2014 price review draft determination

August 2014
Water today, water tomorrow
2014 price review draft determination –
recommendations to Ofwat’s Board on
South East Water’s revised business plan
www.ofwat.gov.uk
2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Contents
1. Background and context
2
1.1 Brief description of company
2
1.2 Recap of risk-based review
2
2. Key issues of focus in the draft determinations
4
2.1 South East Water’s revised business plan
4
2.2 Key issues
4
2.3 Summary of other recommended interventions
4
3. Draft determination – at a glance
14
1
2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
1. Background and context
1.1 Brief description of company
South East Water (SEW) is a water only company (WoC) that supplies
approximately 0.87 million water household customers in England.
South East Water has an annual turnover of £209 million (2013-14) and a regulatory
capital value (RCV) of £1,089 million (2013-14). The average water bill in 2013-14 is
£201.
South East Water has developed through mergers of smaller companies since
privatisation. It operates in two separated geographical areas and roughly 60% of its
customers are served by Southern Water for sewerage services and the remainder
by Thames Water.
South East Water Limited is the main operating company in the group of companies
headed by HDF (UK) Holdings Ltd. The following companies are the ultimate owners
of HDF (UK) Holdings Ltd.



Utilities of Australia Pty Ltd (UTA - 50%) as Trustee for the Utilities Trust of
Australia.
Caisse de dépôt et placement du Québec (CDPQ - 25%).
Desjardins which is a passive owner with CDPQ acting on its behalf (25%).
There are two intermediate holding companies between the Company and HDF (UK)
Holdings Ltd: South East Water (Holdings) Ltd and Hastings Water (UK) Ltd.
1.2 Recap of risk-based review
In this section we briefly recap our assessment from the risk-based-review (RBR).
Table 1 Summary of risk-based review
Area
Summary
Outcomes
We identified that there was a lack of evidence about whether outcome
commitments are consistent with our methodology requirements and
consistent with long term customer interests.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area
Summary
Wholesale costs
We assessed water wholesale costs as more evidence required – the
company proposed totex of £808 million, while our threshold of
acceptable was £771 million and the significantly more evidence required
threshold was £815 million, so the company was marginal to this.
Retail
We rejected adjustments to the average cost to serve (ACTS) as the
company provided insufficient evidence that an adjustment was required
for input price pressure. However, the company provided exceptional
evidence that its costs were allocated correctly.
Legacy
The company provided insufficient evidence that its adjustments for the
revenue correction mechanism, operating performance incentive
allowance and the change protocol were fair and reflected its past
performance.
Risk and reward
The company proposed a wholesale weighted average cost of capital
(WACC) of 4.45% and retail margins of 1.55% for household and 3.50%
for non-household. This was not assessed in the RBR following the
publication of our risk and reward guidance.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
2. Key issues of focus in the draft determinations
In this section we highlight the key areas of our assessment against South East
Water’s revised business plan.
2.1 South East Water’s revised business plan
The revised plan submitted by South East Water reflects a number of key changes
which are summarised below:



For the wholesale control (totex), retail household and non-household (input
price pressure) and for legacy adjustments the company provided further
evidence to support its original proposals.
The company responded to our risk and reward guidance:
–
The wholesale WACC of 3.7% and net margins of 1.0% and 2.5% for
household retail and non-household retail have been adopted. It
retained its claim for a company-specific uplift of 36bp and submitted
customer research to support this claim.
–
The company has strengthened its package of outcome delivery
incentives (ODIs) to include more financial rewards and penalties
–
The company has removed its proposals for uncertainty mechanisms,
except for business rates.
The company completed further work on affordability, particularly in relation
to those customers that are served by Thames Water for sewerage.
2.2 Key issues
We have not assessed any of the interventions for South East Water as key
interventions, our proposed interventions are set out in section 2.3 below.
2.3 Summary of other recommended interventions
Table 2 below summarises our recommended interventions in each area. More
detailed information is available in our working level materials (for example
“recommendations tracker”) which are available on request to support personal
decision making.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Before considering the interventions, we recognise that the company did not
materially close the gap following the RBR. However this could be addressed in
representations to the draft determination. It is also important to bear in mind that the
actual gap faced by the company is smaller than what would be implied when
looking at the totex gap. This is because the use of menus1 and our approach to
setting baselines2 reduces the difference faced by the company. In particular, the
difference between the company’s plan and the amount that it would ultimately
recover from customers is only 2.3%.
1
The menu includes a cost sharing rate whereby any over or underspend by the company relative to
our expenditure allowance will be borne more or less equally by the company and its customers.
2
In calculating an expenditure allowance for a company, we combine our own cost baseline and the
company’s cost projection with weights of 75% and 25% respectively. This works to reduce any gap in
cost baselines.
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2014 price review draft determination – recommendations to Ofwat’s Board
on South East Water’s revised business plan
Table 2 Recommended interventions3
Area of intervention
Recommended interventions
Rationale
Outcomes
We recommend imposing an
overall cap and collar on outcome
delivery incentives for AMP6
(thereby limiting total rewards and
penalties). Consistent with our
recommendations for all other
August draft determination
companies, the maximum rewards
for outperformance are limited to
+2% of return on regulatory equity
(RoRE) and maximum penalties for
underperformance are limited to 2% of RoRE.
We consider that an overall limit on the RORE range from outperformance
or underperformance during AMP6 will help ensure that the overall package
of delivery incentives is calibrated to provide meaningful financial incentives
and protect customers.
Outcomes – direct
comparability (horizontal
check)4
G2 - Average time lost per
property
3
When comparing South East Water to the rest of the industry, we identified
that the company was not moving to upper quartile by 2017-18. We are
Decrease the target and the penalty requiring this of South East Water for consistency with other companies.
from 2017-18.
This table has been updated to reflect the decisions taken by Board.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Recommended interventions
I1 - mean zonal compliance
Outcomes – little or no
comparability (high
materiality)5
Rationale
Introduce a penalty only incentive
with collars, deadbands and
incentive rate
Consistent with our approach across the industry, we have applied a
penalty only incentive to the performance commitment. A penalty collar,
deadband and incentive rate have been set in reference to the other water
only companies in the industry.
N1 - Below ground asset
performance assessment
(infrastructure)
South East Water has not convinced us that a reward is appropriate for its
asset performance measure when it includes non-customer facing submeasures.
N2 - Above ground asset
performance assessment (noninfrastructure)
Remove the reward.
6 PCs (A1, B1, D1, F1, G1 and
H1) – Survey of customer
satisfaction
Increase the penalty range relative
The findings of South East Water’s willingness to pay research found that
the proposed penalty and incentive rates were not in line with customers’
views. Therefore, the penalty rate was adjusted to better reflect customers’
views.
4
We have identified 5 PCs/ODIs in which there is direct comparability: (i) internal flooding incidents; (ii) drinking water quality compliance; (iii) supply
interruptions; (iv) water quality contacts; (v) pollution incidents. For these PCs and ODIs there is a high degree of comparability across all 18 companies and
as such we are able to assess the degree to which the company is proposing to deliver upper quartile performance.
5
For these PCs/ODIs there is a low degree of comparability between companies, however we consider that these ODI are material given that each ODI has a
RoRE range greater than 0.1%.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Recommended interventions
Rationale
to the incentive rates.
H2 - Meeting demand for water
(SOSI)
South East Water has not convinced us that it should be the only company
with a reward for SOSI.
Remove the reward.
C2 - Leakage target
Increase the penalty collar in
2019/20 with a similar penalty
range for preceding years.
Wholesale costs (water) summary
Company plan: £810 million
Basic threshold: £699 million
Adjustments: £75 million
Revised threshold: £774 million
The horizontal check on leakage revealed that South East Water's penalty
range was too narrow compared to other companies and that the maximum
penalty was not large enough to warrant not intervening on the penalty
collar.
It should be noted that the company’s resubmitted business plan includes a
number of adjustments to our cost models (see below) which would have
closed the gap. However we have not allowed these in full (or we have
rejected them entirely) because they were already accounted for in our
implicit allowance.
Difference: £36 million (5%) above
threshold
Enhancement allocation
(wholesale water)
The company proposes £29 million
for three claims: National
Environment Programme (NEP);
environmental costs; and security
and emergency measures direction
(SEMD). We recommend fully
rejecting these items.
We rejected these claims at RBR and confirmed that we have included
enhancement expenditure in our modelling approach, therefore these three
claims are fully covered by implicit allowance. South East Water has not
provided any further evidence in the June submission, nor made any
reference to them in the material provided, apart from the continued
inclusion on the W11 (adjustments to the wholesale cost threshold) data
table. These claims have not been assessed in detail.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Regional network / zonal
strategies
(wholesale water)
Recommended interventions
Rationale
The company proposes £53 million We recommend rejecting the claim. We assessed the claim as follows:
of costs for regional network / zonal
 Need – fail: South East Water has not sufficiently demonstrated
strategies. We recommend fully
why the significant investment they and the rest of the industry have
rejecting this item.
made to improve network interconnectivity does not provide
Note: there is an implicit allowance
of £36 million for this item.
sufficient allowance in the models.
9

Cost benefit analysis – fail: South East Water has not presented
alternative options to their preferred solution or provided evidence to
justify why alternative options are not viable. We would normally
expect this type of activity to be included in WRMP scheme costs to
be considered alongside the costs of other options to develop an
overall best value solution and not separately as appears to be the
case here.

Robustness of estimate – partial pass: The resubmission does
include considerably more evidence to explain the basis of the
estimate and the benchmarking exercise they have carried out to
demonstrate efficient costs. However they have not sufficiently
addressed our concerns that costs should be (to some extent)
recovered through developer contributions.

Customer protection – n/a:– this has not been fully assessed as
the company failed need and cost benefit analysis.
2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Environment Agency
charges (eg, abstraction
charges)
(wholesale water)
Water resource
management plans
(wholesale water)
Abnormal ground water
treatment cost exclusion
(wholesale water)
Recommended interventions
Rationale
The company proposes £20 million
of costs for EA charges. We
recommend that we retain our RBR
decision to reject the claim because
EA costs are covered within the
basic cost threshold.
We rejected this claim at the RBR because insufficient evidence was
provided to substantiate the claim. Our totex models take account of EA
charges; as such an allowance is included within our basic costs threshold.
South East Water has not provided any further evidence in the June
submission; therefore this claim has not been assessed in detail.
We recommend adjusting our
models to account for costs related
to the water resource management
plan to improve the supply demand
balance, but we are adjusting by
£12 million not the £17 million
proposed by the company
The company originally proposed an adjustment of £17 million for this
claim. We adjusted our models to take into account the supply demand
variables, which is consistent with our treatment of other companies. After
reviewing the assumptions on the cost drivers of one model we adjusted
the cost drivers and so the £12 million is reflected in our basic cost
threshold and has not been added as a deep dive adjustment. Customer
protection – n/a.
The company proposes £8.75
We consider this claim is fully covered by the implicit allowance in models,
million of costs for abnormal ground therefore this claim has not been assessed in detail.
water treatment cost exclusion. We
recommend fully rejecting this item.
Note: there is an implicit allowance
of £8.75 million for this item.
Household retail
We recommend rejecting the
company’s proposed input price
pressure adjustment to the ACTS
worth £9 million.
The company has not met all of our criteria for ACTS adjustments:

Material -pass: The adjustment is material (8.4% of household
retail opex + depreciation over AMP 6).

Beyond management control -fail: The evidence provided on
management practices for wages is sufficient and convincing, but is
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Recommended interventions
Rationale
not so for other costs (for example, debt collection agency fees and
meter reading contractor fees).

Materially different -fail: The evidence provided on relative
efficiency includes benchmarking of wages against salaries outside
the water industry that show that for most bands, South East Water
pay below the median, and they demonstrate how staff performance
is managed. However, South East Water is not upper quartile
efficient in the water industry. Therefore the company has not
demonstrated that they are affected in a materially different way to
the average company.
South East Water is not upper quartile relative to other companies in the
water sector suggesting that there is further scope to absorb any cost
pressures.
Non-household retail
We recommend rejecting the
The company did not provide sufficient justification for the proposal.
company’s proposed input price
pressure increase in non-household
costs worth £1.7 million.
Legacy6
We are recommending
interventions for legacy that equate
6
Serviceability: The company has performed poorly on interruptions to
supply for the last three years and therefore we recommend a £17 million
We are only recommending material interventions for these legacy tools; not in relation to the other legacy tools.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Recommended interventions
to £17.3 million for the RCV and
£5.6 million for revenue, both of
which are in the customers’ favour.
Rationale
intervention to shortfall the RCV.
Service incentive mechanism (SIM): The methodology sets out a clear
calculation. As a consequence we recommend a 0.7% adjustment
compared to 0.25% the company proposed in its plan, increasing the
penalty by £4 million.
Revenue correction mechanism (RCM): South East Water has not
followed our guidance in calculating a back billing adjustment so we
recommend reducing revenue by £1 million.
There are also minor adjustments on the CIS and to the financing costs for
an equity injection.
Risk and reward –
company specific uplift
South East Water has proposed a
company specific uplift of 36 bp
(worth £21 million).
Incremental cost of equity: We do not consider that there is sufficient
evidence to justify an uplift for the cost of equity for South East Water.
Incremental cost of debt: We do consider that there is sufficient evidence
We are recommending no company that South East Water faces a higher cost of debt.
specific uplift.
Consequently there is not sufficient evidence that South East Water has
higher incremental financing costs and so we have not allowed a company
specific uplift to the cost of capital.
Risk and reward pain/gain sharing
mechanisms
We recommend removing the
proposed pain/gain mechanism to
share the interest costs of new
bonds variance vs plan assumption
with customers on a 50:50 basis.
The pain/gain sharing proposition will transfer risk to customer with the
potential for adverse as well as favourable impacts on customer bills.
Materiality –fail: The financing scenarios presented by South East Water
indicate that the P10/P90 impacts represent only 0.2% of total revenue.
Controllability –fail: Companies are responsible for their own capital
structures and are able to exercise significant control over financing costs.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Area of intervention
Recommended interventions
Rationale
They are best placed to manage financing risks.
Comparability with other companies –fail: South East Water is the only
company to have proposed such a scheme and it would not be appropriate
to allow this form of protection for one specific company.
Customer protection –fail: We consider that South East Water customers
should not bear risks that are not borne by customers of other water
companies.
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2014 price review draft determination – recommendations to Ofwat’s Board
on South East Water’s revised business plan
3. Draft determination – at a glance
In this section we illustrate the consequences of the recommended interventions by
displaying the following outputs of the financial model7 :




combined average household bills;
allowed costs/expenditure;
allowed revenues: June plan versus Draft determination; and
financial ratios.
These outputs are presented on the basis of the recommended interventions. If
Board were to recommend alternative interventions or quantum of interventions this
would require changes to the inputs in the financial model, and thus produce a
different result when the financial model has been run.
It should be noted, that as with the enhanced draft determinations, the average
customer bill illustrated above reflects a notional allocation (by Ofwat but based on
the company’s split of household and non-household) of the overall revenue
requirement across South East Water’s customer base. In practice companies will
have some flexibility about how they recover the revenue requirement from different
types of charges.
Likewise, the company’s choice of pay as you go (PAYG) and RCV run-off rates
(which affect the level of revenue and bills) may change after companies have
considered the impact of the interventions we are making to protect customers in our
draft determinations.
7
Note: Wholesale figures are expressed in 2012-13 prices & retail figures are expressed in nominal
prices. This applies to all charts and figures.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Figure 1 Average household bill (£)8
200
195
190
190
Cumulative saving £69 over 2015-20
185
180
181
181
180
179
179
2017/18
2018/19
2019/20
175
170
2014/15
2015/16
2016/17
Draft determination average bills
Bills from company revised plan
Table 3 Allowed costs/expenditure1
Wholesale
Water
Totex – 2015-20 total (£m)
768.3
Allowed weighted average cost of capital (%)
3.7%
Allowed wholesale revenue in 2015-20 (£m)
886.6
Retail
Household
Cost allowance – 2015-20 total (£m)
Non-household
96.8
Margin (%)
1.0%
2.5%
Retail allowed revenue (£m)
105.6
17.3
Average bill per household customer – retail
component only (£)
25
8
We have re-profiled the company’s bills for the draft determination because our interventions may
result in uneven bill profile. Consistent with company ownership of business plans, we expect
companies to engage with customers on this issue and therefore there may be changes between draft
and final determination.
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2014 price review draft determination – Recommendation to Ofwat’s Board
on South East Water’s business plan resubmission
Table 4 Ofwat’s calculations of notional financeability ratios
Financial ratios for notional company
Ofwat calculation (average
2015-20)
Cash interest cover
2.88
Adjusted cash interest cover ratio (ACICR) – base case
(avg over five years)
1.73
Funds from operations/debt
8.86%
Retained cash flow/debt
6.28%
Gearing
62.93%
Dividend cover (profit after tax/dividends paid)
1.09
Regulatory equity/regulated earnings for the regulated
company
17.42
RCV/EBITDA
11.40
16
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Email: [email protected]
August 2014
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