Financing the private water and sewerage Companies of England and Wales

The Walker Report and South West Water

Last update Thursday 22 April 2010

In 2008, Defra commissioned an ”Independent Review of Charging and Metering for Water and Sewerage Services” under the leadership of Anna Walker. The terms of reference for the review were -

To examine the current system of charging households for water and sewerage services, assess the effectiveness and fairness of current and alternative methods of charging and consider and make recommendations on any actions that should be taken to ensure that England and Wales has a sustainable and fair system of charging in place. It will look at social, economic and environmental concerns.

The final report of the review, published in December 2008, singled out South West Water charges as being particularly high and recommended subsidies of £33 million a year, or a one off payment of “around £650 million”, to be paid to South West Water in order to reduce household bills in the South West by “say, £50”. It was suggested that this subsidy “could be funded directly by the government or by other water customers”. The report has of course been welcomed without reservation in the South West by the public voices of water customers such as CCWater and Members of Parliament at the time. Unfortunately, the investigation was seriously flawed in that it appears to have assumed from the outset that the Ofwat price determinations are unquestionably fair and that South West Water household bills must inevitably remain high mainly because of the comparatively low number of households in the South West.

In fact, as this paper will show, these assumptions do not stand scrutiny. It will also be seen that any scheme for other water customers to subsidise South West Water will almost certainly be impracticable in the light of this clarification. Neither can it be assumed that there will be agreement that only South West Water customers are being over-charged and should be subsidised.

1. Capital expenditure

Table 1 below is derived from Table 8 in the Walker report and shows, by company, the actual capital expenditure per household up to 2009 and that projected for the next 5 years. As the report implies (paragraph 14.2.5) “The more capital expenditure per property, the higher the bill needs to be to pay for it” and this expenditure is provided for in the Ofwat price determinations. It should be noted that, at £558, the projected capital expenditure for South West Water for 2010-14 is only £9 (less than £2 a year) above the industry average of £551. The cost of funding the capital investment programme therefore cannot be contributory to the higher than average household bills projected for South West Water customers over the next 5 years.

Table 1. Capital expenditure per household since flotation

To 2009
per cent
2010-14
per cent
Anglian£3,557103%£47287%
Dyr Cymru£4,454120%£42678%
Northumbrian£3,767109%£43679%
Severn Trent£3,16592%£35965%
South West£5,197151%£558102%
Southern£3,14491%£703128%
Thames£2,71279%£630115%
United Utilities£4,022117%£738134%
Wessex£3,15691%£46885%
Yorkshire£3,965115%£551100%
Industry average£3,499100%£549100%

As will be seen, the contribution from South West Water customers, for funding the capital investment programme up to 2009, came to no less than £5,197 per household or 151% of the average charge and well above the second highest which was Welsh Water at £4,454 or 120% of the average charge. This substantial element in South West Water household bills has of course been attributed primarily to “Clean Sweep”, the programme to install water treatment plants in place of 200 raw sewage sea outfalls, which was completed in 2007. This presumably explains the substantial reduction in the 2010-14 capital expenditure charges for South West Water customers.

2. Regulatory Capital Value

In considering the RCV, the report comments (para 14.2.3) -

However, given the regulatory regime, in terms of the prices that customers have to pay, the important relationship is between the Regulatory Capital Value (RCV - the amount the company paid for the assets at privatisation, plus any additional capital assets that have been added, less depreciation etc) and the number of customers.

This provides a useful clarification regarding RCV but exaggerates the significance of the low customer base. A larger population in the South West would naturally be reflected in a higher RCV as a consequence of the additional facilities necessary to service the larger customer base. However, the amount of the RCV is important, particularly so because of the method for charging the “return on capital”. As the review team further commented (para 14.3.1) --

This means because new investment has to be paid for in full, whereas pre-privatisation investment in assets is currently paid for at between 5–10 per cent of its real costs, bills in the South West Water area are now considerably higher than the average, but for essentially the same level of service experienced elsewhere in the country.

Table 2 is derived from Table 7 in the Walker report and, for the water and sewerage companies, shows the RCV at flotation in 1989, the RCV in 2008 and the difference between these values which is the new investment RCV.

Table 2. Regulatory Capital Value

RCV per household
increase
1989
2008
(1989 to 2008)
Anglian£796£2,053£1,25787%
Dyr Cymru£449£2,591£2,142149%
Northumbrian£567£2,483£1,917133%
Severn Trent£472£1,604£1,13279%
South West£397£3,450£3,053212%
Southern£574£2,070£1,496104%
Thames£469£1,460£99169%
United Utilities£557£2,427£1,870130%
Wessex£581£2,124£1,542107%
Yorkshire£542£1,975£1,43399%
Industry average£539£1,980£1,441100%

As indicated in paragraph 14.3.1 of the report, the RCV at flotation is charged at 5 to 10% whilst the new investment has to be paid for in full. Here then, in Table 2, is the clear and unequivocal explanation for the excessive South West Water household bills. The South West Water new investment RCV per household (£3,053) on which “return on capital” is charged in full is more than twice the industry average of £1,441.

3. Return on capital

Defra and Ofwat are emphatic that the “return on capital” charges are essential in order to provide water company shareholders with a proper reward for their investment. However, this is weasel wording since the shareholders have made no contribution whatsoever to financing the capital assets accrued since flotation. This new investment has been entirely financed by customers so that any charges based on the new investment element in the RCV defined in paragraph 14.2.3 (and quoted above) must be unwarranted and grossly unfair.

Essentially there is double charging here. First, the customers are subjected to a capital investment charge which relieves shareholders (the nominal investors) of the responsibility for financing the capital investment programme. Second, the customers are further charged in order to provide shareholders with a “return on capital” related to the new investment which has been financed, not by the shareholders, but by the customers themselves. This is obviously not a proper basis for the determination of water charges and completely disregards the statutory financial protection to which customers are entitled. It is certainly unfair, in particular on customers of companies such as South West Water, Dwr Cymru, Northumbrian and United Utilities have been subject to higher household bills to finance capital investment and, as a result, are now subject to higher bills due to the charges on that investment.

4. Conclusions

As suggested above, the details given here are sufficient to justify the complete rejection of the Walker report and a further, more rigorous, enquiry with essentially the same basic terms of reference. This enquiry should also be required to consider the dividends taken by parent companies, especially those taken by Pennon from South West Water, and the profit levels reported by the companies with a view to defining in more detail the statutory financial protection that water and sewerage customers should be due. As an indication of the profit levels budgeted by Ofwat for the next 5 years, the projections of expenditure on which household bills are based include allowances for expected tax demands of about £25 million a year for South West Water and of about £300 million for the industry as a whole.