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PROPOSED PRINCIPLES OF CHARGING FOR 2010-14
45. This section sets out the Scottish Government's proposed principles of charging for 2010-14. Many of the existing principles (including full cost recovery, cost reflectivity, geographical harmonisation of charges, phasing of increases, paying for increased local capacity and stable charges) should continue to apply during 2010-14. A number of other issues require closer consideration including the financial sustainability of Scottish Water, affordability, unwinding of cross-subsidies between groups of charge payers, the small organisation exemption scheme and roads drainage.
Essential principles of charging
46. Subject to the responses to this consultation, Ministers propose that the following principles should continue to apply for the charge period 2010-14:
- Stable charges (i.e. a regime in which charges do not rise faster than general inflation).
Stable charges in the 2006-10 period have given customers certainty and are providing sufficient revenue to allow the essential and desirable objectives set out in Ministers' investment Direction of September 2005 to be taken forward by Scottish Water. The company is also improving its financial strength and value. Ministers believe that this progress can be maintained under a framework of stable charges in 2010-14.
Ministers therefore propose to maintain the principle that the desirable objectives should be delivered only to the extent that they are consistent with stable charges during 2010-14. Ministers recognise that achieving constant average charges in real terms could be consistent with some charges rising above inflation and others falling in real terms, for example where tariff rebalancing is justified. Ministers expect the Commission to inform them if the desirable objectives cannot be achieved within a stable price framework in order that they can reconsider priorities.
- Customers in the same category pay the same rate for the same service wherever they are in the country.
- Charges in general should be broadly cost-reflective - i.e. charges for given services to particular customer groups should be set to recover the cost to Scottish Water nationally of providing that service to that group as a whole.
- A corollary to this is full cost-recovery - that is, charges should cover costs. Where, for whatever reason, this principle gives rise to significant charge increases for individual customers, the Commission and Scottish Water must have regard to Ministers' requirement that such increases be phased gradually to minimise the impact of any increases in any one year unless a more effective means can be found.
- Inefficiencies by Scottish Water which led to any financial under-performance would have to be met by direct financial support from the Government. This reflects the key principle that the customer should pay only the proper economic charge for the service received and should not pay twice to cover poor performance. This is a strong discipline on Scottish Water and on Government as owner.
- Where enhancements to local infrastructure are required to enable new developments to be connected to the public networks developers should meet the net cost to Scottish Water of such enhancements. In doing so, Ministers recognise that this is a new system, which it would make sense to review, prior to the next strategic review of charges.
Key Issues for further consideration
47. In a number of areas the principles of charging require careful consideration.
Investment programme
48. The size of Scottish Water's investment programme is a key determinant of the levels of revenue required to be delivered through its charges to customers.
49. As specified in the Ministerial Objectives, Scottish Water's investment programme must maintain its assets, improve the system in order to comply with statutory requirements in relation to environmental and quality performance and accommodate growth in the system. That programme must be deliverable.
50. The 2005 regulatory settlement costed Scottish Water's capital programme for 2006-10 at £2.5bn. It is clear that the current investment programme is at the absolute limits of what can efficiently be managed by a company of Scottish Water's size. Over the remainder of the current regulatory period, Scottish Water is expected to invest at levels at the highest known in the UK water industry - over £600m per year. This is a huge challenge.
51. Both Scottish Water and the Commission have made their view known to Ministers that maintaining this level of investment beyond 2010 is not sustainable and to attempt to do so would risk non-delivery and inefficiency. Previous programmes have seen significant amounts of investment being deferred into the subsequent regulatory period. This is undesirable, leading, amongst other things, to deferment of benefits and inefficient planning.
52. Ministers accept this view. They therefore propose that the investment programme for this period should be set at a level that is efficiently manageable by a company of Scottish Water's size. This should include any deferred investment from 2006-10 and early start investment for the 2014-18 period. Overall therefore Ministers expect the programme to be smaller than the 2006-10 programme. Ministers will look to the Commission and Scottish Water for advice on the optimum level.
53. Ministers will look to the present Strategic Review of Charges process to confirm that an investment programme at an efficiently manageable level will secure the Ministerial objectives for 2010-14 as set out in the Direction of 2005.
Finance
54. There are a number of important issues relating to the financing and financial position of Scottish Water as a publicly owned utility.
It is essential that Scottish Water is able to finance the investment programme.
Scottish Water has two sources of funding - customer charges and borrowing from the Scottish Government. Unlike other owners, the Government does not extract any funds in the form of a dividend from its ownership. Any surplus on revenue over operating costs, interest and tax is reinvested and supports the capital programme. Without such surpluses maintaining the investment programme at desired levels would require higher levels of lending by the Government or increases in customer charges. Roughly £50m each year (over the period 2002-06) was foregone as a potential dividend to the Government and was instead used to support the investment programme. The Government will take no dividend in the coming regulatory period.
Ministers also recognise the importance of borrowing to the achievement of the Ministerial objectives. The size of the capital programme and the level of revenue gained from stable charges determine the borrowing requirement.
Ministers will therefore ensure that Scottish Water has access to borrowing at, or around, current levels during 2010-14, subject to Government spending review decisions. The Commission should therefore determine charges for 2010-14 taking into account the availability of this maximum level of borrowing per year. In its determination the Commission should identify the amount of borrowing required by Scottish Water for each year, subject to this maximum level.
- Financial strength and resilience
As owners of Scottish Water, Ministers also wish the company to improve its financial stability and sustainability. It should be profitable and resilient. Charges are on average lower in Scotland than elsewhere in the UK and the overall financial strength of Scottish Water is improving. Ministers believe that this progress can be maintained under a stable charges framework for the 2010-14 period.
In the 2006-10 statement Ministers required that, as a minimum, Scottish Water's financial strength should be maintained and if possible, slowly improved. They specified that Scottish Water should strive to outperform the regulatory settlement thereby further improving its financial strength and increasing the value of the company. In assessing the financial strength of the company the Commission has made reference to a number of financial ratios used by OFWAT.
The Commission proposed in its recent consultation on its methodology for the 2010-14 review that it would continue to apply the financial ratios used by OFWAT to the private industry elsewhere in the UK in order to assess its financial strength. The Government has no evidence that these ratios are not appropriate for a publicly owned utility such as Scottish Water. Efficiency targets are drawn from the private industry and it is consistent that the assessment of its financial strength should be driven by the same financial and managerial disciplines.
Ministers expect the Commission to inform them if the financial strength of Scottish Water cannot at least be maintained within a stable price framework taking into account the level of lending that they have indicated that they are willing to make available to Scottish Water.
- Financial reserve - the gilts buffer
In the last Strategic Review of Charges, Ministers and the Commission agreed the creation of a financial reserve in Scottish Water to enable it to manage risk more effectively. The Commission was keen to have an incentive-based approach to regulation whereby they set financial constraints that can be out-performed by a determined management. Ministers believe that incentive based regulation is key to delivering an efficient and effective water industry in Scotland, at least cost to customers. An incentivised management and workforce is essential to meeting that objective.
Ministers and the Commission agreed that financial surpluses beyond the limits set in the determination - out-performance - should be held by Scottish Water in the form of gilts (the gilts buffer). This reserve would be used to ease the impacts of any financial or other shocks on Scottish Water customers. Scottish Water would only be able to sell the gilts with the approval of the Scottish Government following confirmation from the Commission that such a sale would be in the customer interest. The purpose of this reserve is to protect both the owner and customer against the financial impact of unforeseen events. Customers would not have additional costs imposed on them and the Government would not have to find additional finance outwith planned lending.
In its methodology consultation for 2010-14 the Commission sought views on setting a target level for the gilts buffer. The Government will be interested in the views that the Commission receives on this issue and will reach a view on whether an appropriate target can be identified in the light of the responses to the consultation. Meantime, Ministers remain committed to incentive based regulation and the development over time of a reserve in the form of gilts.
Affordability & the impact of moving from council tax to a local income tax
55. Ministers continue to regard the issue of affordability as significant and propose to explore how the present benefits can be maintained during 2010-14.
56. The Government is committed to the abolition of Council Tax and its replacement with a local income tax. It will be consulting separately on its proposals in this area. This change has a number of important implications for water charges;
- domestic water charges are currently set with reference to council tax bands;
- local authorities currently bill and collect water charges on behalf of Scottish Water together with Council Tax, and;
- Water customers receive a range of discounts by virtue of the link with the present Council Tax system.
57. The Scottish Government has not yet formulated its policy in relation to these issues. They are being closely examined at present and will be subject to further consultation at a later stage.
Unwinding of cross-subsidies between customers
58. An area of particular concern to some non-household customers in recent years has been the extent to which charges paid by them have exceeded their fair share of Scottish Water's costs. In 2004, Ministers commissioned economic consultants Stone & Webster to determine the levels by which the non-household sector subsidises the household sector and to recommend what action should be taken to address these. The consultants' report concluded that there was robust evidence that Scottish Water over-recovers costs from non-household customers, resulting in households paying in aggregate £44m a year less (on the water side) than it costs Scottish Water to supply them. Ministers therefore required the Commission to determine charge limits for the current period 2006-10 in such a way that these imbalances were corrected without causing average household charges to increase in real terms.
59. The consultants also reported that data quality needed to be improved and other cross subsidies would probably be identified. In response, Ministers required the Commission and Scottish Water to conduct further work to establish with greater certainty the nature of other imbalances. In light of that work the Commission was to advise Ministers of any further rebalancing that would be required to achieve greater cost-reflectivity in charging in the period 2010-14.
60. The Commission has now concluded this work on the basis of latest available evidence and has identified a number of imbalances between customer groups and in respect of individual services. It has advised the Scottish Government that Scottish Water still over-recovers £25m a year from non-household customers. The Commission's advice is that unwinding these cross-subsidies within a stable charges framework should be achievable, provided that capital investment remains at a deliverable level.
61. Scottish Water also over recovers, on the water side, about £3m from small to medium non-household customers while under-recovering similar costs from large volume non-household water users. Correcting this imbalance implies increases of up to 30% for a small number of large non-household customers.
62. There are also a number of imbalances within non-household sewerage charges. The Commission's estimates are that Scottish Water over-recovers costs for foul waste and under-recovers costs for both surface drainage and trade effluent. Correcting these imbalances could lead to increases of around 10% for some non-household customers who pay for surface drainage and around 75% for trade effluent customers. The impact on individual customers' bills would depend on the mix of services that customers receive. While reductions in foul sewerage charges would reduce the effects of increases for some customers, others would face steep increases.
63. This is a significant issue. While Ministers wish to move towards a properly cost-reflective position, they expect Scottish Water and the Commission to apply the principles which Ministers set out in unwinding these cross-subsidies in the least disruptive manner to customers.
Small organisation water services charges exemption scheme
64. Prior to the creation of Scottish Water, reliefs were granted by the former water authorities to certain water customers on a discretionary basis. These reliefs were removed in the interests of fair and sustainable charging. The current water services charges exemption scheme was introduced to help those organisations with modest financial resources (including charities and voluntary organisations) to adjust to the withdrawal of these reliefs and to prepare to pay for their water services.
65. In 2004, Ministers extended the exemption scheme to 2010. This was to allow more time for that preparation and to ensure that those paying for the first time would not start paying until a more obviously cost-reflective system of charging non-household customers was introduced. That new system is now being put in place.
66. The current exemption scheme costs around £2.4m annually. Scottish Water does not receive public funding for these exemptions which are met from customer charges.
67. The Scottish Government believes that we must now address whether or not to continue with reliefs on water charges. We have to consider whether all customers, including charitable organisations, should contribute to the cost of the water services that they use. We also have to consider if the present scheme should continue, or continue in a revised fashion, if it places an undue burden on other customers, including vulnerable domestic customers and small businesses through increased charges.
68. Ministers therefore propose to confirm, in light of this consultation exercise, whether in their principles of charging statement for 2010-14 there should be plans to extend the exemption scheme on its expiry in April 2010.
Roads Drainage
69. Scottish Water and the Commission estimate that the costs of roads drainage are about £100m a year. While the link between non-household premises and their rateable value has been replaced, this change did not extend to roads (or highway) drainage. Although many non-household customers consider it unreasonable to pay these charges, the Government has yet to be advised of a practicable alternative. Roads drainage is paid for through water charges in other parts of the UK. The only current alternative would be for the cost to be met by local councils and the highway authorities, placing a new burden on Council Tax, business rates or central government support. Consequently, the Scottish Government proposes that roads drainage charges will continue to be recovered in 2010-14 from wastewater services charges set by reference to the rateable value of individual premises.
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