Expenditure to maintain and improve the supply/demand balance

Table 33 summarises the expenditure we included in the CIS baseline to maintain the balance between supply and demand.

Table 33 Expenditure to maintain the balance between supply and demand

£ million (post-efficiency) CIS baseline

capital expenditure 2010-15 Additional operating expenditure by 2014-15 Water service

Supply/demand balance (infrastructure) 957

Supply/demand balance (non-infra) 861

Sub-total – water service 1,818 32

Capital contributions1 (448)

Net expenditure 1,370

Sewerage service

Supply/demand balance (infrastructure) 806

Supply/demand balance (non-infra) 931

Sub-total – sewerage 1,736 26

Capital contributions1 ₍₄₃₃₎

Net expenditure 1,304

Total supply/demand expenditure 2,674 58

Notes:

1. ‘Capital contributions’ includes receipts from infrastructure charges, developer contributions, compensation and requisition charges.

2. Totals may not add because of rounding.

In their proposals to maintain and improve the supply/demand balance, we expected companies to:

• demonstrate any need to invest to deliver the service that customers want;

• base its proposals on a thorough, integrated option appraisal, taking a broad view of the costs and benefits over the long term, consistent with their water resource management plans; and

• form a reasonable view of the costs of the preferred solution, taking into account the best available evidence, including its own recent experience.

4.4.1 Climate change and water resources

In PR09/27, ‘Climate change and water resources’ (February 2009), we said that we would include significant climate change-driven investment in water resources in the final CIS baseline only if it were based on robust evidence using UKCP09 scenario analysis. UKCIP published the latest scenarios in June 2009, two months after companies

submitted their final business plans.

UKCP09 contains extensive data on climate change scenarios and probability assessments. Analysing this data, and identifying its implications for companies’ investment plans, is a major task and it would have been unrealistic to expect the companies to complete this work and for us to take action before final determinations. So, our determinations do not take account of proposals for significant expenditure to address the impact of climate change on the balance between water supply and demand.

Companies’ business plans used the outdated UKCP02 scenario analysis to measure the impact of climate change and suggested a need to invest about £1.5 billion in the period up to 2015 to address the effects of climate change on water supply and demand. Using UKCP09 scenario analysis, companies’ investment requirements could be greater or less than this amount.

If companies can establish clearly and robustly that they need to invest by 2015 to address the impact of climate change, we want them to be able to do so without delay in order to maintain security of supply for consumers. On that basis, we have allowed a notified item relating to changes in water supply/demand balance arising out of the use of UKCP09. As long as companies follow the requirements of the notified item, we will take into account in an interim deterioration any material expenditure they require during 2010-15 to deal with the impact of climate change on water resources (see section 5.3).

4.4.2 Metering

We have assumed that companies will spend £470 million (post efficiency) to install 2.4 million meters over 2010-15. We have accepted most companies’ projections for

optional meters, challenging a minority that had failed to explain satisfactorily why their forecasts exceeded historical trends.

Companies also proposed additional metering either on change of occupier or a compulsory basis. We accepted proposals, either in full or in part, from 13 of the 17 companies that planned additional metering. On our assumptions, about 50% of households will have a meter by 2014-15, up from 37% in 2010. The largest increase will be in areas of serious water stress, where the proportion will climb to about 57% by 2014-15.

We applied a unit cost challenge to all metering proposals. We capped the capital expenditure unit costs of a company’s proposals at the average that the company had experienced over the three-year period 2005-08, unless the company could justify a higher unit cost. We capped the operating expenditure unit costs at the value contained in the targets that we set for each company to maintain a balance between metered and unmetered charges.

We expected companies that proposed additional metering programmes, on top of their optional metering programmes, to demonstrate that their plans formed part of a best value approach to balancing water supply and demand. If there was no supply/demand deficit to address, we expected companies to demonstrate that the long-term benefits of their proposals outweighed the costs. We set out our approach to assessing metering in PR09/20.

None of the companies was able to demonstrate that the quantified benefits exceeded the costs. However, some were able to demonstrate that the gap between quantified costs and benefits was relatively small, leaving a reasonable prospect that unquantified benefits might bridge that gap. So, we accepted companies’ proposals in these cases. We took a balanced approach in reviewing companies’ CBA. For example, we made compensating adjustments if we thought that companies had overstated or understated their costs and benefits. We rejected proposals in full or in part from some companies because we disagreed with their CBA. We rejected proposals from two companies because they accepted that they were unable to demonstrate that metering would be cost-beneficial.

4.4.3 Leakage and water efficiency

We have accepted most companies’ proposals to maintain existing levels of leakage, or to reduce leakage slightly. In some cases, we have challenged companies to reduce leakage by more than they proposed, while in others our analysis suggests that more modest leakage activity would provide a better value outcome for consumers. Overall, we have assumed that leakage will fall by about 3% compared with current levels. We did not include any additional expenditure for activity to meet base service water efficiency targets. However, we have included expenditure for six companies to deliver enhanced water efficiency projects.

4.4.4 Planning for the future

In general, we think that planning is part of each company’s ongoing business, so the costs of this activity should already be part of base expenditure. We have included expenditure for research projects where there is a reasonable prospect that companies need it in 2010-15 to contribute to resolving a future supply/demand deficit, but only

where it is not part of the company’s ongoing business. We have excluded expenditure for contingency planning, which we consider is part of general business risk.

4.4.5 Sustainability reductions

We have included expenditure to address reductions in water abstraction driven by the Habitats Directive, unless a company is seeking compensation for the changes to its abstraction licence(s). We have not included any expenditure to address reductions driven by non-Habitats Directive requirements. In line with the policy agreed with Defra and the Environment Agency, companies should finance such schemes through the Environment Agency managed compensation scheme.

4.4.6 Water supply network reinforcement

Several companies planned to reinforce their water supply networks to maintain levels of service while distributing greater volumes of water. We included justified expenditure for this purpose, taking into account the company's case, along with the views of its

reporter. We excluded expenditure that the company did not justify and its reporter did not support. In addition, we made an adjustment where there was only partial support. In cases where the available evidence supported a partial adjustment, but with no clear view as to scale, we reduced the expenditure by 25%. Unless there was a clear reason to do otherwise, we allocated 75% of network reinforcement expenditure to new

development.

4.4.7 New development – water and sewerage

Companies’ plans allowed for a greater number of new water and sewerage connections over this review period than they experienced between 2004-05 and 2009-10. We

accepted most companies’ assumptions about new connections, but we have challenged their unit costs. As for metering, we have assumed that future unit costs should normally be no greater than historic unit costs. As a result, our challenge capped the capital costs for each connection at the average costs that the company experienced over the three years 2005-06 to 2007-08, unless the company provided robust

justification for greater costs in the future.

In their representations on our draft determinations, some companies argued that our cap on new development operating expenditure double-counted our cost base efficiency adjustment. This is because both challenges compared individual company costs with industry average values. We have accepted this point and have revised our cost challenge. We have also capped companies’ new development unit operating costs at their proposed level less any reduction we applied to their unit operating costs for

optional metering. We did this on the basis that new development operating expenditure encompasses the additional costs associated with operating a metered account, so any challenge that applies to the latter should also apply to the former.

This was a conservative challenge, which effectively accepted the remaining

components of companies’ proposed new development operating expenditure. In cases where companies’ costs still seemed excessive, therefore, we applied an alternative challenge. This capped a company’s proposed costs at one and a half times the industry average. We do not think that this alternative cost cap double counts our efficiency challenge. Even after applying this new cap, companies’ costs are higher than the industry average. In effect, our cap challenges excess scope, while our efficiency assumptions challenge delivery efficiency.

We expect companies to recover from developers a reasonable proportion of the costs of new development in line with their legal entitlement. We have compared the

proportion of new development expenditure that companies recover from developers through enhancement requisitions, grants and contributions, with the proportion they recovered over the three years from 2005 to 2008 (excluding connection charges and the costs recovered by those charges). We know that some companies also report contributions towards new development costs as revenue from rechargeable works, so we have included this revenue in our comparison.

We have assumed that the proportion of new development costs that companies will recover in total from requisitions and – where applicable – revenue (rechargeable works) will be the greater of:

• the proportion that the company proposed for 2010-15;

• the proportion that the company recovered over the three years 2005-06 to 2007- 08, capped at 100%; or

• 50% of the gap between the historical value calculated above and the industry average over the 2005-06 to 2007-08 period.

We checked whether companies had explained why the proportion of new development costs they expected to recover in the future would differ from the proportion they

recovered in the past, so that we could adjust our challenge if appropriate. We applied the adjusted recovery rate to new development capital expenditure after taking account of efficiency assumptions. We increased companies’ projections for annual infrastructure charge revenue to reflect the maximum infrastructure charge for each property.

4.4.8 Operating expenditure for 2009-10 – water and sewerage

We treated supply/demand operating expenditure (excluding new development and metering) as a discrete item. We capped the 2009-10 supply/demand operating expenditure to be the same incremental amount assumed at the last price review instead of rolling forward the actual figure for 2008-09 or using the company business plan forecast.

We assessed operating expenditure separately for metering and new development, calculating the cap for those items using the unit cost assumptions that we made at the

last price review, and applying those unit costs to companies’ estimates of meter and new connection numbers in 2009-10.

4.4.9 Wastewater planning expenditure

For wastewater planning, we expected companies to:

• take a central estimate of the future supply/demand position; • consider all feasible options; and

• select the best value solution for consumers.

We recognise that this is difficult. The small sizes of sewerage catchments mean that planned development may not occur in the particular catchments companies originally expected at the outset. This means that companies then have to change their own plans accordingly. UK Water Industry Research’s (UKWIR) long-term least cost planning for wastewater supply/demand provides a methodology to focus companies’ plans on those areas of greatest risk, and we assessed each company’s plan against this framework.

4.4.10 Sewage treatment capacity

Overall, companies plan to expand sewage treatment capacity, measured in population equivalent (PE) terms, by more than the forecast increase in population. At an industry level, we have accepted the case for this, but we have challenged individual company proposals.

Taking a balanced view of risk, we have assumed that a company will increase PE treatment capacity at the same rate that the population grows. In order to justify increasing capacity at a faster rate a company needed to provide evidence that:

• there was currently insufficient headroom;

• there would be migration within its supply area leading to increasing headroom at some works; or

• it would be more cost effective in the long term to increase capacity further. For each company, we have limited the increase in capacity to the projected increase in population unless the company demonstrated why it needed a larger capacity

expansion.

Some companies planned to increase capacity at a slower rate than the projected increase in population. We have accepted these companies’ plans if we think that they can accommodate population growth within existing capacity and/or if declining industrial discharges are likely to reduce the demands on their capacity. Where such companies are simply taking a deliberately riskier approach, we have increased their expenditure by an amount sufficient to finance additional PE sewage treatment capacity at 75% of

population growth. We have not increased this to 100% because these companies may have a greater amount of spare capacity than is typical in the industry.

4.4.11 Sewage treatment unit costs

We accept that the unit costs of enhancing sewage treatment capacity will vary because of company-specific factors. However, we think that there is a limit to how great this variance should be. We have compared the unit cost of enhancing PE treatment capacity for three categories of sewage treatment works:

• less than 1,500 PE;

• greater than 1,500 PE, but less than 10,000 PE; and • greater than 10,000 PE.

We used these categories in the 2004 price review, and the information that companies provided in their final business plans confirmed that they remain appropriate.

We have compared the unit cost of the investment that each company proposed for each category with the costs that the rest of the industry proposed. We did not think that the evidence the companies provided showed that costs should necessarily vary

significantly. However, if a company conducted robust site-specific option appraisal, we allowed unit costs to vary from the rest of the industry by up to 50%.

We think that this level of variance is sufficient to reflect company-specific factors. If a company calculated costs on a site-specific basis, but did not demonstrate that it had selected a best value plan, we only allowed unit costs to vary by up to 25%. If a company calculated costs for sewage treatment on some other basis, we considered that its plan was not mature, so we capped the unit cost for each category at the average unit cost for the industry.

In their final business plans, we asked companies to separate out the costs of enhancing PE capacity at sewage treatment works from other treatment costs, such as increasing hydraulic capacity. Since these costs are associated with the same projects, we have judged that high unit costs for PE capacity are likely to indicate that other costs are similarly high. We have therefore applied the cost challenge to all treatment costs. We applied a similar test to operating costs. We have not seen any evidence to suggest that operating costs vary significantly between different sizes of treatment works. We have therefore compared unit costs in 2014-15 for all fully operational treatment works. We have reduced the additional operating costs in the same proportions as described above for capital costs. We applied the reductions to all additional operating expenditure for sewage treatment works for 2010-15.

4.5 Expenditure to improve drinking water and environmental