Ofwat review of price controls. A Northumbrian Water Limited response to Ofwat discussion papers

Ofwat review of price controls A Northumbrian Water Limited response to Ofwat discussion papers 1. Introduction Key points We welcome the opportunity to respond to Ofwat s discussion papers This response covers four of the discussion papers because the issues are interlinked We have set out the principles that we believe should govern regulatory change or market reform Vertical separation would be a major and costly change and, therefore, it is essential it is evaluated against these principles and compared with other options This paper describes our views on the form of price control, risk and incentives in the context of Ofwat s market reform proposals We also propose an alternative approach, building on the current price setting methodology The issues raised in four of Ofwat s discussion papers published in the latter part of 2010: The form of price control ; The role and design of incentives ; Allocating risks and managing uncertainty ; and The treatment of regulated and unregulated business in setting price controls are so interdependent that we have decided to comment on them in one response. We agree with Ofwat that this is an appropriate point in time to review the regulatory framework and ensure it is fit to deliver sustainable water services into the future. We, therefore, welcome the opportunity to comment on the important issues raised by the discussion papers. There are a number of challenges facing the industry in the future. The specific challenges may be different in nature but, in our view, they are no more challenging than those the industry has successfully dealt with in the past. However, we do believe changes to the regulatory regime are necessary to ensure continuing effectiveness and efficiency in meeting customers requirements. We are open to well justified and deliverable change, whether this is market reform or changes in regulation, or both. We believe any changes should be: - beneficial to customers; - demonstrably cost beneficial; - a definite improvement over current arrangements and viable alternatives; - tested fully for unintended consequences. - consistent with the sector continuing to attract finance at competitive rates; - practical and deliverable; - consistent with aims to reduce regulatory burden; and - consistent with Government policy. The thread running through Ofwat s discussion papers is that vertical separation of the industry is required in order to address the future challenges. This would be a radical and costly change, fundamentally affecting how the delivery of water and sewerage services is planned, delivered and financed. This being the case, it is essential that this course of action is evaluated against the principles for change 1

listed above and compared against other options to identify the best way forward for customers. This paper describes our views on the form of price control, risk and incentives in the context of Ofwat s market reform proposals. We also propose an alternative approach, building on the current price setting methodology. The paper is set out as follows: Section 2: The drivers for change Section 3: Risks Section 4: Incentives Section 5: The length of the price control period Section 6: Disaggregation of price limits Section 7: Upstream market reform Section 8: Conclusions 2

2. The drivers for change Key points Ofwat has set out a number of important challenges to be met in the future We provide evidence that these are not more challenging than those in the past Required outcomes could be achieved through evolutionary developments of the current regime combined with some market reform Ofwat lists a number of future challenges in its papers which it says are different in nature, scale and complexity from those in the past. This is the reason given for a major regulatory reform programme. The challenges Ofwat mentions are as follows: a changing and unpredictable climate; population growth, particularly in the South East; economic uncertainty and the consequent affordability issues this raises; rising environmental standards, including as a result of the Water Framework Directive; and rising customer expectations. While these are real and important challenges, we are unconvinced that they are significantly different in scale and complexity from those in the past. The industry has met a series of major challenges in the 20 years since privatisation that we believe were as demanding as those we face now. For example, over the period, the industry has successfully delivered: huge investment to meet the Urban Wastewater Treatment, Habitats, Bathing Waters and Fisheries Directives; investment in drinking water treatment and other measures resulting in compliance of greater than 99.9% and amelioration of cryptosporidium and pesticides risk; major water distribution system renovation across the industry in accordance with Section 19 Undertakings; substantial reductions in leakage; and major improvements to levels of service across the board, including water pressure, interruptions to supply and response to customer contacts and complaints. To do this, companies have invested about 90 billion (in today s prices) since 1990 and at the same time have delivered substantial efficiency savings. This has been delivered against a difficult economic backdrop: both high and low inflation (including deflation); interest rates well into double digits compared to the current low base rate environment; and two significant stock market crashes. We describe below how future challenges compare to those we have already met. Investment It is unlikely that the challenges ahead described in the discussion papers would result in investment needs greater than those in the last 20 years. Nor is it likely that investment significantly above this would be affordable for customers in any case. Although we agree the investment required to adapt to climate change is uncertain and is likely to be significant, we believe it will be possible to phase this over time, managing the impact on bills in any one price control period. Population growth will result in security of supply issues if not responded to effectively, particularly in the South East. However, we are demonstrating now, 3

with our water resources management strategy for Essex, that an economic and integrated balance of demand management, leakage control and resource development can enable security of supply to be managed under current regulatory arrangements. Investment to meet future environmental standards is unlikely to be anywhere near the magnitude required in the past to meet the Urban Wastewater Treatment, Habitats, Bathing Waters and Fisheries Directives, even taking into account the impact of second and subsequent cycles of the Water Framework Directive. This is because the major improvements already delivered by companies leave much less to achieve in the future. Affordability We agree that affordability is a key consideration going forward and we must do all we can to keep customers bills at acceptable levels. It is important to set this challenge in context - the absolute cost of water and sewerage services is relatively low. Despite financing the 90 billion investment outlined above, household customers in England and Wales receive both water and sewerage services for about 1 per day on average, compared to 1.80 per day for gas, 1.40 per day for electricity and 1.20 for one loaf of bread. In our view, water and sewerage services represent excellent value for money, considering their essential nature. This position has been achieved by companies and regulators working together under the current regime. Bills for customers are more than 100 lower than they otherwise would have been 1, due to the high level of efficiencies driven out by companies on an ongoing basis over the last 20 years. Ofwat refers to the impact of future economic uncertainty and consequent affordability issues. But we note that similar challenges have been addressed by the industry in the past, for example during the recession in the early 1990 s. Customer expectations Customer services must be improved even further. However, given the already high levels of customer satisfaction in the water industry we do not believe that radical change is required to deliver the expectations of the more sophisticated customers Ofwat refers to. It is clear that there are significant challenges to be met in the future but, considering the points made above, we do not consider them to be significantly different from those in the past. While we are not complacent, and agree that some change will be necessary, the evidence we have presented does not necessarily point to a need for radical change, such as vertical separation of the industry. We believe it would be possible to drive the outcomes required through evolutionary developments of the current regime, perhaps with some market reform. This would cost less and have lower risk than vertical separation. The advantages and disadvantages of a market reform versus a more evolutionary approach are developed later in this paper. 1 Ofwat (March 2010) Delivering sustainable water Ofwat strategy document 4

3. Risk Key points The current regulatory regime is relatively low risk It has the confidence of the financial markets, leading to low financing costs There is emerging evidence from a number of sources confirming the economies associated with vertical integration and the risks associated with separation Our analysis concludes that risks are significantly higher with vertical separation It is doubtful that there are sufficient net efficiencies to be made by vertical separation to outweigh the increased costs Vertical separation does not appear at this point to be in the best interests of customers Conversely, evolutionary change to the current regulatory approach will cost little, will not increase risk, will maintain investor confidence and allow future challenges to be met The current regulatory regime is recognised as relatively low risk. There is stakeholder confidence in the ability of water companies to manage their assets in a coordinated and integrated way to meet customers needs in terms of quality and reliability of service. The stability and transparency of the regulatory regime is attractive to the financial markets. At the recent periodic review in 2009, Ofwat set price limits that delivered falling average annual household bills in real terms. This was in the context of a record 22 billion of capital investment for the five year period to 2015. This was in part achieved by the lowest ever cost of capital for the industry, at 4.5% post tax, reflecting investor confidence in the sector, its relatively low risk and lower financing costs. Vertical separation of the industry would be a major change and there are a number of important risks with its introduction. Evidence from a number of sources on the pros and cons of vertical separation is emerging. In particular: An ICS Consulting paper 2 by Dr Melinda Acutt explores the advantages and disadvantages of vertical integration/separation and provides an excellent insight to the issues that need to be explored before informed decisions can be made on the way ahead for regulation of the water industry. Two papers are expected to be published soon by Deloitte, covering retail competition and accounting separation. The retail competition paper will describe important differences between retail competition in energy and telecoms compared to that proposed for water. It will also conclude that it is not possible to show, on the basis of quite optimistic assumptions on possible efficiency gains, that benefits of retail competition will significantly exceed costs. An ongoing UKWIR project looking at the costs and benefits of separation is expected to be published soon. We understand this will refer to evidence from Stone and Webster 3 and David Saal confirming economies of scope for vertical integration. 2 Acutt (Sept 2010), Regulation Matters To bundle or not to unbundle 3 Stone & Webster (2004), Investigation into evidence for economies of scale in the Water and Sewerage industry in England and Wales: Final report 5

We also note that Cave 4, whilst supporting retail competition, had doubts that further vertical separation would be cost beneficial. The approach as set out in the discussion papers seems to be running ahead of Cave s recommendations. 3.1 Risks from vertical separation We believe vertical separation will increase overall risk and costs. The main contributors include the following: Inability to defray risk The current industry structure allows for cost increases in one part of the supply chain to be balanced by reductions in another. With vertical separation, there will be a reduced ability to defray cost shocks and risks across the rest of the supply chain. For example, unavoidable increases in costs for water treatment chemicals could not be balanced, say, by reduced network costs. Another example is that increased customer debt would be borne solely by the retail entities. This is a significant issue given the rising trend of customer debt that could threaten the financeability of the retail company. A separated retail company may have struggled to cope with the income shock arising from the sudden decline in industrial revenues experienced by NWL in 2009-10. It is likely that the increased risk in this respect will result in the overall aggregated cost of capital for a vertically separated industry being significantly more than for an integrated structure, an upward influence on customers bills. Diseconomies of scale Currently, support functions are organised efficiently to service all parts of the supply chain. With vertical separation, employees will be unable to support more than one part of the supply chain, increasing the number of employees required overall. For example, Human Resources, Accounting, Procurement, Health & Safety, Information Services, Pricing and Regulatory staff will be required in each part of the disaggregated chain. Computer systems will have to be developed separately for each entity thus increasing these costs overall. Transactional costs There will be increased transactional costs between each part of the supply chain, including setting up service agreements, exchanging information, dealing with disputes and ongoing monitoring and administration. The more parts the supply chain is separated into, the higher the transactional costs. Complexity of operations The need for interfaces between each entity within a separated structure complicates operations, communications and works against an integrated and optimal approach to delivering the required service to customers. The activities of different elements of the supply chain will be more difficult to coordinate, responsibilities will be blurred and there is the scope for conflicting priorities that will affect operations and emergency responses. These issues do not affect a vertically integrated industry. Managing the interfaces and split responsibilities of a vertically separated industry would become even more challenging in emergency situations. For example, management of the recent freeze/thaw impacts on the water network in 4 Cave (April 2009): Independent review of competition and innovation (para 4.109) 6

December 2010 required total alignment and seamless working of many of the departments of our integrated water supply organisation, including water production, network maintenance and operation, network planning and customer services/call centre. Personnel from billing and meter reading departments were transferred into other areas to help manage the emergency. Consistent and coordinated communications with customers would be more difficult with more companies involved. Vertical separation would result in the effective management of emergencies becoming more difficult. Currently, companies operate their systems (resources, treatment, network, retail) so that overall efficiency is optimised. Disaggregation will lead to each part of the supply chain being optimised separately and this is likely to lead to a less efficient operation overall. Service level agreements can be put in place specifying the actions required of each player but this is unlikely to be as efficient and effective as one company having full management control. Loss of integrated planning With an integrated structure, the planning departments have full access to relevant information across each part of the supply chain and are able to identify solutions that are optimal overall. It has full responsibility for delivering effective operational strategies. Responsibilities are clear. Integrated planning is made extremely difficult with a vertically separated structure. Each part of the supply chain concentrates on its own objectives and issues, potentially leading to plans that do not result in an efficient and effective system overall. Ofwat indicates that a system operator could perform important long-term investment planning and coordination functions. This may be appropriate for other industries where the system operator typically manages a wider, integrated transmission grid but would not be effective with the diverse and less integrated supply and distribution systems of the individual appointed water companies. A key example of the difficulty of integrated planning with vertical separation is the identification and delivery of a least cost integrated supply/demand strategy to manage security of water supplies for each separate water supply zone. The potential mix of solutions for a supply/demand management strategy includes demand management (responsibility retail?), leakage control (responsibility network), water resource development (responsibility resources) and treatment capacity augmentation (responsibility treatment). We do not think a system operator would be able to effectively gather reliable and detailed information from all companies in the supply chain in order to consider all options and undertake a robust supply/demand appraisal. Even if an integrated strategy is identified, who will ensure each part of the supply chain delivers its part of the strategy and take the responsibility if the strategy does not deliver? There are further questions about delivery. Would the incumbent be required to deliver resource developments not thought to be profitable enough by others? Is there a supplier of last resort duty for the incumbent and what does this mean for planning? 7

We also refer Ofwat to our views about the system operator role for ongoing operations in our response to Valuing water how upstream markets could deliver for customers and the environment. More complex regulation It is clear that regulation of drinking water quality would be much more complex and costly with a vertically separated structure. There will be a number of entities to regulate and there are likely to be difficulties apportioning responsibility for compliance failures and water quality incidents. This does not sit well with a regulatory simplification agenda. We have touched on a number of areas where risk is significantly increased by vertical separation of the water industry and efficiencies from the synergies of a vertically integrated structure lost. The areas Ofwat mentions where risk might be reduced with vertical separation appear of small impact compared to the downside risks described above. We note that the scope for further efficiencies in the water industry is relatively low. This is because major efficiencies have already been driven out in the 20 years since privatisation. The cost of water and sewerage services is, also, relatively low affecting the absolute value of efficiency savings that can be made. It is doubtful that there are sufficient net efficiencies to be made by vertical separation of the water industry to more than outweigh the increased costs. Taking into account the dominating downside risks and the uncertain potential for efficiency savings, vertical separation does not appear at this point to be in the best interests of customers. Conversely, evolutionary change to the current regulatory approach (for example by re-designing the incentive regime) will cost little, will not increase risk and will maintain investor confidence. It would also allow the industry to meet the challenges ahead. 8

4. Setting incentives Key points A different approach to incentives is required to meet future challenges We believe incentives should be targeted at the desired outcome and focus more on meaningful rewards, rather than penalties Incentives need to be understandable, predictable and set in good time Incentivising innovation is key to meeting future challenges We have set out our preliminary ideas about how innovation and opex efficiencies could be incentivised Care is needed to ensure any future Totex type of approach does not cause unintended consequences We have set out, for discussion, the criteria against which to assess proposals for non regulated activity that uses assets shared with the regulated business We have suggested a new process in this regard where the company would propose the most appropriate approach for each business case based on an economic demonstration of benefits to customers We would welcome further dialogue with Ofwat on the regulatory treatment of non regulated activity. We welcome the review of the organic waste market by OFT/Ofwat and look forward to contributing to its work. 4.1 Incentives now and in the future Since privatisation, the regulatory regime has delivered well in overall terms. It could, therefore, be said that incentives have been fit for purpose. However, we are entering a period where a new approach is necessary to ensure future challenges are met. The incentive regime has been characterised in the past by penalties rather than meaningful rewards. For example, very tough opex efficiencies have assumed in price setting, which companies needed to make to achieve even the basic return on capital. This left few companies able to outperform and make a substantive incentive allowance at recent periodic reviews. The industry has performed well in delivering improved service and significantly reducing costs. Further improvements will be harder to achieve in the future ( diminishing returns ) and will require more innovation on the part of companies. A redesigned incentive regime could meet the future challenges without the costs and risk associated with radical market reform. We question whether a regime based predominately on penalties will provide the environment for innovation required going forward. We believe the challenges can be best achieved by targeting positive incentives at the specific outcomes required. This approach has been used successfully by other utility regulators but is to date underutilised in water. In our view, incentives should be: Targeted at the outcome Incentives should be targeted at the desired outcome. Ofwat s discussion paper covers much of the theory of design of incentives but is largely silent on what it wants to incentivise. We believe that the design of an incentive should be tailored to what is being incentivised. We also believe that the focus of incentives should be the outcome itself rather than the business processes or methodology leading to the outcome. This ensures companies have full scope to innovate and 9

develop solutions rather than being restricted to the approach preferred by the regulator. Aligned with the interests of customers Companies should be given incentives to deliver the benefits that customers want. Efficiency incentives should be designed to deliver gains initially to outperforming companies but that will later be transferred to customers. The achievement of temporary excess returns by outperforming companies should be seen as a success of the regulatory regime as this will mean gains to customers in the longer run. Symmetrical Where appropriate to the outcome, there should be equal opportunities for gains and losses according to performance above or below a central baseline. The Capital Incentive Scheme (CIS) is a good example of this. Predictable in advance Incentives should be clear and in place before prices are set. They can only work effectively if they are signalled in advance and can be relied on in decision making. Ofwat is still deciding on how the Revenue Correction and Service Incentive Mechanisms ((RCM and SIM) will work in practice nearly a year after prices were set in 2009. This is not an example of good practice. Understandable Incentives should be as simple as possible and understandable by non experts if the desired outcomes are to be promoted. Although we support the aims of the CIS and RCM approaches, they could be simpler. 4.2 Designing an incentive regime for the future Innovation Ofwat has set out in its document the future challenges faced by the industry. We believe incentives should be introduced to promote the outcomes required to meet these challenges. This includes ensuring innovation is incentivised. How to promote more innovation in the water industry is a current debate. The innovation process, by its nature, requires companies to finance the development of approaches that may not be found to be viable. The current regulatory regime does not provide the best environment for innovation: the cost of innovation processes are not reflected in price limits; the incentives/rewards for successful innovation are not sufficient to make embarking on a costly trial and error process worthwhile; and there is little tolerance of failure to deliver outcomes Ofwat and the Quality regulators tend to apply financial and reputationally damaging sanctions if outcomes are not delivered first time there is little scope to try new approaches that have some risk of not delivering but would bring customer and/or environmental benefits. The first two bullets could be addressed by allowing for some innovation costs in price limits and/or allowing retention by companies of the savings from innovation for a longer period than currently is the case. 10

We think allowing for some innovation costs in price limits would be difficult to administer in terms of identifying the quantum and required outcomes but is worthy of consideration. Retention of the savings from innovation for a longer period would be simpler to put into place and the greater reward would incentivise companies to do more exploratory development work. It is also important that the regulatory process provides equal incentives for companies whether bringing forward schemes as part of business plans or introducing them mid-term. Regulatory intolerance of failure has conditioned companies to adopt tried and tested solutions. A change of mindset is required from both companies and regulators to move forward. Companies need to proactively develop and then come forward with new approaches as and when these emerge (ie. whether during the periodic review process or in period ). Regulators then need to be more flexible in their approach including, where necessary, being receptive to the possibility that there is some risk of outcomes not being delivered at first. There would need to be formal agreement to such an approach from Ofwat, the relevant Quality regulator and CCWater as appropriate. Service Incentive Mechanism Drawing on both financial and reputational incentives, the SIM has the makings of an excellent incentive mechanism if issues of inconsistent data collection, unfair comparisons between WASCs and WOCs and uncertainty about its application can be overcome. But, in essence, concentrating on the customer experience (the outcome) is appropriate and we believe the mechanism should be retained and developed. We welcome the proposed horizontal audit of SIM processes. It may be possible in the future to draw back from some of the quantitative output measures in favour of customers views of service. This will require there to be sufficient confidence in the approach taken to customer research. Operating costs We support the UKWIR project investigating alternative means of setting efficiency targets and look forward to contributing to the debate on possible approaches. Incentivising opex savings is key to keeping bills at affordable levels. We understand Ofwat may move away from using econometric modelling to determine efficiency targets at PR14. If econometric models are retained they must be applied in a way that fully reflects the uncertainty in the analysis. If a benchmarking approach at a disaggregated business level is being considered (eg. using accounting separation information), there must be confidence in the consistency of cost allocation across companies. Otherwise, spurious frontiers resulting from different allocation methodologies could result. With such an approach, we would also be concerned that companies might be expected to catch up towards the most efficient company for each part of the supply chain. This could lead to companies having to catch up to a virtual frontier, made up of performance from a number of companies (ie. a frontier that has not been achieved by any one company). This could result in unrealistic targets. The issue of company specific (special) factors would remain. 11

Whatever methodology is used, we believe incentivising efficiency would be best served by ensuring the targets included up front in price limits are realistic, leaving a reasonable opportunity for innovative companies to outperform. The real possibility of material outperformance would be a spur to innovation. A relatively small change to the opex incentive mechanism would also help ensure companies were equally rewarded for achieving efficiencies in all years. Ofwat acknowledged in its review of PR09 that: Our approach has become increasingly complex and this can reduce transparency. Our incentives have become complicated. They may not send clear enough and simple enough signals to the companies and customers. An example of this is the enhanced operating expenditure rolling incentive mechanism. It aims to overcome some of the disincentives arising from the length of the price review period; but it is very complicated. The specific complication is that Ofwat took its original approach from MD145 in 1999 and constrained it with other conditions. Specifically, Ofwat changed the methodology so that an incentive allowance could only be earned if the total period expenditure was lower than the Final Determination. This removed the marginal incentive in later years of the period to make efficiencies to get closer to the FD allowance, which would have benefitted customers. Reversion back to the MD145 approach would resolve this issue. Opex and capex interactions There has been much consideration of the interaction of opex and capex in setting incentives. We believe there is an issue but it has been overstated. Whilst a regime that does not skew incentives for capex and opex is desirable, any remedy introduced must be practical and not introduce unintended consequences. We are not convinced that Ofgem s Totex approach has successfully addressed this issue. Capital Incentive Mechanism Overall, we welcome the CIS and, even though it is quite complex in its design, we are finding it has improved and clarified incentives for efficient capital expenditure. The strength of CIS is in our view due to the removal of the 100% service capping for overspends of the FD and the assurance of an incentive rate that we are now using in our capex decision making for AMP5. In this sense, it has succeeded as an incentive mechanism. We do not, however, believe that the CIS provided an incentive for companies to reveal better information in business plans as both companies and regulators views are by their nature both best forecasts (but not perfect). We remain convinced that scrutiny from Reporters and Ofwat is the best way to ensure companies forecasts are realistic. Taking the incentive to reveal information aspect out of the equation, the CIS would work just as well (and be much simpler to follow) if a single incentive rate of say 30% were applied for all companies. 12

4.3 Incentivising non regulated activity Encouraging use of regulated assets to provide customer benefit In its discussion paper: The treatment of regulated and unregulated business in setting price controls, Ofwat explores the potential approaches to the treatment of non regulated activity using assets shared with the regulated business. Such activity can result in an outcome that benefits both customers and the company and, therefore, should be encouraged. However, companies will only choose to pursue discretionary activity if this is profitable. The regulatory approach to such activities can fundamentally alter the incentives for undertaking them, affecting both profitability and risk. The current regulatory treatment can vary by specific case and type of activity and includes single till (full capture of costs and income), dual till (with transfer pricing) and profit sharing. Each approach, when applied to a particular scenario, has advantages and disadvantages and may or may not provide sufficient incentive for companies to proceed. We agree with Ofwat s suggestion that different approaches may be justified depending upon the circumstances. We believe it would be beneficial to define the principles that should be applied to ensure an approach is selected in each case that is appropriate to the activity and incentivises activities that will ultimately bring benefits to customers. Building on the factors identified by Ofwat, we believe approaches should be tested against the following criteria: the appropriateness of the balance between customer and company benefit; the degree of use of regulated assets; the degree to which regulated and unregulated services are complementary; the extent to which shared costs exist and can be robustly allocated; and the extent to which market power is a concern. The focus should be on providing the right incentives. This requires an economic analysis rather than a focus on accounting costs. We note that average accounting costs do not necessarily send the correct economic signals. For this reason, Ofwat s test should always take into account customer benefit. Approaches and process Our two favoured approaches are dual till and profit sharing. A single till approach will rarely be appropriate for non regulated activities as the incentive properties are too low. We do not support the use of Long Run Incremental Cost (LRIC), directed tariffs or benchmarked costs as these all add considerable complexity. Where costs can be easily and clearly attributed this would tend to support a dual till approach. Accounting cost allocation is easier for physically separate assets/ processes and more subjective for joint and common costs. Where the allocation of costs is difficult (or contentious) we would support an approach that shares the benefits but ensures that appropriate incentives are in place. Co-digestion may seem to fall into this category. In this respect we welcome the OFT market review of the organic waste market initiated by Ofwat and look forward to contributing to its work. 13

An activity requiring a high level of intellectual, promotional or other input from the company should attract a higher incentive than a less complex endeavour. As a significant reform, we favour a process where the company would propose the most appropriate approach for each business case against the principles outlined above and based on an economic demonstration of benefits to customers. This is in line with Ofwat s desire for companies to be more accountable and for a reduced regulatory burden. Ofwat would only impose an alternative approach if the company s proposal was unsatisfactory. This would mean a minimum of regulation. It would free companies to act commercially rather than being constrained by regulatory uncertainty. It would allow Ofwat to act on economic principles rather than a complex set of rigid rules an approach that is in our view a more effective form of regulation. We understand that this proposal would have to be worked through in more detail and would be happy to discuss the approach with Ofwat. 14

5. The length of the control period Key points Price controls at five yearly intervals can dominate companies work A longer control period would allow companies to concentrate more on delivery However, longer price control periods would also result in higher company risk On balance, adding one or two extra years to the price control period would significantly increase the time companies have without the distraction of the periodic review process The increased risk would increase required returns but this could be managed by adjusting IDoK rules We believe the effect of the price control period on the investment cycle is overstated though earlier confirmation of Quality requirements would reduce backend loading of this investment The periodic review process currently takes between two to three years of each five year control period to complete. This represents a significant commitment from the many managers, engineers and accountants involved. A longer control period would allow companies to concentrate more time on service delivery, improving efficiency and improving processes before being plunged into a further review cycle. That said, a larger part than ever before of NWL s periodic review preparations for PR14 will be on a business as usual basis, though there will always be a significant overhead in producing business plans and in the specific stakeholder engagement required. The longer the price control period, the greater the exposure companies have to more numerous cost shocks not reflected in RPI (which are not a Relevant Change of Circumstance or are not above the IDoK/logging up triviality/materiality thresholds). So a move to a significantly longer period would require reopeners to be amended or introduced, or the cost of capital to be adjusted upwards to compensate for the increased risk. We note that a longer price control period might simply increase the number of interim determinations or other reopeners, which arguably would counteract any gains from the longer control period. We feel that the impact of variations in investment from the five year cycle, on consultants, contractors and suppliers, has been overstated. It is true that Quality enhancement investment is confirmed late in the periodic review process leading, inevitably, to delivery in the mid to late part of the subsequent AMP period. This effect could be reduced by confirming Quality requirements earlier in the price setting process, for drivers where this is possible. It is important in this context that longer term capital projects that span review periods are committed to by both company and regulator. The development of 25 year Water Resource plans was particularly helpful in this respect and a longer planning horizon might be extended to cover other areas as appropriate. As we have indicated elsewhere in this paper, we are not convinced that vertical separation of the industry is the best way forward. But if this approach were to be adopted after full justification, we believe price limits for all parts of the supply chain 15

should be set at the same time. This is because planning for water and sewerage services must be done in an integrated manner (see section 3). On balance, it is worth noting that adding one or two extra years to the price control period would significantly increase the time companies have without the distraction of the periodic review process. Even extending by one year would increase time without periodic review input by around 40%. The increased risk could be managed by adjusting IDoK rules (eg. allowing the aggregation of trivial but allowable costs that together breach a threshold) or increasing the cost of capital. 16

6. Disaggregation of price limits Key points We were surprised that Ofwat indicates definitively that it will set separate price limits for the retail and wholesale parts of the water and sewerage value chain in 2014-15, without consultation In our view, a compelling case for the disaggregation of price limits has not been presented We believe the advantages Ofwat describes in its discussion paper are overstated We seriously doubt producing separate price caps for retail and wholesale parts of the value chain at PR14 will bring benefits that will outweigh the cost and increased regulatory burden This change is also likely to have an impact on investor confidence We understand that the discussion on how future price limits should be set is only at the ideas stage. Ofwat indicated (page 1 of the Form of price control document) that: The aim of these early discussion papers is to obtain stakeholders views and to inform more specific debate on approaches and tools as the project progresses. They are not intended as a definitive statement of our views or as a formal consultation.. We will use the feedback we receive to the issues we discuss in this document, and others, to inform our overall approach to price setting. Given that Ofwat has carefully described the status of the discussion documents as above, we were surprised to see in para. 40 of the document that Ofwat appears to have already decided, ahead of the formal consultation, that it will set separate price limits for the retail and wholesale parts of the water and sewerage value chain in 2014-15. We believe setting disaggregated price caps is a significant departure from previous price setting methodologies and warrants proper consideration and discussion, including in Ofwat s formal consultation phase. In our view, a compelling case for the disaggregation of price limits has not been presented. The decision seems also to have been made without any airing of how the disaggregation would be achieved in practice. We do not believe that disaggregation of price limits for vertically integrated companies will bring the benefits Ofwat describes in the Form of price control discussion paper. It is difficult to see the value in separate price controls since these would simply be a disaggregation of a total price limit. Furthermore, it would increase the regulatory burden at price setting significantly, more than outweighing the reductions in information submission requirements Ofwat is in the process of making in terms of the June Return. We discuss below the advantages Ofwat believes will be obtained from setting separate price limits for different parts of the value chain. Controls that better reflect the underlying economics of different parts of the value chain? At present, all parts of the value chain are non contestable and vertically integrated. It is therefore difficult to see how the underlying economics of different stages of the value chain would be different because of disaggregated price limits. The vertically integrated companies are managed in an integrated 17

way with risks defrayed across all areas of the value chain. All parts of the value chain require capital and operating costs to be reimbursed. Each part has both fixed and variable costs. Many costs and risks such as pensions, energy and taxation cross the functional boundaries. Investors in the water industry do not allocate their investment to particular assets or particular parts of the value chain. They rely on a single form of economic regulation which means there is a single cost of capital and rate of return. In a vertically integrated industry, it is not appropriate or beneficial to artificially assume that some parts of the value chain are riskier than others or to use different forms of price control. Better information for decision making? The information revealed by separate price limits will not allow the integrated business to make more efficient decisions, for example, about investment, network optimisation or use of water resources. Companies already strive to ensure that the total cost of water supply or sewerage services are optimised through integrated operation of all parts of the value chain. We do not see how the separate price caps would drive different decisions in companies. Firstly, the costs used in price setting will be total regional costs and will simply reflect a geographical average. For actual decision-making, the specific local costs of the resource, treatment works and local distribution mains will be required none of which can be deduced from the total regional costs. For example, a company s treatment works price limits may be 30p/m3 (say), but that figure will be a geographical average of works with costs ranging from 50p/m3 to 10p/m3. Indeed, due to the nature of mean averaging, it is entirely possible that there is no individual works with a 30p/m3 cost. Secondly, standard economic theory confirms that decisions should be made with marginal economics in mind (i.e. the net present value of the changes in cash flows due to the decision). Separate price limits and the corresponding costs will be based on average costs (to allow for full cost recovery in price limits) and so will not inform decision making. A better environment for the use of market mechanisms? The only justification provided for the use of separate price limits is to prepare for competition. Even in those circumstances, it is difficult to see how separate price limits would do any more than accounting separation to prevent costs being shifted between different stages of the value chain. Separate price limits would mean an average price would be available for other market participants. However, prices would be geographically averaged and based on average not marginal costs, both of which could be problematic, both for the supplier and the purchaser. It is unclear whether geographically averaged charging would satisfy the Competition Act (eg. Shotton case) and average pricing could risk inefficient entry/exclusion compared to marginal pricing. It is also unclear to us why Ofwat suggest disaggregated price limits could allow more mergers and acquisitions. This implies that setting efficiency targets would be unnecessary under disaggregated price controls. If Ofwat need 22 comparators for total company water opex efficiency modelling, will it not require the same number for separate resources, distribution or treatment efficiency models or benchmarking? 18

The discussion paper does not have any cost benefit analysis or impact assessment, which should be carried out before any decision to embark on a process leading to the determination of separate price controls. Separate price controls, or even indicative separate price controls, would require more information and analysis in Periodic Review submissions and June Returns, which does not fit well with Ofwat s plans for regulatory simplification. We believe Ofwat should seriously consider whether producing separate price caps for retail and wholesale parts of the value chain at PR14 will bring benefits that will outweigh the cost and increased regulatory burden. It should also consider the potential impact on investor confidence of this approach, which would also require licence amendments. 19

7. Upstream market reform Summary We support reform of the abstraction licensing regime We note that progress is slow, illustrating the difficulties in making changes to the water upstream market in what should be one of the least controversial areas of water valuation We draw Ofwat s attention to the joint report by Anglian, Cambridge and Essex & Suffolk Water called Trading theory for practice This report highlights the limited economic opportunities for water trading and provides suggestions for change to promote the remaining trading opportunities 7.1 Abstraction charging reform We support reform of the abstraction licensing regime. Our views are set out in detail in our response to Ofwat s paper Valuing water how upstream markets could deliver for customers and the environment. Progress in this area is very slow. Ten years ago, the issues were identified in Tuning Water Taking which identified abstraction charging reform as a desirable development. Nine years later, the Feb 2009 joint Environment Agency/Ofwat report Review of barriers to water rights trading suggested: consideration of changes to the cost recovery framework within which the Environment Agency sets its charges to allow the Environment Agency to review its charging structure for abstraction licensing and improve pricing signals to ensure that the abstraction charges better reflect the true environmental, social and economic value of the water. We have not seen any progress in this area since that report, although we presume that it will feed into one of the two Defra White papers planned for 2011. We make this point simply to illustrate the difficulties in making changes to the water upstream market in what should be one of the least controversial areas of water valuation. 7.2 Trading theory for practice We draw attention to the joint report by Anglian, Cambridge and Essex & Suffolk Water called Trading theory for practice, which has already been provided to Ofwat. This investigated the scope for water trading to meet water deficits in the future in this area of limited surplus capacity. This concluded that, whilst there are significant volumes of water already shared or traded, there is limited scope to trade water economically in the future in this region. To fully utilise trading opportunities, the following improvements were identified in the way that water company activities are regulated: the process for making sustainability reductions needs to be aligned with the water resource planning process; inefficiencies and complexity in the current process for approving resource sharing need to removed, particularly for transfers between EA regions; and opex efficiency assessments need to take into account the adverse effect of bulk transfer charges. 20