South West Water Services Ltd: A report on the determination of adjustment factors and infrastructure charges for South West Water Services Ltd

Summary of report (html format)
Full text (pdf format)

Adobe Acrobat Reader can be downloaded from http://www.adobe.com

Summary

Under the reference made by the Director General of Water Services (the Director) on 29 September 1994 (see Appendix 1.1), we are required to determine the adjustment factor, K, and the standard amounts by which infrastructure charges are calculated for South West Water Services Ltd (SWWS) for the ten years from 1 April 1995 to 31 March 2005. The adjustment factor, K, is the percentage by which weighted average charges for the supply of water and sewerage services are allowed to change relative to the retail price index. Infrastructure charges are among a number of charges that can be levied to recover the costs of providing new connections both for water and for sewerage.

The Director had determined an adjustment factor for SWWS of +1.5 for 1995/96, +1 for the years 1996/97 to 1999/2000 and zero for the last five years of the period, and standard amounts for the infrastructure charges of £200 both for water and for sewerage connections. In evidence to us, the company proposed an adjustment factor of [*] for the five years 1995/96 to 1999/2000 (K2) and of [ * ] for the subsequent five years (K3), and standard amounts for infrastructure charges of £[ * ] for water and £[ * ] for sewerage: significantly greater price increases than determined by the Director.

SWWS supplies a population of some 1.5 million customers mainly in Devon and Cornwall. Its charges are the highest of any company supplying water and sewerage in England and Wales (some 50 per cent higher than the average charge), due in part to the need to finance the substantial investment programme in the region to meet new environmental standards. It believed that, as a result of the Director's determination, it would be unable to finance the proper carrying out of its functions since his determination imposed major reductions in both capital and operating expenditure.

In reaching our determination, we have taken into account the extensive evidence received from the company, the Director, local authorities, interest groups and individual customers of the company. We noted serious concerns expressed by customers of SWWS about the high level of water and sewerage charges, and considerable unwillingness and, in some cases, inability to pay higher charges, even to secure environmental improvements. We also noted that some parties from whom we heard were concerned about any reduction in the company's programme of environmental improvement. We looked in detail at the constituent parts of the company's business, and made a number of broad adjustments both to the Director's estimates and to the company's estimates, making our own judgments on the scope for expenditure reduction from the company's revised Strategic Business Plan figures.

We have taken the view in setting the adjustment factor K that it is appropriate to allow for some additional capital and operating expenditure over and above that underlying the Director's determination. On the other hand, we also believe there is scope for substantially lower expenditures than were considered necessary by the company. As regards the basic business of the company, ie that associated with maintaining, improving and expanding existing systems, but not associated with measures to meet new legal obligations imposed by the quality regulators, we saw considerable scope for price reductions from present levels. This derives from the current relatively high rates of return being earned on existing capital value and from the scope for efficiency improvements. However, the heavy new investment and operating expenditures associated with meeting new legal obligations over the next ten years will have the effect of outweighing such price reductions.

In our view, the water industry generally is of relatively low risk given the almost complete lack of actual and potential competition, the stable revenue base and the obligation on the Director to ensure that the companies can continue to finance their functions. Given, however, the significant diversity of the companies in the industry in terms of size, access to capital markets and tax status, we have judged the pretax cost of capital for the water industry as a whole to be in the range of 6 to 8 per cent. For SWWS, being a sizeable listed company with limited tax payments and able to attract funds from leading institutional investors and banks, we felt the appropriate cost of capital should be towards the lower end of the 6 to 8 per cent range. SWWS's rate of return is currently well in excess of this cost of capital which suggests considerable scope for reducing rates of return, taking account of the interests of customers without calling into question the company's ability to finance its functions. In our view it would be appropriate in making our determinations to assume a reduction in the company's return on capital value from the current levels of almost 16 per cent towards the cost of capital by the end of the K2 period. The Director, using a different approach to operating and capital cost projections, had assumed a reduction in return toward the cost of capital by the end of the K3 period.

We have determined in respect of SWWS an overall adjustment factor of +1 for the K2 period and zero for K3 as being adequate to enable the company to finance the proper carrying out of its functions. On infrastructure charges we have determined a standard amount of £200 for water and £200 for sewerage services, in line with the Director's determination.

Full text

Back to the top