Portsmouth Water Plc: A report on the determination of adjustment factors and infrastructure charges for Portsmouth Water Plc

Summary of report (html format)
Full text (pdf format)

Adobe Acrobat Reader can be downloaded from http://www.adobe.com

Summary

Under the reference made by the Director General of Water Services (the Director) on 29 September 1994 (see Appendix 1.1), we are required to determine the adjustment factor, K, and the standard amount by which infrastructure charges are calculated for Portsmouth Water plc (Portsmouth) for the ten years from 1 April 1995 to 31 March 2005. The adjustment factor, K, is the percentage by which weighted average charges for the supply of water services are allowed to change relative to the retail price index. The infrastructure charge is one of a number of charges that can be levied to recover the costs of providing new connections.

The Director had determined an adjustment factor for Portsmouth of -1.5 for each of these ten years, and a standard amount for the infrastructure charge of £200. In evidence to us, the company proposed an adjustment factor of [ * ] for 1995/96 (the first year of K2), [ * ] for 1996/97 to 1999/2000 (the remaining four years of K2) and [ * ] for the subsequent five years (K3), and a standard amount for the infrastructure charge of £400. In contrast, therefore, to the price reductions determined by the Director, the company believed moderate price increases were necessary.

Portsmouth supplies water services to some 640,000 customers in Hampshire and West Sussex. Its charges are the lowest of any company supplying water in England and Wales (about 30 per cent below the average charge), and it is amongst the most efficient of the companies in the industry. In its view, the Director's determination was based on an unrealistic estimate of the revenue that could be earned from commercial customers; on assumptions relating to operating cost savings which it could not achieve; on an improper assessment of the capital employed; and on an unacceptable reduction in its profitability. In consequence, it projected that it would be unable to finance the proper carrying out of its functions.

We have been unable to accept several of the assumptions on which Portsmouth's financial projections were based; in particular we do not believe that operating costs need to increase as significantly in real terms. On the contrary, we see scope for a limited reduction in many of these costs, albeit less in K3 than projected by the Director given the company's relative efficiency. On the other hand, we have accepted that the Director's determination was based on an erroneous forecast of commercial metered demand originally made by the company and incorporated in the body of its business plan submissions. We believe it is appropriate to allow for a slight decline in this element of demand, rather than the significant increases originally projected.

In our view, the water industry is of relatively low risk, given the almost complete lack of actual or potential competition, the stable revenue base, and the obligation on the Director to ensure that the companies can continue to finance their functions. Given, however, the diversity of the companies in terms of size, access to capital markets and tax status, we have judged the pretax cost of capital for the water industry as a whole to be in the range of 6 to 8 per cent. We believe the cost of capital for Portsmouth is likely to be toward the upper end of that range, given the relatively small scale of Portsmouth's business, and its comparatively high likely level of tax payments due to its relatively small investment programme. Portsmouth's rate of return is currently well in excess of the cost of capital which suggests considerable scope for reducing rates of return, taking account of the interests of customers without calling into question the company's ability to finance its functions. In our view, it would be appropriate in making our determinations to assume a reduction in the company's return on capital value from its current levels of approximately [ * ] per cent toward the cost of capital by the end of K2. The Director, using a different approach to cost and revenue projections, had assumed a reduction in return toward the cost of capital by the end of K3.

We have therefore found that an adjustment factor of -1.5 for K2 would provide a reasonable return on capital value for that period. A somewhat higher adjustment factor than that set by the Director would, however, seem necessary for K3. We have seen no evidence to support a higher level of infrastructure charges than that determined by the Director.

We have therefore determined in respect of Portsmouth an adjustment factor of -1.5 to be applied (subject to some technical adjustments set out in paragraph 2.96) in K2 followed by -0.5 in K3 as being adequate to enable the company to finance the proper carrying out of its functions. On infrastructure charges we have determined a standard amount of £200.

Full text

Back to the top