Ofwat's assessment of the prospects for water prices are its latest contribution to the negotiations on the water industry's third round of asset management planning (AMP3). The process will culminate next November with Ofwat fixing the prices which companies may charge in 2000-2005. The investments required to meet environmental and quality obligations are a major factor in the calculations.
AMP3 has involved Ofwat and the industry in a battle of words with the Environment Agency, which has fought to ensure that environmental spending is not squeezed out of the reckoning. At the end of the previous AMP2 process in 1994, "discretionary" spending on environmental improvements was slashed from £919 million to £522 million, while water companies were left with enough cash to fund special dividends and share buy-backs worth £1.5 billion shortly afterwards.
AMP3 began in June 1997 with Ofwat calling for a one-off cut in water prices in 2000. The move drew an angry response from the Agency, which was concerned that it prejudged the debate on future levels of environmental spending. However, in September the Government put forward an "ambitious" environmental programme to be achieved in addition to price cuts of around 10% (ENDS Report 284, pp 43-44 ).
The programme was provisionally costed at £8.5 billion and included bathing water, shellfish water and drinking water improvements required by EC Directives, as well as targets to protect wildlife sites threatened by sewage discharges and over-abstraction, tackle low-flow rivers, reduce unsatisfactory combined sewer overflows by two-thirds and reduce non-compliance with river quality objectives by 50%.
Ofwat's announcement in November stemmed from its consideration of the obligations facing companies and the scope for savings due to improved efficiency and reductions in the cost of capital. Ofwat has divided the programme into £5.3 billion of "firmly settled" EC obligations and a further £3.2 billion of other measures which it regards as "for debate". To what extent debate is still possible in view of Ministers' pronouncements in September remains to be seen.
The price cut proposed for 2000 reflects Ofwat's conviction that a large reduction in prices is needed to demonstrate its effectiveness as a regulator and stem the steady increase in prices since privatisation. However, the 15-20% figure exceeds Ministers' expectations and has drawn protests from the industry.
The industry's ability to outperform other stock market sectors in recent years suggests there is considerable room for price cuts. However, Water UK warned that "the sums simply don't add up" and predicted a return to the under-investment which characterised the industry before privatisation. Anglian Water described the proposals as "undesirable" and warned of "serious implications" for the company.
Stock market reaction to Ofwat's announcement was mixed. Although most water shares fell slightly, some rose - suggesting that the figures were generally at or a little below the level anticipated. Financial analysts contacted by ENDS were divided between those who thought the outlook for companies was reasonable and those who felt it was poor and the market had taken an over-optimistic view.
Ofwat has worked out the implications for each company's prices in 2000 and 2004 (see table ). The calculations assume the cost of capital to be 5.25% for the major companies - below that assumed in 1994, but nevertheless regarded by Ofwat as a "cautious" figure.
A key area of disagreement between Ofwat and the Government lies in the future profile of prices. Ministers have spoken in favour of "price stability" and told Ofwat that they want "significant real cuts in average prices in 2000-2005 compared to 1999-2000 levels." However, Ofwat's proposals amount to a short-lived cut, with prices bouncing back to near their former levels by 2004. Proposed prices for half of the ten major companies equal or exceed 1999 levels by 2004 - requiring increases of the order of 20% after the initial reduction in 2000.
Ofwat argues that flattening the profile of prices to avoid confusing customers would involve "leaving companies with greater revenues and profits" in the early years of the review period. It believes that customers would prefer to have the money in their pockets even though this would mean steep increases in subsequent years.
Companies are now costing the schemes in the Agency's enviromental improvement programme. In December, they are due to submit the results to Ofwat for "challenging" - the regulator's process of checking the validity of the estimates. The challenged figures will then be given to the Agency in January for the production of a prioritised list of schemes for each company. The schemes will be included in companies' draft business plans to be completed in April 1999.
Key decisions on the funding of discretionary non-EC schemes - principally those designed to achieve river quality objectives and improve unsatisfactory combined sewer overflows - have yet to be made by Ministers. Although national targets have been set for these, exactly which schemes are funded will depend on the prospects for prices for individual companies. With Northumbrian and Southern Water's prices due to rise above the rate of inflation during the AMP3 period, little extra funding is likely to be available for discretionary improvements in these areas.