Strategic Review of Charges 2010-14: Methodology Response to ...

Volume 4: Approach to capital expenditureBackgroundContextEvery four years, we set limits on the prices that Scottish Water can charge customers forwater and sewerage services. The next price review covers the period 1 April 2010 to31 March 2014.We issued a consultation in four volumes over the period May to July 2007. The consultationdocuments explained our proposed methodology for carrying out the price review. Volume 4of our methodology consultation sought stakeholders’ views on our approach to assessingthe level of capital expenditure to allow for at the price review.This document summarises the responses we received to Volume 4 and our response.All of the responses are available in full on our website at www.watercommission.co.uk.BACKGROUNDAssociated documents• ‘Our approach to the 2010-14 price review: A consultation’, Water Industry Commissionfor Scotland, December 2006.• ‘The Strategic Review of Charges 2006-10: The final determination’, Water IndustryCommission for Scotland, November 2005.• ‘Strategic Review of Charges 2010-14: Methodology. Volume 4: Approach to capitalexpenditure’, Water Industry Commission for Scotland, July 2007.• Information papers 17 to 25, Water Industry Commission for Scotland, July 2007.Water Industry Commission for Scotland1

Volume 4: Approach to capital expenditureRESPONSES AND APPROACHWhat respondents saidRespondents generally welcomed our proposals to assess the extent of investment that canbe delivered efficiently within a single regulatory control period. A number of respondentscommented that the factors we proposed to consider were appropriate. Some made morespecific comments.Representatives of the civil engineering industry suggested that the industry was wellcapable of delivering Scottish Water’s current investment run rate of £500-600 million a year.They stated that the industry delivers outputs more efficiently when there is an even spreadof activities on project preparation, design and construction across the full regulatory controlperiod.One respondent suggested that the future investment programme should not be undulylimited by fears about the capacity of the Scottish civil engineering industry. They suggestedthat the capacity of the UK-wide construction industry should be considered.Respondents also generally welcomed our intention to explore with stakeholders how a morestrategic, long-term approach to investment planning could be taken. One respondentsuggested that a view of investment of up to 25 years would considerably help the process ofagreeing investment priorities.Another respondent supported the proposal, but warned against encouraging Scottish Waterto focus on larger projects at the expense of delaying smaller projects.Our approachWe have commissioned independent research into the size of investment programme thatcan be delivered efficiently. This research will consider the factors we outlined in our originalconsultation. We agree that an assessment of the size of the investment programme that canbe delivered efficiently should take account of broader UK trends. This analysis is publishedwith this response to our consultation.We welcome support for our taking a longer term view of Scottish Water’s investmentrequirements where possible. We will look to work with Scottish Water and otherstakeholders to explore the scope for greater long-term planning and identify projects suchas the Glasgow Strategic Drainage Plan where longer term planning of the requiredresources may prove to be in the interests of customers. However, we will be cautious aboutcommitting customer resources to projects across regulatory control periods where there issignificant uncertainty as to the required outcome and proposed solution. We note that suchuncertainty tends to increase with the length of investment planning horizons.4Water Industry Commission for Scotland

Volume 4: Approach to capital expenditureDefining and reviewing the scope of the investmentprogrammeConsultation proposalsIn September 2008, the Scottish Government will set out the investment outcomes it expectsScottish Water to deliver over the regulatory control period. In our consultation we explainedthat we will ask Scottish Water to define a baseline for its capital programme that is fullyconsistent with the Scottish Government’s objectives. This baseline will be an agreed anddetailed list of outputs that Scottish Water will deliver. It is a key part of the regulatorycontract between Scottish Water and its customers. Scottish Water will set out this baselinein its draft business plans.We explained that we will issue guidance to Scottish Water on its draft business plans on20 December 2007. This information requirement for the investment programme is a centralpart of our guidance. We proposed that the baseline investment programme should be clear,comprehensive and accessible. This will allow stakeholders to monitor Scottish Water’sprogress in delivering the investment programme. It will also ensure that stakeholders’expectations are met.If Scottish Water expects an overhang from the investment financed under the current(2006-10) price review, it should provide similar information on the outputs that would bedelivered after March 2010.We noted the importance of the proposed investment being appropriate to deliver theScottish Government’s objectives. We commented that it is critical that Scottish Water agreesthe outputs of its enhancement investment programme with SEPA and the DWQR. Bothregulators should agree that the outputs proposed by Scottish Water will achieve theoutcomes required by the Scottish Government.We proposed to ask the Reporter to carry out a detailed review of the information submittedby Scottish Water, with particular emphasis on an audit and challenge of:RESPONSES AND APPROACH• the scope of requirements;• the technical solutions proposed; and• the basis of cost estimates and their consistency with Scottish Water’s cost base.The output of our review should be a properly costed, fully defined list of the outputs ofcapital investment projects, which , if delivered in full, will meet the objectives set out by theScottish Government for the regulatory control period.Water Industry Commission for Scotland5

Volume 4: Approach to capital expenditureRESPONSES AND APPROACHQuestion for consultationDo respondents have views on how we propose to define the scope of the investmentprogramme required to deliver ministerial objectives for the water industry?What respondents saidRespondents generally supported our proposed approach. One respondent suggested that ourapproach could be enhanced by requiring Scottish Water to prioritise projects, particularlywith regard to national regeneration projects. Another respondent suggested that localauthorities should play a greater role in the planning stages of the investment programme.One respondent expressed concern that issues regarding sustainable development were notspecifically mentioned in our proposal.Another respondent supported our proposal to carry out an independent review provided itis carried out transparently, and provides an opportunity for Scottish Water to comment.The same respondent, whilst recognising the necessity to set out investment proposals indetail, suggested that Scottish Water should, during the regulatory control period, be able tovary the solutions that it planned to use to deliver outputs. Doing so would not remove theincentive for Scottish Water to seek out more efficient and innovative ways to deliver outputs.Our approachIt is for the Scottish Government to determine its objectives for the water industry. TheCommission’s duty is to allow Scottish Water sufficient resources such that it can deliverthese objectives at the lowest overall reasonable cost.We will carry out our review of Scottish Water’s investment programme as proposed. Informulating its programme, we would expect Scottish Water to have due regard to itsstatutory duty to act in the way best calculated to contribute to the achievement ofsustainable development, as well as consulting with stakeholders, such as local authorities,as appropriate.We recognise the importance of carrying out our review of Scottish Water’s investmentprogramme as transparently as possible. We plan to publish a short paper on how we willconduct the review, including the process we will follow and opportunities for Scottish Waterto comment.We note the rationale for allowing Scottish Water the flexibility to vary the solutions it uses todeliver the required outputs. However, such changes must be made in a transparent way andbe clearly linked to the outcomes required for customers. It is important that allowingScottish Water such flexibility does not compromise the delivery of the Scottish Government’sobjectives in full. We have worked with the Scottish Government-chaired Output MonitoringGroup (OMG) to devise ways in which such flexibility can be incorporated whilst maintainingScottish Water’s accountability.6Water Industry Commission for Scotland

Volume 4: Approach to capital expenditureDetermining an appropriate allowance for capitalexpenditureConsultation proposalsThe appropriate level of capital maintenanceWe explained that Ofwat employs a four-stage approach linked to the UKWIR commonframework for capital maintenance planning. Unfortunately there is currently insufficientinformation available in Scotland to implement the common framework. We proposed towork with Scottish Water to ensure that the necessary information is identified and collectedfor future use.As an alternative for this price review, we plan to improve our understanding of the requiredlevel of capital maintenance by asking Scottish Water to set out its plans in as much detail aspossible; although we recognised that some capital maintenance is reactive and undertakenin response to particular problems.We proposed to use Ofwat’s econometric modelling techniques to establish an initialestimate of the appropriate allowance for capital maintenance. This technique usesstatistical regression analysis to establish the relationship between the costs incurred bycompanies and a defined set of cost drivers.The scope for efficiencyWe explained that inefficient spending results in higher bills and/or reduced outputs.Customers have a right to expect that Scottish Water will deliver its agreed investmentprogramme as efficiently as possible. Capital efficiency can be achieved in a number of ways,including improved strategic and project planning, better procurement and the use ofinnovative techniques.We proposed to use Ofwat’s cost base technique to assess the scope for efficiency in ScottishWater’s procurement. The Ofwat cost base technique uses capital works unit costs to assessthe relative efficiency of water companies in procuring and implementing defined capitalprojects.RESPONSES AND APPROACHFor capital enhancement expenditure, we proposed to require Scottish Water to narrow 75%of any assessed gap in its efficiency.For capital maintenance expenditure, we suggested increasing the modelled estimate of theamount of capital maintenance required in order to reflect the capital efficiency gap thatexists between Scottish Water and the companies south of the border. We proposed to usethe Ofwat cost base technique to establish the size of any efficiency gap.Water Industry Commission for Scotland7

Volume 4: Approach to capital expenditureRESPONSES AND APPROACHQuestion for consultationWhat are respondents’ views on how we propose to determine an appropriate allowance forcapital expenditure?What respondents saidOne respondent suggested that we should use all available evidence in making ourassessment of an allowance for capital maintenance, including the historic data available.The same respondent agreed that Scottish Water should be required to set out its capitalmaintenance requirements in as much detail as possible. However, the respondent notedthat it would only be possible to do so for specific projects above a given threshold as muchcapital maintenance expenditure was reactionary, and difficult to plan for precisely.Two respondents cautioned against a reliance on Ofwat’s benchmarking techniques, botheconometric modelling for capital maintenance and the cost base for capital enhancement.One respondent commented that our proposed catch up target of 75% of the assessedefficiency gap should be a maximum, given their concerns about the reliability ofbenchmarking with England and Wales.Our approachWe will ask Scottish Water to provide as much detail as possible on its capital maintenanceplans, and will use the historic data available where possible. We will use this information toassess the costs of maintaining or improving levels of service – not to second guess themanagerial priorities of Scottish Water. However, we are not convinced that there issufficiently reliable information to adopt the common framework approach to forecast capitalmaintenance requirements.We recognise concerns that capital maintenance expenditure is often reactive. We willtherefore request that Scottish Water only provides information on planned capitalmaintenance projects above £1 million. Other capital maintenance requirements can beidentified at programme level.During 2008-09 we intend to initiate an academic research project into the use ofeconometric benchmarking modelling techniques in water regulation in Scotland. We willinvite Scottish Water to take part in and help inform this research.8

Volume 4: Approach to capital expenditureMonitoring the delivery of agreed outputsConsultation proposalsWe explained that the Scottish Government had agreed to our recommendation to set up theOMG to monitor the delivery of the current investment programme. We considered that it wasimportant that all stakeholders could monitor Scottish Water’s progress in delivering outputsobjectively. In our view this required an agreed single source of information on progress.We noted that we planned to build on this progress by asking Scottish Water to set out in itsbusiness plans its expected delivery profile for each agreed output. We would ask ScottishWater to indicate the progress that it will have to have made, at the end of each quarter, ifthe agreed outputs are to be delivered in full during the regulatory control period.We proposed that the OMG should publish this information at the start of the regulatorycontrol period and report on progress annually.Question for consultationAre the methods that we propose for monitoring Scottish Water’s performance in deliveringthe outputs required by the regulatory contract appropriate?What respondents saidRespondents generally welcomed the OMG and the greater transparency the group provided.Two respondents welcomed the OMG, but warned that it should not tend towards the‘micromanagement’ of Scottish Water and limit Scottish Water’s scope to take alternative,more cost-effective, approaches where possible.Our approachRESPONSES AND APPROACHWe believe it is important that the OMG works with Scottish Water to establish a realisticdelivery profile against which progress can be monitored and Scottish Water held to account.This will help to ensure that monitoring remains objective and presents an accurate pictureof Scottish Water’s delivery position.We will improve the way in which the performance of Scottish Water’s existing assets ismeasured by introducing further measures of serviceability to customers. We plan to ensurethat we use the same suite of serviceability indicators to measure how assets perform forcustomers as does Ofwat.Water Industry Commission for Scotland9

Volume 4: Approach to capital expenditureRESPONSES AND APPROACHEarly start to delivering 2010-14 regulatory controloutputsConsultation proposalsWe explained that an early start to delivering the outputs required in the next regulatorycontrol period could be important, and may help avoid the significant dip in output deliverythat often characterises the start of a regulatory control period.We suggested that Scottish Water may well want to request that it begins work on deliveringthe 2010-14 outputs during the current regulatory control period. We explained that any suchrequest should meet the following criteria:• It is restricted to the assessment of feasibility, design, land purchase or activities requiredto gain planning or other regulatory consents (unless there are good strategic reasons foradvancing proposed investment – such as visiting the same site twice in a short period).• It is proportionate given the likely size of the investment programme for the 2010-14regulatory control period.• It will not lead to delays in delivering outputs required in the current regulatory controlperiod.• Scottish Water accepts that any early start spending will have to be included within theallowance for capital expenditure that is contained in our final determination of the2010-14 price review.We proposed to ask Scottish Water to detail any proposals for an early start programme in itsbusiness plans.Question for consultationShould we consider an application by Scottish Water for an ‘early start’ to delivering therequired investment outputs for 2010-14?10Water Industry Commission for Scotland

Volume 4: Approach to capital expenditureWhat respondents saidRespondents strongly supported the concept of an ‘early start’ programme. A number ofrespondents commented that allowing Scottish Water to start design and feasibility studiesprior to the beginning of the regulatory control period would lead to a more efficient deliveryof outputs during the regulatory control period. They agreed that it would help to easefluctuations in investment during the period.Respondents also welcomed the proposals as a step towards taking a longer termperspective to investment planning in the industry.Our approachWe welcome the support of stakeholders for the concept of allowing Scottish Water an ‘earlystart’. At present, we see no reason why financing should not be allowed during 2010-14 forScottish Water to make an early start on its 2014-18 investment programme.NEXT STEPSWith regard to Scottish Water’s next investment programme we have some concerns that anearly start could come at the cost of a late finish to the current investment programme.Therefore, we will carefully assess whether any request made by Scottish Water matches ourcriteria, and in particular we will have to satisfy ourselves that it will not lead to delays indelivering outputs required in the current regulatory control period before determiningwhether an early start on the programme for the 2010-14 regulatory control period should beallowed for.Next steps with the price reviewWe are making good progress in our programme of work for the price review, and would liketo thank stakeholders for their invaluable contributions to date.On 30 June 2009 we will issue our draft determination of price limits. We will conductanother programme of consultation throughout the year with stakeholders before publishingour final determination on 30 November 2009.Water Industry Commission for Scotland11

20.12.07Water Industry Commission for ScotlandOchil House, Springkerse Business Park, Stirling FK7 7XE.T 01786 430200 F 01786 462018 E enquiries@watercommission.co.ukwww.watercommission.co.uk