Aspectos legales

During price reviews, we use the cost base comparative tool to assess relative efficiency in procuring and delivering capital projects. We do this by comparing company estimates

of capital works unit costs for a representative range of standardised capital projects (standard costs).

Each company provided us with draft and final audited estimates for the standard costs based on, as far as possible, its own current and previous capital works programmes. These estimates were subjected to focused independent audit and review by the reporters.

With assistance from our cost base consultants, Jacobs Engineering, we have carried out a detailed assessment and review of the companies’ and reporters’ reports for each submission. We have issued queries where we have questions about the compliance with our reporting requirements and the comparability between companies. We

published a feedback report on companies’ draft cost base standard costs in PR09/16, ‘Cost base feedback report’ (August 2008).

Our concerns at draft business plan stage related to compliance and consistency. This prompted us to strengthen our approach to reviewing the standard costs in the final business plan. Accordingly, our consultants visited each company with the objective of ensuring that the most material differences between companies were explored and any inconsistencies in the composition of standard costs were identified. We published an executive summary of the key findings and conclusions from this review in PR09/34, ‘Executive summary: findings from the cost base audits (March–May 2009)’ (August 2009).

Our overall approach for final determinations remains unchanged from that set out in PR09/16. For each standard cost, we have:

• looked at the data distribution;

• identified a fixed cost for comparison; and

• measured how far proportionally above or below this, each company’s standard cost is.

We have selected the median value as representing this fixed cost.

For infrastructure, we weight each of these proportional distances from the median values by the forecast proportions of capital investment planned for the 2010-15 period. For mains and sewers, we are able to reflect the composition of each company’s asset stock in this weighting. For non-infrastructure, the link between existing assets and future work is less clear, so for each asset group (such as water treatment works) we take a simple average of the proportional distances above or below the median values in this area and weight this by the associated forecast proportion of capital investment. For mains, communication pipes and sewers we use 100% of the difference to the median value to contribute to overall efficiency. This reflects the confidence we have in the consistency and comparability of these standard costs due to the regular activity

undertaken on these assets. For all other assets, we use only 50% of the difference because we have less confidence in the comparability of these standard costs. Activity on these tends to be less frequent and companies often provide estimates based on quotations and/or costs associated with a relatively small number of schemes.

Changes in the cost base since draft determinations

We reviewed the comments made in Jacobs’ executive summary in PR09/34 and on their advice, changed our approach to household meters.

For household meters, the horizontal audit highlighted differing approaches to deriving these standard costs. The discussions with companies revealed that while some carry out large-scale programmes of meter installation others do this work as reactive one-off installations. Jacobs considered that a sizeable element of the variance in standard costs was not related to efficiency in delivery of similar work. For our final

determinations, we have therefore used only 50% of the difference to the median value for these assets as opposed to the 100% that we used at the draft stage.

We also excluded the standard costs for ‘Replacement UV disinfection’ because Jacobs considered this particular item was not helping to inform the cost base process as a result of being predominantly based on quotations that were not well aligned to outturn costs.

We also removed the standard costs for ‘installation of denitrification’. The low number of costs submitted suggests that this process was not sufficiently widespread to provide a useful standard cost in the analysis.

We carried out a detailed review of the issues and comments that companies and reporters made on cost base and capital efficiency in their representations.

The two main issues identified in the representations were the:

• justification for our continuing efficiency assumptions explained in section 4.10; and

• use and application of the BCIS index which we discuss below.

Many issues were company specific in nature affecting individual standard costs, but four companies (Portsmouth, Southern, Veolia East and Veolia Central) proposed revisions to their standard costs set out in their final business plan submissions. To be fair to all companies and to maintain the integrity of the whole process, in determining whether to make any changes to cost base submissions for our final

determinations, we considered the merit of any argument. We then considered whether there was supporting evidence for any changes.

We accepted a limited number of revisions from one company on the basis that it presented persuasive arguments supported by strong evidence. We considered it

proportionate to do this. We did not progress other requests for changes, as they did not meet the criteria set out above.

We will publish a report on the companies’ final cost base standard costs in December 2009.

Regional price adjustment

We reviewed the concerns raised by some companies in their business plans about the appropriateness of the Building Cost Information Service (BCIS) index. While we note that the basket of construction projects used to generate the index was developed

primarily for the building industry, we maintain that it is still appropriate for use in the cost base, since we are using it to reflect regional differences in labour and material costs. We have reviewed whether regional differences in labour and material costs are comparable across different construction industries and conclude that while the actual costs may vary, the regional differences are comparable. We have therefore continued to use the BCIS index to assess the regional variation in construction prices from the England and Wales average. We weight local indices by population to obtain average figures for each company’s area and the whole of England and Wales. We then compare each company’s index figure to the England and Wales average.

For our final determinations, we have made two significant refinements to our approach based on the representations of some companies.

• The first refinement involves using a five-year average index from 2004-05 to 2008-09 instead of the index for 2007-08 only. This takes account of the

movements in the BCIS index over time and reflects the variations in construction prices over the same AMP4 period from which companies have compiled the unit costs used to derive their standard costs.

• The second refinement concerns the proportions of each standard cost that we consider are affected by regional prices. We acknowledge that regional prices affect companies’ costs and expenditure, and are to some extent outside management control. But some items, such as mechanical and electrical equipment and design services, are procured in a national market. Therefore, regional prices affect only part of capital costs. For our final determinations, we have carefully considered some companies’ arguments that our proportions were not fully applicable to the activities of the water industry. We have reviewed our approach in detail, using a greater granularity of cost breakdown information specific to water industry costs. We have also considered the size and location of the company in our assessment through a series of tests and hypotheses for each cost element.

Table 39 summarises our view on the proportions of standard costs affected by regional prices in our final determination cost base analysis. For comparison, we also show our assumptions for draft determinations.

Table 39 Proportions of standard costs affected by regional prices Draft

determination

Final determination

Large company Small company

All

companies Low cost

region High cost region Low cost region High cost region Water service Mains 70% Communication pipes 74% Household meters 58% 43.1% 66.2% 36.2% 65.3%

Water treatment works – surface 54% Water treatment works – ground 74%

Service reservoirs 82%

Water pumping stations 38%

33.5% 54.2% 27.4% 69.4%

Sewerage service

Sewers 70%

Sewer structures 82% 43.1% 66.2%

Sewage pumping stations 38%

Sewage treatment works 50%

Sludge 74%

33.5% 54.2%

All companies have benefited from this revised element of our approach. We believe our application of the BCIS regional price indices better reflects the characteristics of the water industry and the individual circumstances of each company. We will publish further details on our assessment in our cost base feedback report in December 2009.

Table 40 provides an overview of the combined cost base and continuing efficiencies applied and the impact of these on industry capital expenditure.

Table 40 Overall capital expenditure efficiency challenge

Efficiency challenge (£m) % of capital expenditure

Water +4 0.0%

Sewerage -367 -2.8%

Total -363 -1.6%

As set out in section 4.10, the aggregate capital efficiency assumed at this review of £363 million is considerably less than the £1.7 billion accruing from the approach used at the last price review. Tables 41 and 42 provide a summary of the cost base relative efficiencies applied for each company for each sub-service.

Table 41 Capital expenditure efficiency adjustments Water Sewerage Infrastructure Non- infrastructure Infrastructure Non- infrastructure Simple mean +0.4% -2.8% +0.6% -0.5% Most efficient +17.6% +8.6% +15.8% +13.2% Least efficient -17.4% -15.4% -10.2% -11.1% Standard deviation +10.5% +6.2% +8.6% +8.5% Note:

A positive number means a company is relatively efficient, so we have made a positive adjustment in setting the baseline and vice versa.

Table 42 Catch-up efficiency factors arising from the cost base

Water Sewerage Infrastructure Non- infrastructure Infrastructure Non- infrastructure Water and sewerage companies

Anglian +17.6% -3.9% +15.8% +9.5% Dŵr Cymru -2.9% -0.7% 0.0% -5.6% Northumbrian +10.3% +8.6% -3.5% +4.3% Severn Trent +12.6% -15.4% +1.1% -6.2% South West -9.2% +0.5% -3.3% -6.6% Southern +8.6% -6.2% -10.2% -11.1% Thames -6.1% -3.7% -5.0% -2.5% United Utilities +13.1% +4.4% -8.0% -7.9% Wessex +12.1% +5.4% +7.3% +8.4% Yorkshire +8.2% +7.4% +12.2% +13.2%

Water only companies

Bournemouth & W Hampshire -12.6% -6.8% Bristol +0.1% +0.1% Cambridge -5.7% -4.0% Dee Valley +2.1% -2.0% Portsmouth -6.5% -10.3% South East -13.2% +1.7% South Staffordshire +0.1% -1.7% Sutton & East Surrey -0.9% -5.3% Veolia East -17.4% -10.0% Veolia Central -13.6% -6.9% Veolia Southeast +12.5% -10.6%

Note:

A positive number means a company is relatively efficient, so we have made a positive adjustment in setting the baseline and vice versa.