A review commissioned by Ofwat to help it understand whether sludge and water resource cost and revenue data is robust and comparable with the advent of possible competition in upstream services has flagged up inconsistencies and variations in data provided by the 10 water and sewerage companies.

The regulator is currently developing its policy on the possible removal of sludge and water resource activities from the single wholesale water and wastewater price controls, and the creation of separate sludge and water resource price controls for its 2019 price review (PR19).

Ofwat sees this as a key step in achieving its goal is to deliver significant benefits to customers through greater efficiency and potentially greater competition.

The Water Act 2014 will allow for competition in upstream services including water resources and sludge. Ofwat said it now needs to review and refine the definitions of the water resources and sludge business units. If the regulator were to model costs and revenues in these areas – and particularly if it needs to set separate price controls –good quality data will be needed in 2016-17 and 2017-18.

Cambridge Economic Policy Associates (CEPA) carried out the review on behalf of Ofwat - the regulator identified a number of key areas it asked CEPA to look at in more detail, including:

• Sludge revenues and non-appointed income;
• Sludge related activities outside the price control;
• Reporting of costs – sludge and water resources;
• Interaction with non-appointed businesses; and
• Modern equivalent asset valuation (MEAV) revaluation in 2009
• the choice of “modern equivalent asset” for a certain process - most companies said that their preferred method of treatment had changed in recent years to Advanced Anaerobic Digestion plants, but varied over the desirable mix of Mesophilic Anaerobic Digestion plants, incinerators (which provide resilience) and liming sites (which can be more economical in remote areas);
• the difficulty of valuing certain large assets, bespoke to the location, for which little or no recent comparator data exists - particularly for reservoirs;

Ofwat said that in order to set effective price controls, high quality cost and revenue data is required from companies for both recent past and future years. The data needs to be robust on an individual company basis but must also be comparable across companies.

Ofwat has already mandated accounting separation and has provided guidance, via regulatory accounting guidelines (RAGs) on how this is to be achieved. The CEPA review has considered how effective this approach has been in operation and makes recommendations for improving consistency.

Areas of inconsistency across both water resource and sludge business units

Introducing the review, CEPA said through discussions with the ten water and sewerage companies it had gained a good view of potential issues in the water activities across the industry.

The review finds that while all companies have attempted to comply with the RAGs and have made good progress, there are areas of inconsistency between companies across both water resource and sludge business units.

In some cases these arise because one or two companies do not comply with the current RAGs: for example, by placing certain assets or activities apparently in an unsuitable business unit; or on the wrong side of the appointed/non-appointed divide. In others, companies have interpreted the RAGs in different and perhaps unexpected ways: either because current guidance is insufficiently specific, or because the current RAGs do not address particular scenarios.

CEPA said it had also observed examples of companies’ selecting differing allocation methodologies or cost drivers and identified some instances in which improved coordination across the industry could aid consistency. In others, individual companies take an approach which appears to CEPA to be inappropriate.

Overall, the review has identified a number of water resource and sludge accounting issues, including:

Water resource boundary issues

Although the RAGs are broadly clear on the start and end-points of each water business unit, CEPA says they do not give completely clear direction on some specific cases. As a result the most suitable treatment is currently unclear to companies (e.g. wholly compensating reservoirs without abstraction licences; aquifer recharge schemes; blending).

CEPA also cites some instances where the RAGs are considered to be clear, but companies have not allocated costs or assets in a way which is consistent with them (i.e. pumping upstream of impounding reservoirs; pumps which serve multiple business units).

Sludge boundary issues

Companies currently put the boundary between sludge and sewage activities in different places - especially with respect to thickening at standalone sewage treatment works (STW). According to CEPA’s approximate calculations, the different approaches are likely to be material.

The boundary between appointed and non-appointed activities is also interpreted differently (i.e. combined heat and power (CHP) assets; gas to grid; treating waste from other WaSCs; tankered waste). Given the possibility of a separate sludge price control, companies have emphasised the need for consistency among WaSCs and new entrants in the sludge business, the review says.

Principal user allocation methodology

Allocation by principal use is currently recommended for splitting values across separate price controls, but some companies also use it to allocate management and general (M&G) assets between business units. Given that M&G asset values are up to 8% of water resource and sludge business unit totals, the review says the difference between the two approaches seems likely to be material and worthy of further consideration.

Recharges

Where one business unit provides a service for another, companies are not always consistent as to whether or not they apply recharges (i.e. water sludge; power savings; sludge liquor treatment). In addition, the content of the recharges and charges from the appointee to associated businesses also vary - often only including elements of direct opex rather than being “fully loaded” to include elements to account for overheads and capital costs (e.g. bulk supplies; 3rd party services; tankered waste).

Choice of cost drivers

The review says some companies currently use drivers which do not seem to be the most appropriate available (e.g. allocating rates costs based on estimates of employee time spent on activities). There are also opportunities to achieve greater consistency by issuing guidance on preferred cost drivers where, for instance, nine out of ten WaSCs already follow the same approach.

Commenting on the modern equivalent asset valuation (MEAV) aspect of the review, CEPA found many areas in which companies had adopted different approaches to MEAV calculation or underlying assumptions at the PR09 revaluation.

"Concerns over a lack of consistency and comparability in reporting, which has implications for setting potential future price controls."

Based on its findings, CEPA has made a number of highly detailed recommendations corresponding to each of the issues.

Commenting on wider water issues found during the course of the targeted review, CEPA has made some interesting points concerning Ofwat’s move away from a prescriptive, highly detailed approach to reporting towards a more principles based approach. At a granular level, CEPA said this has led to "concerns over a lack of consistency and comparability in reporting, which has implications for setting potential future price controls."  

Although CEPA is not suggesting a return to a highly prescriptive reporting regime for certain costs, the review says it is crucial that companies apply, and can be seen to have applied the principles which have been laid out in Regulatory Accounting Guidelines so that, for example, the sewage treatment business units of all companies charge their sludge business a fully loaded opex and depreciation charge for liquor treatment.

The review suggests that it may be helpful if companies were required to explain specific details of their approaches to accounting in their Accounting Methodology Statements, for those areas where it found material variances, for example, in how they account for tankered waste.

CEPA concludes by saying that if the review process has been helpful to Ofwat and the companies, it may be useful to repeat it at future intervals.

Ofwat is shortly due to issue a consultation paper on changes to its regulatory accounting guidelines concerning the 2016-17 reporting year to take account of some of the issues discussed in the CEPA report.

Ofwat is also due to publish a decision document on the regulatory framework for the 2019 price review in May 2016, and will consult further on some issues, for example the boundary between sewage treatment and sludge treatment.

Ofwat’s scope for the work was to only cover the ten WaSCs given time constraints and because they are involved in both water and waste water activities. Ofwat will take forward further engagement with the water-only companies and encourage them to participate in upcoming Regulatory Accounting Working Groups and to respond to future consultations including those on the RAGs.

Click here to download the full TARGETED REVIEW OF SLUDGE AND WATER RESOURCES OFWAT by Cambridge Economic Policy Associates