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Paying for Water Services 2006-2010

SECTION 2: APPLICATION OF PRINCIPLES

27) This section considers, and seeks views on how the principles outlined in section 1 might be applied in a number of different cases.

Cross subsidies

28) Given their role in making charges for vulnerable groups affordable, the Executive is not looking to withdraw all cross subsidies as a matter of principle. However, in the interests of achieving broad cost reflectivity in charging generally, the Executive considers that a fuller understanding of cross subsidies needs to be developed.

29) The most obvious form of cross subsidy in the current charging arrangements is that within the household sector, where the link to Council Tax bands and discounts results in higher banded properties subsidising lower banded properties and single adult households being subsidised by those with two or more adults in them. The case for changes in these arrangements is considered below. For the purposes of this section, it is sufficient to note the existence of these cross subsidies and the likelihood, given policy on affordability, that some form of the current arrangements is likely to be needed under any new approach.

30) What is less clear is the extent to which there are cross subsidies between groups of non-household customers. At present, the only clear case of a subsidy to non-households is where some 5,000 voluntary organisations, which previously had benefited from relief on their water charges and which met a number of criteria, including that of having annual income of less that £50,000 a year, are exempted from all charges until 1 April 2006. The cost of this scheme, which is relatively modest, is borne by all customers in the sense that it is a cost that Scottish Water does not recover from the exempted customer, and therefore has to be added to charges generally. This cross subsidy is provided by other non-household customers and also by higher banded households; but not by lower banded households, which are themselves in receipt of a subsidy.

31) It is arguable, even after the recent harmonisation of charges, which included rises for a number of small businesses, that the charges paid by a number of such businesses do not yet reflect the cost to Scottish Water of providing services to such businesses as a group. However, the Executive’s broad intention is that distinct customer groups within the non-household sector should be expected to cover through the charges that they pay the costs of serving those respective groups as a whole.

32) It is also open to question whether the balance between income from households and non-households is right. At present, Scottish Water derives about 63% of its income from households and 37% from non-households. In England and Wales, where it is considered that cross subsidies between the two groups do not exist, the water companies derive between 66% and 79% of total income from households, with businesses contributing between 34% and 21%. The extent of this range reflects the considerable differences in the companies’ respective customer bases. It could be that the present balance in Scotland reflects the peculiarities of the customer base in Scotland. However, as this has not been explored fully, the Executive proposes to undertake research work with Scottish Water and the Commissioner to improve its understanding of the true position in time to inform its decisions on the principles of charging in January 2005.

33) Subject to the outcome of that work, there must be some concern that any significant subsidy flowing from non-household customers to household customers would not be sustainable in the long term. It would be seen by business customers as a permanent surcharge on their operations in Scotland, which business in England and Wales does not face and which therefore could damage the competitiveness of Scottish business, with implications for investment and jobs in Scotland.

34) On the other hand, many households, particularly those on relatively low incomes would be concerned by the prospect of the further charge increases that would be the corollary of withdrawing a cross subsidy. For example, were a more accurate balance between household and non-household income to be 70% and 30% respectively, that would imply a reduction in income from non-households of about £70 million a year (some 20% of the present total paid by the sector), offset by an increase of the same amount for households (representing an additional 12% to be found from households). However, leaving a significant cross subsidy in place could undermine the long term prospects of some businesses that are particularly dependent on water and wastewater services. There is the risk, if nothing is done, that these businesses’ long term prospect could be adversely affected raising the prospect of fewer such businesses in the future making any contribution to Scottish Water’s costs. In these circumstances, charges for households would have to rise anyway, possibly by more than as a result of withdrawing the cross subsidy.

35) Against that background, the Executive is considering whether or not to require the Commission to set charge limits for 2006-10 in such a way as to provide for any cross subsidy to be withdrawn gradually year by year. Were the Executive to pursue this course, and were the sums involved to be particularly large, it might be necessary to require the cross subsidy to be withdrawn over a longer period than the four years of the next review. In these circumstances, it might take two four-year periods to reach the right balance.

36) These decisions will be made as part of a transparent process and their implications for different customer groups will be made clear in advance, so that there will be certainty as to how different charges for different customer groups will change in coming years.

Consultation point 3: If it is established that there are significant cross subsidies between customer groups, should these be retained, or withdrawn gradually over time?

Household charging

37) Any significant withdrawing of cross subsidies from the non-household sector to the household sector would have serious implications for affordability and could call into question the continuing validity of the present basis by which households are charged.

38) At present water and sewerage charges for all households, except the small minority on metered supplies, are billed and collected by the local authorities on behalf of Scottish Water as part of their collection of the Council Tax. The authorities are required to do this under regulations made by the Executive. Draft regulations governing how the authorities should undertake billing and collecting from 2005 onwards were the subject of a consultation by the Executive recently. However, it confirms now its general commitment to the practice, at least for the medium term, and proposes to base any steps to improve affordability for low-income households in the period 2006-10 on that practice.

39) There are several good reasons for retaining joint billing and collection of Council Tax and water charges. Joint billing is convenient for customers in that they are able to pay for two services with one bill and are able to spread the payments over the course of the year. It is cost effective in that the costs of the collection service are shared between the two services, with Scottish Water paying the local authorities for their collection work, thereby avoiding the need for Scottish Water and its customers to meet the cost of establishing and running a separate billing and collection operation. Crucially, the link between Council Tax bands and water charges is the means by which those in higher banded properties, who tend to be better off, subsidise those in lower banded properties who tend to be less well off.

40) Joint billing and collection provides too that Council Tax discounts are applied to water charges. It has the benefit of providing a discount of 25% for all households in single adult occupation, which means that many vulnerable households, including single pensioners and single parent families automatically receive a reduction in their water charges. However, because the sole criterion is single adult occupancy, the discounts do not reflect the ability of the individuals in question to pay water charges. Consequently, it results in households occupied by well-off individuals receiving a discount that is not available to couples on benefits. This is different from Council Tax, where poorer households are eligible for Council Tax benefit. Around 40% of all households are in receipt of full or partial Council Tax benefit.

41) There is also the issue of 50% discount on Council Tax and water charges that is available on second homes (although the Scottish Executive is currently considering reducing or removing this discount). In view of the fixed cost nature of the industry, it is difficult to justify this discount in terms of the costs to Scottish Water of providing the infrastructure to serve such properties. In terms of affordability, it results in the owners of second homes, who almost by definition are relatively well-off, paying only half of what a couple on benefits in a neighbouring property will pay for the service.

42) The Executive estimates that providing these two discounts to all single adult households and all second homes costs Scottish Water and its customers about £75 million a year. These arrangements result in many low-income households paying more for their water services than better off single adult households. Its experience of the transitional relief scheme, which ensures that those on Council Tax benefit pay the same charge regardless of the band of their home, suggests that there may be a means of using the charging system to concentrate assistance on those facing the greatest difficulty in paying for water services. Under such a revised system, the current range of discounts would be abolished. The £75 million a year that this would save could be used to provide households on Council Tax benefit, which is administered by the local authorities, with a discount on their charges. As happens with the transitional relief scheme at present, the extent of a discount could reflect the extent to which a household was eligible for Council Tax benefit, with the maximum discount being available for those on full Council Tax benefit.

43) Under this approach, the 950,000 households receiving discounts would become liable to pay water charges at the standard rate associated with the Council Tax band of their home, unless they were eligible for Council Tax benefit. The 524,000 households that are eligible for Council Tax benefit, including those receiving discounts at present, would receive the new discount. The objective of this change would be to target assistance on low-income households. By providing that assistance to a smaller number of recipients than benefit from the current discounts, its average value to each recipient would be greater in terms of the assistance provided to them in paying for the services that they receive.

44) An approach broadly along these lines could be run in a number of ways. For example, it could be structured to ensure that all households on the same rate of Council Tax Benefit paid the same charge, regardless of Council Tax band. On the other hand, it could retain the link to the Council Tax band of the property served by providing for each household to the charge for its own Council Tax band at a rate reduced to reflect eligibility for Council Tax Benefit.

45) The Executive is committed to considering with the local authorities how the transitional relief scheme should be run in the remaining two years of its life. Therefore, if there is widespread support for the proposal among respondents to the consultation, the Executive proposes that these discussions should be expanded to include consideration of whether a scheme along the lines described above would be feasible. If this proves to be the case, the Executive will explore with all interested stakeholders the approach that would best deliver its objective of ensuring that water charges are affordable for low-income households.

Consultation point 4: Should a new system of better targeted discounts for low-income households be funded from the savings that would be generated by abolishing the discounts currently granted to single adult households and in respect of second homes, or should the current system of discounts be retained?

Non-household charging

46) As discussed above, the Executive recognises the arguments for moving over time to a position where charges for each group of non-household customers, and thus for non-household customers as a whole, are set to reflect the cost of providing services to them. This would enable any cross-subsidies, whether from non-household to household customers, or among non-household customers, to be withdrawn gradually. Achieving this would require a number of changes to be made to the current basis by which charges for different non-household customers are set.

Metered water supplies

47) At present, some 50,000 out of a total of 135,000 non-household customers are on measured (i.e. metered) water supplies. For these customers cost reflectivity in charging for water can be achieved by setting charges to provide a standing charge that reflects the fixed cost of providing the water infrastructure and a volumetric charge that reflects the actual amount of water consumed. The rates for both charges can be varied to reflect the demand that the customer places on the system. Thus, the standing charge can be set to take account of the size of the meter (and the size of the pipe) serving a particular premises; and the volumetric charge can be set to reflect the unit cost to Scottish Water of providing particular volumes of water to a customer in a given period. This enables the charges scheme to divide customers into groups ranging from the relatively small number that are served by the largest pipes and which consume the greatest volumes of water, through those with more moderate consumption to those served by pipes that are the same size as household pipes and whose annual consumption may be no greater than that of an ordinary household.

48) This straightforward approach to categorising metered water customers provides a basis for estimating how much wastewater is discharged into the sewers, so that the standard wastewater (as opposed to trade effluent) charge is a function of the water charge. That too, therefore, is a charge that can be set in a broadly cost reflective manner. Charging for the two other elements of sewerage — surface drainage and highway drainage — is less straightforward and appears to attract les support among customers.

Surface and highway drainage

49) The non-household charge includes an identified element to cover the cost to Scottish Water of receiving into the sewers rainwater that drains from the surfaces of, and adjacent to, non-household premises (such as roofs and car parks). The large volumes of water from these sources place a substantial strain on wastewater treatment works. This is reflected in the surface drainage charge of 1.53 pence per £ of rateable value, as opposed to 4.08 pence per £ of rateable value in the case of wastewater charge paid by non-household customers. Given the significance of this part of the service, there is an argument that charges for it should be cost reflective, so that those premises that in practice place the greatest burden on the system contribute most to the costs.

50) At present, however, the surface drainage charge is set by reference to the rateable value of the premises being drained. In practice, this tends to cause high value premises, with relatively modest areas being drained, to pay more than lower value premises with substantial drainage. An example frequently quoted of the former is the shop or office in the centre of a town, with a high rateable value. While an example of the latter is the large out of town store with substantial car parking attached to it.

51) The Executive recognises that this imbalance in charging is a cause of concern among some customers, who argue that it should be rectified by moving away from rateable values as the basis for setting these charges. It is concerned however that a replacement for these arrangements should not become too cumbersome, for example by requiring each of the 135,000 non-household premises to be measured for this purpose. It has looked at how this issue is addressed in England and Wales (see Annex A). In light of the different approaches adopted by the companies there it has concluded any attempt to introduce broad cost reflectivity in surface drainage charging should follow the approach taken by Yorkshire Water. Therefore, subject to the view of respondents to this consultation, it suggests that a system of charges based on broad banding of properties by reference to the surface area of the property drained would be most straightforward means of meting customer concerns about current practice in this area. This could result in all non-household properties being charged by reference to one of the following bands:

52) It would not be possible to introduce such a significant change in time for the 2006-10 period. Therefore, the Executive proposes that any change should come into effect in time to form part of the charge limits that the Commission will set for the period 2010-14. Until then, the charges will continue to be calculated on the current basis.

53) In addition to surface drainage, non-household sewerage charges also include an element for highway drainage. (Household sewerage charges include unspecified elements for both charges.) The Executive is aware that some customers have argued for this charge to be met by the highway authorities. It recognises that this would place responsibility for meeting the costs imposed by highway drainage, which is another substantial burden on wastewater works, on the bodies responsible for the source of the cost. In practice however this would mean shifting costs to the local authorities, and to the Executive, in their capacities as highway authorities. The consequences of such a shift would be that these costs would be met out of Council Tax, business rates or general taxation. This would be no more satisfactory, or equitable, than charging Scottish Water’s non-household customers, most of which use, or rely upon, the public highways in their day to day business.

54) Moreover, if the highway drainage charge were to be calculated in the same way as is proposed for the surface drainage charge, those premises with the most extensive car parking facilities would be among those contributing most to the costs and to defraying these costs. Accordingly, the Executive proposes that highway drainage should continue as a charge on customers and be calculated as part of the banding system proposed for surface drainage.

Consultation point 5: Should the current arrangements for charging non-household customers for surface and highway drainage be retained, or should preparations be made to establish by 2010 banded charges in respect of these charges?

Non-metered supplies

55) 85,000 non-household premises are not metered and their occupants are charged for both water and sewerage services by reference to their rateable value. This is considered unsatisfactory by the some occupants of such premises in that the rateable value does not necessarily bear any relation to the services that they consume. One answer would be for all non-household premises to become metered. However, as discussed above metering is expensive to install and maintain. The Executive recognises that metering is important in all cases where large volumes of water are being consumed, not least in the interests of encouraging conservation. Otherwise, however, it is concerned that the costs associated with it should be avoided where consumption is modest. In such cases, it suggests that a banding arrangement similar to that proposed for surface and highway drainage should be developed so that premises not served by a metered supply could be charged in a manner that sought to take account of their likely levels of consumption. This might require two or three bands. The lowest band would be for premises, such as corner shops and newsagents, whose consumption was confined to narrow domestic purposes and in practice would be unlikely to exceed that of the typical household. A second band would apply to premises such as restaurants, hairdressers’ shops and other premises where water was used as part of the business and could be expected to exceed that of a typical household. A third band would apply to premises where water consumption was beginning to match that of those on metered supplies. This banding would determine the wastewater charge, and the surface drainage charge would be determined by allocating a separate surface drainage band to the property.

56) Subject to the views of respondents to the consultation, and in common with the proposals to move to system of banding for surface and highway drainage, the Executive suggests that these new arrangements could come into force for the 2010-14 period. Until 2010 however the current arrangements should remain in place.

Consultation point 6: Should un-metered non-household premises continue to pay by reference to rateable value, or should they become metered, or should preparations be made to enable these premises to be charged by reference to a system of bandings to reflect broad consumption levels?

Trade effluent charges

57) As matters stand at present, Scottish Water sets trade effluent charges by agreement with trade effluent customers. Where customers are unhappy with the charge set, they can appeal against it to the Executive. The Water Services etc. (Scotland) Bill includes provisions to make trade effluent charges subject to regulation by the Commission. The Executive considers that the Commission should regulate these charges so that they are set by reference to consistently applied formulae, whose objective should be to ensure harmonised and cost reflective charges across the country. It proposes setting a requirement to that effect in its statement on the principles of charging.

The balance between charging and borrowing

58) The recent inquiry by the Finance Committee of the Scottish Parliament recommended that the Executive should investigate how it can ensure transparency in respect of Scottish Water’s future borrowing provision.

59) The Executive recognises the benefit of greater clarity in this respect. It sets out below how the principles described in section 1 might be applied in striking the right balance between charge income and borrowing in funding Scottish Water.

60) Given that borrowing by Scottish Water counts as public expenditure, the Executive must determine how much should be made available to support water and sewerage services in the light of its other priorities for the public services, whether health, education or transport, and the claims that they make on its resources. Such decisions are taken as part of the Executive’s periodic spending reviews. They necessarily constrain the extent to which the Executive can apply particular principles to setting borrowing levels for Scottish Water. However, subject to these constraints, the Executive proposes that the balance between charges and borrowing should be struck to ensure that Scottish Water’s finances are sustainable and that customers contribute to the cost of the services that they receive.

61) Regardless of wider public expenditure considerations, the Executive is clear that Scottish Water’s borrowing levels must be controlled in the interests of its customers and of the sustainability of the business. All borrowing by Scottish Water has to be funded by its customers in the form of the permanently higher charges that are required to cover the associated interest costs. Continual borrowing would lead to ever higher interest costs and ever higher charge. The consequence of this would be to transfer the burden of funding the business from the present to the future.

62) Given this, the Executive considers that it would be unsustainable to fund current costs, including the costs of maintaining the asset base, from borrowing. If respondents to the consultation agree with this assessment, the issue becomes the extent to which enhancements to the asset base should be funded through borrowing.

63) It could be argued that all enhancements should be funded in full through borrowing on the basis that this spreads the cost over the lifetime of the enhancements. However, this raises a serious question about sustainability. The work undertaken for Q&S III shows that just to meet current known legislative requirements will require enhancements to the asset base for many years to come. To fund all these enhancements from borrowing would mean that charges could be lower in the short run, but that they would have to rise continually above the rate of inflation in the medium term and beyond. Arguably, increases in bills (in real terms) over such a period would pass an unfair burden to future customers and would thus be inconsistent with the principle that present customers should contribute to the costs of the enhancements that require to be met at present.

64) The opposite position to funding all enhancements from borrowing would be for them all to be funded by present charge payers. This would mean that charges would have to be higher in the short run, as the entire capital programme would have to be funded from current charges. However, in the long run, charges would be significantly lower as they would not have to cover ever increasing interest costs. Arguably, that would be unfair to current customers, who would in effect be bearing the costs of enhancements that would benefit future customers.

65) Between these extreme positions a balance could be struck that would be fair to present and future customers and that would be financially sustainable for Scottish Water. This could be achieved by providing Scottish Water with sufficient borrowing to allow its debt to remain broadly constant in real terms over the period 2006-10. This would spread the costs of enhancements between present and future customers by allowing Scottish Water to meet a proportion of the planned enhancements out of new net borrowing.

Consultation Point 7: Do you agree that the Executive has identified the main factors that should have a bearing on the amount of borrowing provision made available to Scottish Water? If not, which other relevant factors should be taken into account?

Do you agree with the Executive’s analysis that to fund all enhancements from borrowing is unsustainable, but that to fund none would not strike the right balance between today’s charge payers and tomorrows? If so, do you consider that allowing Scottish Water’s debt to remain broadly constant in real terms would strike the right balance? If not, which level would strike the right balance and what implications would that balance have for wider public expenditure considerations?

Funding expansion of the public networks

66) A number of local authorities and developers are concerned by the lack of capacity on the public water and sewerage networks in particular areas. This can have the effect of constraining new development in those areas. The scale of these constraints and the estimated cost of easing them are addressed in "Investing in Water Services 2006-14". How these costs are met raises an important issue of principle for charging policy.

67) One option would be for customer charges to be set at a level to cover all the costs of providing new capacity on the network. However that would mean requiring existing customers to meet the costs of enabling new customers to be served by the network. This would be at odds with the principle that customers as a whole should meet the costs of the service provided to them. Moreover, at a time when customer charges will have to rise to deliver improved quality on the existing networks, many customers might consider that it would be unreasonable to ask them to accommodate additional increases in charges when these increases would not be of direct benefit to them.

68) The Executive considers that to be a legitimate concern. Therefore, subject to the views of those responding to the consultation, it proposes that the basic principle of customers paying for the services that they receive could be applied during the period 2006-10 in the following manner. Customers would be expected to meet all the costs of maintaining, operating and upgrading Scottish Water’s infrastructure at current levels of capacity, so as to meet the quality standards set by the Executive at the conclusion of Q&SIII. In addition, they would be expected to meet the cost of expanding Scottish Water’s strategic capacity, in terms of developing new reservoirs and treatment works, as these are major, long-term assets that are necessary to secure future services for existing customers, which clearly are not attributable to any single development proposal. However, insofar as expenditure was required to provide additional capacity for specific local developments, those seeking to advance these developments would be expected to meet the cost of the additional capacity, for example by providing improved local distributions networks, or service reservoirs, or pumping stations.

69) In this way, existing customers would continue to pay for the existing system as a whole and developers would pay whatever costs arise from their wish to expand the system in areas where local capacity is not available. This split in responsibilities would strike a fair and principled balance between the interests of existing customers and developers. It would reflect practice in the water industry in England and Wales and in the electricity industry in the UK generally. Moreover, insofar as limits on capacity of treatment works, or the like, constrain developments in particular areas, these would be removed over time as customer funded investment in these works takes place, enabling presently constrained developments to proceed in a way that has not been possible to date.

70) Sharing costs between customers and developers on this basis would mean developers facing the cost of providing local infrastructure where local constraints inhibit proposed developments. In practice, this is little different from the position at present where Scottish Water’s charge income and borrowing are insufficient to relieve all local constraints. What would be different would be the ability of developers to develop those sites whose constraints would be relieved by Scottish Water being funded in future to provide increased capacity in treatment works and the like.

71) Where developers decide to develop a particular site by providing local infrastructure, the costs would have to be absorbed by the developer, or passed on to the customer through higher prices. As the scale of these costs would depend on the action needed in a given case to relieve the constraint associated with that case, and as the circumstances of constraint vary enormously, it is not possible to offer a reliable estimate of the impact on developers, or customers, generally.

72) Under this approach the Executive and its agencies, where they are the prospective developer of a locally constrained site, would need to meet these costs. As is the case with other developers, this in effect is what happens at present. Thus it would be for the Executive to take account of the continuing impact that local constraints would have on bodies such as Scottish Enterprise, in case of economic development, and Communities Scotland, in cases of social housing, when deciding on the levels of funding that should be made available to such bodies. As with other developers, it would be for these bodies to provide increased capacity on the network where that was consistent with their wider priorities and objectives.

Consultation point 8: Do you agree that developers should be expected to meet the cost of providing increased local capacity where this is necessary to take forward their proposed developments? If not, should all customer groups meet the cost of removing development constraints equally, or should particular customer groups be required to bear the cost? If the latter, which customer groups should bear the costs and why?

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