Ofwat's proposals are the second step in a complex process which will culminate in late 1999 with the setting of prices which water companies can charge for the period 2000-5. The review will be the third round of asset management planning (AMP) for the industry since privatisation.
At the AMP2 review in 1994, Ofwat allowed companies to raise prices by an average of 1.5% above inflation per year to 2000. This was less than the 4% per year allowed between 1989 and 1995, and in the process a request by the National Rivers Authority for £918 million of "discretionary" environmental investments - those not strictly required by EC and other legal obligations - was cut down to £522 million (ENDS Report 234, pp 6-7 ).
The controversy over this decision was revived within a few months when the companies began to reveal that they could achieve the investments included in the AMP2 settlement at significantly less cost than estimated by Ofwat. The regulator assumed that companies would achieve an average 2% operational efficiency saving per year up to 2000, plus a 1% per annum capital efficiency gain.
In fact, the companies have far surpassed these targets and awarded dividends to shareholders outperforming many other industry sectors. Real return to shareholders has not fallen below 11% since 1991, compared with Ofwat's target of 6-8%. Many companies have also found themselves cash-rich and have used share buy-back schemes to pass benefits to shareholders.
After being outwitted by the industry last time, Ofwat is now proposing a "significant" one-off cut in water prices in 2000-1, reflecting past efficiency savings and those anticipated up to 2005. But this decision is again controversial because customers would gain all the benefits calculated by the regulator, with nothing set aside to compensate for the cuts in "discretionary" environmental spending.
The regulator's second main proposal is that real water prices should remain stable or fall slightly after 2000. This is based on the "belief" that customers "expect companies to meet their investment and service obligations without prices needing to rise in real terms, financed through expected efficiency gains."
The proposal has already attracted criticism from the water companies, which have told Ofwat that it is premature to establish a principle of stable or falling prices until their detailed environmental obligations for 2000-5 are determined.
Conversely, the Environment Agency and other environmental interests, already unhappy with the way Ofwat allowed itself to be outmanoeuvred by the companies when it cut back their "discretionary" spending for the AMP2 period, will be concerned that it is now attempting to impose a ceiling on environmental improvement in 2000-5 before it knows with any precision what this will mean.
Ofwat will be asking the companies in November for their estimates of the costs of their environmental and other legal obligations for the AMP3 period. It will then ask Ministers for their view of the issues in early 1998.
The pressures for environmental investments during AMP3 are substantial, and include:
Indeed, the need to strip phosphate from sewage effluents could become a significant new cost driver over the next few years. The Directive requires Member States to review the designation of "sensitive areas" every four years, and the Environment Agency is due to complete the first review by the end of this year.
The case for designating about 150 additional waters, mainly on the grounds of their vulnerability to eutrophication, is now being considered. Removal of nutrients from sewage effluents discharged into newly designated areas would have to be completed by the end of 2004.