2014 Price Review Business Plan Draft Determination Response

Transcription

1 2014 Price Review Business Plan Draft Determination Response 03 October 2014

2 Contents page Section 1. Board Assurance statement... 3 Section 2. Executive Summary... 6 Section 3. Outcomes and Incentives Section 4. Wholesale Costs Section 5. Retail Costs Section 6. Adjustments to price controls Section 7. Financeability Section 8. Company Specific Premium to the Cost of Capital Section 9. Risk and Reward Section 10. Appendix 1 Outcome Delivery Incentives Section 11. Appendix 2 Wholesale Totex Section 12. Appendix 3 Deloitte Statement on R3 and R Section 13. Appendix 4 SMC External Assurance Report Section 14. Appendix 5 Economic Insight report Section 15. Appendix 6 Retail Econometrics Section 16. Appendix 7 Serviceability Supporting Evidence Section 17. Appendix 8 - Frontier Economics report Section 18. Appendix 9 Revised data tables

3 Section 1. Board Assurance statement This statement is additional to and should be read together with the Board Governance and Assurance statement presented with our business plan on 2 December It provides an overview of the comprehensive and detailed review we have undertaken on the draft determination and summarises its implications for our customers, our business and other stakeholders. For this representation we have continued to ensure that we maintain the high level of scrutiny and governance adopted for the preparation of our business plan and further supporting evidence submitted in June The Board has followed the same guiding principles set out in its previous Board Governance and Assurance statement and has maintained its focus on customers, strong Board leadership, high standards of governance and transparency. Whilst analysing our draft determination and considering our representation we have continued our comprehensive engagement with our Customer Challenge Group (CCG). We have ensured the CCG has been fully appraised of the draft determination and the implications it has for our customers. In preparing our business plan we recognised that our collective duty to achieve long term and sustainable success requires us to strike the right balance between the interests of current and future customers, of the communities we serve, of the environment, of our employees and of our shareholders. The draft determination package as a whole no longer represents a balanced approach that adequately considers the interests of all those important elements. Instead, the draft determination represents an unsustainable view of the investment required to secure the level of service our customers expect in the future. It leaves our business facing a higher level of risk around being able to meet not only our customers priorities, but our regulator s newly-revealed expectations of achieving upper quartile performance across a range of performance measures. That increased risk remains inadequately reflected in the rate of return being allowed for those who invest in our business. Investors readily accept that risk, as long as it is fair and balanced amongst all those who have an interest in our business. While we recognise the current economic difficulties facing our customers, we remain concerned that Ofwat s approach to the draft determination appears to have ignored at best in part the priorities of our customers, the longer term consequence to price and performance beyond this five-year price setting process. Financeability In the business plan the Board provided assurance of the financeability of the plan across both our own and the notional structure. The credit ratios produced by the plan showed that there was only marginal headroom and the financeability of the plan was clearly dependent on the Weighted Average Cost of Capital (WACC) of 4.06% as included. As the Board noted, our shareholders were taking reduced dividends to achieve a financeable plan, a strong indication of the combined efforts of South East Water and its shareholders to achieve a plan that balances risk. The draft determination does not represent a balanced plan or shared risk and, unadjusted, would result in a downgrade of the Company s credit rating, undermining the ability of the Company to finance its functions over the period 2015 to It is key that the changes required by the Company to address this issue reverting to a PAYG ratio that reflects the correct Opex / Capex

4 split, increasing the RCV run off rate and the inclusion of a company specific cost of capital are made in the final determination in order to restore appropriate balance to the plan. Totex Baseline In respect of the wholesale cost assessment the Board has ensured additional analysis has been carried out regarding our specific circumstances. This assessment has considered the particular characteristics of our supply area, water sources, and customers current and future needs. The impact of the methodology and models used by Ofwat and their ability to adequately and correctly reflect these specific characteristics has been reviewed and remains an area of concern. Our Water Resources Management Plan reflects our very challenging position for 2015 to 2020 and beyond, where increasing demand and pressure on existing supplies means we have one of the Industry s largest supply demand deficits. Our business plan expenditure requirement ensured sufficient demand management activity and resource development to enable us to continue to meet our statutory obligations and customers expectations in respect to a reliable supply of water. The gap in the Totex baseline within the draft determination, driven by the inability of the totex models to adequately fund water resources expenditure, means levels of service may be compromised Performance Legacy Adjustment Significant analysis was carried out and we provided additional evidence relating to our performance in respect of the asset serviceability assessment for infrastructure assets in the 2010 to 2015 period. The Board is satisfied that the information and analysis provided to date is robust and demonstrates the level of performance we have actually achieved. The shortfall adjustment included in Ofwat s draft determination is based on applying a new methodology - not consulted upon with the industry. This approach does not reflect the overall serviceability assessment, takes no account of the action the Board has taken during the period to ensure customer service performance is returned to expected levels, and applies what we consider is an entirely disproportionate and arbitrary penalty. The Board remains of the view that an adjustment is not justified and that the adjustment proposed in the draft determination does not reflect our actual performance, and so cannot be reasonable or proportionate. Outcomes and Outcome Delivery Incentives Following publication of the risk and reward guidance in January 2014, detailed feedback from Ofwat, further customer engagement, and further feedback from the Customer Challenge Group, the Board thoroughly reviewed our ODIs. In June 2014 the Board submitted a revised package of ODIs, mindful to maintain the strong link between our package of outcomes and measures with customer priorities and ensuring that the incentive values are reflective of the value customers place on them. Given this approach, we would question the premise on which Ofwat has now intervened in a number of areas to apply different performance commitments and incentives. While we agree the principle of applying upper quartile performance seeks to provide a better service for customers, the application contradicts Ofwat s objective that companies need to own their business plans, and those plans must be founded on customers priorities. Ofwat s interventions have at best in part disregarded evidence-based customer support for companies proposals, and their willingness to pay for expected levels of service. The application of upper quartile is also at

5 odds with the funding of average performance in totex baselines. We have, within our representation, suggested an alternative tiered approach for Ofwat s consideration. External Assurance The Board has implemented the same process of external assurance as set out in its previous Board Governance and Assurance Statement to assure itself of the robustness of data and of the analysis used to prepare this representation. External assurance has been provided by Strategic Management Consultants (SMC) and auditors Deloittes. The scope of work of the external assurer described in the previous Board Governance and Assurance Statement remained the same but their work was focused on the subject matter of our representation. The external assurer has provided specific reports in relation to cost allocation, reported performance and IFRS reporting. These reports are included in the relevant sections and appendices of our representation. Conclusion The Board has applied strong governance to the preparation of this representation and is satisfied that the processes and systems of internal controls followed were appropriate, robust and provide a high level of confidence in the information and analysis included in this submission. The draft determination package as a whole no longer represents the right balance between the interests of current and future customers, of the communities we serve, of the environment, of our employees and of our shareholders. The draft determination represents a short term and unsustainable view of the investment required to secure the future level of service our customers rightly expect, and have directly shaped our business plan. This representation seeks to address the consequences of the draft determination and re-balance the plan as a whole. Signed on behalf of the Board of South East Water. Paul Butler Managing Director

6 Section 2. Executive Summary Introduction On 2 nd December 2013 we published our three business plans for the 2015 to 2020 period. Combined, these plans outlined our commitment to deliver the following: Our customers priorities through our customer outcomes Ensure we meet all our legal obligations through our compliance outcomes Protect the water supply service of the future through our sustainability outcomes Continue to improve customer service as a result of our new approach to measuring and delivering customer satisfaction, with financial rewards and penalties for our performance Improve our customer and stakeholder communications Water bills that are affordable, but give extra support to those customers that are struggling to pay A balance of risk between customers, stakeholders and shareholders Invest 475m to maintain high quality tap water, secure a reliable supply of water every day, to develop new water resources, pledge in the longer term to drive leakage levels on our own water mains down to 10 per cent and complete our Customer Metering Programme We recognised very early on in the development of our plans the combined impact this investment, and our day-to-day running costs, could have on customers bills. We committed to keeping the average household bill at 201 before inflation, the same as the average household bill for the current five-year period. In June 2014, following consideration of the feedback from Ofwat and the result of the risk based review, we provided further evidence on components of our plan. That constructive and positive dialogue with Ofwat allowed us to reconsider important issues, such as the overall risk and reward package that will be applied to our future plans; and the cost of borrowing to fund our investment. In summary, we: Reduced our overall expenditure requirement for to 920m; Made a further significant reduction from 4.45% to 4.06% - in the rate of return; and, Reduced the profit margins on the retail services offered to our household and nonhousehold customers. As a result of these downward adjustments, our average household bill for reduced to 195, before inflation. The draft determination published by Ofwat on 29 th August 2014 resulted in an average household bill of 180, before inflation. This reduced average bill is the result of Ofwat interventions namely: Disallowing a number of retail and wholesale expenditure requirements; Rejecting our request for a specific uplift to the cost of capital; and Applying a shortfall adjustment for performance in The draft determination leaves us with a disproportionate level of risk, not adequately reflected in the rate of return, undermining the financeability of the Company. While we have recognised the current economic difficulties facing our customers in the development of our plan, Ofwat appears to have ignored the longer term consequences to price and performance beyond this five-year price setting process. We have set out in this submission our full representation on the draft determination. At the same time we have been mindful to focus on those areas that remain a material issue for us, or where we believe are not in customers best interests. Our key concerns include:

7 Financeability If left unadjusted the draft determination would result in the Company s credit rating being downgraded, a result that is not in the interests of the Company s customers or other stakeholders; The draft determination package as a whole no longer represents the right balance of risk between the interests of current and future customers, of the communities we serve, of the environment, of our employees and of our shareholders; The wholesale cost allowance does not provide sufficient expenditure to ensure delivery of our water resource programme, putting at risk the delivery of our customers priorities; The use of upper quartile performance targets, without explicit funding to meet that level of service, represents additional risks that will erode our customers trust and confidence and affect our wider reputation among stakeholders; and, The serviceability legacy adjustment applies retrospective regulation and results in an unreasonable and disproportionate penalty. Ofwat states that they consider the draft determination to meet key ratio criteria and therefore it represents a financeable package. We do not agree. We focus strongly on the FFO/debt ratio which if we correct Ofwat s ratio to reflect how Standard and Poor calculate it, the ratio does not achieve the minimum threshold we believe would be required of the Company on a notional company basis. This would result in the Company s credit rating being downgraded, this is not in the interests of the Company s customers or other stakeholders. We therefore request Ofwat to make the following changes in the draft determination: Amend PAYG ratios to restore the correct balance between Opex and Capex for the totex level funded. In the draft determination Ofwat has applied the business plan PAYG ratio to the funded totex, meaning that the totex reductions Ofwat have made do not reflect the correct Opex / Capex mix. In line with our discussion with Ofwat we have provided PAYG ratios for a range of totex scenarios. At the level of totex included in the draft determination this would transfer 18m into the Company s PAYG revenue allowance; Increase our RCV run off rate from 3.49% to 3.75%, reverse the reprofiling adjustments made in the draft determination and replace with the modest reprofiling adjustments we propose. The bill profiles these changes generate are supported by our CCG These changes will ensure that on a notional company basis (notional gearing, notional cost of debt) financeability is restored. However, even with these adjustments when the Company s actual cost of debt is taken into account the ability of the Company to maintain its current credit rating is undermined. This is because in the draft determination Ofwat has rejected the Company s inclusion of a company specific cost of capital premium, meaning the cost of capital included in the draft price control is not sufficient to cover the costs of the Company. We do not agree with Ofwat s assessment of our company specific claim. We believe the evidence and arguments that Ofwat rely on lack robustness and, in some cases, rely on inappropriate evidence. We commissioned Frontier Economics to analyse the Ofwat evidence, and they conclude that the increased cost of debt finance that we are exposed to is at least equal to the 25bps identified for the smaller water only companies in the draft determination. Outcomes and Outcome Delivery Incentives In June we presented a revised package of Outcome Delivery Incentives (ODIs) following publication of the risk and reward guidance in January 2014, detailed feedback from Ofwat, additional customer engagement, and further feedback from the Customer Challenge Group. In reviewing our ODIs we were mindful to maintain the strong link between our package of

8 outcomes and measures and customer priorities, and to ensure that the incentive values remain reflective of the value customers place on them. Given this approach, we would question the premise on which Ofwat has now intervened in a number of areas to apply different performance commitments and incentives, using a newly introduced approach to upper quartile. These interventions have changed the risk profile of our package as a whole so that it is no longer balanced. The interventions have increased the penalty range while decreasing the reward range, replaced performance commitments with tougher targets and removed appropriate deadbands. As a useful comparison the draft determination has reverted to a position where the rewards are broadly aligned with our original business plan but the penalties have now doubled. In considering our representation we have sought to restore some appropriate balance so that any risk (and therefore reward) is fairly shared, maintain the link to our customers priorities, improve the overall comparability with other companies, and reflect mandatory changes made to some ODIs across the industry for example the removal of double counting with our own proposed ODIs. While we agree the principle of applying upper quartile performance seeks to provide a better service for customers in particular areas, the application also seems to contradict Ofwat s objective that companies need to own their business plans, and those plans must be founded on customers priorities. Ofwat s interventions have at best in part disregarded evidence-based customer support for companies proposals, and their willingness to pay for expected levels of service. In addition as the risk of failure has now undeniably increased, the changes have now created greater risk for companies and the Industry. The introduction of the mean zonal compliance outcome and associated ODI has created an overlap with our below ground asset performance outcome. This would result in a penalty being applied twice for the same service failure event. To address this unintended consequence we have removed the areas of duplication and replaced our previous outcome on below ground asset performance with two customer-facing performance commitments on discolouration contacts and properties at risk of low pressure. In the draft determination Ofwat has intervened and removed the reward incentive associated with our outcome Meeting demand for water. Providing a reliable supply of water, is one of our customers top priorities and one of our biggest challenges, and so we wanted to ensure this was captured in our outcomes and ODI package. In our business plan and in our revised June 2014 submission, we proposed this outcome should be measured by the Security of Supply Index (SOSI). Given the challenging nature of our supply demand balance we proposed a financial reward and penalty incentive. Taking on board the feedback from Ofwat we have amended this performance commitment to a measure more meaningful to customers and stakeholders which is Meeting the water resource deficit. The adjustments set out in our representation also address the unintended reputational consequences of the interventions, and why it is important to rebalance the package. Wholesale Costs Our June 2014 submission set out our requirement for 810m of totex. Within the draft determination Ofwat has calculated a totex baseline of 774m, representing a gap of 36m or 5%. The primary driver for our gap is the clear inability of the totex assessment models to adequately calculate the supply demand enhancement expenditure requirements, in particular the expenditure associated with meeting the deficit between supply and demand.

9 The fundamental reason the Totex models underfund supply demand expenditure is due to the lack of explanatory factors which truly reflect the supply demand balance requirement. The key explanatory factors used in the Totex models relate largely to size and the physical properties of the company supply area, for example length of mains and connection density. Whilst these drivers are appropriate for base expenditure, they fail to assess specific needs such as supply demand schemes. Our supply demand deficit clearly demonstrates a requirement that is material when compared to an average position. Our proposal is not to seek refinements to the Totex models, since we acknowledge in the round that the suite of models provides a reasonable guide for the majority of the industry. Within our response we have instead provided further evidence and proposed a wholesale cost exclusion adjustment to address the underfunding for us, which we maintain is justified, material and robust. In addition to the need outlined in our Water Resources Management Plan, our business plan, subsequent evidence submission in June 2014 and acknowledgement by Ofwat to support our deficit requirement, we consider there to be sufficient evidence to validate our exclusion adjustment. The implicit allowance of 90.4m for supply demand investment within the Ofwat Totex models is insufficient, and we therefore seek an exclusion adjustment of at least 31.6m. Legacy Adjustments In our business plan we clearly and transparently presented our actual performance in compared to Ofwat s expectations of what we were funded at PR09 to deliver. We also provided further evidence in our June 2014 submission to support our assessment of performance. This assessment has also been externally assured for each annual Risk and Compliance Statement. It is therefore extremely disappointing that in the draft determination Ofwat has included a shortfall adjustment of 17.3m, based on interruptions performance alone. This draft determination response will demonstrate the following: 1. We behaved reasonably and transparently when assessing our below ground assets as stable for the period; 2. The draft determination is clear in that the assessment process for serviceability has changed, however we will show that this is retrospective; 3. The assessment process now being used by Ofwat is inappropriate for assessing serviceability; 4. An approach that has more subjectivity and considers all indicators as well as company actions would have arrived at a very different conclusion to the one Ofwat reached in the draft determination; and, 5. Irrespective of the above, the shortfall penalty is disproportionate. Past Ofwat guidance on the measurement of serviceability has been based on a basket of indicators being used to assess serviceability, where all indicators must be maintained within their performance control limits. If an indicator is persistently close to or persistently above the upper control limit, the serviceability may be classified as marginal or deteriorating; however the pattern of indicators and an assessment of wider factors affecting performance, would be used to assess overall serviceability. This methodology is well established and was clear at the start of the period. There has not been due notification or proper consultation with the industry to suggest this methodology has changed. We are concerned that this methodology is now not being applied by Ofwat in making an assessment of performance in Instead, the shortfall calculation method used in the draft determination is such that exceedance of the upper control limit for a single year and single

10 indicator is used to indicate lack of overall stable serviceability. There is no consideration of trend, persistence or basket of indicators or other factors in this approach. We see this as a significant change in the guidance provided by Ofwat to inform our investment strategy, and consider it is retrospective regulation. We acknowledge that the overall shortfall approach, setting out the maximum serviceability penalty of 50%, was clearly set out at the beginning of this period; however the change to the application of a single indicator single year approach and the arbitrary methodology for calculating an equal penalty value, per indicator per year, was not. This new methodology has not previously been published, nor has it undergone due consultation with the industry. This fundamental change to asset serviceability, had it been known at the beginning of this period, would have had serious implications both on our decision to accept the determination and the reference limits within it, but also on our investment decisions during this period. Setting the process to one side, we do not consider a single indicator to be sufficient in any event to be capable of revealing poor asset performance. We assessed our infrastructure serviceability to be marginal in and stable thereafter on the basis that the serviceability assessment is a basket of six indicators, all contributing to the information an Asset Manager would use in making a judgment on performance in a service area. The primary reason that single parameters are not appropriate is they are subject to considerable variation year on year single parameter variability is not necessarily due to asset performance or operational response, but inherent in the activity measured. Interruptions to supply have considerable in-built variability, as a single event can cause a significant effect, whereas other events measured by other indicators have a single event single count relationship. In our representation we have outlined how our interruptions performance has indeed been driven by a small number of uncontrollable events affecting a large number of customers. We have carefully reviewed each of the unplanned interruptions to supply which have occurred in the three years in question. The high property counts are the result of external factors beyond our control and/or operational difficulties encountered during the management of the incident. In no case is there any evidence to suggest poor asset investment decisions contributed to the occurrence of the event. Given that the majority of the unplanned interruptions result from incidents involving trunk mains, we could not have acted in advance to allow for these external, unpredictable factors without incurring substantial additional costs e.g. dualling of mains or applying numerous cross connections or storage. Our optimal economic analysis confirms that this would not have been in the best interests of our customers. As part of our review of operational performance in response to interruption events, we have identified areas where we can improve our customer service to help mitigate such events, and these improvements have started to show in performance, as demonstrated by our performance this year to date. However, even if our response is fully optimal, we will still be subject to events that are uncontrollable and that have the potential to significantly impact this measure. In their assessment Ofwat has forecast deteriorating performance in We have provided performance data for the first six months of the year in our representation which clearly demonstrates our interruptions strategy has been effective, and that we have had only a small number of events affecting a small number of properties, and so our asset performance is stable. We have provided additional evidence relating to our performance in respect of the asset serviceability assessment for infrastructure assets in the period. The information and analysis provided in this representation, and to date, is robust and demonstrates the actual level of performance achieved in the period is consistent with our own assessment of serviceability. The adjustment to prices included in the draft determination is not justified as it does not reflect our

11 actual performance, and so cannot be fair or proportionate. In our business plan Opex Incentive Allowance (OIA) assessment we included adjustment to deduct the pension deficit contributions paid in excess of the amount included in the PR09 price control. We made this adjustment to ensure that the two numbers were comparable. In our June 2014 submission in response to Ofwat s position on this adjustment, and in the context of the overall balanced package of our business plan, we removed this adjustment but stressed that Ofwat should include this adjustment going forward in the context of companies performance against the totex menu. However, we believe the draft determination does not present a balanced package for our customers and stakeholders and we now request that Ofwat reconsider their approach and ensure that appropriate adjustments are made for the differences between pension deficit contributions made and those included in the PR09 price control. Retail Costs For our business plan we undertook independent research to understand the impact that inflation will have on our retail costs from This research showed the overall retail household costs are at risk of increasing due to inflationary pressures; however these inflationary pressures could be offset by productivity growth (i.e. delivering efficiency savings). We maintain that from our cost to serve per customer will increase due to inflationary pressures. We have minimised the impact of these on customers bills by identifying efficiencies we can make that offset their impact. In June 2014, following feedback from Ofwat, we reviewed our research and provided further evidence that demonstrates our retail costs are accurate and as efficient as they can be to ensure our current retail costs are robust and reflect an efficient service. In our draft determination, Ofwat has not accepted our proposed cost adjustment, stating that there is insufficient evidence to demonstrate these costs are outside of efficient management control, we are not materially different from other companies and that we are not upper quartile efficient on cost to serve. We provide in this representation new evidence to demonstrate our efficient management of costs and new benchmarking analysis. The result is we have further increased our efficiency targets over the period resulting in an additional saving to customers of 1.6m. We believe it is inappropriate to set the threshold for permitting an adjustment for input price inflation using an upper quartile test. The principle that the retail cost to serve is subject to inflationary pressures is a separate test to a company s cost efficiency challenge. The correct approach should be one that recognises well-evidenced inflation pressures combined with an appropriate level of efficiency. This approach naturally results in less efficient companies having a smaller adjustment. We have considered the invitation to re-open the price setting process for non-household default tariffs earlier than the current five year timescale. Our default tariffs are designed so they are simple to communicate to customers and simple to understand, whilst at the same ensuring that they are cost reflective for each customer grouping. It is in the interests of all market participants, regulators and customers to ensure that each company s tariffs reflect the costs of supplying the service and are structured in a way to ensure efficient and compliant competition. Therefore we propose that re-opening the price control would be an option in advance of market opening i.e. in or as charges are set prior to the start of the year they apply.

12 Board Governance and Assurance In reviewing our business plan, we were pleased that Ofwat said we had provided sufficient evidence that our Board had scrutinised and assured itself that our plan is of a high quality; and that our performance commitments would continue to meet our statutory obligations. We are also pleased to note that Ofwat does not have any concerns over the quality of the information we have provided to date, or the assurance processes we have undertaken. When preparing this representation, we have continued to follow a governance process that maintains the high level of scrutiny and governance adopted for the preparation of our business plan and supplementary submission. As described in our Board statement, the Board remains confident that the evidence presented in our original plan, the further evidence submission and this representation is robust, fair and balanced; and the approaches for producing these documents have been subject to the same rigorous controls and assurance mechanisms. Customer Challenge Group We have continued to proactively engage with the independent South East Water Customer Challenge Group (CCG) on this critical stage of the price setting process. We have consulted the CCG comprehensively on the draft determination and the consequences this is likely to have for customers and the company. In particular, we have ensured engagement with the CCG on our representation on: Outcomes and ODIs Financeability Bill profile amendments The option to re-open the price setting process for non-household charges The CCG has produced a separate report which outlines its views of the draft determination and our representation. Conclusions The draft determination package as a whole no longer represents the right balance between the interests of current and future customers, of the communities we serve, of the environment, of our employees and of our shareholders. The draft determination represents a short term and unsustainable view of the investment required to secure the future level of service our customers rightly expect, and who have directly shaped our business plan. We look forward to receiving a final determination that better reflects the expectations of our customers founded on well-evidenced research - and which restores a more appropriate balance of risk and reward for the next five years.

13 Section 3. Outcomes and Incentives Issues and concerns with the draft determination Ofwat interventions have changed the risk profile of our package as a whole, in particular they: No longer reflect a balanced package for our customers and our stakeholders Create undue financial and reputational risk Increase the penalty range while decreasing the reward range Replace customer preferred performance commitments with tougher upper quartile targets Lack appropriate deadbands Our proposed changes for the final determination Deadbands introduced on horizontal applied measures, a move supported by our CCG Amendment to measure F2 from reputational to financial reward and penalty Amendment to measure H2 from a security of supply index commitment to a zero deficit commitment Amendment to measure N2 from asset performance below ground to discolouration contacts Reintroduce a phased introduction of incentive from on all customer satisfaction based outcomes All proposed changes have been reflected in the draft determination tables which are included in Appendix 1. Introduction Following publication of the risk and reward guidance in January 2014, detailed feedback from Ofwat, additional customer engagement, and further feedback from the Customer Challenge Group, we thoroughly reviewed our Outcome Delivery Incentives (ODIs). In June we presented a revised package of ODIs, mindful to maintain the strong link between our package of outcomes and performance measures with customers' priorities for their water supply service, and ensuring that the incentive values remain reflective of the value customers place on key areas of that service. Given this approach, we would question the premise on which Ofwat has now intervened in a number of areas to apply different performance commitments and incentives. The interventions made have changed the risk profile of our package as a whole. The interventions have increased the penalty range while decreasing the reward range, replaced performance commitments with tougher targets and removed appropriate deadbands. The resulting ODI package no longer reflects a balanced package for our customers and our stakeholders. In considering our representations we have sought to restore balance, the link to our customers priorities and to improve the overall comparability with other companies as well as reflecting mandatory changes made to some ODIs across the industry. Our representation therefore concentrates on the following items: Application of upper quartile Unintended consequences of the draft determination interventions Restoring balance where justified

14 3.1 Application of upper quartile Whilst we agree that in particular areas the application of upper quartile performance provides a better service for customers, it contradicts Ofwat s overarching objective that companies should have full ownership of their plans, disregards customer support for companies proposals and creates unintended reputational consequences. The application of upper quartile is also at odds with the funding of average performance in totex baselines. We are concerned that this is a new approach introduced in draft determinations, an approach that is without due notification and industry consultation. Inconsistency with totex funding In the draft determination Ofwat has taken a view that customers have paid for upper quartile performance and should receive it as soon as is possible, and that the totex calculations have been based on funding companies to deliver upper quartile efficiency. Ofwat remain of the view that companies are being funded to upper quartile levels of efficiency covering both cost and performance. We do not agree with this view. The totex models use companies historic and - in some cases - forecast activity levels, activity that reflects performance to maintain current levels of service unless otherwise indicated, and applies an industry average cost. Whilst the models do apply an upper quartile efficiency challenge, this is an efficiency challenge that is calculated based on companies cost performance - not the activity or performance on which those costs are based. We maintain that the draft determination does not allow for the increased level of activity or cost that will be required for companies to achieve upper quartile performance. Reputational and other consequences There are considerable reputational consequences as a result of the application of upper quartile performance commitments. The nature of upper quartile means that three quarters of the industry could be perceived, at best, as trying to achieve better performance, or worst, failing in performance. There is a reputational risk of perceived failure if these companies do not achieve this improvement in performance. This is particularly pertinent in the area of water quality, where companies have built up trust with customers over many years. If the application of the ODIs is as described in the draft determination then an outcome might be that there is significant media and stakeholder interest setting out companies failure to meet water quality targets, despite maintaining current levels of service and despite mean zonal compliance levels being 99.96% or better. Companies would be perceived as failing water quality standards, which we know is a top priority for customers, leading to an unnecessary and undesirable reduction in customer confidence. Ofwat s own vision of trust and confidence needs to be underpinned by a set of supporting measures that are set and reported in a way that does not undermine unnecessarily this vision or existing high levels of customer trust. This new approach has an additional impact for us given we have built our vision on moving from measuring our service to measuring customer satisfaction to ensure we remain highly customer focused and do not resort to a purely delivery focused approach. An industry or company that is now likely to be reporting more failed performance commitments than ever before will undoubtedly lose some of the current customer trust and confidence that it has built up since privatisation, which in turn will feed through to our satisfaction measures, and so we are faced with needing to deliver more just to address this unintended consequence.

15 Appropriate deadbands Ofwat s methodology for ODIs outlined how deadbands could be used for performance measures where there is uncertainty in measuring actual delivery, or if it is inappropriate to apply an incentive unless a noticeable change in service has occurred. The approach described in the draft determination takes no account of either of these factors. ODIs exist which are new and/or have in-built natural variability and therefore the measurement is likely to be uncertain. The draft determination certainly contain ODIs where the industry performance is bunched and differences in the performance number do not reflect a difference in service and should not be rewarded or penalised as such. Deadbands are therefore in all cases appropriate. As the approach of excluding deadbands on performance would have clear reputational risks, as outlined above, we urge that deadbands are applied as appropriate to all horizontal measures. This approach is supported by South East Water s Customer Challenge Group. Alternative Approach We endorse an approach that aims to drive improved performance for the Industry as a whole, and agree with the principle that the application of upper quartile performance ultimately seeks to provide a better service for customers. However, where the use of upper quartile targets is not supported by customers, we would suggest an alternative approach to the one proposed in draft determinations. The current SIM mechanism is designed in such a way that it incentivises companies to achieve upper quartile performance, with a tiered approach above and below industry average. This style of incentive is more aligned to existing methodologies and is a proven approach to improving companies performance but without a potentially arbitrary cliff edge. We recommend this is adopted in the final determination. 3.2 Unintended consequences of the draft determination interventions Wholesale water outcome N1: Below ground asset performance assessment The introduction of the mean zonal compliance outcome and associated ODI has created an overlap with our below ground asset performance outcome. This could result in a penalty being applied twice for the same service failure. Table 1 shows the indicators proposed and those that contribute to the mean zonal compliance measure. Table 1 Business Plan below ground asset performance indicators Indicator Overlap with Mean Zonal Compliance Total bursts (nr) No Iron non-compliance (as 100-Mean Zonal compliance) % Yes DG2 pressure (nr) No Customer contacts discolouration (nr/1000 population) No Distribution Index TIM (as 100-Mean Zonal compliance) % Yes In response to this consequence, we have discussed with Ofwat and propose to replace the basket approach to outcome N1 with separate outcomes for the remaining indicators. Of the remaining three indicators, two are deemed customer facing - customer contacts for discolouration and DG2 low pressure. We have developed an ODI for customer contacts for discolouration using the existing serviceability indicator metric, as shown in Table 2. Use of the existing serviceability indicator metric will maintain the focus on asset performance, while the additional customer satisfaction measures for appearance, taste and odour, ensure customers are fully protected from deteriorating water quality performance.

16 Outcome F2 represents DG2 low pressure properties, on which we had proposed a reputational ODI in our plan on the basis that it was included in outcome N1. We have now, with demonstrable customer support, converted this ODI from reputational to financial reward and penalty as outlined in Table 3. The final indicator, burst mains, is not deemed to be customer facing and so we have not proposed a separate performance commitment. The impact on customer service from burst mains is interruptions to supply, which means customers are protected from poor performance through the separate outcome and ODI on average minutes lost per property; this measure is further underpinned by our customer satisfaction measure on the reliability of supply. As a result the maintenance and health of our assets are strongly reinforced by the package of outcomes and performance commitments we have proposed. Table 2 Performance Commitment N1 Performance Commitment Definition Customer contacts discolouration Number of customer contacts per 1,000 population served discolouration (orange/brown/black), as defined by the serviceability indicator. This outcome will ensure we deliver our customers top priority Clean water. Baseline Committed performance levels Customer Priority Unit: Contact number per 1,000 population Performance commitment Penalty collar Penalty deadband Reward deadband Reward cap Performance Commitment Deadbands Caps and collars Additional detail Incentive Type or incentive Change to draft determination Reflects current levels of service. Customers have shown support for this level of performance. The penalty and reward deadbands have been set at the serviceability upper and lower control limits of 1.71 and 0.63 respectively. ntfinal.pdf The reward cap and penalty collar have been set at a range equal to the control limit range of Therefore the reward cap is 0.09 and the penalty collar is Our customer research carried out on our outcomes shows there is a strong correlation between actual service performance and customer satisfaction. We believe this serviceability measure coupled with our customer satisfaction measures for appearance, taste and odour, ensure customers are fully protected from deteriorating water quality performance. Link to research: df Financial reward and penalty Performance commitment and incentive introduced.

17 Basis of incentive calculation WTP data from customer research provides a value of 4.19 per household per year to improve discolouration performance (intermediate improvement). Average number of households used is 832,000, therefore maximum WTP of 3.486m per year. Assuming a cost sharing percentage of 50%, the incentive is derived from the following methodology for reward: Incentive = WTP * (1- cost sharing %) = 3.486m * (1-50%) = 1.743m = 1.743m / 1.17 properties = m per 0.01 contacts per 1,000 population per year. The reward range has been set as 0.54 (0.63 deadband less 0.09 reward cap). Therefore maximum reward = 54 * m = 0.804m per year. There is no incremental cost associated with the performance commitment; performance is being delivered through the baseline operating costs and investment. Therefore the penalty range is equal to the reward. Therefore maximum penalty = 0.804m per year. Max Performance / Total 16 (Contact No.) 0.01 m m m m m m Lower Upper contac ts per 1,000 pop. /year Penalty m Reward m Timing and frequency of incentive Form of adjustment Additional detail Table 3 Performance Commitment F2 Incentive calculated annually and accrued to the end of the period and applied in the 2019 price setting process. Calculation and accrual of incentive reviewed by the Customer Panel. Adjustment to RCV. Source of willingness to pay: Business Plan appendix APP20 Engagement Final WTP Second Stage report. ereport.pdf Performance Number of properties at risk of low pressure Commitment Definition Number of properties at risk of low pressure, as recorded on the DG2 register. Customer Priority This outcome will ensure we deliver our customers priority reliable supply. Unit: Baseline Committed performance levels Number of properties Performance commitment Penalty collar Penalty deadband Reward deadband Reward cap Performance Commitment Reflects current levels of service. Customers have shown support for this level of performance.

18 Deadbands The penalty and reward deadbands have been set at a level that reflects the best and worst performance since , as shown in the chart below. Caps and collars Additional detail Incentive Type or incentive Change to draft determination Basis of incentive calculation Max. The reward cap has been set as zero properties. The penalty collar has been set at a symmetrical range of 57 properties, meaning the collar is 126 properties. N/A Financial reward and penalty Incentive changed from reputational to Financial reward and penalty. WTP data from customer research provides a value of 0.06 per household per year to improve pressure performance (intermediate improvement). Average number of households used is 832,000, therefore maximum WTP of 49,920 per year. Assuming a cost sharing percentage of 50%, the incentive is derived from the following methodology for reward: Incentive = WTP * (1- cost sharing %) = 49,920 * (1-50%) = 24,960 = 24,960 / 60 properties = 416 per property per year. The reward cap has been set as zero properties and the penalty collar has been set at a symmetrical range of 126. Therefore maximum reward = 57 properties * 416 per property = 0.024m per year. There is no incremental cost associated with the performance commitment; performance is being delivered through the baseline operating costs and investment. Therefore for the penalty value we have assumed an equal 416 per property as the reward. Therefore maximum penalty = 0.024m per year Total Performance (Number of properties) / prop. /year m m m m m m Lower Upper Penalty Reward Timing and frequency of incentive Incentive calculated annually and accrued to the end of the period and applied in the 2019 price setting process. Calculation and accrual of incentive reviewed by the Customer Panel.

19 Form of adjustment Additional detail Adjustment to RCV Source of willingness to pay: Business Plan appendix APP20 Engagement Final WTP Second Stage report. ereport.pdf 3.3 Restoring balance where justified Customer satisfaction As set out in our business plan, we embarked on an incentive-based approach around our future performance that will drive how well we deliver customers priorities, by measuring a change in the level of customer satisfaction. In the bottom up analysis Ofwat has intervened and increased the penalty ranges to one full index point, to reflect the asymmetry in customers views. Our proposed measures reflect an innovative approach to outcomes and therefore create a degree of uncertainty and risk. The design and power of the incentives we proposed reflected the relative infancy of this approach as did the size of the proposed penalties. Increasing the penalty range increases the risk profile of these new measures. Whilst we acknowledge and accept that the new incentive penalty range is more symmetrically aligned to customers willingness to pay, the draft determination intervention has increased the risk profile of these measures. To restore balance we propose to re-introduce the phased introduction of incentives, as originally proposed in our December 2013 business plan. Then, we proposed phasing the introduction of financial incentives on these measures from onwards, to reflect the risks with this new approach and the uncertainty surrounding it. In June 2014, in our revised ODIs, we removed this phased introduction, taking on board Ofwat s guidance on ODIs, the appropriate use of deadbands and the balancing of risk. Given the position we are now in with the draft determination interventions, and to reflect the overall risk profile of the ODIs, we propose these incentives are only introduced in full from onwards. Reintroducing a phased approach will in effect mean that in year one these measures will be reputational only, given the additional risk we are now exposed to. The applicable measures have been amended accordingly in Appendix 1. Meeting demand for water Meeting demand for water and providing a reliable supply is one of our customers top priorities. We therefore ensured that this was captured in our outcome and ODI package. In our business plan and in our revised June submission we proposed this outcome be measured by the Security of Supply Index (SOSI). Given the challenging nature of our supply demand balance we proposed a financial reward and penalty incentive. In the draft determination Ofwat has intervened and removed the reward incentive on the basis of consistency with other companies, citing insufficient evidence that being able to meet SOSI is considered stretching performance. We have reviewed the consistency with other companies and whilst none have proposed reward on a performance commitment measured by SOSI, there are examples where there is reward on alternative supply/demand related measures, such as hosepipe bans or customer demand management. For example: Severn Trent has a performance commitment restrictions on water use, with an incentive of financial reward and penalty applied; and, South West Water has a performance commitment water restrictions placed on customers, with an incentive of financial reward and penalty applied.

20 In considering the feedback from Ofwat in the draft determination we have considered the use of an alternative measure such as these examples. However we believe there are shortcomings with these measures. These alternatives represent only part of the supply demand balance approach, which is demand management. ODIs on these measures only incentivise companies to deliver the demand management aspects of their Water Resources Management Plan, but this alone does not ensure delivery of the outcome, which is that customers receive a reliable supply. A measure which uses SOSI incentivises a company to ensure all aspects of the WRMP are delivered, including both demand management and supply side enhancements. We also have concerns around the regulatory and statutory conflict that would occur if there was an incentive being applied around the introduction of hosepipe bans. There is a clear and well developed process for the application of hosepipe bans, based on environmental considerations and companies planning procedures with the Environment Agency and Natural England, and not least companies statutory Drought Plans. To introduce a separate financial incentive in this process could potentially create a perverse incentive to not apply hosepipe bans when a statutory process would otherwise stipulate they are necessary. This could have environmentally damaging consequences and cause wider reputational, customer and stakeholder trust issues. We note the comments made by Ofwat regarding the achievability of SOSI and whether it represents a stretching commitment. Our water resource position is one of our greatest challenges. At the end of 2020 we will have a supply demand deficit of 61.4Ml/d, 12% of our current supply volumes and over six times the volume of enhancement delivered in This level of deficit also reflects the second largest deficit across the industry, as shown in Figure 1. Figure 1 Deficit as % of water supplied In order to achieve this level of enhancement, we have to deliver some challenging demand and supply schemes early in the period and to tight timescales. The early demand management schemes for water efficiency and metering are higher risk in terms of delivering expected water savings as the demand reductions depend upon our ability to successfully influence the choices and actions of our customers; while several of the supply schemes depend upon the agreement

21 and co-operation of third party organisations (primarily Southern Water and the Environment Agency). The additional risk of meeting demand beyond 2015 has also been flagged by our external assurer as a business risk: We have previously commented in our Business Plan assurance that although SOSI correctly reports a regional score of 100 (which signifies no deficits in any water resource zones), a closer examination of the analysis reveals that several zones are uncomfortably close to showing a SDB deficit. We have also previously commented that, in our view, the SEW AMP6 SDB proposals contain highrisk assumptions regarding leakage control, albeit they are entirely consistent with the approved Water Resource Management Plan. The very challenging targets for AMP6 comprise both a tighter Economic Leakage Target and a number of additional specific demand reduction leakage schemes. We have taken on board the comments received from Ofwat in the draft determination, and through the clarification process, and recommend amendments to the performance commitment we proposed previously. We recognise the difficulties with a SOSI measure and propose a measure more meaningful to customers and stakeholders Meeting the water resource deficit. The new measure is aimed at removing the supply demand deficit in each year, will be measured in Ml/d and will be a pass or fail measure. If we have any water resource deficit at the end of each year customers will be protected by the ODI penalty. Outcome H2 has been adjusted based on the new measure described and is shown in Table 4. Table 4 Performance Commitment H2 Performance Commitment Definition Meeting the water resources deficit Delivery of enhancements to supply, both supply side and demand side measures, to ensure zero deficit in the company supply demand balance in any year. Customer Priority This outcome will ensure we deliver our customers priority reliable supply. Unit: Baseline Committed performance levels Performance commitment Penalty collar - Pass or fail, see rules below Penalty deadband Reward deadband Reward cap - Pass or fail, see rules below Performance Commitment Reflects current levels of service. Customers have shown support for this level of performance. Deadbands This is a pass or fail measure, customer will be protected because as soon as there is a deficit the penalty will apply. Caps and collars No cap or collar as pass or fail approach. Additional detail Performance commitment of zero company level deficit measured by the annual security of supply assessment calculation. Incentive Type or incentive Financial reward and penalty Change to draft Measure revised to a deficit based measure and reward re-introduced. determination

22 Basis of incentive calculation Methodology applied: Incentive (penalty) = Incremental WTP (incremental cost * cost sharing %). WTP derived from WTP for hosepipe bans of 3.61 per household per year. Incremental cost derived from Water Resource Management Plan scenario modelling, improved service level scenario derived an additional cost of 125m across the 25 year planning horizon, equivalent to 5m per year. Incentive (penalty) = ( 3.61 * 832,000 households) ( 5m * 50%) = 0.504m per year. Reward incentive applied as symmetrical to the penalty to reflect a balanced risk profile. Max Performance / pass Total 16 (Deficit Ml/d) or fail m m m m m m Lower Upper /year Penalty Reward Timing and frequency of incentive Incentive calculated annually and accrued to the end of the period and applied in the 2019 price setting process. Calculation and accrual of incentive reviewed by the Customer Panel. Form of adjustment Additional detail Adjustment to revenue. Source of willingness to pay: Business Plan appendix APP20 Engagement Final WTP Main Stage report. port.pdf

23 Section 4. Wholesale Costs Issues and concerns with the draft determination The chosen approach to funding totex expenditure has an adverse and material effect on our overall totex baseline This effect is driven by the clear inability of two of three chosen models to fully explain the activities and costs required to reduce a deficit between supply and demand Our proposed changes for the final determination Request Ofwat recognise specific and material deficiencies in the modelling and allow suitable correction through exclusion adjustments. Include in the final determination an out of model adjustment to the totex baseline of at least 31.6m. Introduction This section of our representation relates to alterations we are proposing through exclusion adjustment to the wholesale cost models and, therefore, ultimately to our Totex baseline. In our original business plan and subsequent submission in June 2014 we provided evidence that supported a change to the model forms and process and cost exclusion adjustments in three areas: 1. Costs relating to complex groundwater treatment 2. Network (zonal) strategies required to move water efficiently around our network 3. Enhancement expenditure including water resource costs In the draft determination Ofwat has not adopted our proposals to change model form and process. In assessing the enhancement cost claim Ofwat recognised the need to alter the drivers for investment in one of the key models for water resource expenditure only, the Botex model. In doing so Ofwat performed a deep dive analysis of the investment needs and cost and found them to be beneficial and least cost. In this response we have decided not to add anything further to the claims regarding groundwater treatment and network strategies, as we are unable to gather further evidence in particular relating to activity and spend undertaken by other companies since there is no shared reporting of the required data available. Subsequently we are unable, to demonstrate that we are disproportionately affected within the totex assessment. This is compounded in particular for the network strategy claim where companies seemingly allocate this spend to a wide variety of drivers, including growth and resilience. We are still convinced that this investment is both needed, cost beneficial and robust but recognise that we are unable to provide further evidence that we are disproportionally affected. We are able, though, to provide further evidence to support our most material and important claim relating to the provision of costs to fund our water resource investment and in particular why a company specific adjustment should be made to the total model approach, rather than for just the botex model. It should be noted that we have taken account of the deep dive analysis Ofwat performed on the Network Strategies exclusion claim and reduced our water resources

24 % AMP6 Deficit of 13/14 DI adjustment claim accordingly. In order to enable Ofwat to easily assess the cost adjustment claim we have produced evidence under the following headings used in the deep dive modelling approach, namely: Our specific challenges when compared to the wider industry The need for the investment The robustness of the costs and the optioneering approach to select the schemes The calculation within the models of the implicit allowance i.e. the investment costs produced by the models, and the adjustment made relating to network strategies The difference between the implicit allowance and the required investment i.e. the cost adjustment claim The claim is supported by evidence both from our own business plan but also from Ofwat s deep dive assessment of our original claims; and information on the approach to this cost exclusion provided by Ofwat in response to clarification SEW005 raised after the publication of the draft determination. Through the use of two approaches we have developed an exclusion adjustment range of 31.6m to 43.9m. For one approach we have adopted the Ofwat mechanism of implicit allowance, whilst for the second approach we have used our own calculation using a bottom-up approach which is fed through the totex models using existing explanatory factors. Our specific challenges when compared to the wider industry The key driver for investment in water resource schemes is the deficit that exists between demand and supply. We operate in an area of water stress and have a significant deficit to resolve in the period of 61.38Ml/d, equivalent to 12% of the water we regularly put into supply. The totex modelling approach results in companies being funded, in general, for an average amount of activity so that there will be companies that are marginally overfunded in some areas and marginally underfunded in other areas. Where there is a material difference in the drivers for investment, such as deficit, that produce a material difference in allowed expenditure, then we believe Ofwat s methodology should allow for an outside model adjustment. The chart below clearly shows that we have an exceptional deficit to recover and therefore this should be the starting point for a cost adjustment. Figure 2 Proportion of deficit versus company ( ) distribution input 16% 14% 12% 10% 8% 6% 4% 2% 0%

25 Source: Ofwat appendix A feeder model inputs / Annual Performance Report The need for the investment Our business plan and Water Resources Management Plan included investment to recover a deficit of 61.38Ml/d over the five year period. The process of assessing the deficit was well supported by all stakeholders and has been made available to Ofwat in previous submissions. We have not reproduced this evidence here as Ofwat has assessed the need for this deficit in Deep Dive 04 (DD04) and concluded Overall, South East Water has provided sufficient evidence to demonstrate that the forecast [deficit] variable should be 61.38Ml/d. The robustness of the costs Least cost Our business plan and Water Resources Management Plan included a cost of 169.6m for the period. The process of assessing the costs and optioneering the solutions was well supported by all stakeholders and has been made available to Ofwat in previous submissions. We have not reproduced this evidence here as Ofwat assessed the cost benefit in DD04 and concluded South East Water has demonstrated that they have identified the least cost long term plan. Cost robustness As well as a cost benefit and appraisal assessment, we note that Ofwat uses an assessment of the robustness of cost. Again we have provided evidence about the robustness of the costing within the business plan and Water Resources Management Plan and do not repeat this evidence here. As for all our costs within the capital investment areas, the costs we have used for water resources are driven from a unit cost database (see business plan supporting appendix APP07: Business Plan Costing) primarily and we note that Ofwat in assessing (deep dive) DD02 comment: South East Water has addressed many of the challenges of the RBR on robustness of estimate. It has provided much more evidence. For example detail is provided about the unit cost database, the use of Jacobs, and a Cost Base exercise (page 26 Early Information Sharing 2nd June FINAL.pdf) to benchmark costs and explain the efficiency challenge Historic cost benchmarking When considering the robustness of costs for this exclusion we would suggest that through Ofwat analysis (pap_tec1408uqwholesale.xls) we have been assessed as an upper quartile company based upon historic data ranging from to We consider this to be strong evidence that our totex costs are robust and efficient and within the upper quartile. The below summary table is taken from Ofwat s analysis to assess individual company efficiency in the period 2008/09 to 2012/13. The table outlines the results of the Ofwat totex modelling process versus actual historic expenditure. We score as an upper quartile efficient company.

26 Table 5 Ofwat Efficiency Summary Historic Costs Rank Company Efficiency score 1 SBW SWT PRT SEW NES UPPER QUARTILE SSC TMS SVT DVW MEDIAN YKY AFW ANH WSX LOWER QUARTILE SRN NWT SES WSH BRL Source: Ofwat calculation of upper quartile (pap_tec1408uqwholesale.xls) As described in our business plan we have used our historic costs via a unit cost database to generate our future programme of work, and applied further self-assessed efficiency of 5% to these historic costs. Water resource expenditure is treated no differently to other aspects of the expenditure programme, and is subject to the same challenging efficiency targets. This approach has been supported by Ofwat with their deep dive (DD04) by commenting: South East Water has demonstrated that they have identified the least cost long term plan. In summary, we consider we have built our plan upon an already proven efficient model, and then further challenged ourselves going forward the consequence is a rigorous and robust cost challenge. Other benchmarking techniques We have reviewed other cost benchmarking approaches that might be applied in this area to assess robustness, namely the water resource unit costs provided in the feeder models and the forward looking efficiency models. We discuss the use of these for this particular test below. Unit cost approach - The unit cost approach for water resources benchmarking would have to assume that the options available to each company are broadly the same. Clearly the costs and type of scheme in water resource optioneering depends largely on two factors: the available resource in the area and secondly on how long the company has been operating in a deficit position as this affects the cost of the next available option.

27 Whilst still remaining least cost as described above, historic deficits have driven us to increasingly expensive solutions, such as metering, lower leakage, reservoir construction and surface water treatment works expansions, as lower cost groundwater schemes are increasingly unavailable. We therefore discount the unit cost model as a suitable benchmark of robust water resource costs. We are also confident that regionally our costs are robust and comparable as shown between the alignment between our own WRMP and the regional solution generated from the Water Resource in the South East group. Forward looking efficiency models we have concerns about the robustness of these models for two reasons: future costs are less certain than current costs as they are to a degree aspirational and unproven, and the adjustments for cost exclusions are yet to be included within the future models so they are still work in progress. As such the argument for South East Water therefore becomes circular. Despite this view we have carried out an assessment of the impact of using future costs in conjunction with historic costs to create an overall efficiency assessment. Including the exclusion we are proposing in this representation our forward efficiency factor would be 1.006, which is a calculation comparison of our company submission versus the adjusted forecast totex value. To reflect the uncertainty of future costs we have weighted historic and our adjusted future costs on a 60:40 basis (historic:future). This produces a weighted average efficiency position still within the upper quartile of the Industry. We have calculated industry upper quartile equal to , which has been obtained via analysis of individual company feeder models. Table 6 Weighting - SEW Historic Efficiency SEW future (adjusted) efficiency Industry Upper Quartile SEW Weighted Average Source: Ofwat calculation of upper quartile (pap_tec1408uqwholesale.xls) Individually and collectively the different available assessments of robustness combined with Ofwat s own assessment of need and least cost prove conclusively that the cost challenge element of the totex adjustment mechanism has been passed. Calculation of supply demand implicit allowance The earlier sections have demonstrated that we have a deficit that is real and exceptional and that the costs are robust and represent the least cost solution. The next stage in assessing a cost adjustment is to calculate the proportion of these costs that are explained within the totex models already i.e. the implicit allowance. In calculating an implicit allowance for our water resources programme we have adopted two approaches. The first is to adopt the Ofwat approach of calculating the implicit allowance as described in clarification response SEW005. In order to validate and confirm the results of this we have used an alternative approach for calculating the implicit allowance. Approach 1 Ofwat Implicit Allowance Mechanism The mechanism used is identical to the approach outlined by Ofwat in response to clarification SEW005. However, we believe the calculation examples used by Ofwat within their response

28 were based on values used for the risk based review. We have therefore adjusted the numbers to reflect the current position. The underpinning assumption to this mechanism is that the triangulated value from the two botex econometric models represents the base operating/capital expenditure in the remaining totex models. This assumption is reasonable and used by Ofwat as confirmed in their response to clarification SEW005: The variables used in the botex model and the refined totex model stream are the same. Therefore we have assumed that the base model forecast from both these approaches is the same. The botex forecast is m. Using this mechanism we are able to calculate assumed enhancement for each of three streams of modelling, namely full totex, refined totex, and botex. These calculations are outlined below: Full Totex Enhancement Expenditure Calculation Using the draft determination feeder model the full totex value is equal to m, following an upper quartile efficiency adjustment. Full totex model enhancement expenditure is therefore 116.7m (i.e m m). Refined Totex Enhancement Expenditure Calculation We confirm the feeder model s triangulation of the refined models of m (following upper quartile efficiency). Given the botex value of m the level of enhancement within the refined totex models is 112.3m (i.e m m). Botex Enhancement Expenditure Calculation Enhancement expenditure for the botex models is the sum of the unit cost model, plus the 8.4% uplift. Hence, enhancement post upper quartile efficiency is equal to 227.2m (i.e m + 6.7m m, representing supply demand, new development, and the uplift respectively). Enhancement Triangulation Following the Ofwat methodology the values from each of the three streams are triangulated to generate an average value. Post upper quartile efficiency enhancement expenditure is therefore calculated as 152.1m (i.e. ( 116.7m m m) / 3). The calculated enhancement value is compared to our submitted plan of 205m, thus a 74% implicit allowance is derived. The above calculations are summarised in the below table: Table 7 Ofwat implicit allowance assumptions (post upper quartile efficiency) million Enhancement Full Totex Refined Totex Botex Triangulated Average Company Claim Implicit Allowance 74.1% Following existing Ofwat guidance on previous deep dives we assume the calculated implicit allowance is relevant to all components of enhancement, hence the implicit allowance for water resource expenditure is 74.1%.

29 Approach 2 SEW Implicit Allowance Mechanism The alternative approach to calculating the implied allowance is to combine the amount of supply demand balance (SDB) funding the Ofwat unit cost model allows for the whole industry. The table below has been collated via the Ofwat feeder models for each company, and indicates that we have the fourth highest SDB expenditure at 171.8m (pre-upper quartile efficiency), which we consider is a reasonable and robust forecast of expenditure for this type of activity. The table also shows that the combined industry funding for SDB is equal to 1,504m for the period. Table 8 Ofwat supply demand unit cost model output (Botex stream) Company AMP6 Deficit, Ml/d SDB Allowed Cost, m Thames * Southern Affinity South East Anglian Yorkshire * Severn Trent * United Utilities Sutton and East Surrey Bristol * South West * Dwr Cymru Dee Valley Northumbrian Portsmouth Semcorp Bournemouth South Staffs Wessex TOTAL 1,504 * Companies assessed using dry annual average conditions Source: Ofwat draft determination feeder models for each company We consider the combined total of 1,504m to be a reasonable reflection of SDB expenditure requirements for the whole industry. This assumption is consistent with Ofwat s approach of calculating the implicit allowance via the use of the botex unit cost models where appropriate. For example, on slide 49 of Ofwat s Wholesale cost assessment workshop pack (8 th April 2014) regarding calculation of implicit allowances, Ofwat utilise the unit cost models to calculate implicit cost allowance associated with lead pipe expenditure. Using the refined totex model D we have used length of mains, connection density, proportion of mains relined and renewed, and proportion of distribution input (DI) from river sources as the most significant explanatory factors (as noted within the CEPA document) to allocate the 1,504m across the industry. To allocate costs we have obtained industry explanatory factor data from Ofwat s feeder models for each company. As a further refinement we have included the explanatory values to mirror the current CEPA modelling approach, and also weighted the explanatory factors according to their correlation factor to ensure a more robust allocation, namely: Length of mains correlation factor (weighting) 2.86 Density 1.07 Proportion of mains relined and renewed 0.07 Proportion of DI from river sources 0.02

30 The results are detailed in the below table, for model D. Table 9 Totex model D assumed allocation of supply demand expenditure Company Length of Mains Km Density % of DI from river sources % of mains relined and renewed Combined % Weighting Assumed SDB expenditure Dŵr Cymru 136, % Anglian 193, % South West 76, % Wessex 58, % South East 73, % Severn Trent 233, % Yorkshire 158, % United Utilities 215, % Northumbrian 128, % Southern 69, % Dee Valley 10, % Bristol 34, % Affinity 83, % Bournemouth 14, % South Staffs 42, % Sutton & East S 17, % Thames 154, % Portsmouth 16, % TOTAL 1, The result is that the refined model D allocates only 91m of expenditure for SDB activity for South East Water. We believe this demonstrates that whilst size explanatory factors (e.g. length of mains, density) are appropriate for forecasting operating and base capital expenditure, they are not adequate indicators of required supply demand balance expenditure, particularly for companies that are operating with significant deficits. As outlined in our supporting document in June 2014, we consider the omission of water resource factors to be understandable since such factors can be lumpy and inconsistent. Additionally for the majority of the Industry it is likely that factors relating to the size of company could be an appropriate driver, however we would argue that our unique requirement and need for a water resource programme are suitably and materiality different to the majority of the Industry and therefore a correction, or exclusion adjustment, is required to allow for the underfunding nature of the totex models. Applying the same methodology to the remaining totex models (outlined individually within the Appendix 2 we can calculate the level of SDB implied expenditure in each totex model. In all cases the SDB value within the totex models is considerably lower than the value derived by the unit cost models. This is shown in the below table.

31 Table 10 Allocation of supply demand expenditure through totex models REF Description m Comment A Full Totex WM3 Model C 91.6m 1/3 weighting B WM6 Model B 84.3m Refined Totex C WM5 Model D 91.3m 1/3 weighting D Botex SDB Unit Cost 171.8m 1/3 weighting E SDB Triangulated Average 117.1m F SDB Triangulated Average with UQ efficiency 109.4m G Actual SEW SDB Claim 169.6m H Approach 2 Implicit Allowance in Ofwat Model 65% i.e / Following triangulation the assumed SDB expenditure in the model is 109.4m post efficiency (line F in above table). This figure compares to our SDB claim of 169.6m. Through this approach we calculate that the Ofwat models implicit allowance for SDB is equivalent to 65% (as opposed to 74% calculated through approach 1). Difference between the implicit allowance and required investment (models exclusion) The exclusion cost adjustment mechanism is a simple approach of calculating the variance between the implicit allowance of supply demand expenditure and the actual value of our supply demand expenditure via two different methods. Approach 1 Ofwat Implicit Allowance Mechanism The implicit allowance calculated via approach one was equal to 74%. We calculated through Approach 1 that the implicit allowance for enhancement activity is 74% (see table 2). Our supply demand programme, excluding network strategies (excluded as a result of Ofwat s previous conclusions), is equal to 122.1m as detailed in Table 11. Table 11 Description m Enhancements to the supply / demand balance (dry year critical / peak conditions) Enhancements to the supply / demand balance (dry year annual average conditions) 60.7 Supply / demand balance total Network Strategies (as included in supply demand balance) Removed as part of separate exclusion claim 47.6 Adjusted supply / demand expenditure Source: SEW business plan, W3 To calculate the implicit allowance specifically for supply demand the approach by Ofwat is to apply the enhancement percentage implicit allowance to our claim. In this case implicit supply demand allowance in the totex models is therefore equal to 90.4m i.e. 74% of 122.1m. The subsequent variance between our supply demand claim and the implicit allowance is therefore our calculated exclusion adjustment cost, i.e. 31.6m ( m).

32 Approach 2 South East Water Implicit Allowance Mechanism Through Approach 2 we calculated that the Ofwat models implicit allowance for SDB is equivalent to 64.5% (as shown in table 5). Applying this implicit allowance allocation to our supply demand claim (i.e m) equates to 78.8m. The calculated SDB exclusion adjustment cost is therefore equal to 43.3m (i.e m 78.8m) A summary of these two approaches is provided in Table 12. Table 12 Summary of SEW exclusion adjustments Approach Company SDB Claim* m Implicit Allowance % Implicit Allowance m Exclusion Adjustment Cost m 1. Ofwat Approach 74.1% m 2. SEW Approach 64.5% * Company SDB claim excludes network strategy expenditure W11 Exclusion Adjustment Given Approach 1 is based upon actual Ofwat methodology we consider the value (exclusion) calculated through this mechanism, 31.6m, to be the most appropriate and consistent across the industry. We have included Approach 2 to provide a validation step and give confidence that an adjustment is warranted of at least 31.6m when assessed via either method. As part of our response we have included a revised table W11. Given the analysis and evidence submitted we consider the Ofwat approach to generate the most industry consistent exclusion, and therefore this approach has been used to populate the table at both P10 and P50 values. We consider our own second approach to be a more precise calculation to highlight the shortfall of enhancement expenditure within the totex models, and so we have used this upper estimate as the P90 value. When completing the five year profile we have applied 1/5 rule to the total exclusion, consistent with the Ofwat approach. An extract of the W11 table for the supply demand exclusion is shown below. Table 13 W11 Supply Demand exclusion H Proposed exclusion Proposed exclusion description Text 0 Supply Demand 114 Proposed exclusion type Text 0 Cost exclusion 115 Alternative uncertainty mechanism proposed Yes/No 0 No 116 Estimate of operating expenditure used for purpose of business plan m Estimate of capital expenditure used for purpose of business plan m Median (P50) estimate of operating expenditure m Median (P50) estimate of capital expenditure m Upper (P90) estimate of operating expenditure m Upper (P90) estimate of capital expenditure m Lower (P10) estimate of operating expenditure m Lower (P10) estimate of capital expenditure m We therefore urge Ofwat to recognise specific and material deficiencies where appropriate in the modelling and allow suitable correction through exclusion adjustments. In this case we believe we have demonstrated through the use of the Ofwat implicit allowance mechanism that supply demand expenditure is underfunded within the totex models to an extent that puts key customers priorities and delivery of outcomes at risk. Excluding network strategy expenditure, our expenditure requirement is 122.1m over With evidence provided in this representation, and in conjunction with our WRMP, we consider there is appropriate and

33 persuasive evidence to demonstrate both the need and the efficient cost involved to meet our supply demand programme. As such the implicit allowance within the Ofwat Totex models calculated at 90.4m using an Ofwat mechanism is insufficient, and we therefore seek an exclusion adjustment of at least 31.6m (as demonstrated by Approach 1). Additionally we consider Approach 2 supports our exclusion further by demonstrating explanatory factors in the totex models are not suitable to appropriately allocate supply/demand expenditure.

34 Section 5. Retail Costs Issues and concerns with the draft determination - Household Business plan cost adjustment of 9.5m has been rejected, on the basis that Ofwat consider: There is insufficient evidence to demonstrate our costs are outside of efficient management control We are not materially different from other companies We are not upper quartile efficient on cost to serve Issues and concerns with the draft determination - Non-household Business plan cost adjustment of 1.15m has been rejected, on the basis that Ofwat consider: The figure was not accompanied by supporting evidence in the non-household retail price control Evidence provided in the non-household retail price control did not pass the criteria on the quality of supporting evidence and was deemed insufficient No evidence was provided as to why the net margin was insufficient for covering input price risks Issues and concerns with the draft determination - Non-household price control re-opening Companies have been invited to consider whether they would prefer to: Set their non-household retail price control for five years; or Change the form of the control in some way that would allow greater time to consider and Our proposed changes for the final determination Reinstate inflationary cost adjustment For household customers, increasing our efficiency from 1.4% per annum to 2.1% per annum saving customers an additional 1.4m For non-household customers, increasing our efficiency from 1.4% to 2.1% per annum saving customers an additional 0.24m Allow South East Water the option to re-open the non-household price control process earlier if certain triggers are reached 5.1 Retail cost to serve adjustment - Household Introduction In our business plan submission we included an adjustment to retail household operating expenditure of 9.5m as outlined in Table 14. Table 14 Business plan household cost adjustment Adjustments to base costs Annual average over 2015 to 2020 (%) m General cost inflation 3.0% 14.2 Specific cost efficiencies (0.4%) (1.6) General cost efficiencies (1.0%) (3.1) Total 1.6% 9.5 Section A3.2.2 and table A3.3 of our draft determination sets out the removal of this adjustment

35 for the following reasons: Table 15 Draft determination assessment Criteria Assessment Ofwat comment Beyond management control Materially different Upper quartile Fail The evidence provided on management practices for wages is sufficient and convincing, but is not so for other costs (for example, debt collection agency fees and meter reading contractor fees). Fail The evidence provided on relative efficiency includes benchmarking of wages against salaries outside the water industry that show that for most bands, South East Water pay below the median, and they demonstrate how staff performance is managed. However, South East Water is not upper quartile efficient in the water industry. Therefore the company has not demonstrated that they are affected in a materially different way to the average company. Fail South East Water is not upper quartile relative to other companies in the water sector suggesting that there is further scope to absorb any cost pressures. The remainder of this section seeks to address each of these points in turn. Beyond management control As outlined in the draft determination the evidence provided for wages has been assessed as sufficient and convincing by Ofwat, as referenced in the report to its Board; therefore these costs are not discussed further in this submission. Meter reading and debt costs Meter reading and debt costs were highlighted as areas where insufficient evidence was provided. As outlined in our business plan both of these costs are driven by wage inflation as the majority of debt fees (87%) and meter reading expenditure is incurred on staffing. Therefore, to forecast the risk of future cost increases for these categories, wage inflation remains the most appropriate index to use. In our business plan we calculated inflationary rates for each individual cost component. Table 16 shows the specific cost elements that have been challenged in the draft determination. As shown the proposed annual inflation rates for debt fees and meter reading are 2.15% and 3.25% respectively both lower than the average wage of 4.35%.

36 Table 16 Expenditure type Basis Average annual inflation rate Salaries Our wage forecast has been taken from the Office of Budget Responsibility s (OBR) March 2014 forecast of average earnings. This produces an average annual wage inflation of 3.6%. We have then researched individual job groups to determine how job specific wages have moved historically in the past. This produces a mark up/down for each job type as shown below. Note - the calculation method by the OBR does not take account of the change in full time/part time workers and in the recent Northern Ireland Electricity price determination was shown to understate wage inflation in constant hours. This would equate to an average annual additional increase of 0.7%. Further details of this adjustment are set out in Appendix % Professional, legal & debt fees Meter reading The main expenditure type for professional, legal & debt fees is salary cost (87%) and therefore we have used the same method as described above for our wage inflation forecasts. Evidence shows an average annual mark down of 2.2% against the OBR forecast. The main expenditure type for meter reading is salary cost and therefore we have used to same method as described above for our wage inflation forecasts. Evidence shows an average annual mark down of 1.1% against the OBR forecast. 2.15% 3.25% Meter reading and debt costs cost control As outlined in our business plan, the contracts that form part of the costs in these two categories are outsourced activities and therefore reflect current competitive market rates. All contracts are regularly tendered to ensure that the services are efficiently procured at the lowest possible cost whilst, at the same time, deliver maximum effectiveness. For example in relation to debt agency fees, the contracts are structured on a success only basis be that a commission payment upon receipt of cash or as a result of a successful outcome (e.g. successful trace of an absconded customer). This is further evidenced by the fact that we have, on average, only 2% of our customers who do not pay their bills each year compared to an industry average of 3%, as demonstrated by analysing company-submitted annual performance data. Materially different efficiency benchmark The draft determination considered we had not demonstrated that we are affected in a materially different way to the average company. The starting point of our analysis is the economic principle that in a competitive market an efficient company will pass on input price pressures to its customers. If we are relatively efficient compared to a relevant benchmark then, by definition, input price pressure would be less within management control and would impact company costs more materially than would be the case for a less efficient company (as the inefficient company would have greater scope to absorb this pressure).

37 We have therefore undertaken further work to determine a frontier position for the most effective company and therefore the level of efficiency catch up that we should use for the period 2015 to This has comprised of the following: Models 1 & 2: Econometric modelling to assess efficiency catch-up. We have used two approaches for our modelling to provide a balanced view; Model 3: Independent research by Economic Insight to compare our unit costs to the frontier position in the water industry; Models 4 & 5: Independent research by Economic Insight to compare our unit costs to the frontier position in a wider group of industries (both including and excluding bad debt); In addition, independent research by Economic Insight was undertaken to quantify the frontier shift that efficient companies should be able to achieve. Details of the evidence above can be found in Appendices 5 and 6. We now explain each of these models in more detail, and the summary of their outputs. Model 1: South East Water econometric modelling Ofwat based One approach to assess efficiency has been to undertake econometric modelling, which identifies the catch-up that would be required to reach the same level as a frontier company. Econometric modelling is often used by regulators and frequently by Ofwat. Our first approach is to draw upon a legacy Ofwat econometric model, previously used to assess business activity. We have updated this model to reflect actual cost, by component build-up of relevant cost to serve indicators and used total customer numbers as the sole explanatory factor. For consistency with the values used in the unit cost to serve assessment our analysis includes the level of debt written off. Given its inclusion within the unit cost (average cost to serve model) we feel it is correct to include the level of debt written off within this analysis. The model is therefore basic, but robust as demonstrated through an r-squared value of When targeting the frontier company, any company with a turnover of less than 3% of the industry has been removed from the analysis in line with previous Ofwat assessments. A low catch up rate and a high catch up rate are produced assuming that either 50% or 60% of the gap could be closed in the period 2015 to The method to identify the frontier company (i.e. removal of companies with turnover less than 3% of the industry) and the low and high catch up rates are consistent for all models. The results of our econometric modelling show that to achieve a 50% or 60% catch up in efficiency against the frontier company an annual efficiency catch up of 1.28% to 1.54% would be required per annum. Model 2: South East Water econometric modelling Company-refined Our second econometric model is more refined, but once again uses actual cost calculated from published cost to serve data in the draft determinations. As per the first approach, debt written off is included with the cost value. Customer numbers are again used as an explanatory factor, but additionally we have found both proportion of metered properties, and length of main to be appropriate inclusions as additional explanatory factors. Finally we have also included a dummy variable to represent WaSCs, and more specifically a requirement to service dual customers. Model strength is high with an adjusted r-squared value of The results of our econometric modelling show that to achieve a 50% or 60% catch up in efficiency against the frontier company an efficiency catch up of 1.61% to 1.93% would be required per annum.

38 Model 3: Economic Insight evidence unit cost comparison to water industry The model produced for this cost comparison analyses cost to serve data as published in the draft determinations. Our relative position is determined against the most efficient company and this is used to generate a total level catch up required to operate at the same level as the frontier company. The results of this analysis shows that to achieve a 50% or 60% catch up in efficiency against the frontier company an annual efficiency catch up of 1.11% to 1.33% would be required per annum. Model 4: Economic Insight evidence unit cost comparison to wider industry, including bad debt The model produced for this cost comparison analyses cost to serve data against wider industry in a comparable retail industry namely, energy, mobile virtual network operators, rail and post. The analysis showed that the most comparable industry was mobile virtual network operators as the energy costs were significantly higher. Our cost data has been used, as data for the wider industry to enable a comparison to be made was not available for Our relative efficiency improved from to and as such any efficiency catch up assumptions using this method would be overstated however the results have still been used in our analysis. The results of this analysis shows that to achieve a 50% or 60% catch up in efficiency against the frontier company an annual efficiency catch up of 2.04% to 2.45% would be required per annum. Model 5: Economic Insight evidence unit cost comparison to wider industry, excluding bad debt The analysis above does not allow for the fact that the level of bad debt cost in the water industry will be significantly higher than that in mobile telecoms, primarily driven by the inability to disconnect. Therefore an additional analysis has been completed to exclude bad debt costs from our cost data. The results of this analysis shows that to achieve a 50% or 60% catch up in efficiency against the frontier company an annual efficiency catch up of 1.16% to 1.39% would be required per annum. Additional evidence: Economic Insight evidence frontier shift When assessing the impact of input price inflation and the level of efficiency that should be achievable, we believe there should be an allowance for a frontier shift which refers to the scope for companies that are already efficient to continue to make savings through general productivity gains. This is typically measured in terms of Total Factor Productivity, translated as an efficiency percentage per annum. The result of this assessment has suggested that the frontier shift that efficient firms should be able to achieve is 0.5% per annum - although it does indicate this figure may be somewhat aggressive with respect to water retail. Total efficiency Table 17 summarises the five models outlined above. To determine the average annual efficiency catch up to be used during 2015 to 2020 we have taken the mid-point from each model and then averaged the result from the five models. Total factor productivity has then been added to this to determine the total annual efficiency rate that we have used in our revised submission.

39 Table 17 Total efficiency Efficiency required per annum Benchmarking method 50% catch up 60% catch up Mid point (% pa) Econometrics model - Ofwat based 1.28% 1.54% 1.4% Econometrics model - SEW refined 1.61% 1.93% 1.8% Unit cost comparison - water industry 1.11% 1.33% 1.2% Unit cost comparison - wider industry including bad debt 2.04% 2.45% 2.2% Unit cost comparison - wider industry excluding bad debt 1.16% 1.39% 1.3% Average of mid points 1.6% Total factor productivity 0.5% Total efficiency per annum 2.1% We have therefore set ourselves an increased efficiency challenge to reflect this analysis as shown below. Table 18 Revised efficiency challenge Business Plan Revised Adjustments to base costs Annual average over m Annual average over m 2015 to 2020 (%) 2015 to 2020 (%) General cost inflation 3.0% % 14.2 Cost efficiencies (1.4%) (4.7) (2.1%) (6.1) Total 1.6% % 8.1 A revised R3 table has been submitted enclosed with this representation, reflecting these changes. Inflation rates for and The total cost adjustment figure of 8.1m above includes an allowance for inflation in and set at 2.9% and 2.6% respectively. The impact of the removal of the inflation adjustment, as set out in the draft determination, removes inflation in and in its entirety. We believe this is inappropriate. Inflation in these years must be included in full as additional efficiency for these years is not required for the following reasons: Inflation that has already been incurred in has effectively been removed. Previous regulatory precedent shows that the method used to inflate costs has been to take a base year (in this case ) and inflate these costs to the start of the price control, and then review future inflation and efficiency adjustments accordingly. Neither we nor our economic partners have been able to locate a regulatory precedent where inflation is in fact frozen mid-way through the previous period. The actual costs used include efficiency already delivered as part of our current PR09 price determination. The forecast costs used include efficiency planned to be delivered as part of our current PR09 price determination. Setting an additional efficiency on top of that set in PR09 has not been identified in any Ofwat consultation for PR14; Ofwat s view on inflation has always been expressed as a challenge for the 2015 to 2020 period. Frontier catch-up versus upper quartile In recognition of Ofwat s move to an upper quartile efficiency assessment for PR14, we have replicated the above econometric models on this basis rather than using the frontier position. This analysis shows that the level of catch up required would reduce by 0.7% per

40 annum. We have set ourselves the more challenging target of catch up against the frontier position to ensure that the impact on customers bills is kept to a minimum. Upper quartile test We remain of the view that it is incorrect to set the threshold for permitting an adjustment for input price inflation using an upper quartile test. The correct approach should be one that recognises well evidenced inflation combined with an appropriate level of efficiency. This approach naturally results in less efficient companies having a smaller adjustment. The central issue with the upper quartile test is that it is binary and so does not reflect what would happen in a competitive market. In a competitive market all firms would look to pass on inflationary pressures to their customers, albeit to a different extent and depending on their relative efficiency. The issue caused by such a binary criteria is that a company which operates marginally less efficiently than upper quartile would have no inflation allowed, whereas one operating marginally more efficiently than upper quartile would have inflation allowed (subject to sufficient and compelling evidence regarding inflation). We would support a sliding mechanism with graduated inclusion of inflationary costs as companies become demonstrably more efficient. Appendix 5 shows independent evidence from Economic Insight supporting this view. Conclusion In summary we consider we have provided robust data and indisputable evidence of the need for an adjustment for input price inflation. This has been founded on the views of independent experts and supported by an additional review by Economic Insight. We have demonstrated that our costs are efficiently incurred and managed and therefore believe this shows the adjustment proposed for net input inflation is for those costs that are beyond our control. By undertaking further analysis into the level of efficiency included in our proposed adjustment and subsequently increasing the efficiency amount from 1.4% per annum to 2.1% per annum we have demonstrated that the net input price inflation affects us in a materially different way to other companies. This increase has led to a reduction in the proposed adjustment over 2015 to 2020 leading to an additional saving for customers of 1.4m. Overall we believe the revised adjustment included in this response reflects the necessary level of expenditure that should be included in our Final Determination for input price inflation, net of efficiency for the period 2015 to Retail cost to serve adjustment Non-Household Introduction In our business plan submission we included an adjustment to retail non-household operating expenditure of 1.15m as outlined in Table 19.

41 Table 19 Business plan non-household cost adjustment Adjustments to base costs Annual average over 2015 to 2020 (%) m General cost inflation 3.0% 1.69 Specific cost efficiencies (0.4%) (0.15) General cost efficiencies (1.0%) (0.39) Total 1.6% 1.15 Section A4.3 of our draft determination outlined that the proposed adjustment for input price inflation has been removed due to the following reasons: The figure was not accompanied by supporting evidence in the non-household retail price control Evidence provided in the non-household retail price control did not pass the criteria on the quality of supporting evidence and was deemed insufficient No evidence was provided as to why the net margin was insufficient for covering input price risks The remainder of this section seeks to address each of these points. Supporting evidence The types of cost incurred by non-household retail are the same as for household retail comprising of salary costs, meter reading, debt collection fees, IT etc. Therefore non-household costs are very likely to face the same input price pressures as household. On the same basis the level of efficiency challenge in the household price control should also be achievable in the nonhousehold price control. Therefore the same assumptions for inflation and efficiency are proposed in the non-household price control as for the household. The efficiency assumptions for household retail have been increased as outlined in Section 5.1 and therefore this has been reflected in the non-household price control as shown below. Table 20 Business Plan Revised Adjustments to base costs Annual average over m Annual average over m 2015 to 2020 (%) 2015 to 2020 (%) General cost inflation 3.0% % 1.69 Cost efficiencies (1.4%) (0.54) (2.1%) (0.78) Total 1.6% % 0.91 A revised R4 table has been submitted enclosed with this representation, reflecting these changes. Inflation rates for and The total adjustment figure of 0.91m above includes an allowance for inflation in and set at 2.9% and 2.6% respectively. The impact of the removal of the inflation adjustment as set out in our draft determination removes inflation in and in its entirety. We believe this is inappropriate. Inflation in these years should be included and additional efficiency for these years is not required for the following reasons: Inflation that has already been incurred in has effectively been removed. Previous regulatory precedent shows that that the method used to inflate costs has been to take a base year (in this case ) and inflate these costs to the start of the price

42 control and then review future inflation and efficiency adjustments accordingly. Neither we nor our economic partners have been able to locate a regulatory precedent where inflation is in fact frozen mid-way through the previous period. The actual costs used include efficiency already delivered as part of our current PR09 price determination. The forecast costs used include efficiency planned to be delivered as part of our current PR09 price determination. Setting an additional efficiency on top of that set in PR09 has not been identified in any Ofwat consultation for PR14; Ofwat s view on inflation has always been expressed as a challenge for the 2015 to 2020 period. No evidence regarding net margin The allowed net margin set at 2.5% does not allow for input price pressure. We note that the PwC report issued in January 2014 Water Retail Net Margins explained the rationale Ofwat used to determine the net margins that should be used. This report relies on regulatory precedent and the price controls referred to in the report all allowed for inflation separately. Therefore the margins used in the report do not appear to include inflation. We also note that the PwC report and Ofwat s Risk and Reward Guidance issued in January 2014 do not indicate that inflation is a component of retail margin. This may have been considered but it is not clear from the published documents. Conclusion In summary, consistent with our response regarding household input price pressures, we consider we have provided robust data and indisputable evidence of the need for an adjustment for input price inflation. We also believe that the margin set at 2.5% is not sufficient to cover these costs. We have demonstrated that our costs are efficiently incurred and managed and this is evidenced in our position against the industry average cost to serve. Consistent with our household price control response, we have further increased our efficiency targets over the period 2015 to 2020 resulting in an additional saving to customers of 0.24m. We are also concerned that if the non-household price control is set with inadequate allowance for net inflation, then this may result in companies being at a higher risk of a margin squeeze claim by other retailers Cost allocation The draft determination stated we note that the company has not obtained any external assurance over its cost allocations, as required by our guidance and that the company has prepared its retail tables on the basis of Generally Accepted Accounting Practice in the UK (UK GAAP) rather than International Financial Reporting Standards (IFRS). Ofwat expect us to submit the following information within our representations: An external assurance report covering the completion of tables R3 and R4 and cost allocations between retail and wholesale and between household and non-household; and, Business plan tables R3 and R4 completed on an IFRS basis We have prepared our retail tables R3 and R4 from on an International Financial Reporting Standards (IFRS) basis. Additionally we do not consider that the use of IFRS instead of Generally Accepted Accounting Practice in the UK (GAAP) has resulted in different retail operating

43 costs. A letter from our external assurer, Deloitte, is attached as appendix 3 which supports this statement. We have also included in Appendix 4 our external assurance report from SMC on cost allocation. 5.3 Default tariff price control Draft Determination issues: Companies have been invited to consider whether they would prefer to: Set their non-household retail price control for five years; or Change the form of the control in some way that would allow greater time to consider and address any issues. Following on from Information Notice IN14/14 companies were asked to make submissions on the form of the non-household price control and, in particular, whether companies would prefer Ofwat to: Set the company s non-household retail price control for five years; or Change the form of the control in some way that would allow companies greater time to consider and address any issues. The default tariffs proposed as part of our business plan are designed to be as simple as possible so they can be easily communicated and understood by our customers, whilst at the same time ensuring that they are cost reflective for each type of customer group. Ensuring our default tariffs are compliant with Competition Law and the rules and processes that are to be determined for the new non-household retail market is essential. We believe that as companies review their tariffs in the lead up to market opening, and as the new market requirements become clearer, there may be the requirement to amend our default tariffs to ensure they remain fully cost reflective and are appropriate for all types of customer. This issue has been demonstrated in the Information Notice IN14/14 showing the range of average gross margins per customer for unmetered water and average revenue controls reported in the technical appendix A5 to the draft determination. It is in the interests of all market participants, regulators and customers to ensure that each company s tariffs reflect the costs of supplying the service and are structured in a way to ensure efficient and compliant competition. Our default tariffs are calculated for six customer classes, five measured (0-5Mla, 5-10Mla, 10-50Mla, Mla and 250+Mla) and one unmeasured. They are made up of two elements, a cost allocation per customer and a net margin. The overall net margin has been set at 2.5 % but the margin varies for each customer class. Table 21 shows the draft determination cost allocation per supply point and margin for each customer class. Table 21 Customer class Cost allocation Net margin 250+Mla % Mla % 10 50Mla % 5 10Mla % 0-5 Mla %

44 Unmeasured % We believe the different elements that could trigger a re-opening of the price control for default tariffs could include: The structure of charges; Definition of customer class; The allocation of costs and margin within each customer class; and, The overall level of non-household charges (total costs plus margin). We propose that the option of re-opening the price control for non-household default tariffs is introduced, should we identify that our default tariffs can be improved, for the benefit of customers and or competition, to improve their cost reflectivity, or if there are Competition Law issues. This also allows for any changes to be made once Ofwat publish criteria on the definition of non-household customers eligible for competition. We propose that the re-opening would be an option to implement once in advance of market opening i.e. in or as charges are set prior to the start of the year they apply. We also propose that the re-opening would have materiality thresholds as outlined below: The allocation of costs 10% threshold of at least one tariff band Margin 0.25% threshold of at least one tariff band We would seek to use our Customer Panel to validate whether the trigger to re-open the price control for non-household default tariffs had been reached. Any change falling under these thresholds could not be used to trigger the re-opening mechanism. Views of our Customer Challenge Group (CCG) Our CCG discussed IN14/14 and the opportunity for companies to request the price control for non-household charges is opened earlier than the current five year regulatory period. The CCG concluded that it would inherently be difficult for companies to engage non-household customers on this issue and that their priority is for price stability, not the mechanics of a price review. However, the CCG also acknowledged that an option to re-open the price control process earlier than five years should be in place, certainly if it would be detrimental to customers to not have this flexibility. The CCG also noted that if the Company proposes this option, the decision criteria for re-opening the price control process should be clearly set out in advance. This view is evidenced in the September 2014 meeting meetings and in the CCG report to Ofwat dated 3 rd October.

45 Section 6. Adjustments to price controls Issues and concerns with the draft determination The proposed shortfall of 17.3m for interruptions >12 hours is unwarranted. The changes to the calculation Ofwat have made have not been through due consultation with the industry A penalty solely on interruptions >12hours is inappropriate There are mitigation measures Ofwat has failed to consider in determination of the penalty: 1. Our current performance (which is only 25 properties in the first half of this year); confirming that our performance earlier in the AMP was not related to asset condition 2. Our selection of schemes for capital maintenance is robust and the mains which failed were not expected to fail nor have they failed since 3. We have invested 19.9m more than our Final Determination in our infrastructure. 4. Several interruption events were caused by third parties and were uncontrollable by us 5. We developed an Operational Strategy at the beginning of the period to improve our operational response, and we have implemented and now improved that Operational Strategy. 6. We have awarded compensation to customers affected and have at the same time also been penalised by our SIM score. This series of mitigation measures should be taken into account by Ofwat prior to the Final Determination. When considering these mitigation measures the penalty will be substantially reduced. The draft determination does not present a balanced package for our customers and stakeholders and we now request that Ofwat reconsider their approach to the treatment of pension deficit contributions in the Opex Incentive Allowance. 6.1 Introduction In our business plan we clearly and transparently presented our performance in We also provided further evidence in our June submission to support our assessment of performance. Our assessment has been externally assured by SMC at each Annual Return. It is therefore extremely disappointing that in the draft determination Ofwat has included a shortfall adjustment of 17.3m based on our interruptions performance when the rest of our serviceability measures, including the leading indicator of burst mains, show we are stable. This paper will demonstrate the following: 1. We behaved reasonably and honestly when assessing our below ground assets as stable for the 2012 to 2014 period. 2. The draft determination clearly shows that the assessment process for serviceability has changed, we however will show that this is retrospective. 3. The assessment process now being used by Ofwat is inappropriate for assessing serviceability. 4. An approach that has more subjectivity and consider all indicators as well as company actions would have arrived at a very different conclusion to the one Ofwat reached in the Draft Determination. 5. Irrespective of the above the shortfall penalty is disproportionate. In our business plan Opex Incentive Allowance (OIA) assessment we included adjustment to deduct the pension deficit contributions paid in excess of the amount included in the PR09 price control. In our June 2014 submission in response to Ofwat s position on this adjustment, and in the context of the overall balanced package of our business plan, we removed this adjustment but stressed that Ofwat should include this adjustment going forward in the context of companies

46 performance against the totex menu. We now request that Ofwat reconsider their approach and ensure that appropriate adjustments are made for the differences between pension deficit contributions made and those included in the PR09 price control. We discuss this in more detail at the end of this section. 6.2 Background to this Submission Past Ofwat guidance on the measurement of serviceability has been based on a basket of measures (or indicators), being used to assess serviceability, where all indicators must be maintained within their performance control limits. If an indicator is persistently close to or persistently above the upper control limit, the serviceability may be classified as marginal or deteriorating, but the assessment was not mechanistic and subjectivity was to be applied. In previous correspondence Ofwat has described how the number of bursts is a primary indicator of asset condition and other indicators are secondary indicators. Subjectivity is therefore entirely appropriate in this case as a basket of indicators was always used when the concept of serviceability was implemented as all parties recognised that no one indicator could or should be used to assess the performance of assets. This methodology is well established and was clear at the start of the period. There has not been due notification, publication or consultation with the industry to suggest this methodology has changed. Indeed our external assurer, SMC, has confirmed our view, see Appendix 4. It is evident that this agreed methodology is now not being applied by Ofwat in making an assessment of performance in Instead, the shortfall calculation method used in the draft determination is such that exceedance of the upper control limit for a single year and single indicator is used to indicate lack of stable serviceability over multiple years. There is no consideration of trend, persistence or basket of indicators in this approach, nor is there any allowance for mitigation measures. We see this as a significant change in the guidance provided by Ofwat to inform our investment strategy at PR09 and retrospective regulation. The application of the single indicator, single year approach applied over four years of investment, and the arbitrary methodology for calculating an equal penalty value per indicator per year have not previously been published or been through due consultation with the industry. They are also at odds with messaging from Ofwat workshops where, for example, Ofwat said [the] shortfalling policy needs to be flexible to respond to circumstances and issues 1 We do not consider a single indicator to be sufficient to reveal poor asset performance and hence the potential need for capital maintenance. Indeed we assessed our serviceability to be marginal in and stable thereafter on the basis that the serviceability assessment is a basket of six complimentary indicators. 6.3 Summary and Structure of this Section A summary of our key responses is set out below. Ofwat has not followed a reasonable process in determining the application of the penalty. In particular it has not consulted on the changes with the industry and the penalty mechanism has only become apparent at the Draft Determination. Ofwat has developed a methodology which is flawed. We challenge the move by Ofwat to the use of a single indicator, single year measure of serviceability (in this case unplanned interruptions to supply) as an indicator of sufficient strength to conclude that a water undertaking is not maintaining the condition of its assets in accordance with its Licence obligations. 1 Ofwat workshop presentation slides dated May 2010

47 The approach adopted by Ofwat is mechanistic and does not take into account considerable mitigation measures adopted by the company. These are set out below and need to be considered prior to the Final Determination. 1. Our current performance (for the first six month of ) consists of three events of >12 hours with a total of 25 properties being affected (against a reference level of 85 and upper control level of 210). Extrapolating this data to the full year clearly indicates that a reasonable forecast is that we will be below our target. 2. We have rigorously applied the principles of the Common Framework for Capital Maintenance Planning (CMPCF) since pre-pr04, including extensions to include concepts of WTP, CBA, Green Book accounting and Outcomes for Customers. Given that investment in water infrastructure during exceeded that identified in the PR09 business plan by 19.9m, we refute in the strongest possible terms, the conclusion by Ofwat that the unexpectedly high level of interruptions to supply during is a reflection of underor ineffective investment in maintenance of the network infrastructure. Our current performance shows that the interruptions in the middle of the period were not associated with either our underlying assets or investment strategies, as these are both unchanged. 3. The assets which failed and resulted in interruptions were not ones with historic burst histories or ones which any deterioration modelling would have indicated needed investment. The failures were not the result of poorly targeted investment. None of the assets have failed since. 4. Several of the incidents which resulted in interruptions were caused by third parties and were uncontrollable. 5. During we identified the need to improve our asset base to reduce the risk of interruption events. We have invested 21.9m to achieve this via schemes such as reenforcing our DMAs and upgrading our generator capacity. We developed a DG3 Strategy (later referred to as our Operational Interruption Strategy ) in 2011 at the beginning of the period, specifically designed to improve our performance. Every year we have reviewed our operational response and developed new approaches to improve our service to customers. This has included restructuring our operations team and the setting up of a specific Interruptions Task Force which has been communicated extensively throughout the business. 6. The customers affected by the interruption events have received compensation via the enhanced GSS payment system, so further penalty is punitive. 7. Our SIM performance and penalty is also impacted by the interruptions concerned so we are being penalised twice for the same events. In summary the mitigation which needs to be considered is set out in the table below: Table 22 Mitigation Value/Cost 1. Current Performance There should be no penalty applied this year reducing the penalty by 4.3m. 2. Application of CF We have invested 19.9m of additional expenditure in IRE above the final determination, confirming that we have not neglected our network. 3. No Evidence of past failure The events which lead to Interruptions >12 hours were not on assets with previous burst histories so there is no evidence these interruptions were as a result of our asset strategies. 4. Third Parties causing 1,305 of the properties affected were the result of uncontrollable incidents events by third parties. 5. Asset investment to reduce We have made 21.9m of targeted investment in schemes to interruptions reduce the impact of bursts on customers.

48 6. Operational Strategy We have spent 1.3m of extra activity to reduce the impact of interruptions on customers supply by improving our operational response. 7. GSS Payments We have made 149k in GSS payments and Enhanced GSS payments to customers affected by these interruptions. 8. SIM Penalty 600k (21%) of the SIM penalty on Water Service is attributable to interruptions. Total The total mitigation is c. 48m. Our arguments are set out in the following sections. 6.4 Process Ofwat state they changed the process at PR09 moving to a single indicator approach. The change process was flawed as no new methodology was published or consulted on, reference within FD09 was made to documents containing the basket approach to assessment, and parts of the FD directly referenced a basket approach. This is in addition to a workshop held by Ofwat in May 2010 where it was clear a basket was being used and assessments should be made all the relevant indicator information together. The slides from the day confirm that the Shortfalling policy needs to be flexible to respond to circumstances and issues 2 PR09 Final Determination and Post-Final Determination Current Ofwat guidance in the PR09 Final Determination and since then has been: We expect all companies to maintain their asset networks so that they are capable of maintaining the flow of services to consumers now and into the future. We will monitor and regulate this by measuring a basket of serviceability indicators for all assets, which include asset performance indicators, water quality compliance, environmental compliance and consumer service indicators. 3 Each indicator measures a different aspect of serviceability. None can be disregarded. Circumstances determine relative importance. 4 We will monitor and regulate this [serviceability] by measuring a basket of serviceability indicators for all assets, which include asset performance indicators, water quality compliance, environmental compliance and consumer service indicators. 5 Serviceability is about trends in indicator values, The indicators used are those which, if they exhibit an adverse trend, would call into question whether the company is doing enough to maintain its assets, Control limits are NOT minimum and maximum values 6 We will assess trends in these serviceability indicators to determine if stable serviceability is being maintained. 7 2 Ofwat, Workshop Presentation Slides dated April/May OFWAT, Future water and sewerage charges : final determinations, Maintaining the asset networks 4 OFWAT, Serviceability Workshop hand-out, OFWAT, Future water and sewerage charges : final determinations 6 OFWAT, Serviceability Workshop hand-out, OFWAT, Future water and sewerage charges : final determinations

49 PR14 Draft Determination In the PR14 draft determination Ofwat has changed its approach: i) Indicators must be persistently close to or persistently above the upper limit for the sub-service to be classified as marginal or deteriorating Values persistently close to or persistently above the upper limit indicate a less than stable trend and will attract intervention by OFWAT. 8 ii) A trend in the pattern of indicators would be used to assess serviceability They should exhibit a stable (as a minimum) or improving trend year on year and demonstrate this in June returns (or equivalent). Where a subservice is classified as marginal or deteriorating we will require the company to prepare and execute a regulatory action plan to recover stable serviceability. 9 We are concerned that this draft determination guidance is now being applied by Ofwat rather than the approach set out in FD09 and subsequent workshops. Ofwat seem to be basing their whole approach change on almost one sentence within the FD09 which says: We expect you to monitor each indicator and to manage and maintain assets such that all indicator values remain well within the control limits and exhibit a stable (as a minimum) or improving trend year on year. This does not represent a methodological change, the sentiment of keeping all indicators within the limits described existed in all previously published approaches. What appears to be different is this is now being used as an immediate trigger for a shortfall whereas previously it led to an overall more in depth investigation into all relevant pieces of information that should be used to assess and understand asset performance. We comment later in this section on communication of method changes and the components that must be used to understand asset performance better. In addition the shortfall calculation method introduced is such that violation of the upper control limit for isolated single year, single indicator measures is used to indicate lack of stable serviceability. There is no consideration of trend, persistence or basket of indicators in this approach. We see this as a significant change in the guidance provided by Ofwat to inform our investment strategy without due notification or consultation with the industry. Summary Given guidance by Ofwat in the Final Determination and subsequent workshop in May 2010 we took a reasonable interpretation of the information and acted in good faith accordingly, describing our serviceability as stable in the 2012 to 2014 period. 8 OFWAT, Draft price control determination notice: technical appendix A3 wholesale water and wastewater, August OFWAT, Draft price control determination notice: technical appendix A3 wholesale water and wastewater, August 2014

50 2006 / / / / / / / / / / / / / / / / / / / / / / / / / 01 Number of Bursts per month 6.5 Methodology Changes to the Basket of Measures Approach As shown above, the process Ofwat has adopted to change from a basket of measures to a single indicator was not consulted on with the industry. A further concern is that the adopted approach of a single indicator is flawed. We do not consider a single indicator to be sufficient to reveal poor asset performance and hence the potential need for capital maintenance. Our optimum asset investment planning process applied at PR04, PR09 and PR14 involves the analysis of all serviceability indicators simultaneously. We agree with Ofwat s historical position that a basket of indictors is required to form an assessment of the serviceability of a system of assets. For a given sub-service, the indicators within the basket are not in general allocated an equal weighting. For water infrastructure it is generally accepted that the bursts indicator is of primary significance, with interruptions over 12 hours fulfilling a secondary role due to its sensitivity to operational factors. It is notable that the UKWIR/Ofwat methodology for mains condition assessment is based exclusively on burst records, reflecting the primary importance of this indicator. 10 Over the AMP5 period, we have spent more than planned on infrastructure renewals and the burst record shows a clear downwards trend over this period (see Figure 3). This is compelling evidence that our infrastructure investment programme is delivering year on year improvements to the condition of our asset stock. Figure 3 Number of bursts per month (Mains >200mm) Month Burst Count Linear (Burst Count) Where the trend in bursts is improving, but interruptions over 12 hours are deteriorating, we argue that a higher weighting should be given to the bursts indicator and that this should at least partially mitigate any shortfall due to deterioration in interruptions. 10 UKWIR, Review of Water Mains Serviceability Indicators and Condition Grading: Volume II - Mains Condition Grading (08/RG/05/22), 2008

51 Summary We consider that the use of an equal weighting of indicator and AMP year is inappropriate in determining a shortfall penalty. We argue that the approach should place greater emphasis on trends and on asset performance indicators which better and directly represent changes in RCV. We reassert that use by Ofwat of a single, and in this case secondary, indicator to assess serviceability was not expected and is inappropriate. Determination of the Service Limits When Ofwat introduced their plans for reference level and control limits, we took part in the consultation process and raised concerns at the time along with all other water companies. We accepted the final Ofwat levels and limits on the basis that they would be used as guided: i.e. with reference to a basket of measures, showing trends and persistence of behaviour. Had we known at the time that Ofwat intended to change this approach then our objections would have been substantially stronger, we may not have accepted the determination and we certainly would have amended our investment strategies to match the change in calculation. We continue to have fundamental doubts about both the principle and method of calculation of the Reference Levels and Control Limits. These include the application of statistical process control techniques to systems which are subject to significant external influences and the questionable approach to how standard deviation is used in setting the upper control limit. Ofwat should not feel comforted that we did not object or appeal against these levels at the time, as the context in which we did not object is considerably different to where we are now and indeed the process for changing these was stringent and arguments of statistical validity where not being accepted by Ofwat. We have compared our unplanned interruptions reference level and control limit with other water companies (see Figure 4). When the data is normalised for differences in number of properties served, we find that we have a significantly lower reference level than the other water companies reviewed (N.B: not all the data is available for named companies however the industry average level shown is calculated from the sum of the anonymized individual company reference levels, divided by the total number of properties served by all 21 companies 11. Figure 4 Reference Levels and Upper Control Limits normalised by properties served Pers Comms, Peter Jordan, 25 September Number of properties served by each company taken from June Return 2009

52 We are concerned that we are being penalised unduly for not meeting individual indicator targets which are unreasonably stringent when compared with other water companies and, that as AMP5 targets were based on historical data, this amounts to a penalty for previous good performance. This is particularly important when the indicator in question is highlight variable in nature and one event can have a large effect, unlike other indicators where each event has less of an impact on overall severability performance. To illustrate this point the graph below is a cumulative histogram showing the number of properties interrupted in all events over the period The graph indicates for example, that there is a 50% probability that a single event will interrupt more than 50 properties. While this includes interruptions of all durations, it demonstrates that a small number of events may cause a significant number of properties to be interrupted; if these events are also greater than 12 hours in duration then our ability to meet our interruptions target can be threatened. Figure 5 Distribution of properties interrupted by individual incident Summary In summary we believe that the use of interruptions as a measure of serviceability is flawed. 6.6 Mitigation and Subjectivity In May 2010 Ofwat said [the] shortfalling policy needs to be flexible to respond to circumstances and events 13 yet within the calculation of the shortfall Ofwat has taken no account of any mitigation measures. The sections below set out the mitigation Ofwat must consider in determining our overall performance and any penalty. Mitigation 1 Current Performance In terms of the number of events, we have analysed historic and current performance (up to and including the 30 September 2014). This year to date, we have had three incidents above 12 hours. During these events 25 properties suffered interruptions >12 hours. (N.B: This data has been verified by SMC and a copy of their audit report is included in Appendix 4). We have analysed the annual profile of events and the analysis shows that performance in the 13 Ofwat, Serviceability Workshop, April/May 2010

53 second half of the year is equal to the first half. Therefore there is no reason to expect that the number of events at the end of this year will be significantly different to the first six months. Based on current performance we expect to report less than our target of 85 properties this year, however that is clearly dependent on the nature of future events and in particular any impacts from third parties or uncontrollable events. Summary We believe it is not appropriate to shortfall us for a performance that has not yet materialised especially given our current performance, which shows there are no underlying issues with our asset base. Mitigation 2: Rigorous application of the Capital Maintenance Planning Common Framework since PR04 Planning approach A key element of an assessment of asset management is a test of the process and procedures and strategies the company follows to optimise and deliver the asset and service programme. In the past Ofwat have looks at his information in assessing maintenance requirements. For PR14 this was not done so we have summarised our approach to asset management below to show that this is consistent with guidance and is not a reason for any shortfall. We adopted the CMPCF wholeheartedly in advance of PR04 and have complied with Ofwat Guidance since then regarding the introduction of full CBA and Green Book Discounting. We have achieved continuous improvement in the quality of our asset information and have embedded leading-edge decision support tools to determine an optimal investment strategy. In particular: Our investment planning approach is risk-based, taking account of both the rate or probability of asset failures and their service and cost consequences. Consequences are modelled with due regard to the mitigating effect of redundancy within the system of assets. Interventions are selected for inclusion in our plan using an optimiser, which identifies the set of interventions required to meet serviceability targets at least total cost, taking account of both capital and operating costs, with appropriate discounting over the planning horizon. Serviceability impacts with and without renewal interventions are estimated using models that have been calibrated using historical failure data. All models have been updated at each successive AMP to take account of the most recent failure information and benefit from advances in modelling approaches. The planning optimisation takes account of a basket of indicators, with each water infrastructure indicator being required to be within its target in 50% of years. Natural variability in the indicator means that there is a non-zero probability that the indicator will breach its Upper Control Limit. Markedly reducing this probability would require a significant level of investment and would not be in the best interests of our customers. For example, we have previously undertaken analyses to assess the probability of exceeding our bursts upper control limit as a result of variations in air temperature and rainfall, prolonged periods of dry weather and so on. These analyses demonstrated firstly that exceedances of the upper control limit owing to uncontrollable factors were not unlikely and secondly that to make even small reductions in the exceedance probability would require major changes in our investment spend of up to twice the historic level. The basket of indicators includes those that reflect asset performance (mains bursts, leakage) and those that reflect service to customers (properties interrupted for >12

54 hours). The inclusion of no deterioration targets for bursts and leakage within the mains renewal planning analysis ensures that the mean condition of the pipe network is not permitted to deteriorate over time. We have previously stated that out total investment in infrastructure was 19.9m above funded levels, demonstrating that we have increased investment in our assets to maintain service to customers. This investment is driven by the above approach and as such is demonstrably effective in delivering service standards. Summary We have invested more than our FD09 to ensure stable assets and our asset investment strategy is fully compliant with guidance. Mitigation 3: The mains which caused interruptions were not high risk As we have stated an assessment must include as it has done in the past, a review of the controllability of the events contributing to the failures as a shortfall should not apply when the failure is due to unpredictable elements outside of reasonable management control. We have reviewed our PR14 infrastructure investment plan against those mains which failed in resulting in unplanned interruptions >12 hours. The results of this review are shown in Table 23 which lists the incidents which have largely influenced the high number of interruptions. Table 23 Information on events causing high numbers of interruptions >12 hours EVENT EVENT LOCATION DATE HISTORICAL BURSTS ON MAIN 14 NUMBER OF PROPERTIES INTERRUPTED Recorded bursts in the records we have FORECAST BURSTS ON MAIN (per 1000km/yr) PR14 PLAN 08/2011 Little Exceat Farm, Lewes Not selected 12/2011 Sutton Road, Maidstone 0 6, Not selected 06/2012 Court Street, Faversham Not selected 07/2012 East Hoathly, Lewes Not selected 03/2013 Hazards Green Power Outages / Ninfield n/a 401 n/a Included in Generator Strategy* 04/2013 Ley Cottage, Beddingham Not selected Lewes 05/2013 Cooksbridge 10", Not selected 08/2013 Flimwell 9" Parsonage Farm, Church Street 1 1, Not selected Dec 13 - Feb Third Party Power Failures n/a 440 n/a Being considered as part of

55 03/2014 Woodside Farm, Brooham Farm Lane, Whitesmith, Lewes * See Mitigation 5 below. the Generator Strategy* Renewal in As shown, the majority of involved mains do not have a high forecast burst rate when compared to those mains that have been selected for renewal nor do any of the mains have a history of bursts. We find that only one of the mains which failed in has been selected for renewal during or This is consistent with it having the highest forecast burst rate of 372/1000km/year, (for reference the average burst rate of our mains selected for renewal at PR14 is 370 bursts per 1,000 km per year). This confirms our view that the higher than expected numbers of unplanned interruptions resulted from external factors; not from allowing our infrastructure assets to deteriorate without properly targeted infrastructure investment. Summary The failures that led to breaches of the UCL could not have been predicted and were not a result of underinvestment in our assets. Mitigation 4: Explanation for high unplanned interruptions for certain years Factors beyond the reasonable control of SEW were involved in a number of incidents. These include: Delays by the gas company in isolating the gas supply running close to our failed main. Delays by the sewerage company in repairing a sewer running close to our failed main. Prolonged power outages. Extreme weather. Livestock in fields adjacent that had to be sympathetically dealt with. Given that the majority of the unplanned interruptions result from incidents involving trunk mains, we could not have acted in advance to allow for these external, unpredictable factors without incurring substantial additional costs. Our optimal economic analysis confirms that this would not have been in the best interests of our customers. We note Ofwat s guidance on external factors 15 : Where the case has been justified, performance data has been excluded to mitigate the impacts of exceptional events (for example, significant and unusual winter frost events, which have happened for the first time in 20 years impacting on increased burst numbers). We have accepted the arguments put forward by companies where the company has provided robust data and demonstrated the impact on the performance of the indicator and shown that this is outside the control of the company. We provided such data in our Early Information Sharing document of June We have carefully reviewed each of the unplanned interruptions to supply which have occurred in In the following cases a total 1,305 properties (>10%) were caused by external factors, 15 OFWAT, Draft price control determination notice: technical appendix A3, August 2014

56 beyond our control. Hazard Green Power Outage resulted in an interruption to 401 properties, and was caused by a failure of supply of UKPN. (Even though we had dual supply at Hazards Green we are now developing a new strategy for reducing the risk at Hazards Green as an extension to the Generator Strategy (see below)). Little Exceat Farm was delayed because of horses in the field which could not be moved without the owner s permission, resulting in 705 properties being affected. Holly Court, Crowburgh was caused by power outages during winter storms resulting in 72 properties being affected twice (144 interruptions in total). The length of the incident at Court Street in Faversham was caused by a delay in Southern Water arriving on site to repair a cracked sewer and delays with British Gas/UKPN making safe a gas main in the excavation. A total of 55 properties were affected. Excluding these uncontrollable events from the data we have reported results in the following changes: Table 24 Number of uncontrollable events Total YTD Reported in JR/AR 128 7, , ,476 Uncontrollable Events ,305 Total excluding uncontrollable Events 128 7, , ,171 Summary More than 10% of the interruptions we have reported were caused by third parties and were uncontrollable. Mitigation 5: Asset Investment Strategy We have undertaken specific projects to reduce the likelihood of interruptions occurring in the first place. These Capex schemes are listed below (further details are provided in Appendix 7) and are grouped around three approaches: 1. When an incident has occurred, identifying changes we need to make to our investment strategy 2. Identifying risks and mitigating them before they become incidents 3. Using new technology to reduce the risk of incidents in the first place The total value of Capex schemes in the period which can be fully or significantly attributed to reducing interruptions is 21.9m. An example of one scheme for each approach is given in the following subsections: Schemes in response to incidents (identifying risk and changing our actions) SEW Standby Generator Project, commenced studies in 2010 as a result of assessed power vulnerability for delivery of project at approx. cost of 3.6m for a number of critical sites. Just prior to the start of , a review of the effectiveness of SEW operations during the winter of 2009 led to the release of the Operations-authored paper: Review of Preparedness for Adverse Weather. It recommended studying the capacity of SEW to supply customers with water in the event of prolonged power outages within its coverage area.

57 Over an initial 12-month period, the Asset Planning team interviewed Production Managers and site-technicians, and visited treatment works and pumping stations to: 1. Establish the availability (and absence) and conditions of states of generators (fixed and mobile) owned by the company; 2. To determine the frequencies and severities of prolonged outages, and; 3. To establish the consequences of these outages on customers in its coverage areas. A ranking system based on the properties supplied and power outage frequencies was developed to prioritise the sites, and from this, a list of sites where fixed sets and incomer points (for mobile sets) were recommended was obtained. Since then there have been numerous reviews of the approach, and further updates to the strategy. We are currently finalising our plans for how we improve resilience at Hazards Green (see previous section) which suffered significant power outages in March 2013 resulting in loss of supply to 401 properties. As a result of this work, a number of generators have been installed and continue to be replaced. This means that the sites identified as high risk of power outage are now much more resilient, providing a greatly reduced risk of interruptions to customers. An example of this is Heathfield Reservoir Booster area where a new generator has enabled the site to run effectively during adverse weather. In the winter event 2013 we experience few interruptions in the Thames Valley despite large power outage event across the South East of England. Our excellent response was largely due to the effectiveness of this strategy. Other example projects are: Castle Valve Replacements Tonbridge, 2010, 25k Stockbury, Sittingbourne Link Main, 2013, 1,613k Kingscote DMA Link main, East Grinstead. In progress, 64k Barcombe WTW Agree service standards with UK Power Networks (UKPN) Flood prevention, throughout , 3.2m Identifying risks and mitigating them before they became incidents DMA Re-organisation projects We have continued with a programme of DMA Reorganisation Projects since AMP 4. These were principally intended as part of our Leakage Strategy however there are other direct benefits that are related to a reduction in the extent and duration of interruptions. Further pressure management has extended the proportion of our calm distribution system where we avoid both high average zonal night pressures but also constant fluctuations which stress the network. DMA Re-organisation in RZ ,241K Changes that have improved monitoring will also lead to shorter or reduced associated interruptions. For example prior to recent work in Wokingham approximately 75% of Wokingham s properties were within a DMA with suitable flow measurement. Following reorganisation this has increased to nearer 98% which will help improve our response time to bursts. The costs for work in Wokingham are 230K of the total above. We have also been mindful of opportunities to introduce an alternative metered feed to each DMA for use in an emergency such as a burst event.

58 Of the schemes that have been installed the following have resulted in a secondary feed to an area: Wokingham there were formerly two single feed DMAs which have now been converted to three pressure managed areas with a new inlet which allows the whole area to be rezoned and supplied should one of the inlets fail. Eastbourne a scheme was advanced to provide an alternative feed for some 2000 properties in the event of an incident. We installed a connection off of the Southern Ring Main in Canterbury as our modelling showed that in the event of a burst in summer we would not have been able to supply the DMA. Other example projects include: Filching Pumping Station, Completed 2010/11 Cost 93k Park Farm, Ashford, in progress, Cost 128k Bloodshots Reservoir Tonbridge, 2013, Cost 147k Burham SWS to New Hythe Strategic Main, in progress, 8,100k New PRV installation, Weir Wood, 2010, 100k Crowhurst Bridge, 2013, 102.8k Bray to Crowthorne Link Main, 2014, 3,151k New technology proactively looking at ways of reducing interruptions using new technology I20 controllers/loggers ,500k Two years ago we introduced I20 controls to pressure reducing valves on our network to enable us to vary their outlet pressures over 24 hours to maintain set pressures at critical points within DMAs. We invested 1.5m at 200 locations and are one of the largest users of I20 technology in the country. Data analysed showed we had pro-actively reduced bursts evident as a reduction of 65K in reactive maintenance in the first year. We are looking to extend this project to I20 Calm Networks, a further new innovative scheme to calm the network and reduce number of bursts by installing similar controls on pumping stations to maintain set pressures at critical points in the network. We are planning Initial expenditure of about 0.5m. Summary We have invested 21.9m in schemes which contribute to improvements in our interruptions service to customers. Mitigation 6: Operational Strategy In June 2010 we began a strategic review of our operational response to see what opportunities were available to improve our response. The review set out the importance of the (then) DG3 target as a measure of serviceability and three key steps the business needed to address: 1. Monitoring our performance on a monthly basis 2. Setting targets 3. Assessing the cost benefit of measures required to meet the targets and agree to implement those measures. Over the following 10 months the Operations Management and Executive developed a DG3 Strategy (later referred to as the Interruptions Operational Strategy (IOS)), which was agreed on in May This IOS set out the response to the third bullet point above.

59 This IOS was the starting point for a series of changes set out to improve our DG3 performance, which has resulted in a sea change in our approach to managing interruptions, which culminated in the new Operational Structure finalised in 2013/14. The IOS strategy set out a series of improvements to limit interruptions to less than 6 hours. Four key changes were made immediately and these are summarised below. Since May 2011, when the IOS was implemented, further changes to our operational performance have been developed, and key elements are summarised below. Implementation of the IOS Strategy The IOS document set out the current interruption performance and modelled the improvements to be expected once the strategy was implemented. Scenarios of different events were developed and hour-by-hour timelines of each scenario were presented. The IOS set out how for each incident the controls introduced would mean that interruptions would be targeted to a maximum of 5.5 hours. The changes and improvements in response time are summarised in the graphic on the following page.

60 Figure 6 Typical Out of HoursTimeline (hours) Interuption Leak reported Tech called Tech onsite Leak located Control advised Crew called leak causing damage/flooding - main shut Crew onsite Supply restored clamp no obstruction 3 Supply restored clamp obstructions 4 Supply restored cut out no obstruction 4.5 Supply restored cut out obstructions 5.5 Supply restored cut out whole length no obstruction 6 Supply restored cut out whole length obstructions 7 Supply restored remporarily then cut out whole length completed leak can be left - main shut Crew onsite Supply restored clamp no obstruction 2 Supply restored clamp obstructions 3 Supply restored cut out no obstruction 3.5 Supply restored cut out obstructions 4.5 Supply restored cut out whole length no obstruction 5 Supply restored cut out whole length obstructions 6 Supply restored remporarily if poss then cut out whole length completed No water reported Tech called Tech onsite Visible leak located/obvious Control advised Crew called leak causing damage/flooding - main shut leak can be left - main shut Crew onsite Supply restored clamp no obstruction 4.5 Supply restored clamp obstructions 5.5 Supply restored cut out no obstruction 6 Supply restored cut out obstructions 7 Supply restored temporarily if poss then cut out completed Supply restored cut out whole length no obstruction 7.5 Supply restored cut out whole length obstructions 8.5 Supply restored remporarily then cut out whole length completed Hidden leak located Control advised Crew called leak causing damage/flooding - main shut leak can be left - main shut Crew onsite Supply restored clamp no obstruction 6 Supply restored clamp obstructions 7 Supply restored cut out no obstruction 7.5 Supply restored cut out obstructions 8.5 Supply restored temporarily if poss then cut out completed Supply restored cut out whole length no obstruction 9 Supply restored cut out whole length obstructions 10 Supply restored remporarily if poss then cut out whole length completed The four key elements of the DG3 strategy implemented were: A. Sending a Repair Crew (Gang) Immediately when an event occurred B. Temporarily restoring supplies after 5.5 hours C. Cutting in valves during an incident D. Applying clamps to splits The benefits of each of these is summarised below: Sending the Crew Immediately Prior to implementation of the DG3 strategy our standard response to an event was for a technician to locate the burst and then call the repair crew, as not all events required a repair crew this avoided unnecessary call outs. As a result the call out period was typically taking an

61 hour and contributing to the length of interruptions. Within the IOS we amended our approach so that for larger events the crew was advised immediately after the Technician was sent to site, so that the Crew would be on site, ready to make the repair, as soon as the Technician had identified the location of the burst. Restoring Supplies after 5.5 hours The IOS included the restoration of supplies after 5.5 hours (for a period of one hour) to provide a supply to customers. The opening of valves to restore supplies results in the complete repair taking longer than otherwise, but allows supplies of water to customers for the refilling of header tanks and cisterns. Cutting in Valves The strategy considered the cutting in of valves during an event to help control the incident and restrict the impacts. In practice although we have considered this on major incidents, there has not yet been an instance where this has been appropriate. Fitting of Clamps Our contractor (Clancy Docwra) maintains a stock of clamps of different sizes which we use on a large proportion of cast iron pipe splits. The size and range of the clamps has increased since 2011, which has resulted in increased (often redundant) stock but maintained supplies until the permanent repair can be made. Based on a realistic set of scenarios, the additional cost for implementing these four measures was 243,000 per annum ( 1.3m over the period). Other Recommendations of the IOS The IOS also suggested a series of longer term improvements including providing instantaneous flow and pressure data during an event and reviewing the priority of mains replacement so that areas where interruptions are more likely are prioritised over for example, burst mains risk. These improvements have subsequently been implemented via, firstly, our investment in our flow and pressure monitoring system Aquanet, which provides live flow and pressure data to field teams and, secondly, the implementation of amendments to our investment strategy using PIONEER investment optimisation software. Further improvements since the IOS Since the IOS was implemented in 2011 a range of additional measures to improve our interruptions performance has been developed, and some of these are summarised below grouped according to the type of improvement:- Identifying bursts more quickly so that we could begin our investigations earlier Locating bursts more effectively so that the length of interruptions was reduced Improving our repair performance so that interruptions had less of an impact on customers Examples of each of these three strands is summarised below and a complete list is given in Appendix 7. Identifying bursts quicker Improvements made: Extended the technical customer service desk to cover out-of hours working (implemented April 2012) Identifying key monitoring points on the network where we have set alarms to the flow

62 and pressure telemetry devices to provide us with early warning of potential interruptions (Spring 2012). Establishing a dedicated technical customer service desk where potential interruptions can be assessed by a technical team and thereby allow the faster dispatch of field technicians and repair gangs to respond appropriately (March 2013). Developing industry-leading algorithms in our company leakage monitoring system, Aquanet, to identify DMAs where the flow is showing immediate signs of a burst occurring. This data is sent to our leakage teams and distribution technicians for immediate investigation (currently being rolled out). Locating burst quicker and minimising the initial Impact As well as improvements to detecting an incident we have improved how we both locate each burst and how we minimise the impact on customers. Firstly, when responding to an interruption, we assess the risk associated in carrying out immediate repairs. If the repair is not required immediately because there are no customers without water we ensure that we have planned and sourced all necessary equipment and repair fittings before we commence work, reducing the risk of making the situations worse. (April 2012) Our method statements ensure that we minimise both the number of properties that are affected by the interruption and those that could be affected by rezoning the area of concern. Further our restoration policy is to deploy over-land and temporary connections to restore supplies. We have and continue to use line-stopping equipment where feasible to restore supplies. (April 2012) Our network modelling teams are on standby to provide support to our operations teams during an incident. (July 2012). We now display the hotspot areas for interruptions as a thematic layer on GIS across the business. This means that personnel in our control room can act appropriately for any customer contact or network event alarm that may occur in these regions. If an incident occurs in a hotpot area two gangs are sent immediately, rather than one as was previously the case (currently being rolled out). Improving our repair performance so that interruptions had less of an impact on customers Once we have identified the best way to repair the burst the next stage is to repair the pipe as quickly and effectively as possible. A number of specific changes have been made to our approach in AMP5. Our repair gangs ensure that wherever possible they minimise the time the main is shutoff and repair actively under pressure using pumps and repair techniques to ensure this is safe and effective (April 2013). We have experienced time delays in travel times for some repairs due to the location of where our repair crews live and the time to respond to some events that are within our rural regions so we have reviewed the potential for locating immediate response crews at strategic points in our region and we have considered establishing 24/7 manned response centres. (June 2014) We have developed and deployed mobile systems so we can dispatch work directly to crews as and when it happens along with electronic plans and details of other services. This mobile system uses the latest IOS application software and interfaces with our work management system (Maximo). The benefits, besides faster dispatch of work and plans, are up-to date progress reports to our management teams (currently being rolled out).

63 Interruptions Task Force Most recently, as part of the improvement to operational performance, we have set up an Interruptions Task Force consisting of senior managers from Operations, Communications, Assets and Customer Services to continually strive to further reduce the number of interruptions and their impact. This has been communicated throughout the business as the every minute and every property counts slogan, which is a headline in all our internal staff communications. Performance in Analysis of unplanned interruptions during the years 2010 to 2014 shows that in c. 99% of cases we managed the incidents well. This is demonstrated in the graph below (Figure 7), showing the cumulative number of incidents causing an unplanned interruption versus the duration. Figure 7 Distribution of durations of interruption events The graph shows that the chance of a failure causing an interruption lasting longer than 12 hours is approximately 1%, giving us confidence that overall we resolve interruptions effectively, and only in a small number of cases (sometimes due to third parties) have the events exceeded 12 hours. The impacts of these most recent performance changes are set out in the table below, which summarises the length of interruption for different events. For example it shows that in we resolved 95% of incidents within 377 minutes, compared to 406 minutes in the prior year. Table 25 Percentile (%) (Time Minutes) (Time Minutes)

64 In addition, the graph below (Figure 8) shows the number of properties interrupted in each incident experienced over AMP5: Figure 8 Distribution of number of properties affected by interruption events From this graph it can be seen that, though generally the number of properties interrupted in an event is small, there is a chance that it could be significantly higher. The graph indicates for example, that there is a 50% probability that a single event will interrupt more than 50 properties. While this includes interruptions of all durations, it demonstrates that a small number of events may cause a significant number of properties to be interrupted; if these events are also greater than 12 hours in duration then our ability to meet our interruptions target can be threatened. Summary At the start of the period we developed a management action plan for interruptions (our IOS) which identified how we could make improvements in our operational performance. These changes have resulted in lower overall interruptions times and we repair 99% of bursts within 12 hours, however it takes only a small number of events, however caused, to result in us failing our target. Mitigation 7: GSS Payments Each of the customers affected by interruptions events has been compensated for the poor service they received via the GSS payment system. Our records confirm that over the AMP period we have paid a total of 158k in GSS and enhanced GSS payments as set out below: Table Total Number of Payments ,388 Total Paid 17,098 22,920 21,470 96, ,298 Our policy has been to pay enhanced GSS of up to 50 on the majority of these cases and standard GSS on the remainder, these represent payments to over half of the customers affected by interruptions of >12 hours. This compares to a customer valuation via our willingness to pay of

65 4.19 for halving the risk of an interruption. This clearly demonstrates that we have already compensated customers for the level of service they have received during the period. Mitigation 8: SIM Penalty In our further evidence submission in June 2014 we set out our view that performance on interruptions has an overlap with SIM performance. In the draft determination Ofwat has concluded we did not provide sufficient evidence to demonstrate this connection. Using the background data to SIM performance e.g. number of written complaints, unwanted contacts and the qualitative score, we have been able to extract the contribution of water service to the overall SIM performance. Table 27 shows the proportion of the SIM performance and therefore incentive, related to water service. Table 27 SIM Penalty Total Water service only Quant. Quant. Qual. Qual. Quant. Quant. Qual. Qual. Year Perf. SIM Perf. SIM Total Perf. SIM Perf. SIM Total Average % 60% 27% 49% SIM penalty m Using data on water service contacts and the proportion of these related to interruptions, we are able to establish 21% ( 610k) of the water service component is attributed to interruptions. This overlap is further demonstrated by the research carried out into our customer satisfaction ODIs. Respondents were asked whether they had experienced any problems with their water supply in the past 12 months. Experience of interruptions to the water supply, around 11% of households had experienced an interruption to their water supply. Respondents were asked to rate their satisfaction with this aspect of service out of a score of 5. The results showed the average satisfaction score was high at 4.7 however those who had experienced a problem gave a substantially lower satisfaction rating at 4.1. The results show a clear link between actual service received and satisfaction and therefore between interruption events and SIM score. It is important that incentives should not overlap; any shortfall adjustment should consider the impact of other incentives measuring the consequence of the event. 6.7 Conclusions We accept that we have not met our interruptions >12 hour target in this AMP. We contest the value of the shortfall penalty set out in the draft determination as the methodology for calculating any shortfall was not consulted on appropriately, and the method of calculation (using a single indicator) is flawed. We disagree with Ofwat s assessment that our assets are deteriorating, and restate that our investment strategies are sound. In May 2010 Ofwat stated that [the] Shortfalling policy needs to be flexible to respond to circumstances and issues but in its draft determination has ignored any mitigation measures, which are summarised in Table 28.

66 Table 28 Mitigation Value/Cost 1. Current Performance There should be no penalty applied this year reducing the penalty by 4.3m. 2. Application of CF We have invested 19.9m of additional expenditure in IRE above the final determination, confirming that we have not neglected our network. 3. No Evidence of past The events which lead to Interruptions >12 hours were not on failure assets with previous burst histories so there is no evidence these interruptions were as a result of our asset strategies. 4. Third Parties causing 1305 of the properties affected were the result of uncontrollable incidents events by third parties. 5. Asset investment to We have made 21.9m of targeted investment in schemes to reduce interruptions reduce the impact of bursts on customers. 6. Operational Strategy We have spent 1.3m of extra activity to reduce the impact of interruptions on customers supply by improving our operational response. 7. GSS Payments We have made 158k in GSS payments and Enhanced GSS payments to customers affected by these interruptions. 8. SIM Penalty 610k (21%) of the SIM penalty on Water Service is attributable to interruptions. Total The total mitigation is c. 48m. Ofwat must consider these mitigation measures in determining the level of any penalty. 6.8 Opex Incentive Allowance In our original business plan we included in our submission on the Opex Incentive Allowance an adjustment to deduct from our actual and forecast Opex the pension deficit contributions paid in excess of the amount included in the PR09 price control. We made this adjustment to ensure that the two numbers were comparable. Such an adjustment is critical as Ofwat s policy position on 50% pension deficit funding assumes/requires the Company and/or its shareholders to contribute more than the funded sum. Indeed in IN13/17 Treatment of companies pension deficit repair costs at the 2014 price review Ofwat confirmed that whilst companies in aggregate may not have contributed the full deficit repair payments that they original forecast they would during , payments have been greater than the level assumed in price limits. If a Company s actual/forecast Opex spend is not adjusted for the difference between actual deficit contributions and the amount included in price limits the Opex Incentive Allowance will be materially reduced. For example if no adjustment is made, a company that has achieved Opex outperformance and has contributed deficit contributions in line with its forecast deficit repair payments could be in the position of having no Opex incentive allowance included in its price limits despite the fact that it has responded positively to the incentive mechanisms put in place by Ofwat. In our June 2014 submission in response to Ofwat s position on this adjustment, and in the context of the overall balanced package of our business plan, we removed this adjustment although we stressed that Ofwat should make this adjustment going forward in the context of companies performance against the totex menu. However, we believe the draft determination does not present a balanced package for our customers and stakeholders and we now request that Ofwat reconsider their approach and ensure that appropriate adjustments are made for the differences between pension deficit contributions made and those included in the PR09 price control. For ease of reference we can confirm that the pension deficit payments made by South East Water for the current regulatory period amount to 7.3m (nominal) per year.

67 Section 7. Financeability Issues and concerns with the draft determination FFO/debt ratio - when the calculation is adjusted to reflect the Standard and Poors methodology the ratio does not achieve the minimum threshold we believe would be required of the Company on a notional company basis, this would result in the Company s credit rating being downgraded When the Company s actual cost of debt is taken into account the ability of the Company to maintain its current credit rating is undermined. This is because in the draft determination Ofwat has rejected the Company s inclusion of a company specific cost of capital premium PAYG ratios need to be amended to reflect the correct split of Opex/Capex in the funded Totex Our proposed changes for the final determination Amend PAYG ratio to restore the correct balance between Opex and Capex for the totex level funded Increase the RCV run off rate from 3.49% to 3.75% Reverse the reprofiling adjustments made in the draft determination and replace with the modest reprofiling adjustments we propose 7.1 PAYG In the draft determination Ofwat has applied the same PAYG ratio from our original business plan to the reduced allowance of Totex. We challenge the validity of this approach, and would suggest Ofwat adjusts the PAYG ratio in our final determination to better reflect the nature of the expenditure in the final totex plan. Our business plan has always been based on the premise that Opex and Infrastructure renewals expenditure would be classified as PAYG (fast money), and as shown in Table 29. Table 29 PAYG ratios from South East Water June 2014 Plan Total Opex (excl. pensions) Capex PAYG Capex RCV BP Totex (excl. pension) 'Neutral' PAYG 60.6% 57.3% 55.9% 59.5% 63.8% 59.3% Pension deficit Expenditure The change to the level of our allowed Totex has resulted from changes to the level of the baseline position resulting from Ofwat s cost models. The majority of the adjustments which Ofwat has made to our baseline position relate to capital spend items, and not Opex or IRE type expenditure. By maintaining the PAYG ratio at the same level in our draft determination Ofwat has reduced the PAYG revenue allowance by 18m, as shown in Table 30.

68 Table 30 PAYG ratios from Ofwat Draft Determination Total Opex (excl pensions) Capex PAYG Capex RCV DD Totex DD PAYG 60.6% 57.2% 55.8% 59.4% 63.7% 59.4% Pension deficit Expenditure This lower level of revenue leaves us with a set of ratios that are at the lower bounds of the range required by our current rating agencies. However, these ratios do not reflect the fact that our debt cost is above that included by Ofwat in its wholesale cost of capital. As a consequence, the actual projected financial ratios on both a notional and actual gearing basis are lower than those stated by Ofwat, and put at risk the retention of our current credit rating. In order to rectify and improve this position we believe that the PAYG ratio should be revised to align with the principles of our business plan. Table 31 shows these principles being applied and recognises that the reductions made by Ofwat are to the RCV Capex component, and not the PAYG fast money component. Table 31 demonstrates the level of PAYG ratio that we consider to be appropriate to the draft determination when following our plan principles. Table 31 Revised PAYG ratios for Draft Determination following SEW Plan principles Total Opex (excl pensions) Capex PAYG Capex RCV DD Totex 'Neutral' PAYG 62.7% 59.3% 58.0% 61.7% 66.0% 61.4% Pension deficit Expenditure We have made representation and presented further evidence within this submission that supports a higher baseline position than that of the draft determination. As we understand it, there will be no further opportunity to change the PAYG ratio following final determinations and menu choices. We raised this concern with Ofwat at our meeting on 19 September 2014 and agreed to provide a guide to acceptable PAYG ratios for different baseline positions (and subsequent expenditure allowances) which are consistent with the principles of our plan. Table 32 shows the PAYG ratios that we urge Ofwat to apply in a range of potential situations between the draft determination baseline and our business plan. These values can be interpolated between the values provided.

69 Table 32 PAYG ratios for different baseline outcomes following SEW Plan principles m prices SEW Business Plan Intermediate #2 Intermediate #1 Draft determination with PAYG following SEW principles Ofwat Baseline 773.6m Totex Pensions Expenditure PAYG 59.3% 60.1% 60.8% 61.4% 62.1% PAYG Opex PAYG Capex RCV Capex Totex The average PAYG ratio is presented and should then be applied over the five years in an annual profile consistent with our business plan. 7.2 Financeability Financeability on a notional company basis The draft determination from Ofwat generated the following average key ratios (notional company basis): Table 33 Draft determination key ratios Cash Interest Cover (ICR) 2.88 Adjusted Cash interest cover 1.73 FFO/debt 8.86% Retained Cashflow / debt 6.28% Gearing 62.93% Dividend Cover 1.09 Regulatory Equity/Regulated earnings RCV / EBITDA Ofwat go on to state that as our calculated financial ratios for the company s business plan are slightly above South East Water, with similar financial ratios for our draft determinations. We therefore consider that South East Water is financeable on a notional basis. In our June submission our financeability assessment focussed specifically on the FFO/Debt ratio as calculated by Standard and Poors and commented that we believed this ratio would need to be above 8% to ensure the Company would be able to retain its current BBB rating. We note that Ofwat s calculation of the FFO/Debt ratio is not in line with Standard and Poors methodology. To align the methods more closely the following material adjustments need to be made: The FFO needs to be adjusted for non-service related deficit contributions, increasing the FFO as calculated by the Ofwat model Interest on the pension deficit needs to be added into the interest cost which is deducted from FFO

70 The debt needs to be increased for the pension deficit net of deferred tax and for any unamortised issue costs Indexation of index linked loans needs to be deducted from FFO. Table 34 shows the original calculation of the FFO/debt ratio and the forecast impact of the adjustments noted above on the ratio. Table Average Draft Determination FFO Average net debt FFO / Net Debt 9.52% 8.98% 8.73% 8.67% 8.43% 8.86% Adjustments to approximate Standard and Poors FFO/Debt calculation Pension Deficit contributions Interest on pension deficit Pension Deficit - latest position Indexation on loans Unamortised Issue Costs Revised calculation of ratios FFO Average net debt FFO / Net Debt 8.33% 7.88% 7.71% 7.80% 7.67% 7.88% As can be seen these adjustments reduce the average Standard and Poors calculated FFO to debt ratio to 7.88%, with a declining profile and four out of five of the years not meeting the minimum threshold for the retention of a BBB rating for a notionally geared business. A reduction in rating would impact the cost of debt raised by the Company, further damaging the financeability position of the Company. As an indication of the consequences of a downgrade, the impact of a BBB- (or equivalent) rating from just one of the two rating agencies who rate us (Moodys and Standard and Poors) would drive a margin increase on our revolving credit facility of 25bp. The changes to the PAYG ratios set out in Section 7.1 are beneficial to the Company s financeability position in 2015 to 2020 but are not of themselves adequate to return this ratio, as calculated on a notional basis, to a level which is sufficiently consistently above the threshold to ensure the financeability of the Company. We have also developed concerns around the profiling adjustments applied by Ofwat and how that profile would impact on customers as we moved from 2020 through to As a result we have prepared a simulation of a steady-state household bill profile through to 2020 to understand the impact on prices. This simulation took the draft determination from Ofwat, adjusted it for a corrected average PAYG ratio of 61.4% and RCV run off rate and new asset depreciation rates constant at 3.49% and 2% respectively. We used forecast property numbers and assumed a continuation of the current retail cost to serve approach. It was assumed that SEW s rating over the period deteriorated and that an upward correction to the WACC would need to be made in AMP7 to reflect SEW s increased costs of raising finance. This analysis produced the bill profile (in prices) shown in Figure 9.

71 Figure 9 As can be seen the profile produced results in a rise in bills for customers in , with the bill only returning to the forecast level by This profile is at odds with the expressed preference of our customers: Our 2013 Annual Tracker survey, detailed in section 5.2 of business plan supporting appendix APP20: Engagement, showed customers would prefer bills to either change every year according to how much work we have to do or to change steadily every year throughout the period, so that they do not see big changes from year to year or one step change in the first year (either up or down). We believe that a smoother, more acceptable bill profile for customers can be achieved by modifying our RCV run off rate. By making a small change to the RCV run off rate (from 3.49% to 3.75%) and by removing most of the reprofiling adjustments that Ofwat has made, we generate a ratio uplift that achieves a more acceptable financeability position for the period (notional basis). We would also note that an RCV run off rate of 3.75% still leaves the Company significantly below the RCV run off rates used by the majority of companies. In producing this alternative bill scenario we have ensured that the NPV of the revenue across the 2015 to 2025 period is identical in each case. The changes we have made result in the following profile for household bills: Figure 10 The profile produced (in red above) presents a much more acceptable profile for customers as bills reduce steadily over time. We discussed the revised profile with our CCG who said: "It is for Ofwat to assess the issue of financeability and whether the suggested reprofiling of bills is acceptable from a regulatory point of view. As far as customers are concerned, research has consistently suggested that customers prefer steady change (preferably downwards) rather than large changes

72 (especially if upwards). To that extent, the new bill profiling proposed by SEW would, in all probability, be preferable to customers than the DD bill profiling all other things being equal. But none of us can know if all other things will be equal. If, in the next AMP, SEW wanted to increase its investment and/or the cost of capital rose and/or some new Government or European requirements came along, prices could still jump at the beginning of the next five year price period. But this would be a matter to be addressed in PR19. Therefore, the CCG asks Ofwat for assurance both that customers are not paying more than they need to for the business plan package and that the SEW Business Plan is financeable, so that any change in bill profile strikes the right balance right between Pay As You Go (PAYG) and Regulatory Capital Value (RCV)." This revised profile produces a Standard and Poors FFO/debt ratio as follows: Table Average Revised Profile FFO Average net debt FFO / Net Debt 9.38% 8.73% 8.53% 8.63% 8.55% 8.76% This profile produces provides sensible but not excessive headroom to the 8% threshold and should enable the Company to continue at its current rating. We would therefore request Ofwat to make the following changes as part of the Final Determination: Increase the RCV run off rate from 3.49% to 3.75% Remove the reprofiling adjustments made as part of the draft determination and substitute with the following limited adjustments: Table SEW Profiling adjustments m Impact of actual debt costs on FFO / Debt ratio calculated on a notional gearing basis The analysis set out in Section is based on notional company with notional gearing of 62.5% and a cost of debt in line with Ofwat s risk and reward guidance. As Ofwat are aware our actual cost of debt is in excess of that number and we include in Section 8 our response on that issue. South East Water s financial ratios will naturally need to be calculated using the Company s actual cost of debt and so we include here the impact of this on the Standard and Poors FFO/debt ratio: Table Average Adjustments for Actual Cost of Debt FFO on notional debt cost basis Adjustment for actual debt costs True FFO Average net debt FFO / Net Debt 8.90% 8.22% 8.00% 8.08% 7.98% 8.24% As can be seen the average ratio is significantly worse than that calculated using notional debt

73 cost and, other than in the first year of the period, it presents a profile that provides no headroom to the 8% minimum. The current credit rating of the Company would be put at risk as a result. This is not surprising as the actual costs of the Company are not reflected in the price control. This issue would be rectified and financeability restored by the inclusion of a company specific premium to the cost of capital Impact of Ofwat setting a lower WACC Ofwat have asked us to provide a response to the potential reduction in the WACC. As can be seen from the analysis above with the requested adjustments to PAYG and RCV run off rate the Company s key ratio on a notional company basis (with the notional cost of debt) is at a reasonable level but would reduce to unacceptable levels if the WACC was reduced. Our key ratio using our actual cost of debt is already too low, hence the need for a company specific premium. Any reduction in the WACC would exacerbate this problem. As South East Water s issue on the cost of debt largely relates to embedded debt rather than new debt the logical response to a reduction in the WACC would be to increase the company specific premium. In extremis the RCV run off rate could be adjusted further to compensate for the loss of return but an adjustment too far on this measure could lead to financeability issues in the future.

74 Section 8. Company Specific Premium to the Cost of Capital Issues and concerns with the draft determination Ofwat concluded that South East Water does not face a higher cost of finance than the average Water and Sewerage company Evidence and arguments, on which Ofwat base their assessment of the company-specific cost of debt premium, lack robustness and in some cases rely on inappropriate evidence Our proposed changes for the final determination Reinstatement of the small company premium least equal to 25bps In its draft determination Ofwat concluded that South East Water does not face a higher cost of finance than the average Water and Sewerage company. As a result Ofwat has not included a company-specific cost of capital premium in its draft determination. We challenge this conclusion and believe that our previous submissions on this matter (as part of the December 2013 business plan and June 2014 submissions) provide compelling evidence of the increased cost of finance we face. In particular, we believe the evidence and arguments, on which Ofwat base their assessment of the company-specific cost of debt premium, lack robustness and in some cases rely on inappropriate evidence. We include in Appendix 8 a report prepared for the company by Frontier Economics which further challenges Ofwat s position, and supports our case as to why a companyspecific premium is appropriate. In particular we note: Ofwat s argument for not taking account of the embedded debt costs of companies is based on a binary all or nothing approach, without recognising that appropriate incentives for efficient financing can be maintained whilst still making an allowance for embedded debt. Such an approach would be consistent with previous regulatory treatments and precedent, and would mirror the approach taken in other areas of the price control such as totex modelling; Clear, new analysis that shows how large water only companies patterns of issuance expose them to a materially greater financing risk as a result of less frequent debt issuance. The draft determination does not make any allowance for this risk; and, That the evidence on new debt costs presented by PWC is somewhat problematic. In particular the Thames Water bond which the South East Water 2029 bond is compared to, and on which PWC s conclusion relies, is not a comparable debt instrument. In its report Frontier Economics conclude that the increased cost of debt finance that we are exposed to is at least equal to the 25bps identified for the smaller water only companies in the draft determination. As Ofwat concluded we did not face a higher cost of finance, they did not go on to consider whether we had also passed test 2 which sets out whether there would be any offsetting benefit to customers of funding a higher cost of finance. Whilst we remain unconvinced over the appropriateness of test 2 we asked Frontier Economics to look at how Ofwat have applied the test, and whether we would pass the test. Section 3 of the report covers Frontier Economics findings in this regard and raises significant issues around the analysis.

75 Overall Frontier Economics analysis shows that a properly formulated method for assessing the customer benefits would result in a figure that significantly outweighs the cost of debt premium to South East Water s customers.

76 Section 9. Risk and Reward Table A20 We have updated the inputs for Table A20 based on the interventions of Ofwat to ODIs at the draft determination and our subsequent revisions to our ODI package discussed in Section 3 of this response. The inputs to Table A20 have come from our Combined Scenario model which aggregates the impacts of each underlying scenario (Ofwat and Company specified). In addition to the ODI changes the only other change that we have incorporated is the financing performance impact. We have removed the impact of the sharing mechanism from this component as Ofwat rejected it in the draft determination. The outputs from the model in lines and 71 to 85 are from the SEW model and reflect the wider proposals presented in this submission. We have populated a RAT model incorporating the changes to the inputs for ODIs and the financing performance. As our starting position we have used the RAT_SEW_DD model, published by Ofwat in support of the draft determination. Within this model we have only modified those inputs which relate to the ODIs and financing performance impacts consistent with the Table A20. The inputs that we have changed in the model we have marked as red text. The attached file is RAT_SEW_DD Ofwat inputs SEW ODIs The resulting RORE graph for the appointed business is shown below. There are not significant changes from the DD position. From a base RORE of 5.8% the upside is 8.4% (DD 8.3%) and the downside is 1.94% (DD 1.91).