Periodic Review 2009 DRAFT BUSINESS PLAN. (August 2008) Part A

Transcription

1 SUTTON AND EAST SURREY WATER PLC Periodic Review 2009 DRAFT BUSINESS PLAN (August 2008) Part A PUBLIC DOMAIN SUBMISSION Ofwat Centre City Tower 7 Hill Street Birmingham B5 4UA LCS/OFWAT/PR2009 Sutton & East Surrey Water London Road Redhill Surrey RH1 1LJ August 2008

2 Sutton & East Surrey Water PLC PR2009 DRAFT BUSINESS PLAN August 2008 Part A: The Company Strategy A0 Executive Summary A1 The Company Strategy A2 Board Responsibility A3 Company Strategy Tables Part B: Key Components B1 The Post 2010 Environment and the Longer Term B2 Improving Efficiency B3 Maintaining Service and Serviceability B4 Quality Enhancements B5 Maintaining the Supply/Demand Balance B6 Consumer Service Strategy and Changes in Service B7 Financial Projections and Measures B8 Revenue Projections B9 Overlap Programme B10 Large Projects Part C: Supporting Information C1 Consumer Views C2 Cost Base C3 Asset Inventory C4 Supply/Demand Appraisal C5 Supplementary Information Proposed Work Programme and Expenditure Projections the PR09 Projects Database C6 Not Used C7 Tariffs and Revenue Forecast Supporting Information C8 Cost Benefit Analysis and Carbon Accounting C9 Aquarius iii Financial Modelling Datasets LCS/Ofwat/PR2009 Page 1 of 2 11/08/2008

3 Additional Supporting Information Index Ref. No. B2-1 B3-1 Referred to in section A1.4.9 B2.2.2 B2.2.5 B2.6.1 A1.4.3 B3.1.2 B3.2.1 B B3.3.1 B3.7.1 B3.8.1 C3.2.2 A3.3.3 B3.2.1 B Content Frontier Economics The scope for efficiency savings: 2010 to 2015 Asset Management Strategy B3-2 Tynemarch Capital Maintenance Planning for PR09 Infrastructure Assets B3-3 B3.3.1 B Tynemarch Capital Maintenance Planning for PR09 Non-infrastructure Assets B3-4 A B7.2.4 Frontier Economics The cost of capital for HR Wallingford B3-5 B3.5.5 Development of climate change scenario time series for Sutton and East Surrey Water s Capital Maintenance Planning Model B3-6 B1.4.4 B Bergen Energi B3.6.4 Energy price forecast for the UK market B3-7 B3.6.4 Entec (UK) Ltd Carbon Management Study B4-1 B Atkins Security survey of AMC B4-2 B B4.2.9 Atkins B4.3.4 B4.3.5 C Security of Sites B4-3 B Atkins Flood protection strategy B4-4 B4.3.3 B4.3.6 Costing of Security Proposals for Redhill Alarm Monitoring Centre (AMC) B6-1 B5 B6 Water Efficiency Strategy B7-1 B7.2.4 NERA Evidence on the Small Company Cost of Capital Premium at PR09 B7-2 B7.2.6 NERA Cost of Capital Final Report for Water UK B8-1 B8.3.1 Frontier Economics Projected Characteristics of Meter Optants C1-1 C1.2 C8.1.2 Water Industry Stakeholder Steering Group (Corr Willbourn) Executive Summary of Deliberative Research concerning Consumers Priorities for PR09 C1-2 A1.3.2 C1.5.4 Accent Consumer Qualitative Research PR09 Research : Final Report C1-3 C1.5.5 Accent Business Qualitative Research PR09 Research : Final Report C1-4 C Accent Quantitative Research Consumer priorities and Willingness to Pay : Final Report C3-1 C3.2.2 Atkins Non Infrastructure asset condition and performance survey C4-1 C4.1.4 Atkins Economic level of leakage C4-2 C3.2.2 Atkins / Frontier Economics Cost Benefit Assessment of Domestic Metering C5-1 C5.2.1 The PR09 Projects database LCS/Ofwat/PR2009 Page 2 of 2 11/08/2008

4 A0 EXECUTIVE SUMMARY A0.1 Key Aim Our key aim is to achieve the best balance of outputs, investment and prices that will: Meet customers overwhelming requirements for adequate, reliable supplies of high quality water; Meet the further investment priorities identified in our customer surveys; Provide greater resilience to help withstand the challenges of climate change, and reduce our impact on the environment; Provide customers with a high level of service that represents fair and reasonable value for money; and Let us make adequate returns to enable us to finance our functions. We will deliver all this at realistic and fair price increases (once unavoidable increases in power and chemical costs are removed) averaging 3.2% pa. A0.2 Background We provide an essential, life supporting, service to the people living in our area of supply. This has been brought sharply into focus following our experience in the last three years when the south east of England suffered two years of severe drought followed by a summer of flooding. In a modern society the water supply system must not fail. Our draft Business Plan has been developed from the research and stakeholder consultations that informed our Strategic Direction Statement (SDS) published in December The SDS, our 25 year vision for the Company is by necessity a high level conceptual document. Since completing the SDS we have published our Draft Water Resource Management Plan (DWRMP) and completed our extensive customer and stakeholder consultations. The SDS, customer research and DWRMP form fundamental building blocks for this plan. Our plan also recognises that we are governed by statute and regulation, that we should provide a high level of customer service, and that we should meet outputs set by our regulators. Everything we have learned since our SDS was published, confirms that the issues and strategies identified in our SDS were the right ones for the Company. A0.3 Strategic Objectives Our strategic objectives, built around customer research and consultations with stakeholders, can be summarised as follows: to maintain the supply of the highest quality water to our customers and to achieve 100% compliance with water quality standards; to maintain an adequate, continuous supply of water to our customers; LCS/Ofwat/PR2009 Page 1 of 5 11/08/2008

5 to improve resilience, and to overcome a deficit in resources to meet peak demands; to maintain very high levels of service to our customers; to carry out our operations in an environmentally friendly and sustainable way; and to maintain an appropriate level of return to our shareholders. Implicit in achieving the above are that we have to: maintain our asset base; comply with all relevant legislation and similar obligations; manage our water resources with a view to the future; ensure our charges represent reasonable value for money; minimise our burden on the environment; continue to innovate and make the most effective use of modern technologies; meet new challenges and obligations; be efficient; maintain an appropriate level of security at all of our sites; be a good and progressive employer; and maintain our credit ratings. A0.4 Key issues The key issues that arise from our selected outputs and strategic objectives, at this price review are: Security of supply; Renewal and maintenance of existing assets; Large increases in specific uncontrollable operating costs; The cost of capital necessary to raise new debt and equity; Metering policy; and Risks and uncertainties; Competition; The need to operate efficiently; and The need to maintain high standards of service. A0.4.1 Security of supply This is of overwhelming importance to us and our customers. The Draft Water Resource Management Plan indicates a deficit in resources to meet critical period (peak week) demands. We have considered a range of supply side and demand side options (a twin track approach) and have adopted a balanced solution. The least cost option is to extend Bough Beech water treatment works, and improve the associated distribution network, at a cost of 49.0m, of which 16.0m is included in base expenditure. The licence variation required to enable the project to proceed has already been granted by the Environment Agency. The proposed project will provide risk free water, enhance service levels and improve resilience in the event of drought and emergencies. On the demand side, we propose to increase meter penetration LCS/Ofwat/PR2009 Page 2 of 5 11/08/2008

6 significantly (see below), maintain leakage at its current low level, and meet water efficiency targets agreed with Ofwat. A0.4.2 Renewal and maintenance of existing assets We will maintain our assets to deliver stable levels of customer serviceability. The proper level of investment to maintain our asset base is fundamental to providing a reliable supply of high quality water. Our modelling shows that the proper level of investment for the AMP5 period is similar to the level of expenditure in the current period. A0.4.3 Large increases in specific uncontrollable operating costs Operating costs are currently rising significantly above the rate of inflation (as measured through the RPI). Most of these are due to items over which we have little or no control, for example: power costs, rates, traffic management, and pensions. The final determination needs to put in place mechanisms that ensure we can recover costs that rise above those that increase above the level included in prices. A0.4.4 The cost of capital necessary to raise new debt and equity Our plan requires significant new tranches of debt and equity capital. To attract the necessary investment, the cost of capital needs to be set at an appropriate level, particularly in the current uncertain economic and credit climate. A0.4.5 Metering policy Customers, the Secretary of State for the Environment and the Environment Agency accept that the fairest way of charging is on the basis of water consumed. We support those views and have included a balanced, cost beneficial programme of increased metering in our plan. The proposed level of metering has been set to minimise the impact on bills, but recognises the importance of metering in suppressing demand which ensures that further resource development is not required for twenty years after the completion of the Bough Beech scheme. Targeted metering will also allow us to put tariff trials in place in the AMP6 period. A0.4.6 Risks and uncertainties Although large increases in costs are inevitable and will have to be met through increases in prices, it is possible that the actual increases incurred will be materially different from the best estimates allowed in the price determination. Material disallowed costs will cause investment to be cut, and unexpected lower costs will produce excess returns. Neither of these outcomes is desirable, particularly as they would not be corrected until the price review. The way to avoid these undesirable outcomes is to designate all large and uncertain costs, revenues, obligations etc, as Notified Items. A0.4.7 Competition The Company believes that the introduction of competition will not benefit all its customers and in particular, it is likely that in the early stages of a market being created large industrial and commercial users may benefit at the expense of domestic customers. LCS/Ofwat/PR2009 Page 3 of 5 11/08/2008

7 We believe that the current system of regulation, comparative competition and capital market competition has delivered significant improvements for customers and society. The case for greater competition should include a realistic assessment of the costs of introducing competition and a recognition that the benefits that competition could bring can also be achieved (at less cost and much less risk) through development of the existing regulatory regime. A0.4.8 Efficiency Our undertaking to customers will be that we will carry out our functions as efficiently as possible, looking to introduce innovation where appropriate, to keep price rises fair and reasonable. A0.4.9 Service to customers We provide a very high level of service to our customers and believe that they are satisfied with our performance. There is no demand for significant improvements or additions. Therefore, we have selected outputs for this plan that, apart from the security of supply which is our customers clear priority, deliver current service levels plus a few minor changes to levels of service that are cost beneficial and for which customers are prepared to pay. A0.5 Prices A total price increase of 25% is needed for the five-year period The reasons for the increase are outlined in the following table: Base service and metering 10.7% Enhanced service levels 1.0% Security of supply Bough Beech 3.4% Increases in the costs of power and chemicals 9.2% The maintenance of adequate financial ratios and returns 0.7% Total 25.0% The following table gives the K factors for each of the five years. The reason for the 12.6% increase in the first year of the period, is because the majority of the cost increases and particularly power and rates impact immediately in that year LCS/Ofwat/PR2009 Page 4 of 5 11/08/2008

8 EXECUTIVE SUMMARY Summary Table LCS/Ofwat/PR2009 Page 5 of 5 11/08/2008

9 Draft business plan Table A0 - Sutton & East Surrey Water - Explanation of the company's plan to deliver now and in the future OVERALL STRATEGY FOR PERIOD AND BEYOND QUALITY AND SERVICE IMPROVEMENTS IN PERIOD AND IN THE LONGER TERM Introduction Sutton & East Surrey Water, together with its predecessors, has provided an essential service to the people living or working in its area of supply for 150 years. Given the essential nature of this service, the Company s objectives are fundamentally governed by statute and regulation, and in more recent years customer service standards have been added. Our strategic objectives, built around customer research and consultations with stakeholders, can be summarised as follows: to maintain the supply of the highest quality water to our customers and to achieve 100% compliance with water quality standards; to maintain an adequate, continuous supply of water to our customers; to improve resilience, and to overcome a deficit in resources to meet peak demands; to maintain very high levels of service to our customers; to carry out our operations in an environmentally friendly and sustainable way; and to maintain an appropriate level of return to our shareholders. Implicit in achieving the above are that we have to: maintain our asset base; comply with all relevant legislation and similar obligations; manage our water resources with a view to the future; ensure our charges represent reasonable value for money; minimise our burden on the environment; continue to innovate and make the most effective use of modern technologies; meet new challenges and obligations; be efficient; maintain an appropriate level of security at all of our sites; be a good and progressive employer; and maintain our credit ratings. Key Issues It is our key aim at this price review to achieve the best balance of outputs, investment and prices that will meet customers aspirations for their water supply as well as enabling the Company to invest appropriately in existing and future assets whilst making an adequate return to satisfy its investors The key issues that arise from our selected outputs and strategic objectives, at this price review are: Security of supply; Risks and uncertainties; Renewal and maintenance of existing assets; Competition; Large increases in specific uncontrollable operating costs; The need to operate efficiently; and The cost of capital necessary to raise new debt and equity; The need to maintain high standards of service. Metering policy; and Prices A total price increase of 25% is needed for the five-year period The reasons for the increase are given in the table below : Base service and metering 10.7% Enhanced service levels 1.0% Security of supply Bough Beech 3.4% Increases in the costs of power and chemicals 9.2% The maintenance of adequate financial ratios and returns 0.7% Total 25.0% If the costs of power and chemicals, which are outside the Company s control, are removed, prices increase at 3.2% per annum. Service Improvements We have continued to deliver a high standard of service to our customers, and our research confirms that our customers are pleased with this performance. However, the research has also highlighted a Willingness to Pay for further service improvements in the forthcoming period. The service improvements comprise the following : Water restrictions Drought orders only to be required once every 40 years. Network improvements Unplanned Interruptions to supply from 10,900 to 9,750. Network improvements Discolouration contacts from 110 to 100. Water efficiency Additional 0.11 Ml/d per annum. Water quality improvements The Company has included in its Draft Business Plan projects to address emergency planning requirements issued by Defra and to accommodate the recommendations of the interim report of the Pitt Review into the floods of Summer It has also included a programme to enable it to deal with the reduction of the lead standard to 10ug/l in The Company expects to agree an Authorisation with the DWI in the near future for it to investigate the presence of the pesticide metaldahyde in its raw water source at Bough Beech. The concentrations detected are not harmful to health. However, the Company is involved in an industry wide research to consider how best to deal with the situation, either at source or with treatment. WHAT IS DRIVING THE CHANGES IN BILLS? ( PRICES) Water Sewerage Average household bill in Less (1) past efficiency savings and outperformance 0 (2) maintaining base services 153 of which Water Sewerage a) changes in revenue 0 b) changes in operating costs to maintain current services to consumers 19 Plus c) changes in costs of maintaining assets 6 d) changes in impact of taxation 0 e) the change in the cost of capital and financeability (3) maintaining and enhancing security of supplies to all customers 14 (4) the impact of improvements in services of which Water Sewerage a) drinking water quality b) environmental improvements 2 0 c) Improvements in service levels 1 Less (5) scope for reduction through future efficiency improvements -3 Average household bill in PRICE LIMITS AND EFFECT ON AVERAGE BILLS ( PRICES) ESTIMATE OF EXPENDITURE NEEDS ( PRICES) Proposed price limit Annual average for the W Indicative price limit (water service) period ( /property/annum) 1 Average measured household bill Average unmeasured household bill Water Sewerage 1 Operating costs to maintain current services to consumers Average household bill Operating costs to improve services to consumers and protect the environment 4 3 Cost of maintaining assets to deliver current services to consumers 56 4 Cost of improving assets to deliver improvements for the environment and consumers 42 1 Pre tax cost of debt and post tax cost of equity basis (Vanilla) Fully post-tax basis S Indicative price limit (sewerage service) 5 Assumed cost of capital (%) Average measured household bill Average unmeasured household bill Average household bill For further information go to [hyperlink to company's website]:

10 A1 The Company Strategy A1.1 The Overall Strategy A1.1.1 Introduction This document is the Draft Business Plan for (SESW) for the years from 2010 to This Plan has been developed over the last year based on full consultation with customers, the Consumer Council for Water, English Nature, the Environment Agency, the DWI, and Ofwat (stakeholders). We have paid a lot of attention to the valuable feedback these processes have given us and have taken account of them within the Plan, together with guidance received from Government. However, this is our Plan and our view of the best balance of outputs, investment and prices that will: Meet customers overwhelming requirements for adequate, reliable supplies of high quality water; Meet the further investment priorities identified in our customer surveys; Give us the resilience to meet the challenge of climate change and to protect the environment; Give customers fair value for money; and Let us make reasonable returns so that we can finance our functions. Essentially our Plan can be summarised as: Business as usual plus improved security of supply all at fair prices. This Plan has been developed from the research and consultations that informed our Strategic Direction Statement (SDS) published in December The SDS is our 25 year vision for the Company, informed by customers views, and is, by necessity, a high level conceptual document. Since completing the SDS we have published our Draft Water Resource Management Plan (DWRMP) which was available for public consultation for 12 weeks from 6 May We have also carried out additional customer consultations. The SDS, customer research and DWRMP form fundamental building blocks for this Plan. Everything we have learned from this additional work has confirmed that the conclusions and strategies identified in our SDS were the right ones for the Company. We provide an essential service to the people living in our area of supply that is governed by statute and regulation and more recently customer service standards. It is pleasing that the preferences our customers have expressed are in accordance with those obligations, but they have also stated a preference for specific additional services that they would be willing to pay for. Our strategic objectives, which have been developed from our selection of outputs, can be summarised as follows: to maintain the supply of the highest quality water to our customers and to achieve 100% compliance with water quality standards; to maintain an adequate, continuous supply of water to our customers; LCS/Ofwat/PR2009 Page 1 of 25 11/08/2008

11 to improve resilience, and to overcome a deficit in resources to meet peak demands; to maintain very high levels of service to our customers; to carry out our operations in an environmentally friendly and sustainable way; and to maintain an appropriate level of return to our shareholders. Implicit in achieving the above are that we have to: maintain our asset base; comply with all relevant legislation and similar obligations; manage our water resources with a view to the future; ensure our charges represent reasonable value for money; minimise our burden on the environment; continue to innovate and make the most effective use of modern technologies; meet new challenges and obligations; be efficient; maintain an appropriate level of security at all of our sites; be a good and progressive employer; and maintain our credit ratings. This strategy is in accordance with the expectations of our customers whose clear priorities are that we provide them with a water supply that is of good quality and reliable. All costs, expenditures, etc referred to in this section of the Draft Business Plan are in prices. A1.1.2 Background Currently we are meeting the strategic objectives set out in our last Business Plan (PR2004) and fulfilling our obligations, despite extremes of weather experienced in the last few years. However, things are changing and it is important that we recognise this and react accordingly. Two recent events illustrate the sort of climatic variations our assets and systems are going to have to deal with in the coming decades. A Summer of 2006 From November 2004 to July 2006 (inclusive) there was an exceptional shortage of rainfall a relatively rare event (in the order of 1 in 75 years). As a consequence, in the spring of 2006, our resources (in particular our groundwater sources which supply about 85% of our water) were at very low levels. In order to protect supplies for essential use we applied to the Secretary of State for a Non-Essential Use Ban. The application had the support of the vast majority of our customers, CCWater, the Environment Agency and DEFRA. The Non-Essential Use Ban was granted and put in place in May It expired in November The consequences of applying the ban were that peak and average demands reduced dramatically. Peak demands were up to 36% lower and average demand was 11% lower than an equivalent dry year. Customers responded well to requests to use LCS/Ofwat/PR2009 Page 2 of 25 11/08/2008

12 water wisely, and recognised that we had managed our resources well. It has subsequently become apparent however that customers were aware that we are entitled to apply restrictions on the use of water, but were not aware that the amount of money they pay for their water is linked to the level of service we are required to provide. In other words, customers hadn t fully understood that we are funded through water bills to provide an uninterrupted supply of water except in the event of a 1 in 20 year drought when we are entitled to ban the non-essential use of water. It was also evident that a Non-Essential Use Ban was not popular with customers and that we should consider finding a way to reduce the risk of having to impose one in the future. The perceived wisdom is that with climate change, similar events are likely to become more frequent. A third dry winter might have resulted in the use of standpipes, and/or the need to impose rota cuts. The costs associated with the drought, purchasing additional water supplies, additional leakage control and administration costs (eg legal, public hearing, and publicity) added 0.8m to our 2006/07 operating costs. A Summer of 2007 During the summer of 2007 we experienced unusually high levels of rainfall. Similar rainfall patterns were experienced across much of England and Wales leading to flooding and operational difficulties for a number of water companies. Some customers in Severn Trent suffered loss of supply for a significant period of time. We were fortunate compared to many, but still suffered operational supply problems at one of our works for a short period. Climate change experts report that we can expect similar major events on a more frequent basis as the world s climate continues to change. A Consequences We have performed well in the events set out above, but in order to meet our customers expectations, we propose to make the investment necessary to ensure that in all but the most exceptional conditions: our sources can be relied upon to give an adequate and reliable yield; our treatment works are robust enough to treat the raw water supplied without interruption; and our mains network is in a condition to deliver safely the treated water to our customers. Our customers do not want to experience a loss of supply for any significant period of time. They want to turn on the tap and receive a reliable supply of high quality drinking water. A1.2 Outputs selected The outputs shown in the Table below have been selected because they; satisfy customers stated requirements; LCS/Ofwat/PR2009 Page 3 of 25 11/08/2008

13 meet our legal obligations; allow reasonable returns; are financeable; improve our resilience; safeguard the future of the Company, customers and the environment, and result in prices which are fair and reasonable. Key Output Unit Base year 2007/08 Level of Performance Target Minimum Levels of Service Base Service DG2 properties at risk of receiving low pressure Nr DG3 supply interruptions (overall performance score) DG3 unplanned interruptions to supply exceeding 12 hours Nr DG6 billing contacts dealt with within 5 working days % DG7 written complaints dealt with within 10 working days % DG8 metered customers receiving a bill based on a meter reading % DG9 telephone calls abandoned % DG9 calls receiving the engaged tone % DG9 call handling satisfaction score % Capital Maintenance Level of Serviceability Water infrastructure Stable Stable Stable Water non-infrastructure Stable Stable Stable Enhanced Service Levels Supply interruptions/discolouration additional length of main replaced* km 0 7 Water efficiency (schools programme) water saved Ml/d Supply Demand Balance Meters installed (optant/selective/compulsory) Nr ,500 Leakage Ml/d Security of supply index (dry year average) Security of supply index (critical period) Water Quality Water treatment works coliform non-compliance % Service reservoirs bacteriological samples failing % Mean zonal compliance with PCV for iron at the tap % * The additional length of main replaced will result in a reduction in the number of unplanned supply interruptions from 10,900 (base level in 2010) to 9,750; and a reduction in the number of discolouration contacts from 110 (base level in 2010) to 100. LCS/Ofwat/PR2009 Page 4 of 25 11/08/2008

14 In addition to the outputs selected, we aim to ensure that sufficient resources will be available so that: a hosepipe ban will only be required when there is a 1 in 10 year drought; restrictions on the non-essential use of water will only be required when there is a 1 in 20 year drought; rota cuts, or the use of standpipes, will only be required in the most extreme droughts or emergency situations. A1.3 Balance of activities and choice of programme A1.3.1 General We have chosen the programme that forms this Plan by adopting the processes outlined by Ofwat in its PR09 Framework and Approach, its Reporting Requirements and additional guidance. All our stakeholders requirements are important to us. This is especially relevant to meeting customers output expectations and the balance of activities required to fulfil them. However, there are also other regulatory and legal requirements obliging us to provide customers with a reliable supply of good quality water and to maintain the condition of our assets. On the other hand, we have to be able to finance our functions and make reasonable returns for shareholders. A1.3.2 Customers views Our customers views are the main drivers that have shaped our Plan and the most difficult one to gauge is their attitudes and perceptions. To understand our customers views better we have commissioned extensive market research.. We have found that the vast majority of customers take our service for granted, as long as they continue to receive good quality water, and we respond to enquiries and any supply problems in an efficient and effective manner. This is confirmed by the industry wide research which concludes that the attitude of customers is one of non-reflective trust and reliance. They assume that the drinking water is safe. Unfortunately, the approach taken in this study has rendered it meaningless for interpreting our customers views. This is mainly because the research to date does not include any customers in our area. Additionally it does not separate cost and bills between water and sewerage services so that we are unable to interpret the answers for water services only. We provide a very high level of service to our customers and our market research shows that they are satisfied with our performance and that there is no demand for significant improvements over and above what we are obligated to provide. However, our market research has indicated they are willing to pay for some specific service level improvements. Our customer research is discussed in sections B1.5.2 and Supporting Information C1-2, 3, and 4. The main findings of our qualitative research (focus groups) were: LCS/Ofwat/PR2009 Page 5 of 25 11/08/2008

15 SESW is highly regarded as a company that provides a high quality service to its customers and good value for money. Customers overwhelming requirement is for an adequate supply of good quality water. Customers were astonished at the level of water leakages and felt the pipe replacement rate to be inadequate. Customers were resigned to hosepipe bans but could not understand why drought orders or standpipes should ever be needed in modern day society. Most respondents simply accepted that interruptions to their water supply happened, but advance warnings of these would be much appreciated by customers. Water metering was embraced as a sensible way to pay for water and compulsory water metering was considered acceptable. Respondents considered climate change and water discoloration to be a low priority for investment. These findings are reinforced by the industry research that concludes customers want an efficient, safe, reliable supply of water at reasonable cost now and in the future and everything else is of markedly less importance. We also conducted research amongst our business customers who confirmed that we are generally held in high esteem. We met their core service need of providing them with a continuous supply of quality drinking water. Similar to their domestic counterparts, business customers main priorities for investment are the conservation of water supplies through pipe maintenance, reduced leakage, water metering, and promotion of water efficiency measures. If the situation ever got to the stage where standpipes were required it should only be a measure of last resort. The next stage of the research was designed to prioritise which improvements, identified in the focus groups, customers value most (a Willingness to Pay survey) and which will provide the tools for us to carry out a cost benefit exercise to help determine the appropriate level of investment for the AMP5 period. The Willingness to Pay (WtP) survey data was obtained through Choice Experiments (CE), where respondents were presented with a series of choices. The analysis of their choices revealed the relative priorities customers have placed upon different improvements, as well as their actual willingness to pay for each. The average WtP value for our residential customers, derived from the Choice Experiments, is 18 per year (once these have been adjusted for packaging effects). The reason for packaging the experiments is to avoid any overstatement in the WtP valuations that might be obtained from the individual choice experiments. For studies of this nature it is also standard practice to use contingent valuation (CV) questions to help validate the overall scale of the potential WtP. The CV analysis reveals an average WtP value of 16 for our customers. The closeness of these results confirms the validity of the WtP survey results. LCS/Ofwat/PR2009 Page 6 of 25 11/08/2008

16 A1.3.3 Supply/demand issues A General In the last three years we have experienced the worst drought since the 1920 s and severe flooding. In that context, in March 2008 we submitted our Draft Water Resource Management Plan (DWRMP) to the Secretary of State for Environment. Our Draft Plan was made available for public consultation for 12 weeks from 6 May The key supply/demand balance issues arising from the DWRMP are: We have sufficient water available for use to meet average demands in a dry year; We have a deficit in water available for use, in both water resource zones, to meet demand in the critical period (peak week); We propose using a balance of supply side and demand management options to overcome this deficit; On the supply side, we will increase the capacity of our Bough Beech treatment works from 45 Ml/d to 70 Ml/d which will increase peak deployable output by 25 Ml/d, and at the same time, we will upgrade the mains network to enable us to distribute the water; On the demand side, we will maintain leakage at 24.5 Ml/d (which is below the economic level of leakage) until 2015 and then gradually reduce it to 12.5% of distribution input by 2035; We propose to install 12,500 meters per annum to achieve meter penetration of 80% by 2020, suppressing the demand line on the assumption that measured customers consume less than unmeasured customers; We will increase our water efficiency programme to make an additional saving of around 0.1 Ml/d per annum. A Bough Beech uprating The refurbishment and uprating of our Bough Beech treatment works, and the upgrading of the appropriate parts of the distribution network, is of fundamental strategic importance. We have a real resource deficit (not a theoretical problem) requiring a risk free solution, as illustrated by the need to implement a ban on the non-essential use of water in 2006 where we were one dry winter away from having to implement even more severe water restrictions and erect standpipes in the streets. Increasing the capacity of the treatment works at Bough Beech means that we are able to overcome the existing peak deficit, and should have sufficient capacity to meet peak demands until at least The Environment Agency has already granted a licence variation to allow increased abstraction from the reservoir in order to accommodate this. Uprating Bough Beech treatment works (and the appropriate parts of the distribution system) will; Allow the resource (Bough Beech reservoir) to be fully optimised; Will satisfy customers requirements regarding a reliable, secure water supply i.e. risk free water supply ; Safeguard water supply to customers for at least 20 years; Provide enhanced level of service to customers in that frequency of drought restrictions will be reduced from 1 in 20 years to 1 in 40 years; LCS/Ofwat/PR2009 Page 7 of 25 11/08/2008

17 Fully utilise the abstraction licence from the EA, which is qualified such that if we are not in a position to distribute at least 50 Ml/d by 2015 then the varied licence will be revoked; Maximise the opportunity to plan the construction work. The treatment works is 40 years old and requires a major overhaul (identified in the Common Framework analysis) which is due to be carried out between 2010/15 regardless of whether its output is increased or not; Provide enhanced protection to customers from cryptosporidium; Provide additional treatment capacity that will make more water available during peak or abnormal demand conditions; Comply with recommendations from the Pitt report to build more resilience into our network to cope with extreme weather conditions e.g. flooding. The Pitt report points out that there has been a significant reduction in spare capacity within the networks to deal with extreme situations and that this position should be rectified; and Significantly help to meet the requirement specified in the Security and Emergency Measures Directive to supply a minimum of 10litres/person/day during emergency situations. A Leakage The Company operates a well organised and efficient leakage management strategy. This strategy is of long standing and the Company s performance in this area is at the forefront of the industry. The current level of leakage is well below the calculated Economic Level of Leakage ( ELL ), and just below the target set by Ofwat. We will keep leakage at the current level during For the longer term, if the control of leakage is to be maintained, it is essential that adequate funding is provided for an on-going programme of mains replacement. Potential increases to the base programme are discussed in Parts B3 and B6. A Water efficiency As required by legislation, we will continue to promote the efficient use of water to our customers. However, it is now widely accepted that little can be done that is cost effective to reduce customer demand until the majority of customers are on metered supplies and tariff structures can be introduced which encourage the use of less water. We plan to continue this level of activity as part of our base service level. In addition, we plan to increase our water efficiency work as a result of the WtP study. A Sustainability We understand from the Environment Agency that we will not be required to make any sustainability reductions in the AMP5 period arising out of the Water Framework Directive or Habitats Directive. We have been asked by the Agency to carry out three investigations in the AMP5 period as part of the National Environmental Programme (NEP). A Metering The current position in relation to metering is that 86% of our 15,500 commercial and industrial (non-household) customers are metered. The remaining 14% (around 2,000 premises), are very low volume consumers, and are charged on an assessed basis. LCS/Ofwat/PR2009 Page 8 of 25 11/08/2008

18 Of our 250,500 domestic customers, 65,300 (26%) are metered. We expect around 30% to be metered by March Our customers are convinced that the only equitable way to pay for water is by meter and that the level of metering should be increased substantially. We agree, and consider that metering offers a real opportunity to manage demand. In its consultation document on water stress, the Environment Agency has classified the Company as being in an area of serious water stress. The effect of this is that, in drawing up and consulting on our draft Water Resource Management Plans, we have formulated and included an assessment of the costs and benefits of compulsory metering alongside the costs and benefits of other water supply and demand measures. We have completed this task as part of our Cost Benefit Analysis work (See Part C8) and metering has proved to be cost beneficial. We believe that we should be aiming for a meter penetration level of at least 70% by 2020 when supply side options will be limited. To achieve this we propose to install 12,500 meters per annum from 2010 by a combination of metering on change of occupancy, providing free meters to optants, and compulsory metering. We are funded to install 9,500 meters in the last year of the current quinquennium (2009/10). We consider 12,500 meters per annum to be an achievable step up from that level. The proposal to move towards charging on a metered basis is strongly supported by customers and the Environment Agency. We are aware that it will be necessary to put in place measures that safeguard vulnerable customers. We propose to investigate the impact of new tariffs by carrying out a pilot study using various tariffs in our smallest charging zone - Northern 2 (Croydon). This zone currently has 23,000 domestic customers of which 4,500 are metered. We propose to meter the remainder of these between 2010 and We will then have a discrete charging area where we can begin to trial various metered tariffs in the period, to understand if these have any impact on consumption behaviour. The Northern 2 trial will form part of our overall meter programme. In the Plan period we anticipate metering 12,500 properties a year so that by 2020 we expect to have 80% of our domestic properties metered. A1.3.4 Quality issues A Lead and discolouration Compliance with the water quality standard for the amount of lead in water remains a major issue for the water industry. During the current period the Drinking Water Inspectorate ( DWI ) has focussed on ensuring that companies optimise the process of dosing water with orthophosphate to control plumbosolvency. The orthophosphate reacts with the internal surface of lead pipes and creates a barrier which prevents lead being leached into the drinking water. The results of our work indicate that we are relatively well placed in that we are seeing very few failures of the lead standard. This is almost certainly because we have been dosing with orthophosphate at a number of our water treatment works for many years and the nature of our water is such that it does not dissolve lead as rapidly as some softer waters. LCS/Ofwat/PR2009 Page 9 of 25 11/08/2008

19 We are not planning a large lead replacement programme. We propose to continue the opportunistic replacement of lead communication pipes as part of our infrastructure renewals (capital maintenance) programme, and the optimised dosing of orthophosphoric acid which controls plumbosolvency (base Opex). As part of the quality programme, we will continue replacing lead communication pipes when a failure occurs. Based on the results of our lead related sampling programmes, our Plan anticipates a very small number of lead communication pipe replacements during , even following the change in the lead standard in This is in the context of a total of approximately 110,000 lead communication pipes in our area, and assumes there is no request from the DWI or customers for wholesale lead pipe replacement. We have decided to enhance our protection of vulnerable customers (schoolchildren) and propose to implement a programme of replacing lead pipes supplying schools at a cost of 0.7m. We also propose to continue our mains renovation programme to control discolouration (iron) in the distribution system at current levels (infrastructure renewals). We do not therefore anticipate any additional expenditure in these areas, however, our customers have indicated in the WtP studies that they are prepared to fund some additional work to reduce discolouration events and interruptions to supply. (See Part B6). A Pesticides There is one potential quality issue that we have factored into our Plan. In February 2008 we detected the pesticide, Metaldahyde in the treated water from Bough Beech. The levels detected have exceeded the PCV (but remain well below any levels that would endanger health) for pesticides. Metaldahyde has also recently been found by other water companies in the UK and is proving very difficult to remove using conventional established pesticide treatment processes. Metaldahyde contamination is being discussed at a national level with the involvement of the DWI. In addition, WRc has commenced a project to review potential treatment processes. Our view is that the most cost effective way of dealing with this pesticide is to reduce the amounts entering water sources by working with the manufacturers, and the businesses (predominantly the farming community) that use the product, rather than installing additional treatment processes. We have exceeded the PCV and we have notified the DWI. They have informed us that they consider the exceedence to be an incident. We expect that the DWI will give us an authorised departure from the quality standard on the understanding that we will monitor the levels, investigate potential treatment processes and research the catchment area to try to deter (or reduce) Metaldahyde use. We have incorporated the costs of those activities in Quality Enhancement operating expenditure. It is possible that by the time the Final Business Plan is submitted we may have some answers to these issues and we may include revised proposals in that Plan. LCS/Ofwat/PR2009 Page 10 of 25 11/08/2008

20 A Security, flooding and other emergencies Our Plan includes an allowance for complying with the increasing requirements of the revised Security and Emergency Measures Directive (SEMD), reflecting the latest guidance from Government and the security services. In the event of an emergency, the Company, along with most other water utilities, has relied on mutual aid from other companies to provide for serious emergencies, as was demonstrated in the recent flooding around Tewkesbury where we loaned our equipment to Severn Trent. Principal guidance from the Secretary of State advises that the Government expects companies to ensure that they have sufficient equipment and resources of their own to deal with such emergencies and not to over rely on the arrangements the industry has in place for borrowing equipment from other water companies in times of emergency. Despite additional guidance from Ofwat, it remains unclear exactly what the Government expects companies to be able to deliver. The difference in cost between being able to deliver a reasonable practicable response in an emergency and being able to deliver the requirements of the Direction to the letter is very large. Our Plan provides for a reasonable practicable response. We are continuing to seek clearer guidance. Our Plan has been based on Pitt s initial suggestion that we should provide for a 1 in 75 year storm event. We understand the final report recommends planning for at least a 1 in 200 storm event. We will review this, and, if appropriate, include any additional costs in the FBP. A1.3.5 Enhancements We are proposing only two modest enhancements in our Plan both of which are supported by customers in the Willingness to Pay study. The first is to increase the amount of water efficiency work we carry out in schools which ties in well with our proposed lead programme. The second is to increase our infrastructure programme to reduce discolouration and supply interruptions. A1.3.6 Protection of the environment Generally, in all of its activities, the Company attempts to adopt the most environmentally friendly solutions. Sometimes this means selecting a project solution that isn t necessarily the cheapest option. For example, when a booster pumping station was built at Buckland (part of the scheme that allows transfer of water from the East Surrey water resource zone to the Sutton water resource zone), the design required the majority of the structure to be built below ground to minimise impact on the environment. We also try to ensure that new and replacement plant is energy efficient in order to minimise the power we use. This has a two fold benefit, as it minimises our operating expenditure while reducing our carbon footprint. Our customer research indicates that our customers have an interest in sustainability and the environment, but it is not one of their top priorities. Nevertheless, customers expect the Company to act sustainably and in an environmentally responsible way, and they are therefore important issues that we need to address. We already carry LCS/Ofwat/PR2009 Page 11 of 25 11/08/2008

21 out Environmental Impact Assessments on a number of our major projects, and look for ways to carry out our works more sustainably (for example, the use of recycled material for trench backfill). We will endeavour to meet our customers expectations in these areas especially where solutions can be found at little or no extra cost. The industry has agreed that by 2020, that 20% of its power requirement will be derived from renewable sources. We have accepted this target and will endeavour to achieve it. However, we have been advised by our consultants, Entec, that the prospects of generating our own power are very limited because of the proximity of airports, microwave and radar pathways, and conurbations. We will have therefore planned to obtain 10% of our energy from green sources by 2015, although it should be noted that this will be at additional cost. A1.4 Resources required A1.4.1 General As stated at the beginning of Part A1, our Plan can be summarised as Business as usual, plus improved security of supply, all at fair prices. The Company does not envisage having to increase its human resources significantly to be able to meet the challenges of the next five years, despite the proposed increase in its programme of capital expenditure. Development of the proposed Bough Beech project is well advanced and it will be possible to manage this project using the methodologies successfully employed by the Company over the last twenty years. The Company s approach to capital procurement endeavours to give the Contractors bidding and working for it, the flexibility to be innovative and to find efficiency savings in their designs and approaches. The proposed increase in the metering programme has also been looked at, and does not present the Company with any resource issues other than finding Contractors with sufficient skilled labour to install the meters, and the challenge presented to manufacturers of meters to be able to keep up with the level of metering proposed in the south east of England. From an Opex perspective, it will be necessary to employ more meter readers and billing staff. The Company does not see this as a stumbling block. The Company will, as always seek ways of carrying out its capital programme as efficiently as possible, but generally in the past, where capital efficiencies have been made, these have been reinvested in the capital programme as part of the Company s deal with customers to spend what it has been allowed. There is limited scope for reducing operating costs, but the increased metering programme may make the introduction of remote read meters more attractive. The Company is currently trialling some sophisticated meters, but as yet the costs are prohibitive. The use of telemetry and SCADA is already well developed and while there are always improvements to be made, there is little opportunity for reducing operations staff as we already run a very tight ship. LCS/Ofwat/PR2009 Page 12 of 25 11/08/2008

22 The one significant resource issue for the Company going forward is the difficulty of financing the capital programme. This is discussed in paragraph Error! Reference source not found. below. The remainder of this section looks at the proposed capital and operating costs required, and reviews efficiencies, financing, and some of the uncertainties the Company foresees. A1.4.2 Total capital expenditure Adequate capital expenditure is crucial to the achievement of our strategic objectives. The following table summarises the capital expenditure requirement for , and compares it to capital expenditure in the current period. The renewal and maintenance of existing infrastructure assets The renewal and maintenance of existing non-infrastructure assets New investment in relation to new or enhanced supplies to satisfy the increasing demand for water New investment to meet water quality standards and to meet environmental and security guidelines New investment to meet customers demand for enhanced service Draft Business Plan m* Current Period m* Total * Before efficiency adjustments A1.4.3 The renewal and maintenance of existing assets A General Over 55% of the capital expenditure programme for relates to the maintenance of existing assets. The condition of these assets is critical to achieving a reliable supply of good quality water to our customers. A Infrastructure assets 33.0m, ( = 31.3m) Our objective is to maintain these assets in a condition that delivers stable levels of serviceability to customers. The maintenance of a mains network is necessary for two reasons. Firstly, mains in poor structural condition are more susceptible to bursts and interruption of supplies to customers, and water being lost from the network. Secondly, mains in poor internal condition lead to discolouration and failures of water quality standards. If a main is in LCS/Ofwat/PR2009 Page 13 of 25 11/08/2008

23 poor structural condition it has to be replaced. Where the problem arises from the internal condition of a main, it can be relined provided it is structurally sound. Where there is internal corrosion, our experience is that about 65% of the mains are suitable for relining. During the current five-year period we expect to replace a total of km of mains. This represents a replacement rate of approximately 1.0% pa. During we are proposing to replace a total of km of mains. This represents a replacement rate of 0.8% pa. In addition, we also expect to reline a further 64 km of mains (0.4% pa) during the current five-year period. During we are proposing to reline 43.2 km (0.3% pa). The Company has improved and enhanced its approach from that used in PR2004 when it utilised a methodology that was fully compliant with the Capital Maintenance Common Framework. We have retained specialist consultant, Tynemarch, to carry out the modelling work and believe that the outputs the model has generated are robust and consistent with the Company s strategy. As set out in our Asset Management Strategy document (included as Supporting Information B3-1), the Company applies best practice in the management of its assets. The aim is to keep the performance of the mains network, in terms of both asset performance (burst mains) and service performance (properties suffering supply interruptions as a result of burst mains) at the current level (ie maintain a Stable level of serviceability to customers). This approach also takes into consideration variables such as climate change. Section B3.5.2 provides a full explanation of this predictive model and how it has been used. Regarding mains rehabilitation, in order to ensure that internal corrosion does not result in failure of the water quality standard for iron, we have used the same methodology discussed above and discolouration contact data to determine the mains renovation programme. Section B3.5.2 provides a full explanation of how this programme has been developed. Our analysis incorporates an assessment of the impact of traffic disruption, climate change and carbon emissions upon this programme. The result of this analysis is that these factors add 8km which is included within the programme discussed above. Our methodology has also identified 5.7m of mains to be replaced as part of the Bough Beech project, which are included within the programme discussed above. The programme is cost beneficial. We are proposing to extend the base capital maintenance programme discussed above by carrying out additional mains replacement/rehabilitation for interruptions and discolouration. This arises as a result of our WtP study and is discussed in Section A1.4.5 below. The additional costs of this work are included within Enhancement. A Non-infrastructure assets 44.0m, ( = 42.9m) LCS/Ofwat/PR2009 Page 14 of 25 11/08/2008

24 Our objective is maintain these assets in a condition so that the level of serviceability to customers remains stable. For PR2004, the Company supported its non-infrastructure maintenance submission with work carried out for it by specialist consultant, Tynemarch using a methodology consistent with the Capital Maintenance Planning Common Framework. For PR2009, we have built on that work, retaining Tynemarch to carry out the modelling and believe that the outputs the model has generated are robust and consistent with the Company s strategy. As set out in our Asset Management Strategy document (included as Supporting Information B3-1), the Company applies best practice in the management of its assets. As part of this process we have established and implemented an above ground maintenance planning and activity/cost recording system (Agility). This system has been used for some months but not long enough to provide all the data required. Consequently we have had to supplement this data with the extensive experience of our engineering team who know our assets very well. To check and modify our assessments we appointed engineering consultants, Atkins, to carry out a comprehensive asset inventory and condition survey of all our above ground assets. The resulting programme has been costed at 44.0m. This amount includes 8.3m capital maintenance expenditure at Bough Beech as part of the project discussed above. Some of this project is allocated to base expenditure because we are taking the opportunity to replace some parts of the works that are not output related and which should be replaced according to our capital maintenance methodology. The allocation of cost between maintenance non-infrastructure and supply/demand balance has been carried out in accordance with RAG2 cost allocation guidelines. The above amount is around the average historic spend on capital maintenance and is consistent with long-term current cost depreciation ( CCD ). The programme is cost beneficial. A1.4.4 Additional expenditure to meet the increasing demand for water 55.4 ( = 21.3m) The steadily increasing number of households in our area and the growth in water using devices associated with rising affluence and changes in lifestyles means that the demand for water continues to increase. Our mid-range estimate of the underlying increase in annual demand for water for the next 12 years is 0.2% pa. This rate of growth is partly offset by assumed reductions in consumption as a consequence of metering previously unmeasured properties, and as a result of new homes being built to improved environmental standards. As explained in 0 (Supply/Demand issues), we have sufficient resources to meet average demands in a dry year up to However, we have a deficit in resources to meet dry year peak demands in both our water resource zones. This deficit can be addressed in a number of ways: by developing new resources, by increasing the output of existing sources, by reducing leakage from the mains network, increasing meter penetration, and by reducing customer s consumption by the introduction of LCS/Ofwat/PR2009 Page 15 of 25 11/08/2008

25 demand management measures. It is incumbent upon the Company to use the most cost effective of these measures to balance supply with demand. All these issues are fully explored in our Draft Water Resources Management Plan. The Plan identifies that the most cost beneficial approach to this problem is to uprate the capacity of our Bough Beech treatment works to 70Ml/d so that we can make more effective use of the reservoir capacity. The merits of this scheme have been discussed above in Section A The Environment Agency accepts this approach and has granted the licence variation required. However, we have to make use of this licence by Part of the expenditure in this area is to fund an enhanced metering programme. We propose to increase the programme from an average of 6,000pa in the current period to 12,500pa in the AMP5 period. This will comprise a combination of optants, metering on change of occupancy and compulsory metering. Customers support metering as the most appropriate way to charge customers and it forms an important part of our demand management programme, helping to suppress demand. Additionally, it will give us the opportunity to trial and develop different tariff structures. A1.4.5 Additional expenditure to improve (enhance) levels of service 1.68m ( = nil) Our extensive market research and WtP study have revealed customers are prepared to pay for higher levels of service in some areas. However, only some of these pass the Cost Benefit Analysis test and others will be delivered as a by-product of other investments. In our Plan we have explicitly included improvements for lower levels of discolouration and fewer supply interruptions at a cost of 1.68m. Improvements that customers asked for in service levels for reliability of supply and metering will be delivered as a consequence of expenditure required to maintain the supply/demand balance. Improvements in water efficiency asked for by customers have been included as Opex. Customers asked for improvements in leakage levels but unfortunately these were not found to be cost beneficial and have not been included in our Plan. A1.4.6 New expenditure to meet water quality requirements 4.1m ( = 0.9m ) A Lead As discussed above (Section A ), we are not planning a large lead replacement programme. We propose to continue the opportunistic replacement of lead communication pipes as part of our infrastructure renewals (capital maintenance) programme, and the optimised dosing of orthophosphoric acid which controls plumbosolvency (base Opex). There has been no clear indication from the DWI as to whether there will be a change in their guidance for lead pipe replacement once the new lead standard of 10μg/l comes into effect in We have assumed from our discussions with the DWI that LCS/Ofwat/PR2009 Page 16 of 25 11/08/2008

26 there will be no significant impact on our proposed programme. We have also assumed that there will not be any significant increase in requests from customers, or local authorities, for replacement of lead communication pipes (we would normally replace a lead communication pipe when a customer replaced their own supply pipe). However, given the large number of pipes that could be involved, the cost of a lead pipe replacement programme is potentially very high. Given this uncertainty, our Plan assumes that expenditure on resolving issues related to lead will be a Notified Item. This would mean that our price limits could be varied up or down depending on how our planned level of replacement compared with the actual number of lead pipe replacements required to comply with the DWI s guidelines. A Discolouration Our current programme to control discolouration (iron) in the mains system is expected to continue at current levels. Therefore, we do not anticipate any additional expenditure in this area. However, our customers have indicated in the WtP studies that they are prepared to fund some work to reduce discolouration events (See Part B6). A Pesticides As discussed above (Section A ), our Plan includes in Opex the cost of carrying out research into Metaldahyde failures experienced at Bough Beech. We expect that the DWI will give us an authorised departure from the quality standard on the understanding that we will monitor the levels, research potential treatment processes and research the catchment area to try to deter (or reduce) the use of Metaldahyde. It is possible that by the time the Final Business Plan is submitted we may have some answers to these issues and will be able to include revised proposals in that Plan. A Security and Flooding Our Plan includes approximately 2.0m of expenditure which we are required to make to meet the revised Security Emergency Measures Directive (SEMD) and a further 1.4m that we estimate will be required to meet the interim protection requirements identified in the Pitt Review into flooding and specified in Ofwat s guidance for assessing the cost of providing flood resilience. As outlined above (Section A ), our Plan has been based on Pitt s initial suggestion that we should provide for a 1 in 75 year storm event. We understand the final report recommends planning for at least a 1 in 200 storm event. This will be reviewed for the FBP. In the absence of clear guidance, and the possibility of future developments, any additional costs of compliance with security, SEMD or flood protection should be treated as Notified Items. A1.4.7 New expenditure to meet new environmental standards 1.5m ( = nil) The Environment Agency s ( EA s ) environmental programme covers three main areas; sustainability reductions, waste discharges to rivers and the sea, and improved flood protection. The Company has not been asked to make any sustainability reductions, and in general does not deal with waste treatment or flood protections, LCS/Ofwat/PR2009 Page 17 of 25 11/08/2008

27 which are the remit of the water and sewerage companies. However, the EA has informed us that as part of the National Environment Programme we are to investigate three issues, the main one being the water table at Reigate Heath. The cost of completing these studies is included in Opex. A1.4.8 Operating costs A Base costs During the current period, operating costs have continued to rise above the rate of inflation. This is particularly true of power costs which have risen very significantly, and employment costs which have followed the long-term national trend of increasing faster than the RPI. A Power costs It has become increasingly apparent for the past three years that the operating costs of the Company are rising at a rate not allowed for in the last price determination. The effect is that the current allowance for costs will be well below the actual costs in The most important area of cost overrun is power. We have a high pumping head and consequently power costs are a high (14%) proportion of our operating costs. The Table below shows how our power costs have been substantially more than Ofwat allowed in the 2004 price determination. In total, power costs have exceeded the determination by 2.55m in the last four years. PR04 determination after efficiency Outturn prices m Actual/Forecast costs Outturn prices m Excess of actual to determination 2005/ / / /09 Budget We firmly believe that there has been a permanent shift in energy costs that will last throughout the next price review period. This view is supported in the recent research paper written by Bergen Energi. They expect baseload power costs to continue at high levels for some time. The price we pay for base load electricity within our existing contract which runs to March 2009 is 48/MWh. Currently, the price for power for 2010 is 80/MWh.. Cost increases of that amount will increase our annual power bill to approximately 6.0m. Given the large increase in costs, the Company was advised to contract immediately, for the year to March Tenders for this period were recently completed and contracts were accepted at 79/MWh. This is within the range, although at the top end, identified in the Bergen report. As a result, of the uncertainty we have included power costs at the top of the range of Bergen predictions on the assumption that it will not be a Notified Item. If power becomes a notified item, we will % LCS/Ofwat/PR2009 Page 18 of 25 11/08/2008

28 review this item very carefully for the FBP. Chemical costs are closely related to power costs. Therefore, we have forecast these to increase in line with the Bergen predictions. During this year we have suffered an 85% increase in Phosphoric acid costs which we have also factored into our forecasts. In addition, during we have been refurbishing our Cheam works which has resulted in our ability to soften the water being temporarily reduced. Full softening resumed in and our forecast costs also reflect that event. A Bad debt The costs of bad debt and debt collection (including Council Commission) costs can only continue to increase in the current financial climate and until there is a change in the legislation. We will concentrate our resources on debt collection and management and have increased our headcount accordingly. However, we do expect an increase in our bad debts charge. A Rates The Valuation Office is currently reviewing water industry rating values. We have been advised that our Business Rates will increase in 2010 by around 300k pa. The specific increase should be known by the time the FBP is prepared and we will incorporate those numbers in that Plan. A Other There are a number of other costs from legislation and similar items that will come into effect in this period. These include the impact of the Traffic Management Act (more rigorous Fixed Penalty Notices, increased inspection charges and the introduction of permit schemes) and the proposed separate accounting for the supply chain costs as a result of Ofwat s competition agenda. Wage and salary costs will continue to rise ahead of RPI, particularly in the South East where employment remains buoyant despite the potential recession, and the cost of living is high. The Company believes that the introduction of competition will not benefit all its customers and in particular, it is likely that in the early stages of a market being created large industrial and commercial users may benefit at the expense of domestic customers. We believe that the current system of regulation, comparative competition and capital market competition has delivered significant improvements for customers and society. The case for greater competition should include a realistic assessment of the costs of introducing competition and a recognition that the benefits that competition could bring can also be achieved (at less cost and much less risk) through development of the existing regulatory regime. A Pensions We currently contribute 30% to our closed defined benefit scheme (WCPS) and 10% to our defined contribution scheme. We are awaiting the latest triennial Actuarial Valuation for WCPS at March 2008, so we cannot be definitive at this stage as to what contributions will be required. However, indications are that contributions will remain at current levels. We have no plans to increase contributions to the defined contribution scheme. With the current turmoil in the equity markets and increasing LCS/Ofwat/PR2009 Page 19 of 25 11/08/2008

29 longevity we are uncertain as to the contribution rates the Trustees of WCPS will require but they will be incorporated in the FBP. A Summary It will be clear that the cost increases explained above are very largely beyond the control of the Company. Some like, electricity and chemicals, are due to market price increases, and in these areas our tendering and risk management processes are fully developed to obtain best value. Other areas, like rates and TMA charges, are costs simply determined by Government or statutory bodies. The following table (in prices) summarises the increases in current base operating costs. It also gives an indication of the impact on prices of these cost increases. It is also clear from the table that costs other than those specifically identified are expected to stay more or less in line with inflation during k* 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 Power 3,410 3,752 5,732 6,336 6,563 6,850 7,155 7,645 Chemicals/softening 1,086 1,506 1,629 1,667 1,681,1,699 1,717 1,747 Bad debts and collection costs 1,489 1,472 1,608 1,684 1,760 1,813 1,889 1,940 Rates 2,022 2,032 2,032 2,323 2,323 2,323 2,323 2,323 Traffic Management Competition Regulation Wage costs 7,720 7,751 7,784 7,817 7,849 7,882 7,916 7,949 Bough Beech extensions Other 8,052 8,130 8,124 8,033 8,094 8,116 8,138 8,161 Total base costs 24,368 25,164 27,430 28,521 28,931 29,733 30,219 30,646 % increase on 2007/08 base costs * before efficiency The above increases in costs translate into price increases of approximately 12.0% over the five-year period of which around 8.0% occurs in principally as a result of power and chemical costs. It is proposed that the costs relating to rates, electricity/chemicals, pensions, TMA and bad debts should be Notified Items at this price review. There have been material changes in these costs during the current period and, in respect of electricity further material increases are already known. LCS/Ofwat/PR2009 Page 20 of 25 11/08/2008

30 A New costs In addition to existing base costs, new and additional costs will arise during These costs are due either to new water quality/security standards and guidelines, or are associated with the rising demand for water and the increase in the number of metered customers. The new water quality costs either arise from the introduction of new investigations or monitoring of water quality. Enhanced service costs arise from the WtP studies indicating customers are willing to fund additional water efficiency work. We are also obliged by the Environment Agency to conduct investigations in endangered habitats. The additional costs relating to the supply of water either arise from the additional demand for water or the management of an increasing number of water meters. The following table (in prices) summarises these costs: k 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 Water Quality Enhanced service water efficiency Enhanced service habitat investigations Supply/demand general Supply/demand - additional meters Total new costs ,164 1,286 1,366 The above cost increases translate into price increases of approximately 2.5% over the five-year period A1.4.9 Efficiency We believe that the vast majority of the efficiencies in the industry have been made since privatisation. We recognise, though, that there is an ongoing process of efficiency improvement throughout the economy. Although an element of this ongoing improvement will be captured within the RPI, we believe that it is appropriate to include for efficiency improvements in the Company s business Plan. For the DBP, we asked Frontier Economics to review the latest research in this area, analyse recent data, and suggest realistic levels of efficiency improvements that the Company could achieve. Based on Frontier Economics report, the following efficiency assumptions were included in the Draft Business Plan. An improvement of 0.1% per annum, applied to all categories of expenditure (frontier shift), is appropriate. The operating catch-up factor is 0.3%. The catch-up factor for SESW for capital maintenance and capital enhancement should be 0.3%. LCS/Ofwat/PR2009 Page 21 of 25 11/08/2008

31 Frontier Economics report Scope for efficiency improvements: 2010 to 2015 is included as Supporting Information B2-1. A Financing The financability of investment post 2010 is a major issue. At privatisation the plans were for a period of heavy new investment and for the industry to be cash generative by now. This is not the case. Significant investment appears likely to be required for the foreseeable future. A further complication is the fact that the water and sewerage sector represents a very small part of the investment market, and as such does not automatically attract investment by the providers of finance. Therefore, if the industry is to be able to raise the necessary finance for new investment, it is essential that the return to both the providers of debt and equity finance is at the correct level, and that the associated financial ratio requirements are met. At the Company level, debt is expected to reach the maximum permitted by its bond covenants by At that stage the Company will have to raise new equity before any further debt is available. To be able to raise new equity, the Company requires a price determination that will enable payment of the appropriate level of dividends on existing and new investment. The appropriate level of dividend is the dividend implicit in the Company s level of gearing and its cost of capital (ie cost of capital x RAV less debt servicing costs) less cash interest. A The cost of capital The ability of a water company to deliver its strategic objectives principally depends on it being properly funded. A failure to properly fund any aspect of the Company s business, ie its operating costs, capital expenditure or finance costs, will result in a reduction of investment on the maintenance of assets, and eventually to asset and service failure. The cost of capital determined at the last price review was appropriate to the industry at that time. Since then and until last Autumn, there has been a benign economic environment with low inflation, high growth rates and the emergence of various large infrastructure funds seeking long-term, modest, but inflation proofed returns. This has lead to water companies being sold at prices above their RCV s. Since last Autumn economic growth has slowed dramatically, credit and capital markets have become very unstable and commodity prices have increased dramatically. This Plan demands a large financing requirement to be completed. Therefore we need to attract capital (both debt and equity) and we need a sensible and realistic cost of capital to do that. In these uncertain times in the capital markets now is not the time to be too aggressive on the cost of capital. The market evidence from the current period is that the cost of capital (post-tax) determined for the Company is 6.0%. LCS/Ofwat/PR2009 Page 22 of 25 11/08/2008

32 Frontier Economics report The cost of capital for is included as Supporting Information B3-4. A Changes to accounting standards and the tax treatment of expenditure International Accounting Standards will be adopted in the UK sometime during the period. The first change is that the amount spent each year replacing water mains will have to be capitalised and depreciated over the estimated life of the mains. From the tax point of view it means this expenditure will attract capital allowances (ie a deduction in the tax computation) of 10%. The current accounting treatment is to capitalise the expenditure. However, as the result of a concession to the water industry in the current UK accounting standards, the depreciation charge is in line with the infrastructure renewals charge. The effect is that 100% of expenditure is allowed as a deduction in the tax computation. We have prepared our Plan on the existing basis of taxation, ie there is no impact on charges, assuming that changes in taxation are a Notified Item. A Notified items The Notified Item mechanism is intended to deal with situations where the uncertainty about future events or costs is such that there is a likelihood of significant differences between the costs, or income, allowed in a price determination and the actual out-turn costs incurred by a company, or the income it receives. Once the accumulated value of these differences exceeds a specified value, prices are re-determined by an Interim Determination of K ( an IDOK ). The IDOK process is restricted to those items specified in the price determination as Notified Items. For various reasons that have been explained in the relevant sections above, there are currently a significant number of uncertainties that could affect our Plan. Further, it appears unlikely that the majority of these uncertainties will be clarified by the time of the final price determination. It is our view that it is fair and transparent, and therefore in the best interests of customers, that material uncertain items should be treated as Notified Items. Our current view is that the following should be treated as Notified Items. It is also our view that the uncertainties surrounding these items, except possibly non-domestic rates, are unlikely to be resolved in time for the price determination. Power and chemical costs - A1.4.9 Pension costs - A1.4.9 Increasing bad debt and the costs of collection - A1.4.9 The Traffic Management Act (inc Section 74, permits, and increased inspection fees) - A1.3.2 Changes in Accounting Standards - A Meter optants (numbers and volumes) - A1.3.5 The replacement of lead pipes and orthophosphate dosing - A1.4.6 LCS/Ofwat/PR2009 Page 23 of 25 11/08/2008

33 The costs of compliance with Security and Emergency Measures Direction and any security or flood prevention measures required- A1.4.8 Treatment of Metaldehyde A The lead programme. Changes in costs that arise as a result of new legislation, etc constitute Relevant Changes in Circumstance ( RCCs ) under companies licences, and flow automatically into the IDOK process. A1.5 Prices The impact on prices in the five-year period is summarised below. 50% of the total price increase of 25% is required in first year, , of the next five-year period. It is followed by a table which gives a breakdown of annual increases for the five-year period Base service and increased metering 10.7% Enhanced service levels 1.0% Security of supply (including Bough Beech) 3.4% Increases in the costs of power and chemicals 9.2% The maintenance of adequate financial ratios and returns 0.7% Total 25.0% Although the estimates are based on the best information currently available, there is considerable uncertainty about what the actual outturn costs will be. It is also the case that the differences between the current best estimates and outturn costs could be material. In order to deal with this uncertainty, and the amounts potentially involved, the Company proposes that these items should be included in the list of Notified Items. Details of the Notified Item mechanism is given in A1.3.3, and the items it should cover for the five-year period are listed in A The following table gives a more detailed analysis of reasons for the price rise that is required during the five-year period The up-front timing of the increases is driven by when cost increases arise (ie the majority arise in 2010/11) and the need to maintain adequate financial ratios. LCS/Ofwat/PR2009 Page 24 of 25 11/08/2008

34 10/11 11/12 12/13 13/14 14/15 Total Base service and increased metering Enhanced service levels Security of supply (incl Bough Beech) Increases in the costs of power and chemicals The maintenance of adequate financial ratios and returns Total LCS/Ofwat/PR2009 Page 25 of 25 11/08/2008

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