to ministerial guidance on social and environmental matters. I will also ensure that companies implement Regulations enacted under the Act. The effect on individual bills will depend on many factors. Not all customers will see the same reduction in their bills next April. Once I have approved the charges schemes, the individual companies must explain clearly to their customers how their bills will be affected. The Periodic Review has involved much research and consultation. I determine the limits on the average prices which companies can charge their customers in each of the five years, and the infrastructure charge limit for customers connecting to the system for the first time. These limits must, of course, be justified and explained. This document does that. Statutory duties When setting price limits I must comply with my statutory duties. This has involved making judgements about: • what companies must do to carry out their functions properly, including their legally enforceable obligations; • the revenue which the companies need to finance their functions and to earn a reasonable return on the investment needed to meet their legal obligations; • the affordability and value for money for customers of the charges which companies need to levy; • the promotion of efficiency and economy, through incentives to reduce costs and improve service performance, and penalties for high costs and poor performance; • facilitating competition by relating prices to the costs incurred by companies. In balancing these factors, there is no answer that can please everyone. 5 Ministerial guidance I have taken account of the Government’s views on the framework for utility regulation as set out in A fair deal for consumers (July 1998), considering how best to distinguish between the income that companies earn through their own efforts and that which results from other factors. In particular, following the advice of my panel of senior industrialists, I have strengthened incentives for companies to make efficiency savings in their operating costs and to deliver good service. In an open letter in April 1998, I sought ministerial guidance on the legal obligations they had placed, or would be placing, on water companies in the years from 2000 to 2005.