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Letters to Regulatory Directors
RD 16/08 1 August 2008 Dear Regulatory Director Review of leakage target setting In RD 02/08 we updated you on the progress of our leakage target review. We informed you that we had commissioned consultants, WRc, to carry out work on developing a frontier approach to leakage target setting. We also said that companies were trialling the guidance for including 'externalities' (costs and benefits that do not have a market value) in the economic level of leakage (ELL) calculation, and that we were expecting final feedback in the spring. This letter provides you with a further update on our progress. Including externalities in the (S)ELL calculation Unfortunately we have still not received feedback from all of the companies trialling the guidance, although we have received helpful contributions from a number of companies. We now expect to finalise the guidance by October 2008. We will share the revised guidance with the sector so that companies can use it to inform their final business plan submissions, in line with the approach we set out in RD 02/08. Over the past few years, we have increasingly emphasised the importance of calculating leakage targets that incorporate all the costs and benefits of leakage control relative to the costs and benefits of other options, to maintain a balance between water supply and demand. In particular, we have been trying to improve the way in which companies incorporate environmental and social costs and benefits, including the value that customers place on leakage control. Reflecting this greater emphasis, we think it is appropriate to describe the target level of leakage as the sustainable, economic level of leakage (SELL). We will use this new term in future, in place of ELL. Frontier approach to leakage target setting You can now find on our website the consultants' final report on the frontier approach to leakage target setting. With this project we aimed to drive less efficient companies to catch up with the performance of the best companies. Due to the time constraints of the project, the consultants were restricted to using published and audited data. They therefore did not try to produce cost efficiency models because consistent cost data is not currently available for all companies. Even with the more limited ambition to explain differences in actual leakage levels, the consultants found that they were unable to produce robust models explaining the differences across companies with the data available. We have set out in more detail the purpose of the report and our concerns with the modelling process in the appendix to this letter. Since the report has been finalised, we have been considering how best to take the work forward. As discussed further in the appendix, we are not convinced that we could assess the efficiency of companies' leakage management operations by using a model that compares actual differences in leakage levels across companies, without taking into account the amount of money each company has spent. However, if we were to use a model which takes account of the cost of leakage management, we would have to consider how to combine these leakage efficiency results with the overall efficiency results for a company. We currently apply each company's efficiency target to its total operating expenditure, and leave it to each company to decide how it will achieve the targets we have set. We do not set companies specific targets for reducing costs in particular areas of expenditure. We think that our current operating cost efficiency targets have been successful in driving increased efficiency in operating expenditure, and can continue to do so. We still think that it is for companies to decide how best to make these efficiency savings. We believe that if we set specific leakage efficiency targets this would not provide the correct incentives for companies to improve their operating expenditure efficiency overall. We want to encourage companies to be efficient in all areas of their business, not just in leakage management, and we will continue to challenge companies to ensure that they do this. If we only set efficiency targets for one area of supply/demand expenditure, we are concerned that companies would have a distorted incentive to reduce leakage costs in preference to reducing other costs. This could mean that companies' plans were less efficient overall, leading to higher bills for customers. In conclusion, we have no immediate plans to do further work on the frontier approach because we doubt whether it would provide the right incentives for companies overall. However, we do not want to dismiss the approach without giving stakeholders an opportunity to identify significant points. In particular, we recognise that there might be a case for leakage-specific efficiency targets if current regulation skews companies' incentives in favour of efficiency improvements in other areas, over efficiency improvements in leakage control. We are not aware of such a bias, but we would welcome stakeholders' views on this. If we receive any material suggestions in response to this letter by the end of August, we will reconsider our position. Several companies have already offered to assist us in developing our thinking, and we are grateful for their support. If appropriate, we will convene a stakeholder group to discuss significant issues. We will report our conclusions in October. If you have any questions or observations about this letter please contact me (details below) or Jenny Humble on 0121 625 1453 or at jenny.humble@ofwat.gsi.gov.uk. Yours sincerely Paul Hope Head of Water Resource Economics Phone: 0121 625 3612 Appendix A 1. Introduction to the frontier report Ideally, we wanted to be able to compare companies' unit costs of leakage control. We would expect some of the differences between companies' unit costs to be attributable to differences in operating constraints (for example population density) and asset conditions (for example age of mains), with the remainder due to different levels of efficiency. We thought that an econometric model could take account of these external factors to give us a measure of companies' leakage cost efficiency. Due to the time constraints of the project, the consultants were restricted to using published and audited data. In particular, they were unable to use the cost of leakage management in the models because companies do not currently report this in a standard format. Instead, their work focused on producing models which explained differences in actual leakage levels between companies. Even with the more limited ambition to explain differences in actual leakage levels, the consultants found that they were unable to produce robust models explaining the differences across companies with the data available. 2. Concerns with the modelling approach We have a number of concerns with both the approach the consultants used to produce the models in its report, and with the variables used in their preferred model. These are summarised below.
In order to produce a robust model which explained differences between companies' actual leakage levels, we would need to carry out more work to address the concerns we have listed above. 3. Using the results from the report to drive efficiency In order to drive efficiency in leakage management, we would need to understand how we could use the results from the preferred model in the report to do this. Currently we are not clear how we could do this with a model which explains the differences in actual leakage level between companies. In their report, the consultants have suggested four ways in which we could use the results from a robust model. We discuss these below. The first suggestion in the report is that reporters use the ranking to challenge companies' ELL submissions. We and the reporters already challenge the ELL submissions and it does not seem that using results from an econometric model would add significant value to this process. It also has timetable implications because the results from the model will not be available until all companies have submitted their data and had it audited by their reporter. The next three suggestions are that Ofwat could set improvement targets to the costs going into the ELL, Ofwat could set leakage targets below ELL based on the ranking of the model, and that Ofwat could incorporate the model ranking into the OPA. With all three of these suggestions our concern is that the model rankings do not tell us how efficiently a company is spending money on its leakage management activity. The model tells us how efficiently a company is managing leakage given its operating environment, but it does not take account of how much money a company is spending to achieve this level of efficiency. We do not think it is appropriate to measure efficiency without taking account of the amount of money that a company is spending to achieve its level of activity. We therefore do not think that any of the suggestions made by the consultants are appropriate ways of using the ranking from the model.  |
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