Determination prepares for challenges
What are the implications of the final determinations? To gauge reaction across the industry WWT invited MWH, Water UK, SBWWI and WRc to present their views of the settlement
The final determination announced by Ofwat on December 2, 2004, strikes a delicate balance between the desires of the Environment Agency (EA) and the willingness of the customer to pay for improvements. The result is five further years of investment in the environment, in a politically acceptable package.
Most water utilities seem positive and confident it can be delivered. There will be ongoing dialogue but the situation is certainly happier than with the draft determination, after which many water companies were seriously considering appealing to the Competition Commission. Many of the measures that caused concern through their exclusion from the draft have now been put in, although there is still anxiety that funding for infrastructure rehabilitation is low. One consideration likely to continue through AMP4 will be the requirement to think more about implementation of the Water Framework Directive (WFD).
Companies should be pleased capital maintenance will no longer be the poor relation to capital investment on the quality programme. Over the next five years water companies will be living with a number of uncertainties. Some of these have been recognised by Ofwat, including the possibility of further bad debt, the unknown uptake of water metering, EA abstraction and discharge charges, environmental obligations and corporation tax liabilities.
The determination also acknowledges construction prices may rise faster than the general economy and, helpfully, Ofwat has factored in COPI v RPI adjustments. However, the scale of other rises, such as energy costs - where Ofwat has assumed a general inflation will offset water bill effects - still remains to be seen. Inevitably, there is a significant expectation and requirement to achieve further efficiency.
The emphasis on wastewater, capital expenditure (CAPEX) and enhancement investment provides more scope for delivering further efficiency than the water service, operational expenditure (OPEX) and maintenance. Moving forward from AMP3. In a big step forward, it appears there will be greater opportunity for further discussion on special cases - particularly for issues that were not fully settled at the time of the determination.
There are likely to be more applications for price adjustment from the regulator as we head towards 2010. Historically, a big downside of the five-year review cycle has been the peak/trough cycle of investment, which appears to be both inefficient and ineffective. This time, one of the most positive changes from earlier reviews is the agreement of an Early Start programme, with a value of almost £880M, in an attempt to maintain expenditure and works programmes through the 'change-over' period.
Looking at the differences in investment requirements between AMP3 and AMP4, we see a similar overall CAPEX but split differently - with 60% more funding on the supply/demand balance, 13% more capital maintenance, and an overall flooding programme value of £1B (greatly increasing its priority). Although Ofwat and other stakeholders have maintained a clear requirement for companies to achieve further efficiencies, there is recognition the scope for this may be diminishing. For instance, OPEX efficiency for the water service though AMP4 is 2.4% per year compared to 3.7% in AMP3, while the water service capital maintenance CAPEX target is 3.6% per year (down from 5.6%).Failures addressed
Accusations of 'intellectual neglect' over capital maintenance at the time of PR99 have led to a profound change for both companies and regulators in their approach to the risk of loss of service to customers and the environment, as a result of structural failure of assets. Companies' methods of addressing risks varied widely in their level of detail and sophistication, and Ofwat has adapted to accommodate this. It now proposes to keep on the pressure to move towards full implementation of the cost-benefit objectives required by allowing 13% more funding than companies have actually spent in the last five years (and 22% more than set for AMP3).
To the outsider, another clear difference in this determination process is that there appeared to be only two submissions to Ofwat, compared to 13 last time. Coupled with more consultation, joint market research and the public domain information put out by Ofwat, there was obviously great pressure on Ofwat's resources. Several companies benefited from having trailed their approaches and plans to Ofwat over several years, allowing both 'no surprises' and an improved understanding of what were often sophisticated analyses - neither of which were easy, bearing in mind the final determination's compressed timetable.
How companies can best communicate the quality of their plans effectively to Ofwat may be something that occupies the industry's thinking in the years leading up to the next price review in 2009. Each water utility continues to look for the best solutions to match its approach and business culture with the need to develop, and AMP4 will continue to see a wide variety of different answers.
The focus on effective investment decisions, making use of the appropriate mix of CAPEX and OPEX investment streams to maintain or enhance levels of service, will encourage the industry to look for yet more ways of effective and sustainable delivery. Solutions from successful implementation within water industries elsewhere in the world (and indeed asset management from other utility sectors) are expected to gain greater exposure within the UK through AMP4. An example of this is the programme management approach (adopted to a greater or lesser degree) that offers benefits in improving efficiency.
While striving to improve efficiency through adapting different procurement strategies there is, none-the-less, a universal trend to provide suppliers with greater visibility of the programme and to develop more of a 'risk and reward' mentality in the employment of suppliers. This will be achieved via pain/gain against targets (where much of a supplier's profit is linked to achieving savings), by working more in partnership and by linking workload to performance - the better you perform, the more work you get.
Each determination has included a tightening of the screw to improve efficiency - although the degree of improvement that is demanded has, this time, reduced slightly. The 'easy gains' have gone and more attention will be focused on how businesses are run to identify areas for improvement. Sewer flooding is rightly high on the agenda but, as with all investment, careful assessment needs to be carried out on whether the solution provides the best value for money. This puts more emphasis on least-cost, whole-life solution approaches. Higher on the agenda, too, will be options needed to accommodate effects of climate change.A hot topic
Lean construction is a hot topic for contractors and there is still a view the industry is not good at learning from its mistakes. Elements of lean construction are determined through 'lean design' - since much of what designers do determines the overall costs of the work. Consultants can offer help using their 'design skills' experience - for example, by assisting others develop their approach to knowledge management. Accessing the right data is also vital for asset management.
Ofwat, NAO and Defra's intentions are clear regarding a requirement for cost-benefit analysis to be the basis for long-term plans. Data acquisition to enable better asset management is especially relevant in AMP4 for wastewater treatment and sewers. Driving costs of data acquisition down and managing data better is paramount if expert judgement gaps are to be filled for the next price review. There is great value in the data already held by the water companies - the key issue will be to unlock this relatively untouched resource by placing this data in context and, by sharing it across the business, set targets and manage the improvement programmes.
With more knowledge, the water companies will be able to focus attention on where they can make a difference and how to do this. Everyone will be placing more emphasis on sustainability issues. Much has been published on involvement in the community on things like recreational space (that is lakes, boating, fishing, walking and so on). This needs to be extended to balancing social and environmental impact with economic value.Barrie Clarke; Water UK
Ofwat made changes to its draft determination but this is a challenging settlement. Ofwat spent the time following its draft price announcement in August talking with all the water companies individually, with its fellow regulators, consumer and environmental groups and other stakeholders.
It also received 'fine-tuning' ministerial guidance on social and environmental requirements. The resulting final determinations published on December 2 last year show significant changes from the draft. Capital spending and prices rise more than anticipated. Efficiency assumptions are reduced for many companies. Investment across the industry will be some £1B higher. There is more for customer service improvements, including a bigger than envisaged cut in the number of households at risk from sewer flooding. Investors' first reaction was to mark shares higher.
So, Ofwat has listened and trimmed its over-aggressive demands. Yet this is no benign settlement. Whichever way you look, AMP4 presents tough challenges. Companies have to decide whether to seek a reference to the Competition Commission. To put it at its simplest, this means deciding if Ofwat has provided them with the right balance between risk and return. Among the main risks is what we inelegantly call 'financeability'. If companies are to finance the work needed to meet their obligations on competitive terms, they have to be attractive to investors. The terms really do matter because the task and the new investment needed - £16.8B between 2005 and 2010 on top of £50B invested since 1990 - are both massive. And this at a time when a) water holdings are no longer essential to a balanced investment portfolio; and b) overall industry debt to the markets has risen from practically nothing in 1990 to £21B in March 2004.
No wonder the City and the industry were 'engaged'. And no wonder Ofwat director general Philip Fletcher (core duty to ensure efficient companies can finance and carry out their functions) has invested significant effort in communicating with financial audiences. In the event, early market comment (and share buying) will have reassured many that Fletcher has got the balance right. But for many CEOs, finance and regulation directors, the judgement is not so easy. Ofwat has allowed price increases still only two thirds the size of those sought by the industry - its efficiency assumptions and the continuing uncertainties (not necessarily the regulator's fault) must be carefully analysed for potential effect on returns.
The financial pressures are different for different companies, but in this price review no decision about involving the Competition Commission either has been or will be taken without some soul-searching. More and more people know continuing substantial investment in water and wastewater services is necessary. It is encouraging that the programme puts asset maintenance in pole position.
The industry made a strong case with the help of a new common approach. Neither the urgency nor the benefits need spelling out to WWT readers. Provision is made for a major part of the industry's plans for quality improvement, a better supply/demand balance (especially in drier parts of the country), and service enhancements, including more customers freed from risk of sewer flooding. So are there reasons to be cheerful as a new year begins? Well not exactly. Infrastructure expenditure is increased by about £1.5B to a total of £8B, but still not all company proposals are in. A more sophisticated asset base requires more frequent, dearer updating. Also old sites and facilities face new problems, for example, odour from a sewage treatment works is now a serious issue for some companies.
Or look at demand - more funding is allowed (in fact £0.5B more) but will this get the job done or come quickly enough? Working within a land use planning system many see as itself in need of reform adds to the uncertainties. On the environment, the next five years will see 3,000 separate improvement schemes across the country. Again, funds rise against the draft determinations but Ofwat says a lot more may have to be done on habitats, wastewater treatment, bathing waters and the WFD. Efficiency, eagle-eyed and hook-beaked on everyone's shoulder, will be a constant companion. Let us agree this is as it should be in well-run businesses but let us also accept that when cost is king, delivering complex investment to time and budget is always tough.
What about the reason the industry exists? Companies had worked closely with customers on their business plans. Some were unhappy when projects affecting drinking water aesthetics and foul flooding were jettisoned in the draft determinations. In the finals some of these are back but bills will be higher. From an industry perspective the outcome is good and bad. Better service is in prospect but so are more bill protests.Can pay, will pay
We badly need new investment to protect progress in the things customers care about, especially drinking water quality and security of supply. We know from research carried out with other stakeholders (including Ofwat) that many are willing to pay a bit more for these benefits. Also value for money looks just fine.
The Daily Star on Sunday (December 5, 2004) took a robust red top look at responses to final determinations with the headline "Water Prats Spout Drivel". The writer could not credit the fuss over an average price rise of £46 over five years and dubbed a rival's "Millions Set For Misery as Price of Water Soars" as not quite accurate. It is hard to disagree. Average prices will rise by just 7% real in the decade 2010 despite major quality and other improvements - and yet few customers are average. Many face up to half the total 2005-2010 rise in their first PR04 bills due at the beginning of next month (because that is how the costs fall on companies).
Differences between regions and measured or unmeasured customers will be emphasised. How will all this be received? Customer debt is a growing problem. Attempts by customer groups and others to persuade government to do more to help people on low incomes have made little headway. Prices had to rise and arguably to a level above that allowed in final determinations. In the current environment, keeping the customer satisfied on the back of above inflation increases is undeniably a challenge but not one we can duck or want to.John Batty; SBWWI
SBWWI's membership is made up of contractors, manufacturers and consultants from the water sector. SBWWI members, working in partnership with the water companies, will have the task of delivering the AMP4 capital maintenance and investment programmes authorised by Ofwat in the final price determinations.
In the determinations Ofwat states its role is to act as a surrogate for a competitive market1. To achieve this the regulator relies heavily on comparative competition, identifying the most efficient water companies in each area of activity and using their performance as a benchmark to which the less productive companies can aspire. This 'aspiration' is given teeth by what Ofwat refers to as a mixture of 'carrot' and 'stick'.
The efficiency 'stick' means Ofwat assumes water companies will catch-up a proportion of the potential efficiency gains compared to the benchmark organisations - as well as out-performing efficiency gains in the economy as a whole. The 'carrot' comes from any efficiency gains made over and above the targets set for each company, which they can retain for five years before they are factored into the following price review.
These efficiency gains are at the core of Ofwat's strategy. The immediate response of both suppliers - and I suspect the water companies - is, to paraphrase Winston Churchill, "&..some carrot, some stick!" SBWWI's members are primarily concerned with the capital investment aspects of the final determinations.
Ofwat has split capital investment into two distinct categories - capital maintenance and capital enhancement, the latter relating to new-build and upgrading of existing facilities. Ofwat recognises identifying efficiency gains in repetitive maintenance activities is harder to achieve than in new capital works but has stated a belief that the water companies have the potential 'scope' to improve water services by 5% and sewerage services by 6% in this area over the five years of the AMP4 period (2005-2010). The capital enhancement figures for the same period are 6% and 8.8% respectively.Challenging efficiency
targets represent an opportunity and a threat for companies in the supply chain. The threat comes from the knowledge water companies will put pressure on suppliers to lower prices and may seek to source cheaper products overseas, particularly if the British supplier is unable to demonstrate any added-value differentiators for its product or service.
The opportunity arises because the water companies, at this time, more than any other, should be receptive to both technical innovations and supply chain integration techniques that can improve service quality and deliver efficiency savings. A problem voiced by smaller, innovative suppliers is the difficulty in influencing the supply chain early enough in the cycle to make an impact.
The tendency for water companies to establish all-encompassing framework agreements with major contractors and to use their resources to manage this critical relationship with a view to achieving supply chain savings can, ironically, lead to delays in vital information being disseminated down the chain. The result is suppliers frequently have to be reactive rather than proactive in their marketing and sales activities.
The final determinations document reports at an aggregated, industry level. Nevertheless, certain supplier growth opportunities can be clearly identified - none more so than in water quality and environmentally-related consultancy and contracting. Between 2005 and 2010 many new European directives should start to impact on the water industry in addition to existing legislation and government policies. Examples include the WFD, Urban Waste Water Treatment Directive, Habitats Directive, the Countryside and Rights of Way Act 2000 and the UK Biodiversity Action Plan3.
In total, almost £3.5B has been earmarked for the sewerage service quality programme in PR04 and the corresponding figure for the drinking water quality programme is more than £2B. With draft river basin management schemes to be published by 2008 and the target date to achieve the WFD's environmental objectives set at 2015, the environment will continue to play a significant role in the next price review in 2010.
A second growth opportunity is in the supply and installation of both optional and selective water meters. The determinations include capital expenditure of £206M to provide more than 1.2M optional meters and £77M for almost 354,000 selective meters. The figure for optional meters appears overly optimistic as there is little incentive for the water companies to install them. By law, they are obliged to install a meter free of charge when requested, often leading to both a fall in revenue and an additional operating cost in collecting meter readings. The targets for selective metering appear more achievable.
Ofwat states: "Accelerated selective metering will increase meter penetration and the scope for demand management options in the future, in parts of the country where water resources are likely to be under pressure."4 Folkestone & Dover Water even proposes to seek water scarce area status during the PR04 period. The mainstream press has concentrated on the headline figures as far as water bills and capital expenditure are concerned. Ofwat makes it quite clear, however, it assesses each water company against the delivery of output requirements, not on how much it spends.5 The final determinations set out in detail the output expectations for each company - often in a project-specific format6.
Unfortunately, these outputs are detailed in confidential supplementary reports not made available to water industry suppliers. This is an opportunity missed by Ofwat as the availability of such information would help clarify the goals the supply chain has to meet and help identify projects, which could generate multiple outputs combining, for example, water quality, security of supply and environmental objectives.Work programme
Previous comments on the environment and metering in this article should not detract from the fact there is still a huge work programme on core water and sewerage infrastructure (underground) and non-infrastructure assets. Between 2005-2010 Ofwat indicates it expects around 23,400km of water mains to be laid renewed or relined and, the replacement, renovation and laying of around 6,400km of sewers - including a staggering 1,200km of the London mains network alone being upgraded. Many of the nation's WTWs and WwTWs will be refurbished or rebuilt.
(A note of caution - these figures should be treated prudently because of the way in which they are calculated. For example, the repair of a 1m-long defect in a 100m section of sewer counts as 100m of sewer that has theoretically been renovated.) In its draft determinations Ofwat admitted to the "&inefficient 'roller coaster' pattern of investment seen at previous price reviews."7 This terminology reflected that used in an earlier document, RD 42/03: "This investment roller coaster increases supply chains costs and risks loss of much-needed resources to the sector."
To combat this destablilising trend, Ofwat established the Early Start initiative, which identified almost £1B of specific projects well in advance of the beginning of AMP4. To many SBWWI members it appears, however, water companies have not felt sufficient confidence in the Early Start process prior to the final determinations to instigate any meaningful programme that fully engages the supply chain. This unwillingness to clearly commit resources not only causes a fall-off in volume and revenue but, more seriously for the long-term, leads to the loss of skilled and experienced manpower that will inevitably seek employment elsewhere.
The knock-on effect is that, in the medium-term, project costs will increase as demand rises, making it extremely difficult for the water supply chain to meet Ofwat's efficiency targets. While the efficiency savings targeted by Ofwat are challenging, there can be few suppliers who would relish a return to the days before privatisation when water industry investment came from the same exchequer pot as education, health and defence. The experience of suppliers in the highways sector is testament to what can happen when investment decisions are subject to the stop-start vagaries of political and ideological expediency. The water industry knows Ofwat has authorised a significant increase in capital expenditure over the next five years and the SBWWI and its members are ready and willing to take up the supply chain baton in what should be a hard but exciting race.
1 Future water and sewerage charges 2005-2010: Final Determinations. Ofwat Periodic Review 2004, p52. 2 Ibid, p20 - Table 20, capital expenditure efficiency. 3 Ibid, p203 - For a more detailed list see Table 38, what the environment quality programme will deliver in 2005-2010. 4 Ibid, p186. 5 Ibid, p21. 6 Ibid, p183. 7 Draft determination summary document, p36.Paul Conroy and Ross Crosbie; WRc Utilities
The dust is settling on Ofwat's final determination and water companies are focussing on the twin challenge of delivering the investment programme within the price limits and being ready for the next periodic review. In setting the price limits, Philip Fletcher has established something of a reputation as a performer - he combines the skills of the juggler and tightrope walker and even describes his own approach as "a balancing act".
The price limits, in effect, determine the revenue the companies can raise from consumers in order to deliver a safe and reliable supply of water and collect and treat wastewater. Ofwat positions itself in the middle of the companies, the customers, shareholders, the City, the other regulators and endeavours to ensure a 'fair deal' is struck. Above all, the provision of water services must be sustainable and safe.
Sustainability requires that the companies can attract investors and secure loans in order to finance their capital programme and that longer- term environmental management issues are addressed. Safety demands compliance with quality regulations and investment to safeguard security of supplies. The value Ofwat has placed on achieving this balance amounts to an average increase in water bills of 4.2% per year, before inflation for the period between 2005 and 2010. In other words, a total average increase of £46 per household by 2010. So far, the response to the determination has been cautiously positive.
However, there are a few 'bones of contention'. For example, the ability of the poorest of customers to pay, which is a problem exacerbated by some of the highest individual bill increases being in areas of relatively high poverty. Another key issue is that of delivery of long-term environmental sustainability, which is compounded by the associated uncertainties regarding cause and willingness to pay.
Ofwat has proclaimed the companies are now adequately funded to tackle key customer service issues but this has been tempered by an expectation that tough efficiency targets will be met. It is assumed past and future efficiency savings will offset bill increases by some £16 per household over the coming period. This article explores a selection of they key technical challenges and considers the implications for meeting efficiency targets.
Certain water companies are regularly 'keel-hauled' by the media and taken to task by Ofwat on the grounds they have not done enough to control leakage and prevent costly bursts on their water pipes. A number of companies have declared leakage will be reduced and this will be achieved by a combination of replacing pipes and implementing better methodologies for detecting and repairing leaks. To the layman, this sounds logical. However, leakage, as opposed to a major burst, does not occur at a single readily identifiable point. A burst, which results in loss of pressure or visible running water, is usually a result of a big fracture that breaks the back of the pipe or a catastrophic joint failure.Cumulative effect
Leakage, on the other hand, also includes the cumulative result of all the minor seeps and undetectable leaks that are distributed across the pipe network. Estimates are made for losses on customer supply pipes but there is significant uncertainty about these values. Consequently, it is much harder to find the source of leakage and to target specific sections of pipework for replacement. Using typical available data, the main option is expensive, large-scale replacement of the pipe stock and the hope the leaky pipes are amongst those replaced.
Dealing with leakage cost effectively can only be achieved by understanding exactly which pipes and joints are contributing to the problem. The understanding of the impact that different mains (and communication pipe) renewal options (for example, pipe-bursting, open-cut replacement) have on pipe performance also needs to be enhanced. This is a major challenge and will require a commitment to metering, monitoring and utilisation of up-to-date detection and analysis technology.
Internal foul flooding is about the worst and most distressing serviceability incident that can happen. Not only is the event itself horrendous but so is the fear that it can re-occur. Ofwat has been careful to ensure the final determination states clearly that price limits will enable companies to deal with sewer flooding, as identified in the company plans. Ofwat considers two types of flooding - that caused by hydraulic overload and that associated with other causes (for example, blockages).
Of interest is that for many of the companies, the reference is to overloaded sewers, which implies inadequate hydraulic capacity, compounded, possibly, by pumping station failure or overload. This may be a concern. Already, companies would have been expected to have taken the 'quick wins', dealing with hydraulic inadequacies that were relatively easy and cost-effective to do so. The cost of dealing with remaining hydraulic issues may be much higher than anticipated. Flooding due to other causes is just as significant. Blockages and especially repeat blockages are a major issue and it is thus important to understand the causality and effects of sewer cleaning programmes on these events.
Routine preventative maintenance may have already been dropped by some companies (on the grounds it incurs a significant opex cost) but without really understanding the impact on the frequency and severity of future flooding incidents. Experts in this area feel a change in operational practice is needed, supported by a better understanding of the costs and benefits of sewer operational maintenance programmes. Some go further, insisting the industry also needs to grasp the benefits of new asset monitoring technology.
This would enable, for example, more effective responses to pumping station alarms, reducing significantly the time wasted responding to false alarms. The need to meet stiff efficiency targets is, perhaps, the major sting in the tail. There is no doubt the target is tough. Companies have already taken quick wins in terms of efficiency and reducing OPEX. Capital investment since the early 1990s has seen a significant increase in the numbers and sophistication of control and monitoring systems installed.
This has permitted enhanced levels of quality to be achieved, while keeping labour costs under control. However, how will this increased value of relatively short-lived assets impact on capital maintenance expenditure? Additionally, many utilities have significantly altered their procurement strategies over the past five years, with the aim of delivering efficiencies. So, where else can efficiencies be achieved? Generally, companies will need a much better grasp of problem assets in terms of cause, location and cost if they are going to be able to achieve efficiency targets.Vital statistics
There is a fundamental need to understand costs (whole-life) at the asset level. Schemes must be prioritised and cost-benefits understood, not only in terms of capital costs but also for their impacts on future OPEX and capital maintenance requirements. Furthermore, there is a need to be able to compare investment options across the asset groups, to understand risk and whole-life costs and to do so in a consistent and equitable way. Why is this so difficult? Consider the analogy of a family on a limited budget faced with immediate needs and restricted options.
First, there is a need to increase living accommodation - the family is growing and the current resource (the house) has a limited capacity to meet the demands of the family. Secondly, the family car is ageing and service and repair bills are escalating - this is an essential asset for getting the kids to school and the parents to work. Should it be replaced or should a major overhaul on the key components be undertaken?
How is this decision made and is there data available to support the decision making process? The first step is to identify the options, then to assess the costs and finally the benefits. The aim is to maximise the benefits of the limited budget by prioritising, while ensuring essential needs are met. This process is based on striking the right balance. It is called 'least cost planning' and to be done effectively it requires a good understanding of costs and benefits. The analogy is useful, because it illustrates an approach for evaluating the needs for two very distinct asset types. It also introduces issues relating to capacity, quality of service and capital maintenance.
The solutions include additional maintenance, replacement, procuring of new assets or a combination. This is therefore a question of optimisation. It can only be done effectively by having a thorough understanding of the asset's lifecycle and costs of ownership. This includes the costs of day-to-day maintenance (OPEX) and CAPEX associated with replacement, extension and capital maintenance. Because the asset owner is making a decision across asset types, they need a whole-life costing approach that enables comparisons to be made. In the case of the house and the car this is not a problem - the costs and options and lifecycle data are readily available and the householder will have a detailed knowledge of the assets and all the maintenance history they need to inform the decision.
The reality for the water company is that it has a far more complex range of assets, much more limited lifecycle information and lack of an effective decision making process for multi-asset investment prioritisation. The first step in filling this gap will be the implementation of systems for capturing and analysing OPEX data and for linking this to assets at the right level to support investment prioritisation and delivery of efficiency
Paul Conroy and Ross Crosbie are senior consultants for Asset Management within WRc Utilities. For further information contact email@example.com.