Pennon Group - South West Water Regulation

REGULATORY & COMPETITIVE ENVIRONMENT

APPOINTMENTS

In 1989, the UK Government appointed companies (appointees) to provide water and waste water services (the Appointments). Economic regulation pursuant to the Appointments is the responsibility of Ofwat.

The Appointments impose conditions which Ofwat enforces, along with the appointees' principal duties under the Water Industry Act. An Appointment may be terminated on 25 years' notice by the Secretary of State, with more immediate revocation in certain specified circumstances (including, for example, failure to comply with an enforcement order made by Ofwat).

The water industry is also subject to Government direction and legislation in relation to investment requirements and social policy (for example the protection of vulnerable customers). From a customer interest perspective, water industry activities are also reviewed by the Consumer Council for Water, a separate statutory body.

COMPETITION

The Government has introduced a regime whereby customers using more than 50Ml per year can contract with alternative suppliers for water supply. South West Water has 36 customers in this category whose aggregate water charges account for approximately 1.5% of its total water and sewerage revenue or 3.2% of its water revenue. No single customer accounts for more than 1% of revenue.

The Government’s independent review of competition and innovation in the water industry led by Professor Martin Cave published its final recommendations in April 2009. Legislation will be required for any further significant extension of competition in the water and sewerage markets. During the year Ofwat consulted on extending the current 50 Ml criteria for competition under water supply licensing arrangements to cover customers using more than 5 Ml. This extension to the existing competition regime is expected to apply during 2010/11. Ofwat has published a number of consultation papers concerning the potential for future retail and upstream market reform.

The review into fairer water charges commissioned by Defra, known as the Walker Review, was concluded in 2009. The review noted that, while the regulatory regime in the water industry has served customers well over the last 20 years, improvements can be made to address the twin aspects of affordability and fairness for water customers. The Government has asked Ofwat to advise it on one or more of a number of options to address the issue of water bills in the South West:

a one-off or other financial adjustment by Government
contributions by other water customers across the country
a package of tariff proposals for South West Water customers.

Ofwat and South West Water have established a joint working group to develop and examine the options which could address the recommendations in the Walker Review.

PRICE CAP REGULATION

Ofwat regulates water and waste water charges by determining the maximum increase in charges which a company can impose in any year. The water regulator conducts a Periodic Review and sets price limits every five years. Prices are set by reference to inflation as measured by the Retail Prices Index (RPI) plus an adjustment factor known as ‘K’ which is specific for each company.

The ‘K’ factors for the period 2010 to 2015 for South West Water were determined by Ofwat in its Final Determination in November 2009 and are shown in the table below:

GROWTH IN REGULATORY CAPITAL VALUE

Regulatory Capital Value (RCV) is the financial base used by Ofwat to allow a rate of return and set prices at each Periodic Review. The RCV at 31 March 2010 amounted to £2.621 billion. After adjustment for PR09 log up/down and other Final Determination adjustments the figure is £2.555 billion which represents an increase of 3.8% in the year. From 31 March 2005 to 31 March 2010 the company achieved a 31% growth in RCV, the highest percentage increase of any quoted UK water company.

The gearing ratio in relation to adjusted year-end Regulatory Capital Value improved to 60.6% from 63.8% in 2008/09.

The growth in RCV adds directly to shareholder value as the allowed return is attributed to South West Water’s asset base by Ofwat.

Regulatory Capital Value

The 2004 Final Determination provided for total capital expenditure of £762 million (2002/03 prices) over the five-year period 2005-2010. All major projects required in the period 2005-2010 were delivered in line with Ofwat’s, the Drinking Water Inspectorate’s and the Environment Agency’s expectations. The required customer service and infrastructure outputs at 31 March 2010 included:

Target_chart

PERIODIC REVIEW 2009

Following submission of South West Water’s Final Business Plan in April 2009, the company’s Final Determination was made by Ofwat on 26 November 2009. Key elements of the Final Determination for the company included:

a cost of capital of 4.5% (real, post tax basis), applicable to the whole industry
'K' price increases (above RPI inflation) averaging 1.9% per annum over the five years
a capital programme of around £705 million at 2007/08 prices
a Capital Incentive Scheme (CIS) score of 105 (water) and 110 (sewerage), in line with the industry average
operating efficiency improvements of 2.8% per annum, comparable with K4 delivery
over the period 2010-2015 average bills decreasing by 1% before inflation
capital investment priorities, including protection and maintenance of the improvements made over the last 20 years, further improvements to meet EU Directives and their corresponding UK legislation, achievement of operating cost savings and delivery of projects to increase levels of renewable energy generation and to improve sustainability of the company’s activities.

Further information on the Final Determination is available on the company’s website southwestwater.co.uk

LEGISLATIVE DRIVERS

The water industry in the UK is subject to substantial national and EU regulation. This places significant statutory obligations on South West Water with regard to, amongst other things, the quantity of water abstracted, and the quality and quantity of waste water discharged. Examples of relevant EU directives include the Drinking Water Directive, the Habitats Directive, the Urban Waste Water Treatment Directive and the updated Bathing Water Directive.

The Water Framework Directive was incorporated into UK law in 2003. It provides a framework for the protection and improvement of the quality of water resources, together with the promotion of sustainable water consumption. To comply with the Water Framework Directive, EU member states will have to achieve the challenging target of ‘good’ status for groundwater, rivers, estuarine waters and coastal waters, in three six-year cycles, the first running from 2009 to 2015. The Final River Basin Management Plan, published by the Environment Agency in December 2009, confirmed that the Plan’s implications are unlikely to require changes to South West Water’s assets at least until 2015, due to the successful delivery of a wide range of river, estuarine and coastal water environmental improvements by the company since 1989.

Further legislative regulations are expected for the water industry following introduction of the Flood and Water Management Act in April 2010. Many of the changes are expected to implement the recommen-dations of the Pitt Report which was commissioned after the severe flooding in other parts of the country in summer 2007.

CLIMATE CHANGE

South West Water is working closely with many organisations to assess the implications of climate change for water supply and waste water services. Adaptation and mitigation plans are being developed which will involve innovative approaches and new methods of influencing catchment behaviour upstream of its water supply systems, in sewered areas and downstream of its waste water systems to protect the wider environment.

The company’s final Water Resources Plan for the next 25 years was published in the summer of 2009 and was approved by Defra. It includes information relating to rainfall and temperature variations. The plan includes allowances for demand changes associated with climate change. Predictive models are in place to address uncertainty. Infrastructure developments have been identified, the timing of which can be adjusted if the expected rate of climate change alters. Increasingly efficient and careful use of water plays a major part in adapting to the expected effects.