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Investing in Water Services 2006 - 2014

ANNEX A - QUALITY AND STANDARD III METHODOLOGY

Quality and Standards III — history, objectives, governance and methods

1 Quality and Standards III (Q&S III) is the third post devolution investment programme for water services in Scotland. Focusing on the period April 2006 - March 2014, it will advise on the investment required to meet public health and environmental standards and on the need to improve and extend the existing networks.

2 The Scottish Executive’s overall aim is to produce a cost effective, sustainable and affordable water services investment programme that will meet legislative standards in a practical way without burdening customers with overly steep increases in charges. This will be challenging as it requires a very delicate balance between the demands of numerous factors including legislative standards, customer preferences and the amount customers, and Scotland as a whole, can afford to invest.

3 The Q&S III Project is due to report in January 2005. The final conclusions, as agreed by the Scottish Ministers, will establish the key outputs from Scottish Water's investment plan for 2006-2014. The Water Industry Commissioner will utilise the Q&S III Project report, along with other influencing factors, to produce his next Strategic Charges Review, in which he will make recommendations regarding the charges to be borne by customers.

Project governance

4 The Quality and Standards III Project is sponsored and led by the Scottish Executive.

5 A wide-ranging variety of stakeholders and experts have been directly involved from the outset to ensure that we utilise expertise effectively and that we are aware of customers’ views. These stakeholders sit on the Project Board which considers strategic Project issues. The Board, and specialist groups working with the Board, include the following to whom the Executive is most grateful:

• Communities Scotland
• Confederation of British Industry (Scotland)
• CoSLA and local authorities
• Drinking Water Quality Regulator
• Historic Scotland
• Homes For Scotland
• Scottish Environment protection Agency
• Scottish Executive Departments
• Scottish Federation of Housing Associations
• Scottish Natural Heritage
• Scottish Water
• Water Customer Consultation Panels
• Water Industry Commissioner

6 A number of specialist groups were set up to ensure effective consultation and that the wide-ranging variety of complex topics were given sufficient expert consideration. These groups were accountable to the Project Board and the Scottish Executive. They were tasked with reporting to the Board on investment needs, costs, benefits and risks in their field. These specialist groups were:

• Maintenance and extension of water/wastewater networks
• Transition from Quality & Standards II/Improving Project processes
• Environmental issues
• Drinking Water Quality
• Additional Customer Service Issues

Methodology for appraisal of investment needs and costs — overview

7 A major part of the water services investment process is ensuring that public funds are spent on activities that provide the greatest benefits to society, and that they are spent in the most efficient way. To achieve this, the Quality and Standards III Project adopted the standard central government appraisal methodology, as set out in ‘The Green Book — Appraisal and Evaluation in Central Government" (http://greenbook.treasury.gov.uk/). This guidance, which encourages a thorough, long term and analytically robust approach to appraisal and evaluation, underpinned the Project throughout.

8 The process involves establishing:

1 a strategic case — the high level strategic need for investment;

2 an economic case (or option appraisal) — establishes the value for money of each potential project and typically has the following steps:

• setting objectives;
• creating options;
• estimating the costs;
• analysing the benefits and risk associated with each option;
• choosing a lead option.

3 a financial case (or affordability assessment) uses information from the option appraisal to decide the optimal combination of projects given limited funds and other constraints.

Establishing an economic case (or option appraisal)

9 The specialist groups (see above) followed a number of steps to ensure that their approach was systematic, thorough and transparent. These steps are outlined below.

Step 1 - Identification of drivers i.e the issues that "drive" us to invest
Ensuring that all requirements have been identified, fully understood and recorded
(e.g. legislation; policy; economic development; health and customer preferences)

Step 2 - Setting objectives based on the drivers and drawing those objectives into bundles to form initial outline investment packages
The requirements identified at stage 1 were analysed and converted into objectives (such as specific standards to be achieved).

Step 3 - Gap analysis
Measuring the gap between objectives identified at step 2 and the delivery standard expected to be current at the beginning of the new investment programme (1^st April 2006). This complex process ensures that the use of the existing asset base is maximised, which in turn reduces the overall cost of achieving compliance with the standards. The approach also identifies where assets have sufficient treatment already in place. This again minimises the investment and identifies where process optimisation efforts should be targeted to improve the performance of existing assets. A fundamental assumption of this approach is that any capital maintenance requirements, to ensure that the existing asset is fit for purpose, has been covered by the capital maintenance section of the Quality and Standards III Project.

Step 4 - Development of options
Using the results of the gap analysis from step 3, options were created that would allow the gap to be closed.

Step 5 - Estimation of costs, benefits and risks for each option
The Quality and Standards III investment programme has been costed by Scottish Water. The costs are based on an assessment of the work required to meet the outputs identified for the various different investment scenarios, for example on water quality, environmental improvement and customer service.

Scottish Water has employed a wide range of techniques to establish the relevant costs. For capital maintenance, standard industry tools have been employed to determine the investment required to maintain a defined level of service. In other areas, such as the cost of tackling development constraints and achieving quality enhancements, the costs have been provided by Scottish Water’s joint venture capital delivery group, Scottish Water Solutions. Certain specialist parts of the investment programme such as Telemetry and Health and Safety have been costed by individual consultants who are specialists in these fields. Extensive use has been made throughout of Scottish Water’s standard cost base which provides schedule rates for a range of investment activities.

Where different options exist to meet the specified output, the appraisal of these options has been based on the methodology outlined in the Treasury "green book" which outlines best practice in this area. This includes the use of "whole life" costs covering the initial capital cost, running costs, maintenance, any capital renewals, decommissioning costs and any residual value. A real discount rate of 3.5% has been used, falling to 3.0% for costs (and benefits) accruing more than 30 years into the future. The appraisal period has been set by the useful lifetime of the assets for the options under consideration

The "do nothing" costs have been assessed to provide a baseline against which the costs, benefits and risk implications can be compared. For many of the elements of the Quality and Standards III investment programme, the "do nothing" option can be defined as the scenario of the existing Scottish Water asset base with only routine maintenance and component replacement being carried out i.e. no capital investment in the asset

Benefits and risks have been assessed for programme elements. The risks have been scored using a matrix of probability and consequence scores.

Scottish Water’s cost estimates are deemed to be accurate to +/- 25% on a project by project basis. However, when considering over the whole portfolio of projects, the impact is expected to be neutral.

A number of assumptions have been made in determining costs. These include:

• The predecessor Quality & Standards II investment programme is delivered in full;
• Population forecasts have used data from the General Register Office for Scotland. The assumption is that economic growth will have no significant impact on water usage in the period.

All the costs provided are in October 2002 prices.

The investment programme costs identified by Scottish Water for the Quality and Standards III investment period will be subject to scrutiny by the Water Industry Commissioner for Scotland as part of the Strategic Review of Charges. This process follows on from the assessment of the objectives of the investment programme that is being carried out in Quality and Standards III. It includes an assessment of the efficiency that can be applied to the programme i.e. the extent to which the same set of outputs can be delivered for less money.

Step 6 - Selection of lead options and formation potential investment packages and Step 7- Selection of recommended investment package

Steps 1-5 allowed a first cut of the potential investment scenarios in each of the specialist areas. An iteration process was then undertaken whereby the scenarios were re-worked to provide realistic investment scenarios given the affordability and other constraints. This re-working allowed for several investment scenarios to be created in each of the areas identified above. The re-iteration/refinement process will continue over the summer of 2004.

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