Ofwat: Draft 2015-20 price control
determination for
Dŵr Cymru Welsh Water
Consumer Council for Water Representation
July 2014
1.
Introduction
1.1
The Consumer Council for Water (CCWater) is the statutory consumer organisation
representing water and sewerage consumers in England and Wales. CCWater has a
committee for Wales and four regional committees in England. We welcome the
opportunity to respond to Ofwat’s 2015-20 draft price control determination for Dŵr
Cymru Welsh Water (DCWW).
2.
Summary
2.1
CCWater is broadly supportive of Ofwat’s draft determination in terms of:


the range of outcome/service commitments reflecting evidence of customers’
priorities and preferences, and local Customer Challenge Group (CCG) input. This
should lead to service improvements in many areas.
the reduction in prices compared to the company business plan.
The draft
determination proposes a real term reduction in the average household water and
sewerage bill from the current £416 to £396 in 2019-20. This has been driven partly
by the company’s acceptance of Ofwat’s 3.85% Weighted Average Cost of Capital and
the downward adjustment of some costs from the business plan submitted in
December.
2.2
We urge caution as there is a risk that customers may still react negatively to bills that
will increase during 2015-20, albeit under the rate of RPI, should the prices proposed in
the draft determination be reflected in the final determination in December 2014.
Evidence from recent research from Which, the Office of National Statistics and the
Joseph Rowntree Foundation shows there is a low level of consumer confidence in terms of
the cost of living and how household income growth compares to the rate of inflation.
2.3
As a consequence, we would like to see DCWW demonstrate further to its customers



what improvements customers will see in their locality in return for their bill;
how DCWW can help those who may experience problems paying, using its social tariff
and other affordability initiatives; and
how the company’s ‘gain share’ initiative will see future financial success benefit
customers.
This should, over time, also help improve customers’ view of the acceptability of prices and
the value for money of the services they receive.
2.4
Additionally, Ofwat could go further in challenging the costs and price for its final
determination in December 2014. We consider there to be scope for further reductions in
the cost of capital and in the allowed retail revenue to accommodate bad or doubtful debt.
2.5
It is also useful to consider the company’s current reputation and performance in
customers’ eyes and how Ofwat’s determinations should positively influence this. In 2012-13
DCWW achieved

the second highest customer service performance as measured by the Service Incentive
Mechanism (SIM)1.
1
Companies’ performance 2012-13 (Ofwat) http://www.ofwat.gov.uk/regulating/reporting/prs_web201213performance
1



the highest level of customer satisfaction with the value for money of water services
(78%) across England and Wales.
the second highest satisfaction with value for money for wastewater services (79%)2.
the second lowest number of complaints per 10,000 connections in 2012-133.
We expect performance against these measures to show further improvement over time as
the range of outcome commitments for 2015-20 are realised.
2.6
In terms of the specific details of the draft determination, CCWater is supportive of:




2.7
Ofwat’s reduction of the overall financial effect of the package of Outcome Delivery
Incentives (ODIs), weighting the potential impact on penalties more than rewards.
Ofwat's intervention in the outcome commitments relating to wholesale wastewater to
ensure that service targets relating to ex-private sewers and lateral drains are not
excluded from the performance measures the company will use.
the removal of outcome commitments relating to company ‘inputs’ such as the training
and performance of company staff and financial factors such as the company’s credit
rating. These outcomes do not reflect the ‘end service’ received by customers.
the company’s ‘gain share’ commitment which should lead to customers receiving some
benefits should the company outperform its financial targets in the years ahead.
However, CCWater does have some concerns that we would like Ofwat to address in its final
determinations for all companies, covering:

the 3.85% Weighted Average Cost of Capital, which we believe could be lower, based on
analysis CCWater has commissioned.

the risk to both DCWW and Ofwat of a negative customer reaction in the future to
paying rewards for services and outcomes customers may expect the company to deliver
as a matter of course. In particular, based on customer research we and some water
companies have carried out, we believe customers may react negatively if an area of
performance where they may have to pay a reward to a company is not reflective of:
o a level of performance that is not a significant improvement above industry
average; or
o reflects a level of performance other companies have achieved or exceeded, but
where customers of the other companies are not being asked to pay a reward.
2.8
As it is hard to predict the impact of the balance of rewards and penalties into the future,
we believe this represents a reputational risk both to companies and to the regulatory
regime.
2.9
Customer research by CCWater and some water companies has shown that many customers
oppose the principle of paying rewards for service outperformance. Our concerns with some
of the individual service commitment targets are detailed in this representation.
2.10 We have a specific concern with the DCWW draft determination concerning the allowance of
a £37.8m retail cost adjustment to accommodate bad or doubtful debt. While the company
2
Water Matters: Household customers’ views on their water and sewerage services 2012-13 (SPA for
CCWater) http://www.ccwater.org.uk/wp-content/uploads/2014/05/Water-Matters-household-customersviews-on-their-water-and-sewerage-services-20133.pdf
3
Complaint handling in the water industry 2012-13 (CCWater)
http://www.ofwat.gov.uk/regulating/reporting/prs_web2012-13performance
2
presented evidence to justify this adjustment, we question whether this is justifiable given
the company’s commitment to assist customers who are struggling to pay. The company
should be challenged to improve its revenue collection to help drive down bad and doubtful
debt further. A reduction in the allowance for bad or doubtful debt could help achieve this.
3.
Customer acceptability
3.1
DCWW’s business plan proposals, when ‘tested’ in market research in 2013, achieved 94%
acceptability from ‘informed’ customers4 when the potential effect of inflation over 201520 was taken into account.
3.2
However, we urge caution as there is a risk that customers may still react negatively to
bills that will increase during 2015-20, albeit under the rate of RPI. This because of low
consumer confidence in the wider economy and its impact on the cost of living,
particularly in how household income growth compares to the rate of inflation for many
households.
3.3
This is corroborated by recent research of consumers' views of the cost of living gathered
by Which?5, the Office of National Statistics (ONS)6 and the Joseph Rowntree Foundation7
(JRF) highlighting the following:





31% of people are cutting back spending on essentials (Which?).
Only 38% of people think the UK economy will improve in the next 12 months
(Which?).
Average household disposable income remains lower than at the start of the
economic downturn – falling £1200 in real terms since 2007/8 (ONS 2012).
Disposable income in Wales is the lowest in the UK at £14,623 (ONS 2014).
The basket of minimum household requirements in 2014 remains the same as it was
in 2008 – but the costs have risen significantly above inflation. Neither benefits nor
wages have come close to keeping up over this period. (JRF)
3.4
In this context, we consider that Ofwat and DCWW should take further action to use the
final determination to address the potentially negative perception of customers to future
charges.
3.5
Ofwat could make further change to the cost of capital and proposed retail costs. This
could help reduce prices further, while DCWW should tell customers about



what is being received in return for their bill;
how the issue of affordability is being addressed by the various billing and tariff
‘tools’ the company has available; and
the company’s commitment to share the benefit of future financial gains with its
customers.
4
‘Informed’ customers receive detailed information about the outcomes and service improvements the
company proposes to deliver in its plan, before being asked for a view on the acceptability of the
price/service package.
5
Which? – Consumer Insight
6
The Effect of Taxes and Benefits on Household Income 2012/13, ONS and Report on gross disposable
income issued , June 2014, ONS
7
A Minimum Income Standard for the UK in 2014, Joseph Rowntree Foundation
3
4.
Price profile and affordability
4.1
Average water and wastewater bills, along with the average bill for combined services,
will see a gradual reduction across the five years before inflation, as set out in Table A1 of
the draft determination.
4.2
While the draft determination does not contain any new actions to address customer
affordability issues, DCWW has worked constructively with CCWater to develop its social
tariff and other initiatives to assist customers with affordability issues.
4.3
Along with the customer views on the affordability of the draft determination as detailed
above, CCWater’s annual tracking survey for 2013-148 shows that in Wales nearly 1 in 5
(18%) of customers now consider their water bills to be unaffordable9. This shows that it
is important for DCWW to use its package of affordability initiatives to address the
concerns of customers’ who find this price package unaffordable and may struggle to pay.
We are supportive of DCWW’s outcome commitment that reflects this.
5.
Outcomes - Performance Commitments and Outcome Delivery Incentives
5.1
We are supportive of the specific outcomes (and the service performance measures for
each outcome) that the draft determination sets out. The package of outcomes and
specific service measures for each one are reflective of customer priorities and
preferences revealed through customer research in the development of the company’s
business plan. DCWW has responded to challenges from the company’s CCG, including
CCWater, to demonstrate that performance commitment targets will lead to a significant
service improvement for customers and the wider environment.
5.2
The draft determination proposes only three outcome commitments that include financial
ODIs where both rewards and penalties will apply (in addition to SIM). In addition to this,
there are a further 9 penalty-only ODIs. We note that DCWW will not apply financial
rewards to the company RCV. Any rewards will apply to revenue and will be used to
benefit customers through the company’s ‘gain share’ initiative (a commitment DCWW
made to its CCG).
5.3
We also recognise that the potential effect on the Return on Regulatory Equity of this
financial ODI package will be -1.8% to +0% for water and -1.1% to +0.3% for wastewater.
This is a modest range of financial incentives compared to the recommended parameters
in the Ofwat risk reward guidance (+/- 1% to 2%). We agree with this adjustment as it
means there is a greater weighting on the financial penalties that can be applied for
failure to achieve required commitments, which should give a stronger incentive to
prevent service failure for customers.
5.4
Prior to the submission of its revised business plan, DCWW carried out customer telephone
surveys that showed that 68% of customers support the concept of linking bills to company
performance. CCWater raised concerns with DCWW that the principle of rewards and
penalties was not fully explained or understood by the participants.
8
Water matters – household customers’ view on their water and sewerage services 2013-14 (CCWater)
http://www.ccwater.org.uk/wp-content/uploads/2014/05/Water-Matters-household-customers-views-ontheir-water-and-sewerage-services-20133.pdf
9
In 2014/15, DCWW have the third highest average charges amongst Water and Sewerage Companies in
England and Wales at £440.
4
5.5
While we acknowledge that in this context customers demonstrated willingness to pay
rewards for enhanced performance in some areas of service, CCWater remains concerned
that there may be a negative customer reaction to a package of rewards for
outperformance if this is a driver of price increases beyond 2019-20.
5.6
We recognise the regulatory rationale for applying financial incentives to move the
emphasis for potential company returns from financial performance to service delivery.
However, customer research by several companies in England and by CCWater10 shows that
there is a significant risk that many customers may react negatively to having to pay for
rewards for company outperformance. DCWW’s own research shows that there are still a
significant number of customers who have a negative view of the ODI ‘package’ proposed
in its revised business plan.
5.7
DCWW’s research also indicated that customers wanted to see the company use rewards to
benefit them through additional investment for improvement in service levels. Therefore
DCWW’s non-shareholder structure and its ‘gain share’ proposal (see 9.1 below) should
mean that any increase in revenue due to the achievements of ODI rewards are shared
with customers. We would like to see this confirmed in the final determination and
expect the company to further explore how ODI rewards can be used to benefit customers
in future ‘gain share’ research.
5.8
We also note that, in its conclusion to the recent consultation on the Service Incentive
Mechanism (SIM) Ofwat has increased the weighting of the qualitative element of customer
service performance (to 75%). This means that companies could look to revise their SIM
performance commitments in the light of this change. We would not like to see any
reduction in companies’ customer service commitments as a result of the change in
Ofwat's methodology, particularly where evidence shows that this is a priority for
customers.
5.9
We would like to see Ofwat, for final determinations, use the SIM range to its full and
adjust price limits by more than -0.5, used in previous reviews. While DCWW have shown
a leading SIM performance, a strengthening of the SIM ‘penalty’ will help protect
customers further from any decline in customer service quality. Moreover, the final
determinations must demonstrate that individual company’s SIM targets are stretching and
will lead to a level of performance that will lead to DCWW continue as industry best.
5.10
Table 1 sets out our comments on some of the specific outcome commitments and ODIs in
the draft determination.
Table 1: CCWater comments on specific outcome commitments and incentives
10
Outcome
Service Measure
CCWater comment
Wholesale water:
Safe drinking water
Safety of drinking
water % of compliant
samples
We agree that this should be a ‘penalty
only’ incentive as there is a lack of
customer evidence or DWI approval to
support a reward mechanism. The DWI
is also able to take corrective action if
the company fails to comply with
required standards.
CCWater – Outcome and Delivery Incentives in the Water Industry
5
Wholesale
wastewater:
excellent customer
service
Customer
acceptability –
contacts per 1,000
population
We agree with Ofwat’s application of a
penalty only incentive to this measure
as the company has allocated totex
costs to deliver this target. As
customers will fund this improvement,
we agree that the use of a penalty
should discourage failure.
Sewer flooding –
number of properties
We agree that these measures should
include recently transferred private
sewers and lateral drains as customers
affected by sewer flooding will not be
concerned whether the incident was due
to a transferred asset or not. While
separate monitoring of ex-private
sewers and lateral drains will show how
the condition of these assets are
improving over time, they should be
included in this outcome measure.
Wholesale
wastewater asset
serviceability
Wholesale
wastewater asset
resilience
We are concerned that there may be a
negative customer perception of a
company being rewarded financially
when properties have been flooded by
sewage (even if the number of
properties flooded annually represents
an improvement in performance). As
one of the worst service failures a
customer could experience, the concept
of a company achieving a financial
reward when properties have flooded
runs the risk of a customer backlash in
the future. This incentive should be
reviewed.
Wholesale
wastewater:
Responding to
climate change
Number of properties
covered by surface
water removal
schemes.
We agree with Ofwat’s application of a
penalty only incentive to help prevent
failure in delivering this commitment,
particularly as customers will fund
surface water removal schemes.
Non-household
retail: Business
Customer
satisfaction
Business customer
satisfaction increases
to 90% in 2019-20
(from 87% starting
point)
We question whether the penalty
applied if the level of satisfaction
deteriorates is adequately challenging.
A variable penalty beginning at zero
applies if performance drops to 80%,
rising to £5m if it drops to 70%.
Business customers in Wales will not
have a choice of supplier in 2017, so the
company should have a stronger
incentive to prevent customer
satisfaction declining from its current
level.
6
5.11
We agree with Ofwat’s removal of the incentives DCWW proposed relating to the
company’s credit rating and outcome commitments relating to ‘developing our people’
and ‘business efficiency’. These proposals do not directly reflect the delivery of outcomes
relating to customers’ experience of the quality and value of the service they receive.
Moreover, they are not reflective of customer priorities as shown in earlier ‘willingness to
pay’ research.
5.12
We aim to work closely with the company in the development of its annual reporting
processes to measure and challenge the company’s progress in the delivery of its outcome
commitments.
6.
Wholesale costs
6.1
We note that DCWW’s proposed wholesale water totex was relatively close to Ofwat’s cost
threshold for this type of expenditure and therefore Ofwat did not need to adjust the
company’s proposal.
7.
Retail costs
7.1
We note Ofwat’s decision to adjust the company’s proposed retail cost adjustment
associated with bad or doubtful debt, which the company’s plan states is influenced by
economic deprivation and bill size. Ofwat and PwC’s review of DCWW’s supporting
evidence has led to an adjustment of £37.8m, compared to the £46.8m the company asked
for.
7.2
Despite Ofwat’s reduction, we question whether this significant debt allowance is fully
justified given that DCWW has a range of ‘tools’ to assist customers who have difficulty
paying (including the introduction of a social tariff), along with a reputational ODI to
provide help to disadvantaged customers. We would like to see a stronger commitment
from DCWW, with Ofwat’s support, to ensure that savings achieved from reducing the
level of bad or doubtful debt through the use of these ‘tools’ are shared with customers,
to offset any allowance for bad or doubtful debt in the final determination.
7.3
We also agree with Ofwat’s removal of the company’s proposed retail cost adjustment to
accommodate the cost of debt management (£9m) because the company has not provided
sufficient evidence to show why its debt recovery costs should be regarded as a ‘special
factor’ that justifies an upward adjustment.
7.4
We note that for the 29 August determination on default tariffs, Ofwat will apply the same
1% retail margin to default tariffs for customers in Wales who use less than 50 Ml of water
per year, with an efficiency challenge to DCWW on its non-household retail costs. We
support this action as we expect Ofwat to ensure that both the tariff and efficiency
challenge will be comparable with equivalent tariffs available to customers in England.
8.
Financeability
8.1
We note that DCWW has accepted Ofwat’s view of the Weighted Average Cost of Capital
(WACC) for 2015-20, at 3.7% for the wholesale business and a margin of 0.15% for the
retail business. Ofwat’s range for the overall WACC was 3.6% to 3.9%. DCWW has
provided assurance that its outcome commitments are financeable at this cost of capital
and allows the company to achieve an investment grade credit rating.
8.2
However, Ofwat has an opportunity to reconsider the cost of capital on the basis of the
regulator’s own analysis and market analysis available from other parties. Ofwat’s 3.85%
7
Vanilla WACC is in the higher end of Ofwat’s 3.6% to 3.9% range, indicating that there may
be scope to lower the current point figure.
8.3
This is reinforced by an analysis of the cost of capital for CCWater by Economic Consulting
Associates (ECA)11. They suggest that a Vanilla WACC with a point estimate of 3.5% for a
range of 3.0% to 3.75% would be an appropriate balance between keeping prices for
customers as low as possible while ensuring business plans are financeable.
8.4
The component parts of ECA’s assessment of the Vanilla WACC differ from Ofwat’s view in
a number of instances. While the two parties’ cost of debt assumptions are similar, this is
not true of the cost of equity. In particular, ECA’s analysis suggests that Ofwat may have
overstated systemic risk in the sector in the equity beta, with Ofwat’s assumption of 0.8
significantly above ECA’s range of 0.5 to 0.6.
8.5
We would like Ofwat to give further consideration to ECA’s assessment of how the cost of
capital, particularly the equity beta, should reflect more fully market expectations. This
could have the effect of reducing DCWW’s average bill further by around £4.
8.6
In its revised business plan, DCWW proposed to increase its PAYG rate from 47% to 63%
(with a reduction in the RCV run off rate to 2.6%) to increase cost recovery in the 2015-20
period. DCWW made a case that this adjustment is required to ensure long term financial
resilience. We note that DCWW gained support for this from its CCG. As this change does
not impact on customers’ bills or the level of the RCV, we agree with Ofwat’s acceptance
of DCWW’s proposed cost recovery ratio.
9.
Risk reward
9.1
In September 2013, DCWW’s CCG looked at a proposed policy to use any financial gains
from the Return on Regulatory Equity to fund a ‘customer distribution reserve’. This
would be used to directly benefit customers through additional investment, assistance to
vulnerable customers or a direct ‘customer dividend’ payment. This ‘gain share’
mechanism reflects the non-shareholder structure of DCWW and Glas Cymru, and is
summarised in DCWW’s Business Plan12 .
9.2
The draft determination makes no reference to DCWW’s commitment to share with
customers the benefits of financial gains achieved in the future. CCWater is supportive of
this commitment by DCWW. We look forward to working with the company to:




9.3
explore the options available for sharing gains;
look at how customers can be engaged in the process of identifying the right areas
to apply such benefits (should the company achieve gains that warrant this);
understand how the final ODIs can help increase the amount to share with
customers and inform how this could be done; and
ensure that there is transparency to customers and stakeholders as to how the gain
share mechanism will work and when.
We would like to see Ofwat acknowledge DCWW’s commitment to sharing gains in the final
determination as this would give a positive message to customers.
11
Recommendations for the Weighted Average Cost of Capital 2015-20 (Economic Consulting Associates)
http://www.ccwater.org.uk/wp-content/uploads/2014/07/ECA-CCWater-Cost-of-Capital-summaryreport.pdf
12
DCWW Business Plan 2015-20 Page 33
http://www.dwrcymru.com/library/pr14/Welsh_Water_Business_Plan.pdf
8
10.
Managing uncertainties
10.1
CCWater would like to see companies carry risks associated with uncertainties.
Mechanisms that allow companies to pass this risk onto customers through the availability
of revenue adjustments should only be allowed if there is compelling evidence that it is in
customers’ interests to do this. On this basis, we agree with Ofwat’s decision to only
allow an uncertainty mechanism for possible changes to business rates, limiting this to 75%
of these cost being passed to customers.
11.
Other issues
11.1
We agree with Ofwat’s decision to reduce the revenue requirement for DCWW relating to
2010-15 performance in terms of responding to supply interruptions by £2m, along with a
shortfall RCV adjustment of £32m. This downward adjustment should act as an incentive
for the company to improve in the years ahead.
Contact:
Steve Hobbs
Senior Policy Manager
Consumer Council for Water
[email protected]
0776 817 5006
9