Agency, Ofwat still at loggerheads over water industry investments

The debate over the next round of environmental spending by the water industry began in earnest in May with water companies estimating the cost of improvements at £11 billion between 2000-2005. Water regulator Ofwat believes the figures are too high, but is still in conflict with the Environment Agency over what environmental improvements are necessary and affordable. The Agency has set out its own priorities in a submission to Ministers which has been written in a way which will make it difficult for Ofwat to propose cuts in the programme at this stage.

The limits on prices which the water companies will be able to charge in the period 2000-5 will be set in November 1999 by Ofwat. By then, the formal debate between the companies, the Government, Ofwat and the Environment Agency over the scale of the industry's environmental programme and desirable levels of water prices will have been running for over two years.

Ofwat's Director-General, Ian Byatt, fired the opening shot last June by proposing a one-off cut in water bills in 2000, with no subsequent increases above inflation to 2005 (ENDS Report 269, pp 40-41 ). The move drew an angry response from the Environment Agency, which rejected the presumption that improvements to the water environment should depend on a pre-determined price limit regardless of customers' and Ministerial preferences and its own statutory duties.

The Agency's predecessor, the National Rivers Authority, lost out in the previous price-setting round, AMP2, in 1994, when its proposals for a five-year, £919 million programme of environmental investment were pared down by Ministers to £522 million.

Within a year, the water companies had announced share buy-backs and special dividends to shareholders worth £1.5 billion. They were able to do so because they had persuaded Mr Byatt that the costs of their improvement programmes would be higher, and the scope for efficiency gains lower, than the companies knew they would be - as subsequent events have continued to demonstrate.

The AMP3 negotiations entered a new phase on 30 April when Ofwat published the industry's costings of its anticipated investment programme for 2000-5.1 Companies priced their total obligations at £11 billion - enough, when added to the £4 billion already allowed for the period in the AMP2 price limits, to add £65 to the average water bill by 2005.

However, Ofwat has "challenged" the companies' estimates based on its own interpretation of their new obligations, its experience during AMP2, the opinion of its consultants and a comparison of unit costs. It believes that the full programme may add as little as £46 to the average bill by 2005 - £19 less than the industry estimate.

Ofwat believes that the increase in bills could be kept to just £18 if only a basic programme was implemented. However, in putting this forward it has again brought itself into conflict with the Environment Agency.

The reason is that a basic programme would exclude environmental improvements which the Agency believes it has a statutory duty to pursue. Foremost among these is the achievement of river quality objectives (RQOs) which were mostly in place before the industry was privatised in 1989, and which the then Government promised to achieve.

In fact, the RQOs will only be achieved on some 70% of river stretches when existing commitments, especially under the 1991 EC Directive on urban wastewater treatment, are fulfilled. The water companies estimated that full compliance would entail capital costs of £1.6 billion - but Ofwat's "challenged" estimate is under £1.2 billion.

In his report to Ministers, Mr Byatt suggests there is a "major trade-off" between expenditures under the 1991 Directive, which will mainly benefit coastal waters, and the Agency's proposals for improving river quality. The Agency maintains there is no need for such a trade-off.

One reason why even the challenged estimates may be too high is evident from Ofwat's own report, which points out that for some water companies the cost of quality may be offset by greater efficiency. But only "some" adjustment of an unspecified size has been made in the challenged estimates to take account of the scope for efficiency gains.

A separate Ofwat report on this issue shows how badly it was outflanked by the water companies during AMP2.2 When setting price limits at the last review, the regulator assumed average efficiency gains of 2% per year for the five years to 1999. But Ofwat now concedes that actual gains over this period may be as high as 20%. It says that the scope for efficiency improvements for 2000-5 "could be well in excess of 2.5% and possibly up to 4% or 5% a year."

Further work on this issue will be crucial in the continuing debate about what environmental improvements should be funded. Also important will be further challenges to the water companies' estimates, which have generally been based on generic costs rather than site-specific data.

The Agency put forward its own case for AMP3 in May in a submission to Ministers.3 It includes a 13-point action plan for a "National Environment Programme". The Agency urges the Government to adopt the plan in full, saying it is all "required by legislation" - although in fact Ministers have discretion over some elements of the programme.

The Agency wants Ministers to reject Ofwat's plan for a one-off price cut in 2000. It believes that efficiency savings since 1994 and prospective savings during AMP3 could fund the required investment. Ministers are believed to have some concern about the idea of a one-off price cut, and may prefer to see prices stable in real terms throughout the five years.

The Agency's Chairman, Lord de Ramsey, commented: "This is not some green rush by the Agency, but an overdue balancing of the environmental books. We know what needs to be done. There is a question mark over how fast we do it. All the information shows that the improvements we are seeking are affordable over 2000-2005 with stable prices - and that is what our consultations with the public tell us people want."

One feature of the Agency's submission will have caused considerable irritation to Ofwat. The price regulator has been pressing for the Agency to set out the benefits of its proposals in financial terms. But the Agency has contented itself with setting out general principles for its preferred programme.

The Agency's move appears to be a deliberate ploy to limit Ofwat's ability to interfere in the water quality area at this stage and to avert a repetition of events during AMP2. With costed benefits in front of him, Mr Byatt would have been able to compare them against the costs of particular schemes and strike out those which showed no net benefit. But the Agency is anxious that this process should at least be deferred until firmer and properly challenged costings have been obtained from the water industry so that Ministers do not cut out elements of its proposals on the basis of inflated figures.

The key areas the Agency identifies for environmental investment are:

  • Adoption and achievement of river quality objectives (RQOs), as noted above, and elimination of bad and poor quality rivers.

  • Protection of wildlife sites from water company abstractions and sewage discharges. The statutory conservation body, English Nature, and the Royal Society for the Protection of Birds have urged the protection of 80 Sites of Special Scientific Interest (SSSIs), 37 of which are so-called "core" sites protected under EC Directives (ENDS Report 278, pp 8-9 ). The remainder are classified as "non-core" and are designated only under UK legislation.

    Industry estimates suggest that dealing with over-abstraction will be more costly than countering eutrophication. Some £240 million is required for investigating and dealing with over-abstraction at 50 core sites, and a further £110 million for remedying problems at 27 non-core sites. By contrast, only £30 million was estimated for phosphate stripping from sewage works - although some of these expenditures may be needed anyway to comply with the EC Directive on urban wastewater treatment.

  • Implementation of the Directive on urban wastewater treatment. The Agency highlights areas where the Government has some discretion on this issue. These include the provisions for protecting "sensitive areas", where nutrient removal from sewage effluents is required to prevent eutrophication.

    Sensitive area designations are currently under review and new designations may have substantial funding implications for some companies. Water companies have estimated that an investment of £840 million will be required during the review period, although the standards required - particularly for SSSIs - remain uncertain.

    The Agency also wants to see secondary sewage treatment of coastal discharges "identified as requiring it". Areas designated "less sensitive" under the Directive do not require discharges to receive secondary treatment provided that "comprehensive studies" have shown that they will not adversely affect the environment. Potential "less sensitive area" designations made by the previous Government are currently under review and decisions have yet to be made on many schemes. There could be considerable costs for companies such as Northumbrian and Southern Water (ENDS Reports 273, p 12 , and 276, pp 9-10 ).

    Companies have estimated the potential capital costs of additional secondary treat

    ment at £420 million - though after challenge by Ofwat the figure was trimmed to £360 million.

    The Directive also requires improvement of unsatisfactory combined sewer overflows. The industry and the Agency have agreed a remedial programme due for completion in 2015. The total cost is estimated to be £1.68

    billion, and Ofwat is assuming that one-third of the investment - £560 million - will be required during 2000-5.

    Phase-out of the disposal of untreated sewage sludge in agriculture. The Directive on urban wastewater treatment will double sewage sludge arisings by 2005, and the impending ban on sludge dumping at sea will also increase the quantity needing disposal on land. Water companies are responding by expanding other disposal routes such as incineration, but plan to dispose of additional quantities of sludge to agricultural land (ENDS Report 279, pp 17-20 ).

    The Agency believes that the use of sludge in agriculture must be "a sustainable and safe practice that is completely auditable and open to public scrutiny." It endorses a recommendation by the Royal Commission on Environmental Pollution (RCEP) in 1996 that land spreading of untreated sludge should be discontinued to reduce the risk of pathogens entering the food chain (ENDS Report 254, pp 23-26 ). The House of Commons Environment Committee recently backed this proposal, and specified that treatment should take the form of pasteurisation (ENDS Report 277, pp 31-32 ).

    Water companies estimate that the capital cost of meeting the RCEP's recommendation would be £620 million - though Ofwat believes that the figure may be as low as £330 million on more conservative assumptions.

    The Government's policy on sludge disposal to farmland is expected to be announced shortly. But water companies may have little choice in the matter. The major retailers wield considerable power over food producers, and have been insisting on a phase-out of untreated sludges in talks with the water industry (ENDS Report 278, p 14 ).

  • Implementation of the 1976 EC Directive on bathing water quality. Although investment to achieve compliance with the Directive should be largely complete by 2000, there remain supplementary schemes such as North West Water's £100 million programme to rectify failures on the Fylde coast (ENDS Report 277, p 3 ) and any works associated with new designations. These include at least nine inland waters whose designation is due to be announced shortly (see pp 36-37 ).

    The Agency also wants to achieve the Directive's more stringent guideline microbiological standards "wherever we are confident of the effectiveness of the action." Increasing emphasis is being placed by both the Government and the Agency on guideline standards in EC Directives as a result of pressure from the European Commission. Legal action against other Member States has confirmed that they are an integral part of Directives which they must endeavour to observe.

    Water companies have estimated that obligations under the bathing water Directive will involve £210 million of capital expenditure during the review period.

  • Implementation of the 1979 EC Directive on shellfish waters. The Government is reviewing implementation of the Directive following a legal challenge. Initial implementation was by administrative means - a practice highlighted as inadequate in legal actions brought by the Commission against other Member States. The Government issued new regulations implementing the Directive last year (ENDS Report 269, pp 38-39 ).

    The review is likely to see the number of shellfish waters increase substantially, from 29 designated in the 1980s to as many as 311 - the number of shellfish production areas recognised by the 1991 Directive on the quality of shellfish flesh. The measures will require water companies to provide secondary sewage treatment and disinfection at many coastal works. However, companies have been unable to estimate the costs until the designations are made.

  • Implementation of the 1978 EC Directive on water quality for freshwater fish. As with the shellfish Directive, implementation is currently under review for the same reasons. New designations are probable, though still uncertain, and companies have estimated costs of £660 million for improvements to some 600 sewage works to ensure that rivers meet more stringent quality standards.

    The Agency is seeking measures to prevent failures in designated waters, particularly for ammonia, and a progression toward guideline standards where appropriate.

  • Implementation of the 1980 EC Directive on groundwater protection. The Government recently issued draft regulations to implement the Directive in response to pressure from the Commission (ENDS Report 276, pp 42-43 ).

    The Agency highlights the need to ensure that any discharges to groundwaters by the water industry, such as soakaways, do not contain List II substances specified in the Directive, including ammonia. However, this requirement has not been costed and may be of limited significance.

    The next stage in the process will come in July, when the Government will issue guidance on its priorities for the national environmental programme. The Agency will then invite public representations on the programme before putting priorities for approval by the Government in November. The Government's decisions will follow next March, with scope for further adjustment after the water companies have submitted detailed applications for the AMP3 price limits in April.

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