Contents BUSINESS PLAN Part A Business Plan Summary

Transcription

1

2 Contents Executive summary... 4 A1 Introduction A1.1 Building the plan A1.2 Overall Business Plan structure A1.3 Structure of this document A2 The right outcomes for customers A2.1 Development of outcomes A2.2 The role of our Customer Challenge Group A2.3 Key messages from our research A2.4 How outcomes have informed our plans A3 Context and strategy A3.1 Summary A3.2 About Thames Water A3.3 Recent performance A3.4 Operating strategy how we will deliver the plan A4 Our wholesale water business plan A4.1 Introduction A4.2 Our wholesale water business A4.3 Wholesale water service outcomes A4.4 Longer-term supply deficit A4.5 Outcome delivery incentives A4.6 Wholesale water operating strategy A4.7 Summary of planned expenditure for the wholesale water business A5 Our wholesale wastewater business plan A5.1 Introduction A5.2 Our wholesale wastewater business A5.3 Wholesale wastewater service outcomes A5.4 Thames Tunnel Tideway A5.5 Outcome delivery incentives A5.6 Operating & delivery strategy A5.7 Summary of planned wholesale wastewater expenditure A6 Our retail household business plan A6.1 Introduction A6.2 Operating and delivery strategy A6.3 Summary of planned household retail business expenditure A7 Our non-household retail business plan A7.1 Introduction A7.2 Our retail non-household business A7.3 Retail non-household service outcomes A7.4 Operation and delivery strategy A7.5 Summary of planned expenditure Contents Part A

3 A8 Finance & risk A8.1 Summary A8.2 Total expenditure and efficiency challenge A8.3 Build-up of required revenue A8.4 Cost of capital A8.5 Financeability assessment A8.6 Risk A9 Customer charges A9.1 Summary A10 Board leadership A10.1 Board Endorsement A10.2 Governance and assurance arrangements A11 Appendices Appendix 1 Summary of approach to the cost of capital Appendix 2 - Outcome delivery incentives Appendix 3 Risk mitigation proposals Tables Table A-1 Average household customer charges... 9 Table A-2 Wholesale water totex expenditure summary Table A-3 Wholesale wastewater totex expenditure summary Table A-4 Retail household totex Table A-5 Retail Non-household Totex summary Table A-6 Total expenditure Table A-7 Total allowed revenues Table A-8 Wholesale totex recovery rate and depreciation rates Table A-9 Wholesale RCV Table A-10 AMP5 True-up adjustments Table A-11 Cash flow and net debt summary Table A-12 Financeability assessment using notional capital structure Table A-13 Residual cash flow risk and potential impact on bills Table A-14 Proposed risk mitigation mechanisms Table A-15 Average household bills Table A-16 Principal factors affecting the changes in household bills Table A-17 Average household charge water service Table A-18 Average household charges sewerage customers Contents Part A

4 Figures Figure A-1 Current company price levels... 7 Figure A-2 Principal factors affecting Average Household Bills... 8 Figure A-3 Our planned average household bills... 9 Figure A-4 Structure of Business Plan submission documents Figure A-5 Changes in summer and winter rainfall Figure A-6 Water availability in England and Wales Figure A-7 Proposed organisational structure Figure A-8 Mapping of Wholesale water outcomes to company outcomes Figure A-9 Mapping of Wholesale wastewater outcomes to company outcomes Figure A-10 Mapping of retail (household) service outcomes and performance measures to company outcomes Figure A-11 Mapping of retail (non-household) service outcomes and performance measures to company outcomes Figure A-12 Risk and reward in our business plan (RoRE) Contents Part A

5 Board foreword We, the members of the Board of Thames Water Utilities, commend this business plan to Ofwat for review and consideration. We confirm our ownership of this business plan submission. We have satisfied ourselves that governance and assurance arrangements have provided sufficiently robust processes and systems of internal control to confirm that the information submitted, insofar as we are aware, is of a high quality, is materially accurate and complete, and conforms to Ofwat s reporting requirements in all material respects. In addition, we confirm that: the business plan has been produced under the strategic leadership from the Board; the company is operating transparently, and the business plan has been produced through a transparent process; we, the Board, have overseen the development of outcomes and associated commitments and incentives that reflect customers, views and priorities; also that our outcomes are consistent with relevant obligations and statutory requirements; we have approved our statement of company performance over (Supporting Evidence SE-4, AMP5 Performance), which includes our proposed adjustments to price controls; the company operates in compliance with its licence; and the company is compliant with the Financial Reporting Council s UK Corporate Governance Code where appropriate. 1 Chapter A10 provides a summary of the governance and assurance processes that give us the confidence to commend this business plan to you unanimously, with further information available in supporting evidence document SE12, on the subject of Board leadership. 1 The Code acknowledges that departure from its provision may be justifiable in particular circumstances and requires that companies explain those departures. A summary of our compliance with sections of the Code which require a specific response or statement is contained in Supporting Evidence document SE12. Board foreword Page 1

6 Signed, as follows: Page 2 Board foreword

7 28 November 2013 Board foreword Page 3

8 Executive summary Our plans for 2015 to 2020 This document summarises our wholesale and retail plans for the period 2015 to Our plans have been developed to deliver the outcomes that our customers and stakeholders have told us that they want. They have been prepared by the relevant business units, under the guidance and supervision of the Board. We have run a full quality assurance programme with independent external bodies to ensure the plan is robust and backed up by strong evidence. Our plans have been independently scrutinised, and endorsed, by our Customer Challenge Group (CCG) which was set up for the purposes of assessing whether we had effectively engaged with customers in the preparation of its plans. Our proposals have also been reviewed by our regulators the Drinking Water Inspectorate, the Environment Agency, and Natural England and found to be acceptable. Most importantly of all, recent testing has indicated that in excess of 70 per cent of our customers find our plans acceptable. In line with this positive support, we commend these plans to Ofwat. What our customers want In drawing up these plans, we have undertaken extensive consultation with stakeholders and carried out over fifty separate pieces of customer research. Our customers have told us that they want us to: provide a safe and reliable water service that complies with all necessary standards and is available when they require it; provide a safe and reliable wastewater service that complies with all necessary standards and is available when they require it; demonstrate to them and stakeholders that they can trust us, that we are easy to do business with and that we care; provide the level of service they require in the most economic and efficient manner to ensure that bills are no more than necessary; limit our impact on the environment and achieve a socially responsible and sustainable business for future generations, including reducing levels of leakage; and provide them with a choice of easy to use contact options. Page 4 Executive summary A0

9 Consistent with these outcomes, our customers have told us that while they would not wish the service we typically provide to deteriorate over the next five year period nor for us to act in a way that could jeopardise our ability to continue to provide services beyond 2020 they would expect us to do all we can to keep bills as low as possible. We understand these messages, and we have reflected them in our plans. Main features of our business plans In line with forthcoming changes in the way we intend to organise our business, we have prepared four separate plans: a wholesale water plan; a wholesale wastewater plan; a retail household plan; and a retail non-household plan. The main features of these plans are set out below. Our wholesale water business will: maintain our drinking water quality at per cent compliance with the relevant drinking water standards; maintain security of water supply; reduce leakage by 10 per cent by 2020 (from the current target of 673 Ml/d to 606 Ml/d); install over 900,000 water meters, providing benefits in terms of reduced consumption, and better information about the operation of the water network to facilitate more efficient operation in future; reduce average time of lost supply due to interruptions greater than four hours from 13 minutes to 8 minutes; and replace - in a targeted way - around 880km of distribution mains. Our wholesale wastewater business will: continue to collect, treat and dispose of wastewater to a good standard, in line with the relevant regulatory requirements; reduce the risk of sewer flooding at around 1,800 properties where flooding has occurred inside customers' homes in the past; reduce the risk of pollution incidents; reduce the risk of odour for around 6,600 homes; and Executive summary A0 Page 5

10 improve the efficiency of the business by increasing the proportion of our total energy needs met by the renewable energy we generate ourselves (mainly from our sludge treatment) to around 33 per cent. In addition to our normal wholesale wastewater operation, we will also progress the development of the Thames Tideway Tunnel (TTT). This is a major 4 bn project designed to tackle the problem of London s sewers overflowing into the tidal River Thames, and which is necessary to secure compliance with the Urban Waste Water Treatment Directive. Under proposals that are supported by both the Government and Ofwat and which should offer value for money to customers around a third of the project (e.g. the development and interface works) will be delivered by us, and around two thirds of the project (e.g. the main tunnel itself and the connecting shafts) by an independent Infrastructure Provider appointed after a competitive process. Our retail household plan is based on doing the basics well, getting things right first time and giving customers choice. It will: take action to improve overall Customer Satisfaction (or CSAT) to 4.65 out of 5 by 2020, for example, by increasing first time resolution of written complaints to 95 per cent; work to secure an improved SIM score of circa 83 points by 2020; implement a new on-line account management system to increase self-service options; improve cash collection rates from 88 to 91 per cent; introduce a new on-line service channel; introduce a social tariff to help those who genuinely struggle to pay their bill; and provide additional services to vulnerable customers, and help all customers to save water. Our retail non-household plan has also been prepared to respond to the requirements of our 250,000 customers. Over the next five year period, it will: provide a single point of contact with someone who takes time to understand their business needs and can ensure a quick response when things go wrong; provide reliable, accurate billing, with the option to receive consolidated bills if they have multiple premises; develop the systems that give customers the capability to access billing information online with self-service of accounts, with an ability to understand their consumption in near real time and access this data electronically; and provide assistance in order to help lower their consumption and waste disposal. Page 6 Executive summary A0

11 Impact on customer bills The costs associated with investing in and operating the largest water and wastewater company in the UK are substantial. In the period 2010 to 2015, we will have invested around 1 billion pa to maintain the assets of the business. A comparably sized investment programme will be required in the period 2015 to 2020, even before the TTT is taken into account. Such substantial investment inevitably puts upward pressure on bills, as customers pay not only a contribution to the capital invested, but also a return on the (rapidly growing) outstanding amount invested to date (known as the Regulatory Capital Value or RCV). These pressures are also more marked for us than other companies given the relatively low current level of our bills compared to other UK water companies, as shown in Figure A-1. Figure A-1 Current company price levels Source: Thames Water We are acutely aware that our customers are facing tough times. The economy is in the early stages of recovering from a serious economic downturn, which has resulted in a squeeze on household incomes and an increase in those struggling to pay their bills. Accordingly, in drawing up these plans we have looked at ways in which we can mitigate the impact of the necessary yet substantial investment programme on customers bills: we have developed an innovative alliance with major international experts in delivering complex infrastructure to challenge our costs and drive performance improvements which should result in significant capital (and potentially operating) expenditure efficiencies; we have undertaken a Business Improvement Programme, which has identified potential benefits of around 85m a year; Executive summary A0 Page 7

12 we have set ourselves an additional efficiency challenge of around 80m of as yet unidentified savings over the business plan period; we have examined our financing costs and propose a substantial reduction in allowed returns (i.e. a post-tax real Weighted Average Cost of Capital of 4.0 per cent), thereby allowing customers to share in the outperformance that we and other companies were incentivised to achieve in the current regulatory period; throughout our planning we have generally sought to identify least cost solutions, e.g. in our Water Resources Management Plan, that take into account the whole life cost of solutions; we have also sought to innovate where possible to reduce the scope or cost of activities, e.g. through the adoption of a technology previously used in the cider-making industry (i.e. the Bucher Press) to dewater sewage sludge; and using the information available to us, we have benchmarked our costs against other water companies in order to check that our costs are efficient. The effect of the substantial investment programme and associated increases in operating expenditure together with the efficiencies (on both capital and operating expenditure) and the reduced WACC can be seen on Figure A-2. Figure A-2 Principal factors affecting Average Household Bills Source: Thames Water analysis. 2. Numbers may not add due to rounding. 2 Other movements includes legacy adjustments (SIM, opex roller, CIS, RCM), changes in tax and working capital funding, and a re-profiling adjustment. TTT impact includes IP revenue 24; (tax and doubtful debt): 7; unfunded AMP5 TTT capex: 5; AMP6 capex: 3. Page 8 Executive summary A0

13 This shows that the efficiencies and reduced WACC keep bills flat in real terms before taking into account the effect of the TTT. However, once this impact is included, overall bills increase. The profile of average household bills including the impact of the TTT over the period 2015 to 2020 is shown in Figure A-3. This shows a modest increase in average household bills of around 8 a year in bills before inflation. Figure A-3 Our planned average household bills TTT Wastewater Water Source: Thames Water The equivalent projections are presented in Table A-1. Table A-1 Average household customer charges, prices Average household water charge Average household wastewater charge (excl TTT) Average household charge pre TTT Average annual change (%) (0.1%) Average household TTT charge Average household bill (incl TTT) Average annual change (%) 2.0% Source: Thames Water totals may not add due to rounding. Executive summary A0 Page 9

14 We recognise that any bill increase is unwelcome, however modest. However, even after the addition of these costs, assuming that other company charges remain steady in real terms at levels, our average customer charges will still be amongst the lowest in the industry. If the Government were to introduce legislation to make landlords responsible for water and sewerage charges (or at least responsible for informing companies that a premises is occupied), this would reduce doubtful debts and therefore lead to downward pressure on bills. Protecting customers from undue risk An efficient regulatory framework is one where the responsibility for managing and mitigating a given risk is allocated to the party best placed to manage and mitigate that risk. There are a number of risks to delivery of the plan, and we are confident that we have responded to these risks appropriately and mitigated them where necessary. For some potential events we have proposed change mechanisms that allow for regulated revenues to be adjusted, for example, over the timing of the TTT project. It is important that the regulatory framework incentivises good performance. Cost performance is important and we have set a sharing factor of 50 per cent so that we have a strong incentive to reduce costs and consumers share in any outperformance. We have proposed a limited set of financial incentives to encourage us to find ways to deliver more of what consumers want, reducing supply interruptions and sewer flooding. We have, in addition, set a strong penalty regime for our outcome delivery incentives so that if we deliver our commitments, customers bills will be no higher. If we under-deliver, the penalties will reduce customers bills beyond Longer term impacts A number of longer-term influences are likely to affect our plans beyond 2020 most of which will continue to exert strong upward pressure on costs. These include: climate change. This is increasingly affecting rainfall patterns, which, combined with population growth, is increasing pressure on security of supply and the capacity of our networks and treatment works; rising energy and chemical costs; the recent requirement to adopt private sewers and pumping stations from 2016; and assets reaching the end of their lives and the resulting requirement for replacement expenditure Page 10 Executive summary A0

15 In addition, the Water Bill proposes significant change to the market. Given these longer term pressures and the need to respond to provide our customers with the outcomes they want at an affordable price, we have considered our organisation structure and have set in place a process to develop a more decentralised structure around our four business units, each with their own Managing Director and management team. This will allow them to focus on their own specific challenges and delivery issues and prepare the company to facilitate and lead the development of the industry in future. This is a plan that meets the needs of our customers, balancing investment with affordability, addressing the challenges of today and preparing for the future. Executive summary A0 Page 11

16 This page has been intentionally left blank Page 12 Executive summary A0

17 A1 Introduction This chapter sets out the structure of this document and explains how it aligns with the suite of documents that form our plan, including the business plans for wholesale water (Part B), wholesale wastewater (Part C) and retail household (Part D) and non-household (Part E) and the associated supporting documents that provide additional detail on specific subjects. This document provides an accessible summary of all the wholesale and retail activities that we plan to undertake over the 2015 to 2020 period, to deliver the outcomes that our customers and stakeholders want and also to prepare and position the company to deliver in AMP7 and beyond. It provides the key rationale, analysis and evidence to demonstrate that this plan will deliver for our customers and stakeholders, that the planned costs are efficient and that there is an appropriate balance of risk and reward. We are confident that the process we have followed in building the plan, the analysis we have undertaken and the degree of challenge and independent review, combined with the quality assurance programme we have followed, means that this is a high-quality plan. A1.1 Building the plan We have followed a comprehensive process of customer engagement to understand what our customers want and to identify what this means in terms of commitments and delivery. Our plans have been constructed carefully, taking account of the views of our customers: to ensure that we meet future legal requirements; to ensure that we do not impose increasing risk of failure on future generations or allow our assets to become run down or degraded and to ensure that we reduce any unacceptably high risks of service failure; to ensure that we meet the levels of service our customers want; and to include additional investment or expenditure only where customers have expressed a clear preference and willingness to pay for the additional benefits. The scope of work and associated costs have been fully evaluated and built from the bottom up. A significant portion of our investment programme has been challenged, developed and verified by our Alliance partners, and overseen by the Executive and the Board. The Board Customer Service sub-committee has paid particular attention to customer service. The planning process includes an independent quality assurance programme to audit the data underlying the plan to ensure it is robust. In addition, we have a top-down audit to sense check the outputs and an advisory panel to provide feedback on the development of the plan documentation. This quality assurance programme has assisted the Board in providing its endorsement of the plans. Chapter A1 Page 13

18 Our CCG has been established with two clear objectives. First, to assess our customer and stakeholder research activities and, second, to ensure we embed the results of our research in our plan appropriately. Our CCG is independent of us, and, in addition to members who are our customers, its members include representatives from Environment Agency (EA), Natural England, Consumer Council for Water (CCW) and representatives from business, local government and organisations including Age UK and Citizens Advice. Since its formation, we have had valuable and robust challenge throughout the planning process. More information on the way we have built the plan is set out in detail in a supporting document (SE1 Building the Plan) and further details regarding our customer engagement and our quality assurance are set out later in this document. A1.2 Overall Business Plan structure This overall business plan summary (Part A) is supported by individual business plans, supporting documents, data tables and technical appendices, as illustrated in the figure below. Figure A-4 Structure of Business Plan submission documents Summary Part A Wholesale Water Part B Wholesale Wastewater Part C Retail Household Part D Retail Non- Household Part E Data tables Supporting evidence documents SE1 to SE13 Technical appendices c500 documents Source: Thames Water Page 14 Chapter A1

19 Subsequent documents (Parts B to E) set out the business plans for each business area, as follows: Part B Wholesale Water Part C Wholesale Wastewater Part D Retail Household Part E Retail Non-Household There are a number of companywide activities that have underpinned and provided the foundations for the individual business unit plans. We are therefore including as part of our submission separate supporting documents that provide additional detail and an in depth analysis of these specific subjects. The supporting documents are: SE1 Building our plan: explains in detail how we have developed the plan and why we are confident that the plan is well founded; SE2 Customer engagement: provides a comprehensive description of our customer research and summarises key messages from our customers and stakeholders that have shaped our plans. This document also explains the process we have used to translate the messages into outcomes and performance measures; SE3 Mobilising for delivery: explains our approach to resourcing to ensure that we have the appropriate systems, operating model, delivery partners, people and processes to deliver our plan; SE4 AMP5 performance: provides a full analysis of our performance during ; SE5 Innovation: brings together the many facets of innovation that we have embedded in our plan; SE6 Cost efficiency: provides additional detail relating to the efficiency of our costs. It includes references to a report from Oxera describing their comparative efficiency modelling included as a technical appendix; SE7 Risk: describes our wide range of risk management activities and processes and how we have balanced risk across the programme; SE8 Long-term strategy: explains our long-term strategy derived from earlier strategic direction statements, analysis of historical performance, assessments of future challenges and changes, and the results of our customer engagement; Chapter A1 Page 15

20 SE9 Finance: provides the detail underlying our financial costs including the appropriate cost of capital and financeability analysis and includes references to reports from Europe Economics as technical appendices; SE10 Thames Tideway Tunnel: provides the detail on the 4bn project that will help tackle the problem of overflows from the capital s Victorian sewers and will protect the River Thames from increasing pollution for at least the next 100 years; 3 SE11 Customer Challenge Group (CCG): explains our programme of engagement with the CCG, the impact the CCG has had on our plan and how we have addressed their challenges; SE12 Board leadership: describes in detail how the Board have directed the development of our plan and the quality assurance processes they have put in place; and SE13 Outcome delivery incentives: describes our proposed incentives and both the choices made and the process followed in their development. It includes a technical appendix on the calculation of the incentives. Finally, throughout our plan we refer to technical papers, studies and reports that underpin the development of the plan. These have been provided as part of our plan submission as Technical Appendices. A1.3 Structure of this document Returning to this overall business plan summary document, we have structured it as follows. Chapter A2 sets out in summary our extensive engagement with consumers and other stakeholders and our research and analysis, which has enabled us to establish our outcomes with a high level of customer support. Chapter A3 sets out the context within which we have developed our plan. It includes information about the size and scale of our business and our performance during AMP5. It also describes the changing external and regulatory environment in which we need to operate to deliver our strategic outcomes. Chapter A4 sets out for the wholesale water business the service outcomes and key performance measures that we plan to deliver in this period, the outcome delivery incentives and the costs involved. 3 It should be noted that the TTT section of the business plan is not a standalone plan but rather supporting evidence to the wastewater plan. It reflects the current stage of project development and discussions with Ofwat and Government which are on-going and has been prepared assuming a level of prior knowledge by those at Ofwat. We welcome Ofwat s continued engagement on the project and specifically the link to PR14. Page 16 Chapter A1

21 Chapter A5 sets out for the wholesale wastewater business the service outcomes and key performance measures that we plan to deliver in this period, the outcome delivery incentives and the costs involved. It also references the Thames Tideway Tunnel. Chapter A6 sets out for the retail household business the service outcomes and key performance measures that that we plan to deliver in this period, the outcome delivery incentives and the costs involved. Chapter A7 sets out for the retail non-household business the service outcomes and key performance measures that we plan to deliver in this period and the costs involved. Chapter A8 describes the building blocks of our revenue proposals including expenditure levels, financial assumptions (including the cost of capital) and RCV projections. It also provides a summary of our financeability and risk assessments. Chapter A9 sets out the result of our plan on customer charges and explains the key drivers affecting bills over the plan period. Chapter A10 provides further detail on the leadership of the Board and the assurance programme that they have used to provide their formal endorsement. Chapter A1 Page 17

22 This page has been intentionally left blank Page 18 Chapter A1

23 A2 The right outcomes for customers A2.1 Development of outcomes Since the last Price Review in 2009, we have sought customers views through a range of activities and carried out over fifty separate pieces of customer research in drawing up our plans. Our extensive research and customer engagement comprised four main types of activity: Insight: Review day-to-day contact with our customers, in the form of calls and correspondence Research: Investigate specific issues using qualitative and/or quantitative methods Consultation: Seek customers and stakeholders views on our strategies and plans Involvement: Direct local engagement with key customer and stakeholder groups on specific issues In total, this work has captured the views of over 30,000 customers, and 233 stakeholder groups, in addition to the day-to-day feedback provided in customer queries and complaints. It has included 139 focus groups, telephone and face to face interviews, eight deliberative events, 5 18,238 online surveys, 2,446 computer assisted personal interviewing ( CAPI ) surveys, 411 computer assisted telephone interviewing ( CATI ) surveys and two public consultations. 6 It included coverage in local newspapers, radio and television. The consultations held were: June 2012 Making the most of the essential service 7. May 2013 Our draft five-year plan which also included the chance to comment on Our draft long-term strategy The detail on the approach for each consultation and the full results are in technical appendices T0172, T0176 and T Involving 1,177 customers customers 6 Details found in T0174: TW Research Figures 2013 (2 nd tab) 7 T0172 Mott McDonald, SDS Strategic Approach Consultation (Making the most of the essential service), December T0176 Opinion Leader, Thames Water Consultation on its draft five-year plan and long term strategy, August 2013 Chapter A2 Page 19

24 Between June and September 2012, we held a public consultation to seek views on the longterm challenges we face and on our priorities for the 25 years to per cent of respondents either agreed or strongly agreed that we had correctly identified our long-term priorities. 9 Based upon the results of the consultation and the feedback from a series of deliberative events we evolved the long term priorities into five provisional outcomes. The provisional outcomes were then tested with stakeholders through an engagement process and a deliberative style event. Feedback from the customer engagement activities has been used to further develop the provisional outcomes. 10 The outcomes were further consulted upon as part of the draft business plan in May per cent of our customers agreed with the five outcomes with some describing them as customer focused. 11 A final refinement of the outcomes was carried out which led to our final company outcomes. We provide a more comprehensive analysis of our customer research and engagement in our supporting documents SE2 Customer Engagement. A2.2 The role of our Customer Challenge Group Our CCG has been an important part of our customer engagement and was established with two clear objectives. First, to assess our customer and stakeholder engagement activities and, second, to ensure we embed the results of our research in our plan appropriately. Our CCG is independent of us, and, in addition to members who are our customers, its members include representatives from Environment Agency (EA), Drinking Water Inspectorate, Natural England, Consumer Council for Water and representatives from business, local government and organisations including Age UK and Citizens Advice. Since its formation in February 2012, we have had valuable and robust challenge throughout the planning process. The CCG helped ensure we sought and considered the views of a wide range of people and groups across our 15 million, geographically and socially diverse, customers. Specifically the input of our CCG ensured we gave hard to reach customers more opportunity to have their say on our plans. The changes we made included holding additional road show events to ensure our most disadvantaged customers have been able to have their say and sending suitablyreformatted versions of documents to those customers listed on our special needs register as blind or partially sighted or deaf. 9 T0172 Mott McDonald, SDS strategic approach consultation (making the most of the essential service), December T0201 Thames Water, Statement of response table, T0176 Opinion Leader, Thames Water Consultation on its draft five-year plan and long term strategy, August Page 20 Chapter A2

25 Members questioned both how we had formed our proposals and how we intended to consult with customers. As well as discussions among the full group, the CCG established a number of sub-groups - Customer Service, Finance and Environment - to examine specific issues in detail. Our customer and stakeholder engagement activities were debated in detail by a CCG subgroup that focused solely on customer research. CCG members challenged us to be as accurate and clear as possible in showing the likely impact of inflation and the Thames Tideway Tunnel on future prices, both in the consultation on our draft five-year plan and the subsequent acceptability testing. An area the CCG challenged strongly was to ensure that we understood at a high level the balance of risk in our plans between our shareholders and our customers. They also wanted us to better reflect the importance of water efficiency to customers by making clearer how much water will be saved by the various activities we propose. We have conducted nearly 70 meetings with the CCG and its sub-groups and submitted over 230 papers and presentations to them. Further details can be found in supporting evidence SE 11 Customer Challenge Group. A2.3 Key messages from our research Our research can be distilled into 23 key messages from our customers. 12 These key messages can be grouped under five broad themes. What customers want when they contact us: o Fix urgent problems quickly. o Keep promises. o Keep customers informed e.g. about disruptions. o Get things right first time. o Provide a choice as to how customers engage with us. Customer satisfaction: o Customers are satisfied with existing water and wastewater services. o They are frustrated by supply restrictions. o Leakage should be reduced. o Supply interruptions are the most unwanted service failure. 12 In March 2013, we commissioned independent consultants Office for Public Management ( OPM ) to review the results of our engagement activities over the previous four years. The OPM report confirms that our plan is focussed on doing the things those customers want and are willing to pay for. Chapter A2 Page 21

26 o Sewer flooding should be reduced. o Customers have polarised views on tackling odour from sewage works. o They place a high value on reducing water hardness, but lack awareness of the cost and public health implications. Delivering affordable services: o Keep bills affordable and ensure any rises are gradual. o Provide social tariffs. o Customers believe everyone should get the same level of service. Protecting the environment o Improve river water quality. o Be environmentally responsible. o Reduce pollution incidents. o Most customers want us to become more water efficient and some welcome support to help them do the same. Raising awareness and engaging with customers: o Most customers are willing to use water more efficiently and expect us to do the same. o Customers have polarised views on water meters. o Educate customers to help them save water and properly dispose of waste materials. o Increase awareness about our work. These key findings formed the foundations of our company outcomes for customers. A2.4 How outcomes have informed our plans The company outcomes that resulted from our customer research and engagement are: We will provide a safe and reliable water service that complies with all necessary standards and is available when our customers require it. We will provide a safe and reliable wastewater service that complies with all necessary standards and is available when our customers require it. We will demonstrate to our customers and stakeholders that they can trust us, that we are easy to do business with and that we care. Page 22 Chapter A2

27 We will provide the level of service our customers require, in the most economic and efficient manner, to ensure their bills are no more than necessary. We will limit our impact on the environment, to achieve a socially responsible, sustainable business for future generations, including reducing levels of leakage. We will provide our customers with a choice of easy-to-use contact options Our six company outcomes together with our customer research and analysis have given us a clear view of our longer-term priorities and helped shape our plan. In forming our view on the best way to deliver these outcomes we have considered the external environment in which we are operating and the likely long-term impacts on us. We set out in the following chapter the context in which we must deliver these outcomes. In chapters 4-7 we describe how these outcomes have been translated into business specific service outcomes and performance measures in the light of the customer research and the external challenges facing each specific business unit. Chapter A2 Page 23

28 This page has been intentionally left blank Page 24 Chapter A2

29 A3 Context and strategy A3.1 Summary This chapter sets out the context and challenges through which we need to deliver the outcomes that our customers want and our strategic response. These include: the scale and complexity of our business and our recent performance; the need to facilitate the delivery of the Thames Tideway Tunnel; the need to manage ageing infrastructure; the expected increase in population and climate change effects which will, in combination, pose challenges for our security of supply and the capacity of our networks and sewage treatment works; the expected increases in energy prices and recovery from the recent period of stagnation in the economy which has resulted in a squeeze on household incomes; and the changing regulatory environment with increased competition and market opening. These issues are described in more detail in our supporting document SE8 - Long-term strategy and the technical appendix, Long-term impact assessment of external drivers on Thames Water. 13 The remainder of this chapter provides an overview of the challenges facing the business and our strategic response, both in our plans and through fundamental organisational changes. A3.2 About Thames Water We are the UK s largest water and sewerage company serving the equivalent of 25 per cent of the population of England & Wales covering an area of around 5,000 square miles across London and the Thames Valley. Among our activities we: Treat and supply 2.6 billion litres of water per day to 9 million people using three discrete water distribution networks Transport and treat 4.2 billion litres of sewage per day from 15 million people 13 Technical appendix - T0112 Chapter A3 Page 25

30 Operate 94 water treatment works and 350 sewage treatment works Maintain an 140,000 km network of water mains and sewers enough, if laid end to end, to stretch more than three times around the equator Generate 170 Gwh of renewable electricity 14, enough to power a city the size of Oxford Answer over 3.5 million calls and 575,000 written enquiries per year Employ around 5,000 staff and an even greater number of contractors Spend around 2bn per annum on operating, maintaining and enhancing our assets. We are therefore a large and complex business and we have to overlay on this the particularly difficult operating environment of central London, with the associated difficulties of traffic delays (and a high uptake of traffic permitting by London councils) and working in high levels of building density and congested utility services with ageing assets. We also have a legacy of keeping bills low for customers by deferring investment until it is necessary with the result that, despite our difficult operating environment, we have the second lowest bills in the industry as our RCV is relatively low compared to the underlying value of our assets. During this plan period we also need to progress a major infrastructure project across central London - the Thames Tideway Tunnel - a 4bn project to improve London s sewage network to last at least 100 years. This project is currently envisaged to be developed by a separately owned and separately regulated independent Infrastructure Provider. However, we will still need to deliver the interface works, manage our credit rating and attract investors. This project has inherently high technical and financial risks, which will be managed by the Infrastructure Provider, with the support of Government, but will present us with on-going risks due to its embedded nature. We will also have to manage other effects such as the impact of the increased bill on doubtful debt. We are also mindful of the impact on customers of water only companies in the area. A3.3 Recent performance Over the period since 2010 our performance has been good in many areas and we are on track to deliver our key regulatory output targets, although we recognise there are areas where we could do better. 14 The annual performance report shows 156GWh of renewable electricity which excludes 14Gwh of unaccredited renewable generation. Page 26 Chapter A3

31 For example, we have consistently delivered amongst the best quality water in the industry with compliance with water quality standards at per cent in We have the lowest rate of customer complaints regarding drinking water quality of all water and sewerage companies (WaSC s) with 0.62 complaints per thousand of population, compared to an industry average of We have outperformed our leakage targets for the last seven years and achieved full compliance against strict standards set by the EA at our sewage treatment works. We are making good progress and are on-track in delivering our biggest ever capital programme, including upgrades to London s five major sewage treatment works and construction of the Lee Tunnel, the industry s largest-ever single engineering project. We have opened the first desalination plant to provide London with protection against drought, and generated 170 Gwh of renewable energy from various sources including renewable gas derived from sewage sludge and put into the local domestic gas network for the first time in the UK. Although we received the lowest level of complaints regarding the quality of our drinking water and the number of written complaints fell in 2012, our CSAT score fell in resulting in a relatively low SIM score of We believe that as a consequence customers should receive a rebate. The information needed to calculate this rebate is not yet available, so we have provisionally included a 50m SIM penalty in our plans, taking into account the scores of others and our likely performance in , pending a final analysis when the SIM scores in the current year become clear. We have undertaken a detailed analysis of the fall in our CSAT performance. This analysis enabled us to put plans in place to improve this to a level of 4.3 by Whilst we have maintained the health of most of our assets at the stable level, our wastewater infrastructure serviceability slipped to marginal in , primarily due to increased pollution incidents and sewer flooding incidents. We have a clear strategy and plan with the additional expenditure necessary to return serviceability to a stable level by Our financial performance in the first two years of the price control was on or ahead of target. However, we have increasingly incurred rising costs in respect of a number of items including doubtful debt, EA charges, the adoption of private sewers and the cost of developing the TTT which have affected us more than other companies. These costs have resulted in our regulatory return in falling below that envisaged at PR Drinking Water Inspectorate Annual Report, This is set out in more detail in SE4 - AMP5 Performance. Chapter A3 Page 27

32 A3.3.1 Challenges We face significant challenges over the coming years, many of which mean that we need to work hard just to ensure we maintain our current service levels. Some of these challenges will only begin to be felt in the next five years, but we need to plan for the long-term, well beyond A3.3.2 Thames Tideway Tunnel The TTT is a 4bn project that will help tackle the problem of overflows from the capital s sewerage system and will help protect the River Thames from increasing pollution for at least the next 100 years. This project is a major undertaking, which is envisaged to be delivered in part through an independent undertaking and will add around to bills in this period. A number of options have been considered and this solution has been endorsed in the Government s Wastewater National Policy statement. Although a large part of this project is likely to be delivered by an independent Infrastructure Provider there will be on-going challenges. In the short term, we need to achieve a Development Consent Order through the statutory planning process and attract investors. Once the project is in delivery mode we will have to manage interface works and collect the revenue for the infrastructure provider, including managing the impact on doubtful debt of increasing customer bills. A3.3.3 Demographic changes The population in our water supply area is projected to rise from 9 million to 10.4 million by This will increase demand by 342 million litres per day, with about 80 per cent of this rise is expected in London. The population in our wastewater area is forecast to rise from 15 million to 17.5 million over the same period. This will put more pressure on our sewer networks and sewage treatment works and increase the volume of sludge we will need to treat and recycle. A related challenge comes from new homes and the consequential loss of green space to absorb rainwater. This could increase the amount of rainwater that runs into our sewers. Housing developments near our sewage works could also require additional measures to reduce odour attributable to the Infrastructure Provider 18 Water Resources Management Plan Page 28 Chapter A3

33 A3.3.4 Climate change The latest official predictions lead us to expect, on average, that summers will become hotter and drier, leading to increased demand for water. By the 2040s, average summer rainfall could fall by 13 per cent from today s levels as shown in Figure A-5 below. Winters are predicted to become generally wetter, with more intense storms. This will put additional pressure on our sewer network and increase the risk of flooding from it. By the 2040s, average winter rainfall could be 12 per cent higher than today s levels as also shown in Figure A-5 below. Overall, it therefore seems likely that average rainfall over the course of a year will be largely unchanged. However, the timing and intensity of the rain will be significant and will affect our capability to provide services. Figure A-5 Changes in summer and winter rainfall Summer rainfall Source: UK Climate Projections 09 Maps and Key Findings: South East England Graphs, Medium Emissions Scenario Winter rainfall Source: UK Climate Projections 09 Maps and Key Findings: South East England Graphs, Medium Emissions Scenario Chapter A3 Page 29

34 It can be seen from the graphs above that summer rainfall is declining, leading to an increased risk of drought, whilst winter rainfall is intensifying leading to an increase likelihood of flooding. Both of these changes present challenges for the water industry. These two factors will put pressure on the capacity of our networks. On the water supply side these factors will, in combination result in security of supply issues with an expected supply deficit in our London network of 414 Ml/d and in the Thames Valley of 34 Ml/d by 2040, absent any mitigating action. This will have consequential implications for reducing leakage and increasing water efficiency. We will also need to consider new supply options. As shown in Figure A-6 below we are situated in a part of the country where water availability is low. Figure A-6 Water availability in England and Wales Source: Environment Agency 2008 Water resources in England and Wales current state and future pressures A3.3.5 Deteriorating equipment Some of our equipment, although currently working well, is nearing the end of its life, putting it at higher risk of failure and increasing maintenance requirements. We will face a greater number of decisions about whether, when and where we should replace equipment. This will require the best possible understanding of the rate at which our assets deteriorate and the effect on customer service, so that we strike the right balance between the risk of failure and the cost of replacement. Page 30 Chapter A3

35 A3.3.6 Rising energy costs Energy costs form a significant portion (around 15 per cent) of our operating costs with prices predicted to rise steeply in the coming years (Government forecasts suggest an increase of around three per cent per annum in real terms). 19 This will have a significant effect on our costs of pumping water and wastewater around our 5,000 square-mile region. The price of the chemicals we use also tends to increase in line with energy costs, and rising road fuel costs will change the economics of recycling treated sludge to farmland. This trend will require us to consider options to reduce costs and volatility through, for example, increases in our levels of self-generation of renewable energy. A3.3.7 New laws and regulations Legislative and regulatory changes have an impact on our business. For example, the recent requirement to adopt privately-owned sewers added 40,000km of sewers and lateral drains a 60 per cent increase to our network. The adoption of around a further 4,500 pumping stations in 2016 will add to the 2,649 for which we are already responsible. The Water Bill currently going through Parliament is likely to result in increased market opening with choice for all business customers over their retail supplier and suppliers having some choice over the commodity (i.e. water supplier and wastewater treatment provider) for their customers. In addition, changes to the regulatory structure to encourage trading and reduce abstraction will impact on our options for new supplies. Other changes include the implementation of the EU Water Framework Directive, which seeks to improve the quality of lakes, rivers and streams. This could require us to make major changes at our sewage treatment works, to reduce levels of phosphorous, nutrients and metals discharged into rivers in treated effluent, which could increase our use of energy and chemicals. The Directive, and other environmental requirements, could also reduce the amount of water we are allowed to take from rivers and boreholes, by over 180 million litres per day. 20 This would represent a decrease of nearly 10 per cent from today s level. 19 Based on DECC Forecast of Electricity Prices (Industrial Sector Central Case) in the supplementary tables to the DECC/HM Treasury Green Book supplementary appraisal guidance on valuing energy use and greenhouse gas (GHG) emissions (data tables published December 2012) 20 Thames Water, Water Resources Management Plan Chapter A3 Page 31

36 A3.3.8 Affordability The issues discussed above will all exert strong upwards pressure on our costs. However, customers pay for the services we provide and these have to remain affordable. The economy has been in stagnation since the financial crisis of 2008 with GDP at the same level as This has resulted in household incomes rising more slowly than costs, with significant increases in energy bills and transport costs providing a squeeze on household finances. Whilst our customer bills are relatively modest at around 1 a day on average, they have been increasing in recent years. Our customer research has highlighted the need to limit further increases to the minimum, although consumers also consider that we should not pursue shortterm gains in affordability at the expense of longer-term pain..22 This focus on affordability has been reflected throughout our plan with a need to ensure our scope of works and associated costs are efficient and that we only enhance our services in response to customer driven outcomes when justified by customers willingness to pay. A3.4 Operating strategy how we will deliver the plan Our response to the challenges set out above will impact our customers. Nearly all the challenges will put strong upward pressure on prices and will require creative, efficient and innovative responses from us. These issues will affect the various parts of the business in different ways. Over the last few years we have continuously strived to prepare the company for the challenges of delivering our customer s needs in as efficient and effective way as possible, while keeping bills affordable, both today and for the future. We have driven efficiency through productivity improvements in the operational and customer service functions. We have also delivered significant savings through our procurement strategy, appropriate outsourcing of some of our central support functions, such as our previously in-house legal department, and the delivery of our capital investment programme through our joint venture partnering and delivery models. In addition to these traditional activities, we have also continued to seek out innovative ways to deliver the needs of our customers effectively. For example: We have reduced leakage to record low levels, and continue to outperform the targets set by Ofwat, mainly through targeted pressure management activities rather than replacing pipes. 21 Office for National Statistics, Quarterly National Accounts bulletin 22 SE2 Customer Engagement Page 32 Chapter A3

37 We have worked closely with external regulatory bodies to make sure that emerging environmental obligations are dealt with appropriately, striking the right balance between protecting the environment and keeping costs at a proportionate level e.g. Priority Substances Directive. We are working closely with Ofwat and Government to develop a delivery model for the Thames Tideway Tunnel that will allow this major infrastructure project to be financed and delivered through a competitive process. We investigated the possibility of bulk water transfers into our region through the issuing of an OJEU to establish the possibility of third parties wanting to provide water to us in the future. We continue to explore and develop these proposals. In May 2013 we signed an industry leading Early Contractor Involvement ( ECI ) contract with our Alliance partners for the delivery of around 50 per cent of the business plan capital programme. This was an industry leading step for us and presents a completely new way of working for all the parties involved. We have introduced innovative ways to release more of the energy present in our sludge, for example, introducing Bucher presses typically used in the cider industry to reduce the water content of our sludge. While we have improved our level of performance in the current period we also recognise that if we want to achieve our company outcomes, and give customers the level of service that they expect, we need to make a step change in our operational performance going forward. We are keen to ensure we have the most appropriate structure to deliver our activities. In line with this, we undertook a business improvement exercise in This included a dedicated work stream to investigate whether it would have been appropriate to move to different organisational structure within this AMP. We have concluded that the business should be re-organised over time from our current centralised structure into four separate businesses, each with its own managing director and executive team able to focus on its own specific issues, supported by a central support services unit as shown in Figure A-7 below. This will create clear alignment to the delivery of the discreet elements of the business plan and all of the outcomes, measures and targets that fundamentally underpin the delivery of the plan for our customers. Creating clearer distinctions between business units would allow them to operate in the way best suited to the functions that they carry out and would sharpen accountability, with each business unit taking greater responsibility for its cost performance. Chapter A3 Page 33

38 Figure A-7 Proposed organisational structure Retail Household: Provides customer facing activities such as billing and revenue collection. Retail Non-household: Responsible for all aspects of retail service delivery to all business customers. Wholesale Water Services: Responsible for all aspects of water abstraction, treatment and distribution. Wholesale Wastewater Services: Responsible for all aspects of wastewater collection and treatment to environmental standards. Central Services: Responsible for shared services across the wider organisation such as financial control, human resources, external affairs and strategy & regulation. Source: Thames Water This new operating model should lead, in the longer term, to efficiencies through the targeted accountabilities of each area, better decision making, and the ability of each business unit to adopt an appropriate structure, and culture, to deliver its business plan as effectively as possible. This would also enable the wholesale elements to interact with the retail activities in the same way as any other third party retailer. The devolution of centralised decision making has already begun in the current regulatory period, most noticeably within the finance function with the appointment of senior finance officers within Operations, Asset Investment and Customer Services within our current structure. This approach will need to be translated and extended as the new structure develops. To derive the maximum benefit from our new structure, we are also introducing improved incentive arrangements for managers and operational staff. Although we have made the decision to structure the business in this way we recognise that such a fundamental change to a company of our size is not one to be entered into lightly or hurriedly. We are developing a detailed implementation plan, with the help of external expertise, and we are committed to structuring the company in the most appropriate manner to deliver our long term strategy as efficiently and effectively as possible. Page 34 Chapter A3

39 A4 Our wholesale water business plan A4.1 Introduction This chapter provides a brief summary of the activities that our wholesale water business undertakes, before going on to describe the outcomes that customers have told us they would like to see and the level of performance that we plan to deliver by The chapter then explains how we will ensure serviceability of our key assets to make sure that we get the basics right, before outlining the levels of service that we will provide to end customers and how we will compensate customers if things do not go as planned. A4.2 Our wholesale water business We provide water services to about nine million customers, ranging from the urban metropolis of London to the Thames Valley with its mixture of fast growing towns and rural countryside. Our customers are very varied; we serve both some of the richest, and some of the poorest, boroughs in the UK. The mission of our wholesale water business is to deliver 2,600 million litres of high-quality drinking water to our customers every day. The wholesale water plan has been designed around delivery of this essential service. In particular the big issues that our wholesale water business needs to address are maintenance of this high-quality product, improving customer service and meeting the longer-term challenge presented by the forecast supply deficit. The wholesale water business comprises three main services: The abstraction of raw water from the environment, from either rivers or underground water sources (some 2,600 Ml/d) and its storage in our 34 reservoirs (storing 220bn litres of water). The treatment of water at each of our 94 water treatment works. The distribution of water to our customers, both domestic and business, through a 31,500 km network of water mains, large and small, 221 pumping stations, 239 service reservoirs and 32 water towers. Chapter A4 Page 35

40 A4.3 Wholesale water service outcomes We have developed our planning process to ensure we can deliver the outcomes which meet our customer, stakeholder and longer-term business objectives. We have used the results of our customer engagement to define six company outcomes which reflect what customers want us to deliver, of which four are applicable to the water service. These have been translated using our customer research and engagement into 11 water service outcomes against which performance measures, targets and incentives have been defined. These are shown in Figure A-8. Our customers have told us that their primary concern is the safety and reliability of their service at an affordable price they simply want it to be there and to work effectively without causing them concern. Although customers were concerned about the affordability of their water service there was little interest in accepting a reduction in service level in exchange for a reduction in their bill. Customers supported a limited number of enhancements to service; these being reductions in the number of interruptions to supply and leakage. It is also evident that while the vast majority of our customers never have cause to contact us, when things go wrong our response sometimes falls short of what they expect. Underpinning the achievement of all our wholesale water outcomes and targets is the stewardship of our wholesale water assets. Our primary outcome and performance measure is therefore maintenance of the health of our assets in a stable condition. We incur most of our expenditure on this activity, which supports achievement of all our outcomes and has the biggest impact on providing our wholesale water services in the most economic and efficient manner. We balance our asset stewardship activities to reflect customers concerns around affordability without prejudicing the operation of the network for future generations and to support achievement of the performance targets we have set. This includes maintaining our treatment works and our distribution network to maintain the level of service that we are forecasting by the end of this current period and on, through to Both have performance measures covering serviceability and include the development of asset health measures to improve longer term asset stewardship. The end result will be more predictable and better targeted investment in our assets, with benefits to customers in terms of reliable service and affordable bills. Page 36 Chapter A4

41 Figure A-8 Mapping of Wholesale water outcomes to company outcomes Source: Thames Water Chapter A4 Page 37

42 Building on our asset health service outcome of maintaining our assets in the long term, the related performance measures and targets for our other wholesale water service outcomes are described below. Demonstrating to our customers that they can trust us, we are easy to do business with and that we care includes doing the basics excellently by getting things right first time. We have therefore set targets to reduce written complaints from 22.8 to 6.5 per 10,000 connected properties and improve our customer satisfaction score to 4.6. We will also help our customers to save water with targets for the distribution of water efficiency devices (845,000 devices) and the provision of free repairs to customers with a customer side leak outside their property. Our wholesale water customer satisfaction score of 3.24 in lags significantly behind the water service industry average of 4.4 and shows that we have a lot of work to do to improve our performance. Historically, we have been asset-centric rather than focused on the level of service provided to customers. This was reflected in our processes and systems and within the culture of the company. We have made significant changes including a major re-design of our processes and improvements to our systems. We have also reviewed our contractual arrangements, to ensure that we can hold our wider team to account for the service provided to customers and are taking steps to change the culture to be more service-orientated. Maintaining a safe and reliable water supply at the right level of pressure has individual performance measures and targets for maintaining stable service for: Properties experiencing chronic low pressure (34 per year); 23 and Average hours lost supply per property served due to interruptions in supply with a duration greater than 4 hours (0.13 hours). Maintaining confidence in a safe water supply is important for customers. Our overall drinking water compliance performance has consistently been amongst the best in the industry over recent years. We also have the lowest rate of customer complaints regarding drinking water quality of all water and sewerage companies (WaSCs) with 0.62 complaints per thousand of population, compared to an industry average of 1.91 complaints per thousand. 24 Our focus is on maintaining this position. We will enhance our asset stewardship activities through a targeted replacement of lead communication pipes to address the change in lead standard from December This risk-based approach, targeted at areas of highest lead concentration, has been discussed and agreed with the Drinking Water Inspectorate (DWI) as an acceptable way forward. 23 DG2 measure 24 Drinking Water Inspectorate Annual Report, 2012 Page 38 Chapter A4

43 We have set a performance measure which encompasses compliance with all drinking water quality targets (99.95 per cent compliant by 2020). We will limit our impact on the environment through sustainable management of the water cycle. We will measure this through our performance on leakage (606 Ml/d by 2020, which is a reduction of 59 Ml/d) and under the Abstraction Incentive Mechanism to be developed with Ofwat. We will also deliver 100 per cent of the new environmental regulatory requirements specified by the EA and protect and enhance biodiversity through continued investment at our sites. We will continue to be a socially responsible business, running educational campaigns, providing visitor centres at our sites and contributing to community and charitable projects. We know the importance of educating younger customers about water efficiency, and will do so at three more classrooms we plan to open at treatment works, bringing the total to nine. By 2020, we aim to be welcoming 20,000 schoolchildren per year to these sites. We will ensure that we have a resilient water supply under extreme events by: ensuring our Security of Supply Index remains at 100 throughout the period; achieving 100 per cent compliance with the Security and Emergency Measure Directive (SEMD); and increasing the resilience of 27 of our water treatment works to a 1 in 100 rainfall event. We will reduce dependency on the energy grid in water services by improving energy efficiency and reducing our net energy import from the grid by 8.7 per cent by We will reduce the carbon emissions for our water services to 34 per cent below our 1990 level by A4.4 Longer-term supply deficit Looking forward, forecast population increases and anticipated changes in climate will increase the demand on available water resources. Our analysis shows we are likely to face a deficit of 414 Ml/d in our London supply zone and a 34 Ml/d deficit in the Thames Valley by Our focus in the short term is, therefore, on reducing leakage, minimising wastage and lowering average consumption, whilst we plan for the longer term. We are increasing metering both at customer premises and around our network. We will install a total of over 900,000 smart meters over the plan period. The information available from smart metering will form an increasing part in our identification and reduction of leakage. Chapter A4 Page 39

44 We are replacing distribution mains and improving the resilience of valves. In addition, we are undertaking a programme of customer education, fitting water efficiency appliances and have changed our policy to repairs to leaks on customer side connections. We also have a new agreement with Essex & Suffolk Water providing an extra 17 Ml/d of capacity for our customers. We will also undertake tariff trials aimed at reducing usage. We know leakage is a big issue for our customers and we will continue to seek cost effective ways to reduce leakage further. However, even allowing for these and other demand management measures, we believe that by the late 2020s, a major new water source will be needed, not just for our region but for the wider South-East. We will take the lead over the next few years in working with stakeholders, regulators and other water companies to agree on the best course of action. We will develop three long-term options for the new water resource needed for the wider area wastewater re-use, regional water transfers and reservoir storage to a greater level of detail. Our aim will be to find the solution that provides the best overall value for customers and the environment. A4.5 Outcome delivery incentives The package of outcomes and commitments forms the basis of our proposal to customers. To provide the appropriate incentives to deliver these service levels (and look for innovative ways to outperform them), we have developed a series of outcome delivery incentives (ODIs) specific to each commitment. We have established our plan on the basis that it provides the level of service that customers want. If we fail to achieve this level our general approach is that financial penalties should apply. We only include upside financial incentives where we have established a clear willingness to pay by our customers. We have followed a structured process based on clear principles and criteria to establish whether and at what level ODIs should apply. This process is described briefly in appendix 2 and in more detail in SE13 Outcome delivery incentives. The package includes financial penalties for underperformance (up to 100m) and, in limited cases, rewards for outperformance relative to target performance (up to 10m) for the following measures: Supply interruptions (financial penalty or reward); Leakage (penalty only); and Asset health infrastructure and non-infrastructure (penalty only). Page 40 Chapter A4

45 In each case we have applied appropriate thresholds and caps and collars on the incentives. We will monitor and report on performance against targets on an annual basis and calculate financial rewards and penalties for true-up at the next price review. This approach will incentivise better levels of service while smoothing the impacts on customer bills. Our other performance targets are subject to reputational and/or procedural incentives or are covered by the operation of other existing incentive schemes. For example, our performance against our customer service targets will impact on the overall Service Incentive Mechanism (SIM). We will agree how the SIM reward and penalty are shared between Wholesale and retail, which we expect to include in service level agreements. The package also includes change mechanisms for a number of specific investment areas relating to recovery of costs for either material reductions or increases in scope or outputs. These mechanisms are described later in Chapter A8 and include: compliance with new environmental legislation and regulations, including the National Environment Programme Phase 5 outputs required to be compliant with the Water Framework Directive (WFD); and compliance with the SEMD. We will work with Ofwat and the industry to develop incentives on abstraction and water trading. A4.6 Wholesale water operating strategy The changes in the overall organisational structure and strategy will enable us to consider how we operate as a business unit in a more focussed way to address the issues that we face. We will build on the work already put in place following our business improvement programme and our customer research to improve processes and customer service. We have started the process of updating our water network contracts which are due for renewal in late We are building on the work recently undertaken in wholesale wastewater (see chapter A5) and are seeking contracts that build a collaborative way of working to increase customer satisfaction, reduce supply interruptions and improve response times. We have also put in place a new delivery Alliance 25 for a substantial portion of the capital programme that brings a wealth of international experience and has innovation as a key feature with the inclusion of IBM as the technology and innovation partner. 25 The alliance brings together Thames Water with two design and build joint ventures (Costain, Veolia Water, Atkins (CVA) and Skanska, MWH and Balfour Beatty (SMB)), a programme manager (MWH) and an innovation and technology provider (IBM). Chapter A4 Page 41

46 Moving forward we will build on these improvements with: enhanced SCADA and the move to pre-emptive interventions; customer measures and proposed service level agreements ( SLAs ) with the new retail businesses; and SLAs with our central services. We will move to a position where rather than use SCADA and IT to react to events and analyse data after the event, we will see, manage and optimise performance in real-time locally on site and at our regional control room. In essence we will understand operational issues before they impact customers. As we transform our wholesale businesses we will develop stronger links with retail businesses managed by clear SLAs focused on giving customers the service they need and develop clearer relationships with those services that remain centrally provided. It is clear that with a significant shift in our organisational operating model, industry structure and increased focus on customer service and outcomes, our operating practices will need to change. We also need to ensure our people are equipped with the skills and capabilities to thrive in this new environment with an increased use of technology, devolved decision making and focus on customer service and outcomes. A4.7 Summary of planned expenditure for the wholesale water business The table below summarises the planned expenditure for the wholesale water business. Table A-2 Wholesale water totex expenditure summary m, prices Total Opex Capex Pension deficit repair Total Source: Thames Water Page 42 Chapter A4

47 A5 Our wholesale wastewater business plan A5.1 Introduction This chapter provides a brief summary of the activities that our wholesale wastewater business undertakes before going on to describe the outcomes that customers have told us they would like to see and that we plan to deliver. We explain how we will ensure serviceability of our key assets and make sure that we get the basics right first time before outlining the levels of service that we will provide and how we will compensate customers if things do not go as planned. We also set out a summary of the planned expenditure. A5.2 Our wholesale wastewater business The mission of the wholesale wastewater business is to remove and safely treat 4,200 million litres of wastewater for our 15 million wastewater customers every day. The wholesale wastewater plan has been designed around delivery of this essential service and the outcomes that customers want in the context of the challenges described in Chapter A3. In particular the big issues for our wastewater business are facilitating the Thames Tideway Tunnel, improving customer service, reducing sewer flooding and pollution incidents, maintaining river quality and making full use of our potential to mitigate rising power costs. The three core services are: the collection of wastewater involving a network of over 100,000 km of sewers and 2,649 sewage pumping stations; the treatment of wastewater at each of our 350 sewage treatment works; and the disposal of sludge either directly to farmland or subject to thermal destruction with energy recovery. A5.3 Wholesale wastewater service outcomes We have developed our planning process to ensure it delivers the outcomes which meet our customer, stakeholder and longer-term business objectives. We have used the results of our customer engagement to define six company outcomes which reflect what customers want us to deliver, of which four are applicable to the wastewater service. These have been developed using our customer research and engagement into a further 11 wastewater service outcomes against which performance measures, targets and incentives have been defined. These are set out in Figure A-9. Chapter A5 Page 43

48 Figure A-9 Mapping of Wholesale wastewater outcomes to company outcomes Source: Thames Water Page 44 Chapter A5

49 Our customers have been clear that their primary concern is the safety and reliability of our service at an affordable price they simply want it to be there and to work effectively without causing them concern. Although customers were concerned about the affordability of their wastewater service there was little interest in accepting a reduction in service level in exchange for a reduction in their bill. Customers also supported a limited number of enhancements to service; these being reductions in the number of incidences of blockages and sewer flooding, number of properties impacted by odour and improvements to river water quality. It is also evident that while we provide good service to the vast majority of our customers who never have cause to contact us, when things go wrong our response sometimes falls short of what customers expect. We are already taking action to improve and will continue to do so. As with our wholesale water business, achievement of all our outcomes and targets is underpinned by the stewardship of our assets. Our primary outcome and performance measure is similarly therefore maintenance of the health of our assets in a stable condition and we are developing asset health measures to improve longer-term asset stewardship. Building on our asset health service outcome of maintaining our assets in the long term, the related performance measures and targets for our other wholesale wastewater service outcomes are described below. Demonstrating to our customers that they can trust us, we are easy to do business with and that we care includes doing the basics excellently by getting things right first time. Currently our customer service lags behind the wastewater industry average, with a customer satisfaction score of 3.69 compared to the industry average of 4.4. As with our wholesale water business we have changed processes to improve customer service and are working to change the culture of the business. We have set targets to reduce written complaints from 14.6 to 5.8 per 10,000 connected properties and improve our customer satisfaction score to 4.7 by Properties and public areas protected from flooding have performance measures and targets of: reducing risk by moving an additional 1799 properties to within a 1 in 30 year risk of internal flooding; providing an additional 20 hectares of sustainable drainage. Resilient sewage treatment service that minimises the impact of extreme events on rivers will be achieved by 100 per cent compliance with the SEMD. Additionally, 24 sites will be made more resilient in terms of flooding. These include sewage treatment works and pumping stations that have been identified as presenting a customer service risk today based upon a 1-in-100 year rainfall event. The mitigation measures adopted will reflect the future impacts of climate change. We are addressing risk today, and protecting for the future. Chapter A5 Page 45

50 We will ensure river quality meets customer expectations and regulatory requirements through a combination of aiming for 100 per cent compliance at our wastewater treatment works and reducing the level of pollution incidents. Our aim is for zero category 1-2 incidents and we will pay a penalty if the total number of category 1-3 pollution incidents from sewage related premises exceeds 274 per annum. Additionally, we will improve or protect up to 13 water bodies with our wastewater catchment management activities. Working with the EA, our Plan will address remedial action at nine pollution hotspots. We are also targeting 200 polluted surface water outfalls, where sewage enters watercourses during rainfall through what are intended to be surface water only discharge points. We are also trialling a catchment approach with farmers that does not require investment, to reduce phosphorous in rivers. We will reduce dependency on energy from the grid by improving energy efficiency and increasing our self-generation percentage, reducing our net energy import from the grid across wastewater services by approximately 33 per cent. We will increase our power generation of renewable energy to 405 Gwh. The increased use of thermal hydrolysis will enable us to obtain energy from all our sludge and improve the level of energy generated. We will also replace old CHP engines and increase our use of wind and photovoltaic solar cells. We are also tackling energy efficiency through installing LED lighting and replacing older equipment (pumps etc.) where economically justified. We will reduce our carbon emissions from our wastewater and water services to 34 per cent below their 1990 levels by We will maintain our 100 per cent compliance with sludge disposal requirements, remove around 6,600 properties from risk of odour nuisance, ensure 100 per cent of the schemes agreed with the EA as necessary to meet new environmental regulations are completed on time (including upgrades to eight sewage works to cope with increased population) and protect and enhance biodiversity through continued investment at our sites. We will continue to be a socially responsible business, running educational campaigns, providing visitor centres at our sites and contributing to community and charitable projects. We will target sewer flooding hotspots and send customers information packs and disposal equipment to highlight how best to dispose of fat, oil and other materials that can cause blockages. We will also educate schoolchildren on this issue during the visits to our classrooms mentioned in Chapter A4. Page 46 Chapter A5

51 A5.4 Thames Tunnel Tideway A key project for us is bringing London s sewer system up to date, achieve Urban Waste Water Treatment Directive (UWWTD) compliance and contribute towards compliance with the WFD. The TTT is a major 4bn project to provide a deep tunnel, across London to relieve the overloaded sewerage system and prevent tens of millions of tonnes of untreated sewage from entering the River Thames in a typical year. The TTT is the final part of a three-stage programme that has been agreed with Government to reduce discharges to the river, improve its condition and achieve compliance with UWWTD. The programme, known as the London Tideway Improvements, comprises upgrades to five sewage treatment works (STW) the construction of the Lee Tunnel and the proposed TTT. The STW improvements and the Lee Tunnel are currently under construction with completion expected by As the final part of this programme, the new TTT is crucial and without it the overall London Tideway Improvements objectives will not be achieved. Following extensive discussions with Government, Ofwat and other parties, the majority of the work is proposed to be completed by an independent Infrastructure Provider, with its own licence from Ofwat. Its charges will however be recovered via our wholesale wastewater charges and have a significant impact on the bills of our customers. The business plan for the TTT project is provided in supporting evidence SE10 Thames Tideway Tunnel. A5.5 Outcome delivery incentives This package of outcomes and commitments forms the basis of our proposal to customers. To provide the appropriate incentives to deliver these service levels (and look for innovative ways to outperform them), we have developed a series of outcome delivery incentives (ODIs) specific to each commitment. We have established our plan on the basis that it provides the level of service that customers want. If we fail to achieve this level our general approach is that financial penalties should apply. We only include upside financial incentives where we have established a clear customer willingness to pay or it is cost beneficial to consumers. We have followed a structured process based on clear principles and criteria to establish whether and at what level ODIs should apply. This process is described briefly in appendix 2 and in more detail in SE13 Outcome delivery incentives. Chapter A5 Page 47

52 The package includes financial penalties for underperformance (up to almost 110m) and, in limited cases, rewards for outperformance relative to target (up to 10m) for the following measures: Sewer flooding incidents, other causes (financial reward or penalty) Pollution incidents, category 1-3 (financial penalty only) Properties removed from odour (financial reward under change mechanism or penalty) Asset health infrastructure and non-infrastructure (financial penalty only). In each case we have applied appropriate thresholds and caps and collars on the incentives. We will monitor and report on performance against targets on an annual basis and calculate financial rewards and penalties for the next price review. This approach will incentivise better levels of service while smoothing the impacts on customer bills. Our other performance targets are subject to reputational and/or procedural incentives or are covered by the operation of other existing incentive schemes. For example, our performance against our customer service targets we envisage will impact on the overall Service Incentive Mechanism (SIM). We will agree how the SIM reward and penalty are shared Wholesale and retail, which we expect to include service level agreements. The package also includes change mechanisms for a number of specific investment areas relating to recovery of costs for either material reductions or increases in scope or outputs in AMP6. These mechanisms are described later in Chapter A8 and include: Internal hydraulic flood protection; Properties removed from odour; Compliance with new environmental legislation and regulations, including the National Environment Programme Phase 5 (NEP5) outputs required to be compliant with the WFD, and the Industrial Emissions Directive; and SEMD compliance. Page 48 Chapter A5

53 A5.6 Operating & delivery strategy The changes in the overall organisational structure and strategy will enable us to consider how we operate as a business unit in a more focussed way to address the issues that we face. We will build initially on the work already put in place following our business improvement programme and our customer research to improve processes and customer service. This has included changes in our contractual arrangements with partners and contractors which provide for: longer-term contracts with co-located staff and integrated management systems; new purpose built vehicles which have the capability to clear blockages, use CCTV, undertake root-cutting and mark-up civil works before leaving the site; and delegated authority allowing contractors to make decisions regarding ancillary works, thereby improving response times and improving service. As with our water wholesale business we have also put in place a new delivery Alliance with the inclusion of IBM as the technology and innovation partner and in addition are moving towards: pre-emptive rather than re-active interventions; and building customer measures into proposed SLAs with the new retail businesses and our central services These changes will lead to a wider review of our processes to provide devolved decision making and a need to develop our people to succeed in this environment. A5.7 Summary of planned wholesale wastewater expenditure The table below summarises the planned expenditure for the wholesale wastewater business. Table A-3 Wholesale wastewater totex expenditure summary m, prices Total Opex Capex Pension deficit repair Total Source: Thames Water Chapter A5 Page 49

54 This page has been intentionally left blank Page 50 Chapter A5

55 A6 Our retail household business plan A6.1 Introduction This chapter provides a brief summary of the activities that our household retail business undertakes and describes the outcomes that customers have told us they would like to see and that we plan to deliver. The chapter then goes on to explain how we will provide the improvements in the levels of service that we will provide to our customers. A6.1.1 Our retail household business Our retail household business includes all customer-facing activities: billing, payments, debt management, meter reading, customer queries, correspondence and complaints handling, and everyday water efficiency advice. We provide 3.4 million households with water and wastewater services. A further 1.8 million households receive our wastewater service only and are billed on our behalf by the relevant water supply company. We have around 1,200 employees including delivery partners. They handle over 15 million customer interactions per year, including issuing almost 7 million bills, and dealing with more than 3.5 million phone calls and over 0.5 million pieces of written correspondence. A6.1.2 Retail household business service outcomes Some aspects of the customer service that we deliver today need to improve as they are not good enough. Too many customers have to contact us more than once because we do not get the basics right first time. And we do not meet their requirement for online services as standard. Three of our company-level outcomes are specifically relevant to this part of our business. Each has a corresponding retail household service outcome based on feedback from our customers. In analysing the results of our customer engagement, recurrent themes included fixing urgent problems quickly, keeping our promises, making sure customers are kept informed about service disruptions, and getting it right first time. To address these concerns, our service outcome is: Improve customer service by doing the basics excellently and getting things right first time. Chapter A6 Page 51

56 Analysis of feedback suggests our customers want bills to be kept as low as possible, with any rises gradual. Our customers also support fairness, for example, by taking firm action against those who can pay but choose not to, while recognising that some customers need additional support. We will tackle these issues through the following service outcome: Improve cash collection from those that can pay and help those that are struggling to pay. A recurrent theme throughout our engagement was that our customers prefer to use the phone for urgent problems, while some wanted other forms of communication to be available when they need them to resolve queries. We have echoed the wording of the company-level outcome in our service outcome: Offer a choice of easy-to-use contact options. For each performance measure we have set ourselves a challenging target. We consider that the SIM 26 will continue to provide appropriate overall financial incentives. In delivering these targets, our overriding objective is to continue our recent improvements in customer service as a key element of achieving our vision. The mapping of company outcomes to service outcomes and performance measures is shown in Figure-A We have assumed that the revised version will be broadly similar to the existing measure, but exclude contacts from non-household customers. Page 52 Chapter A6

57 Figure A-10 Mapping of retail (household) service outcomes and performance measures to company outcomes Source: Thames water A6.1.3 Improve customer service, doing the basics excellently and getting things right first time Customers are frustrated when we cannot resolve issues promptly, fail to keep promises or do not keep them updated on progress. Our performance, although improving, still lags behind the industry average. We have therefore set these demanding targets for : minimise the rate of written complaints from unmetered customers, with a target of 21 per 10,000 properties Chapter A6 Page 53

58 minimise the rate of written complaints from metered customers, reducing this from 35 to 30 per 10,000 properties increase first-time resolution of written complaints from 90 to 95 per cent improve response time for 90 per cent of s to two days improve customer satisfaction with charging and billing activities from 4.4 to 4.65 out of 5, and with our Operations Contact Centre from 4.2 to 4.65 for metered customers, increase the proportion of bills based on an actual reading from 85 to 96 per cent Below we highlight the key areas we will seek to improve, to ensure we meet these targets. Designing customer journeys: We are already improving our customers experience by fixing issues that cause them dissatisfaction when they contact us. In AMP6 we will go beyond this to improve the experience for the various household customer segments we have identified, taking into account the specific needs of each group. This critical activity will inform the design of our replacement customer information system (see below). Operating model: We need the flexibility to respond swiftly to changing customer needs and require a mix of in-house and outsource partners, of whom we currently have three supporting our office-based activities in the UK and in India. We will retain this model and change the mix of work and the performance we expect. We will manage simple customer contacts and activities through our outsource partners, but give highly skilled and experienced in-house teams the responsibility for more complex work. Smart metering: As noted in Chapter A4, we will continue with our programme to fit smart meters. We have also introduced a new meter reading system, which is activating over 100,000 smart meters we have already installed and is ensuring we miss fewer readings from our existing 1.2 million dumb meters. These current and planned improvements will enable more reliable and accurate bills, allow customers to better understand their usage and help us identify leaks on their pipework. Improved IT systems: Our ageing customer information system is at increasing risk of failure and prevents us making some of the key service improvements our customers expect. We anticipate replacing it by , which will also enable us to provide customers with selfservice online account management. This is a major project that will require significant planning and development. We will therefore investigate the feasibility of developing online account management in the meantime, using our existing technology. Page 54 Chapter A6

59 Training and coaching: It is imperative our staff have the right skills and attitude. We will train them to provide the new end-to-end customer experience to take full advantage of our new system when it goes live in We are also investing in training for all managers to help them motivate our people to provide great service. Culture: We will continue to focus on creating a culture where everyone thinks like a customer and focuses on driving continuous improvement. A6.1.4 Offer a choice of easy-to-use contact options Customers expect a choice of contact options and to be able to interact with companies through digital channels, including online self-service and . For complex online transactions, we will also provide a web-chat facility, in which a member of staff can help them through their enquiry. Customers want a simple online experience that allows them to easily resolve their need, and expect this as standard. We have set ourselves the following targets: Introduce a new online self-service channel by 2017 and introduce a web-chat facility as described above Extend Saturday call centre opening hours Provide customers who are waiting to have their call answered with a specific time at which we will call them back Pilot discounts for online account management, direct debit payment and e-billing A6.1.5 Improve cash collection from those who can pay and help those who are struggling to pay We have set ourselves three targets in this area: Increase the number of customers on payment plans to 60 per cent by Increase the cash collection rate to 91 per cent by Introduce a social tariff and benefit entitlement checks in 2015 We will focus on making these improvements through the following activities: Cash collection: We will continue to employ tried and tested methods to encourage customers who can pay to do so. A new debt management system, backed by support and training for staff, will ensure we offer customers the most appropriate and affordable payment plan. Chapter A6 Page 55

60 The new technology will allow us to: Further develop the segmentation of customers, so we can offer the most appropriate payment option and tailor the debt recovery action to drive the right behaviour Effectively use credit referencing bureau data to inform us of customers ability to pay Report via the credit bureau on customers propensity to pay Continuously improve our processes to ensure our operating structure lends itself to efficient recovery of debts and to helping those who are struggling to pay Helping those who struggle to pay: Many households are struggling in the current economic climate and the cost of the TTT will increase the average bill of our household sewerage customers by around 40 by 2020 We will continue to provide our Customer Assistance Fund, Trust Fund, and the statutory WaterSure scheme, all of which give assistance to vulnerable customers. We will also introduce the following initiatives: We will introduce a social tariff, WaterSure Plus, from This will give qualifying customers (including our wastewater only customers) a 50 per cent discount, and will be available to both metered and unmetered households. We predict the social tariff will be providing assistance to about 37,000 customers by As well as helping customers to reduce their water bills, we will introduce benefit entitlement checks. This will be part of an integrated strategy to assist those customers most struggling to pay their bills. Our work with specialist financial assistance organisation Auriga suggests around 25,000 customers will take up this service. Our research suggests customers would welcome help in reducing water usage, and believe recipients of a social tariff should adopt water-saving measures. We will help metered customers to reduce their bills by providing free water-saving products and assistance, targeted at those on low incomes. A6.2 Operating and delivery strategy The changes in the overall organisational structure and strategy will enable us to consider how we operate as a business unit in a more focussed way to address the issues that we face as a business. We will build initially on the work already put in place following our business improvement programme and our customer research to improve processes and customer service. This has included mapping high usage end-to-end customer journeys where there is a low customer satisfaction. This has identified pain points for customers and where processes are broken so that improvements can be made. Page 56 Chapter A6

61 The end-to-end management of the processes that support our water, wastewater and billing and charging customer journeys brings teams together from across the business on a regular basis to review and improve end-to-end performance. It focuses on behaviours and cultures within the team and ensures key measures of performance are understood by everyone. Issues are identified and actions are agreed and implemented. The internal customer satisfaction monitor is used to track performance and gain customer feedback. We will also, focussing on the outcomes our customers want, develop suitable SLAs with our wholesale providers to ensure that customer service has the appropriate priority and our central services provide the services we need to in turn provide our customers with what they want. A6.3 Summary of planned household retail business expenditure The table below shows the cost of the retail household business. These costs are discussed in more detail in the retail household business plan Part D. Table A-4 Retail household totex m, prices Total Opex Capex Total Source: Thames Water Chapter A6 Page 57

62 This page has been intentionally left blank Page 58 Chapter A6

63 A7 Our non-household retail business plan A7.1 Introduction This chapter provides a brief summary of the activities that our retail non-household business undertakes, and describes the outcomes that customers have told us they would like to see and that we plan to deliver. The chapter then goes on to explain how we will provide the improvements in the levels of service that we will provide to our customers. A7.2 Our retail non-household business Our retail non-household business includes all customer-facing activities: billing, payments, debt management, meter reading, customer queries, correspondence and complaints handling related to non-household customers. This includes providing everyday water efficiency advice for our 250,000 non-household customers and services for our 62,000 wastewater only customers. An important feature of the non-household market is the potential for direct competition for customers. At present, customers using more than 5 million litres per year are able to choose their retailer about 3 per cent of our customers. It is expected that from 2017 all nonhousehold customers will have this option. This will be the ultimate test of our vision to be the water retailer of choice. A7.3 Retail non-household service outcomes Competition is an exciting prospect, and we recognise we must adopt a new attitude if we are to compete in a new market. Our discussions with our customers have given us a clear view of what they want from us. This engagement has included talking to 3,421 non-household customers and 233 stakeholders, in addition to the running of a quarterly business forum in parallel to regular challenge sessions with the CCG. Three of our company outcomes are specifically relevant to this part of our business. We have developed five retail non-household service outcomes to address these. These are shown in Figure A-11. Chapter A7 Page 59

64 Figure A-11 Mapping of retail (non-household) service outcomes and performance measures to company outcomes Source: Thames Water A7.3.1 Improve customer service by doing the basics excellently and by getting things right first time We must ensure our core services are consistently delivered to a high quality. Customers have told us that bills should be easy to understand, accurate and arrive on time, and that they want a single point of contact for issues or queries. They also want a quick response to any issues or queries, and swift resolution. Page 60 Chapter A7

65 The vast majority of our non-household customers are smaller businesses. For these customers, we have mirrored the retail household targets set out in chapter A6. These state that by 2020 we will: reduce written complaints from metered customers from 35 to 30 per 10,000 properties; increase first-time resolution of written complaints from 90 to 95 per cent; improve response time for 90 per cent of s to two days; improve customer satisfaction with charging and billing activities, and with our Operations Contact Centre, from 4.4 to 4.65 out of 5; and for metered customers, increase the proportion of bills based on an actual reading from 85 to 96 per cent. A7.3.2 Help customers reduce water consumption We will offer customers a comprehensive range of products and services aimed at reducing consumption and cost. Customers have told us they want a better range of services to help with their usage. We will, as a trusted advisor offer enhanced products and services, for example, in the field of customerside leakage detection, water efficiency and water audits. We will focus part of our water efficiency programme specifically on the non-household sector, with the aim of helping customers save a total of 3.45 Ml/d across AMP6. A7.3.3 Provide tiered levels of service, with costs allocated for the services selected We will build deeper relationships with our customers to understand their ongoing needs by engaging with them through forums and newsletters and by consulting with them on individual matters that may affect their service. We will also drive for a greater understanding of customers through improved segmentation, and tailor our approach and services according to the needs of each. Chapter A7 Page 61

66 A7.3.4 Enable customers to view their consumption online, analyse trends over time and benchmark levels of usage Customers have told us they want to access and amend their account online, and to be able to view consumption, analyse usage trends and benchmark this against other companies. We will be able to provide these improvements partly through introducing a new Customer Information System, specific to our non-household business. Another key change enabling this will be the use of smart meters. Only those meters replaced in the last two years have this technology, significantly restricting the amount of information we can collect from the majority of non-household meters. We are replacing all our largest customers meters with fixed network meters. Initial pilots have shown more accurate billing, greater consistency in billing periods and more information on usage. Part of this installation work will be delivered by our wholesale water business. We will also ensure we maintain cost relativity and avoid cross-subsidisation in our tariffs to ensure customers value is maintained. We have been involved in developing the default tariff structure, working jointly with Ofwat and Economic Insight. We understand the importance of getting tariffs right and intend to change our tariff structure based on our understanding of the cost variations across the various segments. One of the improvements we propose is to refine our tariffs to reflect doubtful debt costs more accurately. We propose to implement seven consumption bands with fixed and variable elements that maximise cost reflectivity. In pursuit of more understandable tariffs we will put forward these simplified tariffs to replace the existing 126 tariffs, with an even distribution of the retail margin. We recognise that market changes mean we will need to ensure we can appropriately manage the process of our customers switching supplier. We will develop our transfer process to ensure it is quick, efficient and accurate. A7.3.5 Make consolidated billing available to customers with multiple sites, to help reduce administrative costs Those customers with multiple sites want the ability to have their bills consolidated, to make things simpler and reduce administration. We will make this available with a new Customer Information System, specific to our non-household business. Page 62 Chapter A7

67 A7.4 Operation and delivery strategy We have already started moving to an operating model that has enabled us to deliver a number of initiatives for our retail customers, these include: Recruiting additional key account managers to support our larger commercial customers. Moving away from a regulated meter reading service level, which saw many large commercial customers only get one actual meter-read every year, to ensure that our tier 1 and tier 2 customers have their meters read every time a bill is due. Revamping our consolidated billing service so that it aligns with what customers have told us they need. Investigating how we can take customers own Automated Meter Reading ( AMR ) data and use this information as the basis of their bills. Enhancing our ability to provide customers with billing and consumption data that can be more easily downloaded into the energy management systems that our customers use. Carrying out a small number of trials with customers to provide them with smart meter data so that we can understand what they need from us, how they want to use the information and how they would like it delivered. However we recognise that this is only the beginning of truly making our services customercentric. In AMP6 we will continue to improve the customer service experience by building a model that delivers exactly what customers are telling us they require from us. A7.5 Summary of planned expenditure The table below summarises the expenditure for retail non-household activities. Table A-5 Retail Non-household Totex summary m, prices Total Opex Capex TOTAL Source: Thames Water Chapter A7 Page 63

68 This page has been intentionally left blank Page 64 Chapter A7

69 A8 Finance & risk A8.1 Summary In this chapter we set out the costs and assumptions that affect our overall revenues. This includes expenditure, the PAYG rate and depreciation profile, the RCV, the cost of capital and the true-ups from previous price controls. In addition, it includes our financeability and risk assessment. In summary, our plan includes: total expenditure of 8.5bn a weighted cost of capital of 4.0 per cent real post-tax (equivalent to 4.3 per cent real vanilla) for both wholesale businesses a 0.8 per cent margin for retail household and 3 per cent for non-household 1.5bn increase in net borrowing (based on notional capital structure of 60 per cent gearing) This results in an overall RCV of 12.4bn by 2020 and revenue over the period of 10.3bn of which 415m relates to the Infrastructure Provider for the TTT (all figures in prices). Our financeability assessment shows that the plan is financeable using the notional capital structure with an investment grade credit rating although, in downside scenarios, the rating metrics are stretched. The rest of this chapter sets out in summary how we have assessed the various building blocks that result in the overall level of revenues. More detailed information can be found in the two supporting documents SE9 - Finance and SE7- Risk. Our cost of capital proposals are based on analysis provided to us by Europe Economics who advised Ofwat at PR09. Their report provides further explanation and rationale for our proposal and is included as a technical appendix. 27 A8.2 Total expenditure and efficiency challenge The table below shows the total expenditure included within our plan by business unit. These costs have resulted from our three annual planning cycles, which have challenged both the scope and cost of our programme to ensure that it is aligned to delivery of the outcomes that 27 Technical appendix T0213 Chapter A8 Page 65

70 customers want and at an efficient level of costs. They include the effects of significant efficiency challenge and include a number of upward cost drivers affecting the business but largely beyond our control including increased business rates, energy prices, market opening and competition costs and the adoption of private pumping stations. Table A-6 Total expenditure m, prices Total Wholesale Water Wholesale Wastewater Retail (household) Retail (non-household) Total Source: Thames Water. retail costs have been deflated by RPI even though the ACTS control will not include RPI indexation. Our approach has been to challenge the plan from three different directions to ensure customers get value for money: building an efficient plan to ensure that we have identified the right scope of work bottom-up challenge to ensure we have identified the most efficient way of delivering the scope of work top down challenge to ensure that in comparison to available benchmarks our costs are at an appropriate level. A8.2.1 Bottom-up efficiency challenge to our planned costs We have used two main approaches to undertake a full bottom up challenge of our costs. For capital expenditure we have used our Alliance partners who have huge technical expertise in delivering infrastructure to challenge our costs. They identified efficiency savings of around 155m (7.8 per cent of the overall capital expenditure assigned to the Alliance). This efficiency was challenged and peer-reviewed by a panel of technical experts to ensure that it was robust, correct and deliverable. These savings have been included in our projections. For our operating costs we have undertaken a full business improvement review across the whole business during 2012 with the objective of improving customer service, processes, systems and data in order to provide enduring improvements in service and efficiency. This identified 61m in potential wholesale efficiency improvements and we have assumed these will be fully implemented by 2015 and are therefore included in our projections (Further details on the business improvement exercise can be found in SE6 Cost efficiency). Page 66 Chapter A8

71 A8.2.2 Top-down efficiency challenge to our planned costs We have also undertaken top-down challenges using comparative efficiency analysis. For capital expenditure we have used cost base as used by Ofwat at the last price control review. Our analysis shows that we have improved our capital expenditure efficiency. We estimate our costs to be 2 per cent below the median position (used by Ofwat as the efficiency benchmark in PR09) after allowing for a 5 per cent efficiency improvement in the median position since PR09 in wholesale water and 2 per cent above the median in wholesale wastewater. We have commissioned Oxera to undertake comparative efficiency at the Totex level (excluding enhancement expenditure which we do not consider to be suitable for comparative benchmarking at the total cost level). The Oxera modelling uses advanced econometric modelling which seeks to eliminate the need to identify special factors for persistent differences between networks. 28 This analysis was undertaken for the period over which consistent data was available. This shows that our efficiency position at that time was below the median company in wholesale water and marginally better than the median in wastewater. The adverse performance of wholesale water is largely explained by the high burst rate of our large water mains in London which would cost customers far more to replace than the cost of repairs. However, these costs are backward looking and we have made significant efficiency improvements since that time. Although we do not have information on the efficiency improvement of others we have assumed the frontier will have improved by 0.5 per cent pa (twice the rate assumed by Ofwat in PR09). Compared to this rolled forward position our efficiency (after removing real price effects and volume changes for consistency purposes) we estimate our wholesale water business to be within 0.5 per cent of the theoretical best performing WASC and 3.7 per cent ahead of the median position. Our wholesale wastewater business we estimate to be within 5 per cent of the theoretical best performing WASC and 1.4 per cent ahead of the industry average. We expect these to be within the range of efficient costs modelled as part of Ofwat s cost corridor approach. A8.3 Build-up of required revenue The revenue needed to continue delivery of what customers want and provide appropriate returns to investors has been constructed using the building blocks set out in the Ofwat methodology. The results are summarised in the table below. 28 We have included data relating to totex that should be excluded from any cross-industry comparison as a result of specific factors that differ from industry or our historical costs in the data tables. This is in case Ofwat s econometric modelling is less sophisticated. These exclusions may need to be reviewed when we receive information about the form and specification of Ofwat s models. Chapter A8 Page 67

72 Table A-7 Total allowed revenues m, prices Total Totex: PAYG ,745 Totex: RCV run off ,056 Totex: depreciation Return on RCV ,570 Taxation AMP6 incentives and corrections 7 (5) (5) (5) (5) (12) TTT IP pass-through Total wholesale 1,743 1,781 1,830 1,887 1,984 9,226 Retail household revenue Retail non-household revenue Total revenue requirement 1,936 1,986 2,045 2,113 2,212 10,293 Source: Thames Water Financial model. Note: TTT IP pass-through excludes tax Our approach and the values of each element are described briefly in the following sections. A8.3.1 Totex recovery and depreciation rates The effect of the above expenditure on customers bills will be affected by how much is treated as fast money through the Totex recovery rate and how fast the RCV is depreciated by the depreciation rates. Our view is that decisions over the timing of cash flow are largely an issue of intergenerational equity and that todays customers should fund the assets and costs that they consume. In addition, current customers are, relative to future customers, disproportionately enjoying the benefits of the privatisation discount of RCV to replacement cost and any significant deferral of revenue would be unfair. Our starting position is therefore that Totex recovery and depreciation rates should reflect the existing basis of sharing these costs. However customers have told us that if bills have to increase (and with the TTT bills will have to rise just as bills rose when the beaches in the West Country were cleaned up) they would like such increases to be as smooth as possible Most customers believe that Thames water provides an affordable service, however, they don t want to see significant increases in bills. If bills are to increase over the next few years to pay for keeping services functioning well, these bills should increase gradually. Office for Public Management, What Customers are telling us Review of PR14 customer engagement and research studies for Thames Water, page 10, July 2013 Page 68 Chapter A8

73 Accordingly we have sought to smooth total bill increases across (including the effects of the TTT IP revenue pass through). We have considered a number of ways to achieve this and found that adjusting the RCV run-off rate in each year for existing assets within the Wholesale water and wastewater price controls is the best approach. The table below summarises our totex and depreciation assumptions, although for simplicity it shows an average value rather than each year s individual rate. Table A-8 Wholesale totex recovery rate and depreciation rates Wholesale water Wholesale wastewater Pay-as-you-go (PAYG) % (average for AMP6) RCV run-off rate on existing assets (average for AMP6) Average asset lives for new assets in AMP6 (by 2019/20) Source: Thames Water financial model 57.28% 44.89% 3.71% 4.21% 21.2 years 29.0 years A8.3.2 RCV assumptions Our assumptions with regard to the RCV use opening balances consistent with those notified to us by Ofwat. They take account of Ofwat s Final IDoK Determination. As Ofwat is aware, we plan to spend more in the period up to April 2015 on Deephams and alleviate more properties from sewer flooding that Ofwat claimed in its Final IDoK Determination. We have treated this expenditure as early expenditure on AMP6 targets. We have also taken the other aspects of Ofwat s Final IDoK Determination into account in the RCV, from which point we roll forward to take into account additional logging and outperformance under CIS for the remainder of the AMP5 period. The RCV for the component water and wastewater controls within Wholesale is based upon the split inherent within the PR09 control (as adjusted for Ofwat s Final IDoK Determination and other opening balance changes). We have considered whether there is a materially more costreflective method to allocate the RCV between the services and have concluded that as any reallocation would have an adverse impact on our wastewater customers at a time when their bills are rising due to the TTT, now is not the right time to make any adjustment. In summary, our Wholesale RCV rises from 11.3bn at the end of AMP5 to 12.4bn by Chapter A8 Page 69

74 Table A-9 Wholesale RCV RCV ( m) Total Opening balance 11,275 11,525 11,836 12,118 12,310 Midnight adjustment: for 2009/10 actual vs. PR09 assumption (161) Midnight adjustment: CIS for AMP Totex: RCV additions ( slow money ) Totex: RCV run off (505) (450) (382) (358) (362) Totex: depreciation on AMP6 capex (16) (50) (84) (115) (143) Closing RCV 11,525 11,836 12,118 12,310 12,400 Source: Thames Water financial model A8.4 Cost of capital A8.4.1 Context Over the period our plan, using the notional capital structure, we anticipate that we will need to increase net borrowing by 1.5bn to fund the services that customers tell us they want. It will therefore be important that investors are attracted by the returns available. Traditionally, the UK water industry has been seen as relatively low risk, operating within a stable and highly regarded UK regulatory framework. Providing the allowed return on the RCV is seen to be consistent with the risks and investors remain confident in the stability of the regulatory regime we should be able to continue to raise the funds required by the business at efficient rates. We note, however, that there is evidence that investors perceive increased regulatory risk, as reported, for example in the 2013 Water UK Investor Survey. 30 We have been assisted in our analysis by Europe Economics who are leading economic consultants and who provided advice to Ofwat at the last price control and have advised other economic regulators, in particular Ofgem, in recent years Survey of Investors in the water sector, a report by Indepen for Water UK, June Page 70 Chapter A8

75 We have used a post-tax real Weighted Average Cost of Capital (WACC) of 4 per cent 31 across both wholesale businesses as we do not have any reason to differentiate between them. The rate compares favourably to the 4.7 per cent set by Ofwat in PR09 32 and is similar to the 4.2 per cent vanilla WACC set for the gas distribution network businesses and proposed by six out of seven electricity distribution businesses in their recent equivalent business plan submissions. The WACC has been based on: A post-tax cost of equity of 6.68%; (Ofwat 2009: 7.1%). A pre-tax cost of debt of 2.74%; (Ofwat 2009: 3.6%). A notional gearing level of 60% (Ofwat 2009: 57.5%). Retail Margin For our retail businesses, we have applied a net margin approach as proposed by Ofwat. We have used a net margin of 3 per cent for non-household, which is within the range of returns obtained by Business Stream and energy retailers where there are already competitive retail markets. For household we have estimated a margin of 0.8 per cent based on a bottom-up assessment of that required to cater for financing working capital, capital investment in retail assets and uncontrollable operating cost increases. Cost of Equity Our cost of equity proposals are based on taking a market cost of equity approach and disaggregating into its component parts. Although we have considered a wide range of evidence our market returns are largely based on the widely respected Dimson, Marsh and Staunton analysis. This results in a rate of 7.2 per cent. Our disaggregation is based on a risk free rate of 2 per cent and a market premium of 5.2 per cent. The risk free rate is similar to recent regulatory settlements in the energy sector and based on analysis by EE on the linkage between growth rates and risk free rates. There is a strong consensus around an equity risk premium of circa 5 per cent across recent regulatory determinations and estimates. Our analysis acknowledges that observed equity betas for listed water companies have fallen in recent years. However, we consider that this is largely a function of a flight to quality during the recent financial upheaval and is likely to unwind over the coming years. We have therefore only partially reflected this fall and used an asset beta 10 per cent below the rate used by Ofwat in PR09. With the slightly higher notional gearing our equity beta of 0.90 is broadly the same as at PR Equivalent to 4.3% vanilla WACC as used by Ofwat to set allowed revenues. 32 When adjusted for consistent tax rates. Chapter A8 Page 71

76 Cost of debt Our cost of debt assumptions recognise that we have been able to raise debt relatively cheaply in recent years and our average cost of debt has fallen. Consistent with the principles of incentive based regulation we consider that these reductions should be passed onto consumers from The approach used by Ofwat at PR09 does this effectively through weighting embedded debt costs with forward looking new debt costs. Our estimate is that industry embedded debt costs have fallen to 2.5 per cent and that forward debt costs are 3.45 per cent. Our analysis suggests that the 75:25 embedded debt cost to forward cost ratio used by Ofwat in PR09 remains appropriate and have used this to arrive at our overall cost of debt assumption of 2.74 per cent. A longer summary of the basis of our cost of capital assumptions is set out in appendix 1 and our full analysis is included in supporting evidence SE9 Finance which references as a technical appendix the reports from Europe Economics. A8.4.2 AMP5 True-up Amounts The wholesale revenue controls also include adjustments required through operation of key AMP5 correction and incentive mechanisms for which we have followed guidance set out in Ofwat s published guidance on these topics. Table A-10 below shows the adjustment made. Table A-10 AMP5 True-up adjustments m, prices Adjustments Capital Incentive Scheme adjustments (96) Revenue Correction Mechanism 129 SIM estimate (57) Opex outperformance 12 Total Adjustments (12) Source: Thames Water financial model A8.4.3 Dividends and dividend policy The money we receive from customer bills is not sufficient in any one year to pay for all our operating costs and capital investment. We therefore need to seek additional funding from debt and equity investors. Equity investors seek a return on their investment, commensurate with risk, it is therefore right that we should pay them a dividend. This Plan assumes dividends of 1,127m ( prices) are paid. This is based on a notional capital structure (at 60 per cent gearing) financed at the 6.7 per cent cost of equity assumed within the WACC (less retention of Page 72 Chapter A8

77 2 per cent as a buffer for risk and to ensure that the company can maintain ratios necessary to protect its investment grade credit rating). We also assume 70 per cent of net profits after tax from the retail businesses are distributed, included in the distribution set out above. A8.4.4 Cash flow We remain cash flow negative and therefore net debt rises by 1.5bn over AMP6 before inflation. Table A-11 Cash flow and net debt summary m, prices Opening net debt 7,216 7,683 8,030 8,360 8,611 Net cash outflow notional basis Closing net debt 7,683 8,030 8,360 8,611 8,740 Source: Thames Water financial model A8.5 Financeability assessment We have undertaken our financeability assessment assuming a notional capital structure assuming 60 per cent gearing, a vanilla WACC of 4.3 per cent and an assumption that 20 per cent of new debt will be index-linked. We have considered a number of the key credit metrics used by the rating agencies. The analysis shows that our plan, taken as a whole, is financeable with credit metrics consistent with a BBB+ credit rating on a notional balance sheet basis, albeit with very limited headroom as shown in the Table below. Table A-12 Financeability assessment using notional capital structure Ratio Target Cash interest cover 3.0x 3.48x 3.33x 3.19x 3.19x 3.31x Adjusted cash interest cover 1.6x 1.71x 1.70x 1.71x 1.72x 1.74x FFO/debt 10% 10.32% 9.84% 9.29% 9.39% 9.94% RCF/debt 8% 7.12% 6.78% 6.10% 6.03% 6.56% Gearing (net debt/rcv) 65% 60.68% 60.61% 60.41% 60.09% 59.49% Source: Thames Water financial model Chapter A8 Page 73

78 A8.6 Risk We have carried out a structured process to understand and articulate the risk that is shared between the customer and the shareholder. We have employed Oxera to support us in the development of a risk framework to ensure that we have a good understanding of the risks in the plan and have quantified the risks through the various metrics required in the Ofwat guidance. The full details of this analysis are contained in the associated technical appendix T0211. Our overall risk analysis is summarised in Figure A- 12. The Return on Regulatory Equity (RoRE), a measure of shareholder returns during AMP6, has a mid-case that is just below our proposed cost of equity, 6.7 per cent, due to certain risks (particularly around the capital programme, but also ODIs) being asymmetric in nature. The distribution of risks shows that there is a broadly symmetrical balance of risk between shareholders and customers. Figure A-12 also shows a lower downside risk (shown as a red dotted line) which includes the impact of one-off downside events. Figure A-12 Risk and reward in our business plan (RoRE) Source: Oxera modelling Oxera s analysis shows that once Ofwat s regulatory mitigation mechanisms-such as the revenue correction mechanism and the TOTEX incentive-have been applied, the residual cash flow risk to which our customers and shareholders will be exposed in AMP6 is equivalent to that in AMP5. Specifically, the table below shows that of the 300m pa cash flow risk to which our shareholders are likely to be exposed in , the residual risk which they retain would be Page 74 Chapter A8

79 around 175m pa, regardless of whether the previous AMP5 incentive mechanisms or AMP6 incentive mechanisms are applied in the modelling. Table A-13 Residual cash flow risk and potential impact on bills Downside risks to base case (95% case, 2018/19) Estimated impact on consumer bills, % of AMP7 Key assumed regulatory mechanisms Operating cash flow (after CAPEX) risk within period Up to 300m p.a. n/a RPI adjustments only Net of AMP5 mechanisms Up to 175m p.a. Potential 3% increase (in a downside scenario) 100% RCM, 100% CAPEX log-up (net of CIS) Net of proposed AMP6 mechanisms Up to 175m p.a. Source: Thames Water and Oxera modelling Potential 3% increase (in a downside scenario) 50% TOTEX incentive, 100% RCM and revenue cap, ODIs The table also shows the potential impact on customer s bills in AMP7 if the full effect of the risk exposure were to be realised in AMP6-3% increase. There would be a similar size beneficial impact on bills if we outperformed to the same extent. A8.6.1 Sharing the risks of cost performance The totex menus and incentive rates are mechanisms through which cost over- or under-spends on our wholesale business are shared between us and our customers. The totex incentive rate therefore has an important role in determining the balance of cost-performance risk. We have proposed an incentive rate of 50 per cent. A8.6.2 Risk mitigation mechanisms We have planned on the basis that we should bear those risks that we are best placed to control and manage. In line with this principle, we have identified only a small number of risks where we consider it appropriate to put in place alternative mechanisms. These are summarised in the table below. Chapter A8 Page 75

80 Table A-14 Proposed risk mitigation mechanisms Item Business Mitigation Mechanism Compliance with new environmental legislation and regulations, including Water Framework Directive NEP5 and Industrial Emissions Directive SEMD compliance Local authority business rates Competition (central costs and compliance with national standards) Thames Tideway Tunnel TWUL costs Thames Tideway Tunnel Infrastructure Provider costs Hydraulic sewer flooding (additional schemes) Odour (additional schemes) Source: Thames Water Wholesale water Wholesale wastewater Wholesale water Wholesale wastewater Wholesale water Wholesale wastewater Wholesale water Wholesale wastewater Wholesale wastewater Wholesale wastewater Wholesale wastewater Wholesale wastewater Change mechanism for outputs Change mechanism for outputs Trigger with pass-through Trigger with pass-through Ofwat review for land and development costs Separate regulatory arrangements for other risks TWUL Licence modification Separate regulatory arrangements for other risks Change mechanism for outputs Process for agreeing additional schemes with potential benefits sharing Change mechanism for outputs Process for agreeing additional schemes with potential benefits sharing Page 76 Chapter A8

81 We have limited the number of alternative mechanisms to items that meet the following criteria: costs that are uncertain in size, scope or timing; costs that are outside the control of management and cannot be managed by prudent management action; and the risk would have a material impact on the cost base (e.g. greater than 2 per cent of annual service turnover) 33 if it materialised. We have considered other cost items for alternative mechanisms (e.g. pension deficits, Ofwat licence fees, EA abstraction charges, traffic management act, energy prices). However, we consider that the cost performance incentives in the Totex menu should share these risks appropriately between customers and shareholders. The alternative mechanisms for each item are summarised in appendix 3. Full details of this assessment are provided in SE13 Outcome delivery incentives. A8.6.3 Sharing upside We recognise the importance of sharing any potential gains from financial outperformance with our customers. We therefore examined whether additional mechanisms should be used to share upside in AMP6. We found that the AMP6 regulatory framework is designed to share most of the upside from financial outperformance with customers, such as through the cost incentives and embedded cost of debt. Moreover, potential mechanisms that are simple and transparent have significant limitations, including potential for double-counting and unintended consequences. While we did find a case for proposing a specific mechanism, during AMP6 we will consider other options for sharing upside in the event of financial outperformance. A8.6.4 Testing the appropriate balance of risk The Outcome Delivery Incentives, cost performance incentives and alternative mechanisms have a material impact on the risk around our base Plan. Figure A-12 above shows the risk around our Base Plan, in terms of Return on Regulatory Equity (RORE), after accounting for the regulatory mechanisms proposed in this chapter and those specified by Ofwat in its final methodology This is consistent with the triviality threshold for change protocol and IDoKs in AMP5. We consider that this threshold remains appropriate for use in AMP6. Chapter A8 Page 77

82 The overall level of return for the appointed business, reflecting wholesale returns in line with the WACC and cost of equity plus an additional return of c.0.1% (ROCE) or c.0.25% (RORE) which comprises the contribution of the retail business. When testing financeability of the combined scenario, results demonstrate that, should risks crystallise (as per the high case ) these will fall primarily on shareholders such that reduced dividends or an equity injection may be required in order to maintain credit quality. RORE in the base case averages 7 per cent over the plan period at 60 per cent notional gearing, in line with our cost of equity assumption in the WACC. This falls to 5.3 per cent in the high case and rises to 8.0 per cent in the low case. This range of movement compared to base, from -1.7 per cent to +1.2 per cent, helps demonstrate that our plan provides a fair balance of risk and reward between the company and its customers. 34 SIM, RCM, Totex Incentive rate Page 78 Chapter A8

83 A9 Customer charges A9.1 Summary Customers have told us that affordability is an issue for them but also that they do not want us to compromise on providing a safe and reliable water and wastewater system. They do not want any reduction in service levels and in some areas they are prepared to pay for improvements. Throughout this document we have highlighted the efforts that we have undertaken to ensure that customers only pay the right amount for the outcomes they want and this is more fully demonstrated in the individual business plans. The table below shows the average customer bill before and after the TTT. We have shown the TTT impact separately as this is recognised as a major project that will last for a 100 years and bring major improvements to the quality of the Thames in London. This step change in capability simply cannot be achieved without a significant upward influence on customer charges. Table A-15 Average household bills, prices Average household bill (excl TTT ) Average annual change (%) (0.1%) Average household TTT charge Average household bill (incl TTT) Average annual change (%) 2.0% Source: Thames Water As can be seen in the above table, average household bills (before the impact of the TTT charges) are broadly flat with a 0.1 per cent pa decrease over the period in real terms. Including the TTT, average household bills will rise by 2.0 per cent pa with the result that prices will be 3.10 per month higher by Our average customer bills will still be amongst the lowest of water and sewerage companies with only three other WASCs currently with annual average household prices below 400. Chapter A9 Page 79

84 A9.2 Key drivers of bill changes The main drivers of the increase in customer charges are the TTT, increases in the RCV and a small percentage increase in operating expenditure offset by reductions in the allowed return for investors as shown in the table below. Table A-16 Principal factors affecting the changes in household bills to at prices Total ( ) Average household bill in 2014/ Changes in bills (1) Changes in respect of AMP5: a) revenue correction mechanism 9 b) SIM penalty, CIS true-up/reward -1 (2) Maintaining/improving services: a) changes in operating costs (before efficiency) 17 b) changes capital investment (before efficiency) 21 (3) Financial drivers: a) changes in impact of taxation -2 b) change in cost of capital -17 c) change in working capital 1 d) re-profiling adjustment -4 (4) Scope for reduction through future efficiency improvements: a) opex efficiency -20 b) capex efficiency -6 Average household bill in 2019/2020 (excluding Thames Tideway Tunnel) 358 (5) Thames Tideway Tunnel 40 Total average household bill in 2019/ The table above shows the impact of our plan on overall average household charges. However, we have a number of sewage only customers and the impact on average bills for all our customers will depend on their water only provider. The tables below show the average change in charges for our two services. For our water service, average household charges decrease by Page 80 Chapter A9

85 1.5 per cent pa and for our sewerage service average household charges will increase by 1.7 per cent pa before the TTT. Table A-17 Average household charge water service, prices Average household charge Change ( ) (15) Average annual change (%) (1.5%) Source: Thames Water Table A-18 Average household charges wastewater customers, prices Average household charge (excl TTT) Change ( ) 13 Average annual increase (%) 1.7% Average household TTT charge Average household charge (incl TTT) Change ( ) 52 Average annual increase (%) 7.0% Source: Thames Water A9.3 Profiling of charges Customers have told us that if there is a need for price increases they would prefer the increase to be smoothed over the price control period. We have therefore adjusted revenues by flexing regulatory depreciation rates, on an NPV neutral basis, so that increases over the period, including TTT charges, are smoothed. 35 The TTT charge in this table is slightly different to that in Table A-15 as a small part of the TTT costs relating to doubtful debt are allocated to the water service. Chapter A9 Page 81

86 Average bills for non-household customers will change by broadly similar amounts, although there will be some variations as tariffs are re-balanced and simplified as described in the retail non-household business plan. In the current economic climate we would have preferred to have avoided any increase in bills. However, we believe we have taken all the reasonable actions we can to minimise charges and propose to introduce a social tariff to protect those who genuinely cannot afford to pay. The increases in smart metering will also allow many to have some influence over their usage and exercise some control over their bills We recognise that for some the introduction of smart metering could result in an increase in charges and we have therefore committed to allow customers to continue paying on a rateable value basis for up to two years, to allow for a period of transition. As set out in the retail household business plan we are also providing water efficiency products alongside the roll-out of smart metering. A9.4 Customer acceptability In its entirety, our plan delivers what customers want in a sustainable and environmentally sensitive way, with increases in customer charges minimised to an acceptable level, as demonstrated by our acceptability testing undertaken in October and November Our plans for final acceptability testing were developed between ourselves and our expert consultants, eftec, and were extensively shared with the CCG and CCW to develop and agree our approach. The research has also been peer reviewed by Professor Ken Willis, Newcastle University. Our CCG has advocated the approach we have taken. The survey was undertaken with a representative sample of 921 household and 303 nonhousehold customers across our combined water and wastewater and waste only customers. As part of the final acceptability survey we also asked our customers what percentage of customers should say that the plan is acceptable for us to consider it reasonable to proceed. They told us that over 65 per cent of our customers need to find the plan acceptable. The results of our acceptability testing are that in excess of 70 per cent of our customers support the plan. The plan will ensure we can meet our statutory obligations and shares risk and reward equitably between customers and shareholders. Page 82 Chapter A9

87 A10 Board leadership A10.1 Board Endorsement The following statement was approved unanimously at the Board meeting on 28 November We, the members of the Board of Thames Water, confirm our ownership of, and accountability for, the development of this business plan. We have ensured that our submission has been produced under agreed governance and assurance arrangements, which have enabled us to confirm that, insofar as we are aware, both the business plan narrative and data tables are of high quality and are materially accurate and complete, and conform to Ofwat s reporting requirements in all material respects. In line with the general characteristics of high quality business plans contained in Ofwat s guidance 36, we confirm that we believe that our plan: is designed to deliver good outcomes for current and future customers and the environment; has a coherent narrative based on sound reasoning and contains proportionate evidence; is designed to meet our statutory obligations; is based on good-quality engagement with customers and consumers, and the results of this engagement are reflected in the proposed outcome commitments and the plan more generally; is cost efficient, containing projections and estimates based on reasonable assumptions; proposes a reasonable balance of risk and reward between customers, investors and other stakeholders, with efficient proposals to share pain and gain with customers; is both affordable and financeable; contains estimates and data that have been arrived at appropriately, and independently of other companies and competitors; and does not seek to game the regulatory process in any way. 36 p11 Ofwat. Setting price controls for final methodology and expectations for companies business plans, July 2013 Chapter A11 Page 83

88 In addition, we confirm: that the production of the business plan, in line with overall company activity, has been delivered based on strategic leadership from the Board; that the company is operating transparently, and the business plan has been produced through a transparent process; that we, the Board, have led the development of outcomes and associated commitments and incentives that reflect customers, and wider consumers, views and priorities; also that our outcomes are consistent with relevant obligations and statutory requirements; our approval of our statement of company performance over (Supporting Evidence SE-04, AMP5 Performance), which includes our proposed adjustments to price controls; that the company operates in compliance with its licence; and that the company is compliant with the Financial Reporting Council s UK Corporate Governance Code where appropriate the Code acknowledges that departure from its provision may be justifiable in particular circumstances and requires that companies explain those departures. A summary of our compliance with sections of the Code which requires a specific response or statement, is contained in Supporting Evidence document SE12, Board leadership. We have already taken significant steps in three specific areas to ensure more complete compliance with the Code: the Chairman is now independent and a new committee with independent non-executive directors in the majority, established to nominate future Chairs; we have appointed a senior independent non-executive director; and we have enhanced disclosure in our accounts and now report, essentially, on the same basis as a UK listed company. Furthermore, we intend to implement the following measures in the near future to become more aligned with Ofwat s proposed principles: 37 we will appoint a fourth independent non-executive director; independent non-executive directors will comprise the majority and chair all Board committees; and 37 Board Leadership, transparency and governance Principles, 19 September 2013 Page 84 Chapter A10

89 we will remove the right for directors to appoint an alternate to attend Board meetings. We continue to believe that investor participation in company matters is a real positive for the company. Beyond this it is, of course, both encouraged and required by the Code. Our Board composition (with the relative number of independent non-executive directors and investorappointed directors) was agreed by Ofwat in 2007 and reflected Ofwat s then requirements. This structure has been incorporated in the company s constitutional documents. Any change to the current arrangements requires unanimous shareholder consent and is, therefore, not something which the company itself undertake to deliver. In this regard, our situation is not very different to a public company. Notwithstanding this challenge, the company is committed to work with its shareholders to be in a position to publish, not later that the end of March 2014, a governance code along the lines outlined by Ofwat. We will discuss any difficulties in achieving this aim with Ofwat in a timely matter. The governance and assurance arrangements that have been established for the delivery of a high quality plan are summarised below, and explained in more detail in Supporting Evidence document SE12, Board leadership. A10.2 Governance and assurance arrangements Throughout the process of developing the PR14 business plan, we have understood the importance of having controls in place to ensure that our business plan is of a high quality. We, the Board, are accountable for the company strategy and the business plan itself, including its quality and completeness. As such, we have led the development of our business plan, and have established governance and assurance arrangements that have enabled us to deliver a high quality plan. The framework which has been followed to provide assurance over the quality of the business plan is explained in section SE12, and consists of: Governance forums Regular meetings have been held from Board-level to workinglevel to direct, manage and coordinate the development of the business plan. These meetings have enabled the Board to lead the business planning process, and have ensured that all material developments have received appropriate scrutiny and direction from the relevant forums. Challenge sessions Business plan content has been subject to review and challenge throughout the process. Internal meetings and detailed sessions have been held at timely intervals with the Board, the Executive and the Management team which have shaped the direction of the plan. The Customer Challenge Group has been engaged since February 2012, and has provided robust, independent challenge, in line with its required scope, throughout the process. Challenge has also been arranged from Chapter A11 Page 85

90 informed external parties, including through an Independent Expert Panel, which was requested to scrutinise material components of the plan. The feedback from all of the above stakeholders has been factored into the business planning process. Audit and assurance Over the course of its production, the business plan content has been subject to quality procedures, and a programme of audits, through which it has been challenged and refined. During the finalisation of the business plan, a coordinated programme of assurance took place to provide the Board with an overall view of the quality of the plan. An independent top-down assessment of the business plan against an agreed set of quality principles, which included both our assessment of Ofwat s expectations, and our own expectations of a high-quality plan has been completed by Mott MacDonald. They reported their findings to the Board and concluded that on balance we have produced a high quality plan. The data within the business plan has been subject to a bottom-up audit by Halcrow Management Sciences. They reported their findings to us and confirmed that there were no material outstanding issues. KPMG LLP has provided an agreed upon procedures report, in respect of certain tables. Our Directors have reviewed the exceptions highlighted in KPMG LLP s report dated 28 November 2013 and do not consider these to be material to the plan. The latest results of our six-monthly programme of Asset Management capability audits (based broadly on the AMA framework applied by Ofwat at PR09) have also fed into the Board s consideration of business plan quality. Our Internal Audit function has been involved in auditing specific aspects of business planning activity as well as the overall assurance framework to assess its scope, adequacy and effectiveness. Finally, the plan has been subject to a legal review, including an assessment of the evidence underpinning the content of this Board statement. The findings of these audit activities have been reported to the Board at timely intervals, with any areas of concern identified for further action. Declaration sheets As part of our standard assurance arrangements, declaration sheets have been signed by all contributors to business plan content up to company directors. These forms demonstrate the degree of ownership placed on individuals in the process, and request confirmation of, amongst other things, compliance with regulatory requirements, and consistency of business plan content with our longer term strategy. These declaration forms have been presented to the Board to support the overall assurance position. Please refer to SE12 for further information regarding the assurance arrangements for the development of the plan. Page 86 Chapter A10

91 A10.3 Material Issues and Relevant Factors Our process has enabled the identification of the material issues that, at this point in time in the Price Review timetable, we consider will arise, or we have reasonable grounds to expect will arise in or might impact beyond that period. The Board considers, however, that it cannot reasonably provide for the implications of any change in global economic circumstances and in this eventuality would seek to review its plans as part of the remaining Price Review process. In addition, this plan has been produced for the purposes of obtaining enhanced status following Ofwat s risk based review and taken as a whole provides a balance between investors and customers. In the event that this plan does not obtain enhanced status, we would need to update any and all aspects of the plan as appropriate in the light of new information in any resubmissions that Ofwat may request. Our plan contains the relevant factors known to us at this time to enable Ofwat to commence the determination of fair and reasonable price limits for our customers and the company consistent with our statutory duties. Where items are uncertain we have commented as necessary. There a few non-material areas where our plan departs from Ofwat guidance and where in our final Quality Assurance we identified a few small discrepancies following financial model closure. These are set out in Technical Appendix T0593. The Board confirms, on the basis of this plan that it continues to have sufficient processes and internal systems of control to fully meet its obligations for the provision of information to Ofwat. Based upon the processes and internal systems of control described above, within the bounds specified, the Board confirms that, insofar as it is aware having made reasonable enquiry, it has fully met its obligations for the provision of information to Ofwat for the PR14 business plan. Chapter A11 Page 87

92 A11 Appendices Appendix 1 Summary of approach to the cost of capital Cost of equity In assessing the appropriate cost of equity and in common with Ofwat, other economic regulators and regulated businesses we have primarily used the Capital Asset Pricing Model (CAPM) 38 with cross checks against a number of alternative methods and regulatory precedent to determine our estimate of the cost of equity. Our approach is to estimate the market cost of equity and disaggregate this into its component parts. We do this as there is more stability and consistency in this approach over time and this is a view we note is shared by Ofwat s advisors, PwC, in their final methodology document 39. Numerous studies have been produced which support the market cost of equity to be around 7 per cent including the highly regarded annual Dimson, Marsh and Staunton (DMS) 40 study of market returns for the UK, which shows a total return of 7.2 per cent on long term values. We have consequently used a total market return of 7.2 per cent in our analysis, which is consistent with the rate used recently by other economic regulators in recent determinations and is broadly in the middle of the range estimated by our consultants of per cent. Disaggregation of the cost of equity In disaggregating the cost of equity we have found that using 2 per cent for the risk free rate and 5.2 per cent for equity risk premium provides the most appropriate balance. It is accepted by commentators that distortions from quantitative easing mean that gilt yields have ceased to be an appropriate method for inferring risk-free rates, as this policy, by design, creates demand for gilts and thereby forces their prices up, artificially lowering yields. Quantitative easing also causes distortions along the yield curve, meaning that forward rates 38 Under the CAPM approach a firm s cost of equity is comprised of a risk free rate, the equity risk premium and the firm s specific equity beta. The risk free rate and equity risk premium are market wide factors and sum together to form the market cost of equity. 39 Cost of capital for PR14: Methodological considerations. A cost of equity approach which first assesses total equity market return requirements is likely to be more stable and robust than building the cost of equity up from estimates of the component parts of the CAPM formula. 40 Credit Suisse Global Investment Returns Sourcebook, 2011 (as reported by Europe Economics in their report to us) Page 88 Chapter A11

93 cannot be relied on as accurate measures of the expected future risk-free rate. Europe Economics therefore contend that the most appropriate way to determine the risk-free rate is to examine expected changes in the growth rate and, using projections from the Office for Budget Responsibility consider that a risk free rate of per cent remains appropriate. In our view the analysis supports a continued use of a risk free rate of 2 per cent as used by Ofwat in PR09 and Ofgem 41 in their recent price control determinations. Using a 2 per cent risk free rate also results in a 5.2 per cent equity risk premium (given our total market return of 7.2 per cent) and there is a strong consensus around this rate across recent regulatory determinations and estimates. Equity beta Our advisors, EE, have undertaken analysis of equity betas for the remaining listed water companies to estimate changes. Their report estimates that equity betas have fallen since PR09 by between per cent. However, there has been ample evidence of a flight to quality during this period and the UK regulated utility sector with its highly regarded stable regulatory environment has been an obvious place for investors to deposit funds, resulting in utility share prices retaining their values and equity betas falling. As the economy slowly improves it is likely that some of the flight to quality will unwind and we have therefore placed more reliance on longer term values consistent with our approach to the cost of debt (see below). We have used an underlying asset beta of This is some 10 per cent below the value used in PR09 and results (using 60 per cent notional gearing) in an equity beta broadly similar to that used for PR09 at This is comparable to the rate use by Ofgem for its recent gas distribution decision, which was largely based on analysis of listed water companies as there are few listed energy network companies. Gearing We note Ofwat s preference to assess the appropriate allowed return by reference to an industry notional gearing structure. We have therefore followed this approach. EE have estimated that across the water industry actual gearing is currently around 65 per cent and Ofwat have set an appropriate range of per cent in their final methodology document, having used 57.5 per cent in PR09. However, taking into consideration: 41 RIIO-GD1: Final Proposals - Finance and uncertainty supporting document (Table 3.4) and RIIO-T1: Final Proposals for National Gris Electricity Transmission and National Grid Gas Finance supporting document (Table 3.5) Chapter A11 Page 89

94 Ofwat s concerns that the sector may need to reduce gearing to some extent, 42 The need to ensure that the level of gearing is reflective of the overall risk of the regulatory arrangements; and The need to ensure appropriate credit metrics are obtained to ensure the plan is financeable (see below) we consider a more moderate increase from PR09 is appropriate. On this basis, consider that a range of per cent is appropriate. We have, therefore used 60 per cent in our proposal, which is in line with EE s recommendations. Cost of debt Water companies have been able to raise debt at relatively low cost during PR09. We consider that this should now be passed to consumers, consistent with the philosophy of incentive based price controls, through recognition of the lower levels of embedded debt that now exist. We have therefore followed the embedded cost of debt approach used by Ofwat in PR09 which achieves this objective. Our estimate of the industry embedded cost of debt is 2.5 per cent. Europe Economics argue strongly in their report that the forward looking cost of debt should be based on an estimate of the debt premium and risk free rates. They argue that based on historical data, the appropriate debt premium is around 1.45 per cent. Using a 2 per cent risk free rate therefore results in a forward looking cost of debt of 3.45 per cent. We have combined the embedded cost of debt and the forward cost of debt in the same proportions as used by Ofwat in PR09 as our analysis suggests this is still appropriate. This results in an overall cost of debt of 2.74 per cent. Retail margins We have based our assumption for retail non-household (net 3 per cent margin) using comparators for the competitive water market in Scotland ( per cent) and in UK energy supply ( per cent). For our retail household business we have undertaken a bottom-up estimate of the return necessary to cover the cost of working capital, future capital investment and uncontrollable input prices. This resulted in a calculated required margin of 0.8 per cent. 42 Lecture by Jonson Cox, Chairman of the Water Services Regulation Authority (Ofwat), Observations on the regulation of the water sector to the Royal Academy of Engineering, 5 March Page 90 Chapter A11

95 Appendix 2 - Outcome delivery incentives Our package of financial outcome delivery incentives is set out below. Outcome measure Form of Incentive Business Asset Health Financial penalty Wholesale water Wholesale wastewater Leakage Financial penalty Wholesale water Supply interruptions Financial penalty or reward Wholesale water Internal sewer flooding incidents (other causes) Financial penalty or reward Wholesale wastewater Category 1-3 pollution incidents Financial penalty Wholesale wastewater Properties removed from odour Service Incentive Mechanism Financial penalty (or reward through change mechanism) Financial penalty or reward Wholesale wastewater Household retail (sharing with Wholesale to be agreed) Overarching principles The plan has been developed in response to customer feedback to provide the appropriate balance between the levels of service that customers want and the prices that they are willing to pay. Our aim has been to design an incentive package that supports the plan and ensures that customers and stakeholders interests are protected in the short and longer-term. Our process for developing incentives against the individual measures and commitments has been guided by the following, overarching principles: financial penalties should be paid to customers in the event of underperformance against outcome commitments that customers value; financial rewards should be available where there is evidence that customers would value service delivery beyond the outcome commitments and we have identified innovation to reduce costs; performance should be reported regularly against all of the commitments made to customers to provide strong reputational incentives for delivery; Chapter A11 Page 91

96 procedural incentives to be included where appropriate to provide additional protection against under-delivery where financial incentives are unsuitable; and the overall package of incentives to apply in AMP6 needs to be appropriate, including performance incentives through the Totex menu approach and water trading and sustainable abstraction incentives. Criteria-based approach We have developed the following set of key criteria that would each need to be met before introducing a financial incentive: Materiality: how material is the outcome for customers and how much Totex is are we planning to spend related to the outcome during AMP6? Measurability: can measures of relevant outcome delivery be identified and recorded over time in a transparent manner that is sufficiently reliable/robust? Adequacy of other/existing safeguards: To what extent are there other existing and/or planned measures that can be expected to provide incentives for outcome delivery? Controllability: to what extent can the measured level of outcome delivery be affected by factors that are outside of the control of the regulated business? Potential for unintended consequences: does generating incentives to improve measured performance in relation to one defined outcome undermine performance in relation to other things that matter to customers and/or the environment? In summary, our criteria-based approach has led us to propose financial incentives in those areas that are directly relevant to the services that our current and future customers will receive where there are not already sufficient existing incentives in place and where the use of a financial incentive would not give rise to potential risks of unintended consequences. Additionally, we have identified outcomes that are not directly customer facing, but are vital to support the delivery of service to customers. In many cases, the scope of outputs to be delivered is uncertain. We have therefore proposed a change protocol process to allow for inperiod changes in scope and costs relative to our expectations as we developed this Plan. This change mechanism is proposed for the following outcome measures: Compliance with new environmental legislation and regulations, including the National Environment Programme Phase 5 (NEP5) and Industrial Emissions Directive; SEMD compliance; Hydraulic sewer flooding (additional cost-beneficial schemes); and Page 92 Chapter A11

97 Odour (additional cost-beneficial schemes). More detail on the rationale and operation of the proposed change protocol can be found in SE13 - Outcome Delivery Incentives. Setting financial rewards and penalties To set the appropriate level of financial penalty for underperformance, we have considered: Customer valuation the loss to the customer from underperformance; Regulatory and statutory obligations there should be strong incentives to achieve compliance. We have considered whether financial incentives would overlap (and therefore potentially double-count) existing incentives; Sustainability in addition to the loss to current customers, we need to consider the long-term risk to levels of service through taking investment holidays or insufficient investment; and Incremental costs what are the potential costs saved/required to the company for under/over performance including the impact of the totex incentive rate. For setting rewards, we have additionally looked at customer willingness to pay for higher levels of performance. For each financial incentive, we have considered the appropriate incentive rate, ranges around target performance for reputation-only incentives around target performance and any caps/collars to limit total financial exposure. We have done this using willingness-to-pay survey evidence and internal cost data to assess customer value and company cost for out- and underperformance against targets. The incentive rate for underperformance has been calibrated so as to compensate customers for the benefit foregone, net of the proportion of avoided cost they could receive through the Totex cost performance incentive. For those outcome incentives for which a financial reward is appropriate, the incentive rate for outperformance has been calibrated so as to recover the incremental benefit delivered to customers, net of the proportion of cost customers would be required to pay through the Totex cost performance incentive. Chapter A11 Page 93

98 Where the level of outcome delivery is sensitive to natural variation in external factors outside management control, we have looked to set ranges around target performance on the basis of historical variation and set incentives based on average performance over the first four years of AMP6. Furthermore, for some outcome incentives we have identified the need to set caps/collars in order to limit the maximum size of the reward and/or penalty. This has been done so as to ensure an appropriate balance of risk between us and our customers, whilst taking care not to blunt the power of the outcome incentives. Below these levels, we would start to face strong reputational incentives to improve performance in any case. SE13 Outcome Delivery Incentives sets out the specific detail on how rewards and penalties have been set for each of the outcome incentives including how they have been calibrated with the Totex cost performance incentives. Setting non-financial incentives For those outcome measures for which financial incentives have been identified as inappropriate we have proposed either procedural or reputational incentives. We have proposed procedural incentives in one case (Drinking water quality) where we consider that whilst financial incentives are not appropriate, additional protection against underperformance is required. The form of this procedural incentive is to undertake an internal review of the performance risks should drinking water quality fall below its target level. This includes a commitment to publish the results of this review in a publically available format and to undertake continued reporting against an action plan for performance improvement. In doing so, the procedural incentive provides confidence of additional protection against poor performance, and that there are no undue risks for customers and/or the environment in the medium to long term. Where both financial and procedural incentives have been identified as inappropriate, we will commit to publically reporting performance in our annual performance report. In allowing for the monitoring of performance against our target and also of any improvement or deterioration in performance over time, this mechanism should provide strong reputational incentives for outcome delivery. Details on the outcome measures for which we have proposed reputational incentives can be found in SE13 - Outcome Delivery Incentives. Page 94 Chapter A11

99 Appendix 3 Risk mitigation proposals We have proposed change mechanisms for two cost items: Costs of compliance with new environmental legislation and regulations, including the National Environment Programme 5 ( NEP5 ) outputs required to be compliant with the Water Framework Directive ( WFD ) and outputs to ensure compliance with and Industrial Emissions Directive; and cost of delivering compliance with the Security and Emergency Measures Directive ( SEMD ). We propose symmetrical change protocol mechanisms should the expected scope of work required in AMP6 be materially 43 lower or higher than forecast. This would provide a two-sided adjustment to the Totex baseline and our plan, with a true-up at the end of AMP6 (to be applied to AMP7 revenues at PR19) of the difference in operational and financing costs. This should be NPV neutral. We have proposed change mechanisms with an additional incentive to identify costbeneficial schemes for odour and hydraulic sewer flooding. The change mechanisms would be work in the same way as those for NEP5 and SEMD should the expected scope of work required in AMP6 be materially lower or higher than forecast. To incentivise the identification of additional cost-beneficial schemes during AMP6, we are also proposing that, within the change mechanism, we can receive a share of the net benefit (above cost), to be trued up at PR19 with the cost of the schemes. This sharing of net benefits would be decided on a project-by-project basis, to only apply where appropriate, and would be capped at the lower of 50 per cent sharing of net benefits, 5m for Odour and 10m for Hydraulic sewer flooding, in total over AMP6. We consider that this will maintain strong incentives to identify cost beneficial schemes in period, but limits any rewards to a proportionate level. We would submit the results of our cost-benefit analysis to Ofwat to provide assurance that the efficiency of the scheme is well-evidenced. Subject to this demonstration of the net benefits of the scheme, we have proposed that there be an adjustment to our totex baseline costs and plan to fund the programme of work. We have proposed a trigger process with cost pass-through for Local Authority business rates and competition costs (limited to the central market costs from the open water programme and the reasonable costs of complying with national standardised requirements). 43 Based on using the existing triviality threshold where the AMP6 NPV of capex and 15-year NPV of opex should be larger than 2% of annual service turnover for each cost item. Chapter A11 Page 95

100 We have included a forecast of business rates costs and central market costs in our plan. However, rates are subject to a revaluation in Our consultants in this area have suggested that this could lead to costs being materially higher or lower than forecast, for reasons outside management control. In addition, the extent of our share of central market costs and cost of complying with the national standardised requirements are both very uncertain at this stage. Under this mechanism, our plan and the totex baseline would be automatically adjusted following specific trigger events the rates revaluation and clarification of open water programme costs and the national requirements determining the costs of compliance, if they lead to material differences in costs. 44 Any underspend or overspend relative to this revised forecast following the trigger event would be at our own risk, using the cost performance incentives in the Totex menu as normal. The proposed regulatory treatment for the Thames Tideway Tunnel ( TTT ) costs associated with the Infrastructure Provider IP and TWUL are set out in full in the Supporting Evidence SE10 Thames Tideway Tunnel-. In summary: Development and land costs costs excluded from totex menu, with continuation of AMP5 treatment (i.e. annual economic and efficient Ofwat review for development costs and no pain/gain principle for land costs), including allocation of D&PG and risk; Construction and programme management costs within totex menu, but with additional flexibility due to programme decisions that the IP may make either after its appointment or through the construction period. These decisions may impact on the timing of activity or even a change in the split of works between Thames Water and the IP; Licence modification and L-factor to allow us to pass through IP charges collected from our sewerage customers; Other true up or change mechanisms to address risks from the IP procurement (which is on-going at PR14), the tax impact of annual IP corrections, programme driven changes, key milestone or decision point risks, catastrophic risks activities, and risks around dedesignation, de-specification or discontinuation. Further detail on these mechanisms is provided in SE7 - Risk. 44 Materiality would be tested using the triviality test for change protocols and IDoKs in AMP5, i.e. comparing the NPV of capex (in AMP) and opex (over 15 years) with 2% of annual service turnover for the appointed business. Page 96 Chapter A11