United Utilities Response to Draft Determination

United Utilities Group PLC3 October 2014 UNITED UTILITIES RESPONSE TO DRAFT DETERMINATION As scheduled, United Utilities Water PLC has submitted its representations inresponse to the draft determination (DD), covering the 2015-20 period,published by Ofwat on 29 August 2014. Ofwat is expected to publish finaldeterminations on 12 December 2014. Our response addresses the gap between Ofwat's totex assessment and thebusiness plan revision we submitted on 27 June 2014. It benefits from furtherdetailed discussions over this period with Ofwat, the Customer Challenge Groupand other stakeholders. Performance and efficiency improvements United Utilities has delivered significant performance improvements across the2010-15 regulatory period. We are one of the most improved companies oncustomer satisfaction, our serviceability and environmental performance placesus amongst the leaders in our sector, and we are delivering our ambitious costsaving targets. In providing our response to the DD we have reflected our aim to continue toprovide the best service to customers, at the lowest sustainable cost and in aresponsible manner whilst delivering value for shareholders. In light of this,we have challenged our efficiency plans further and set, where practical, morestretching targets beyond those contained in our original business plansubmission. Our revised plan would result in average household bills falling by4.1% in real terms over the 2015-20 period, compared with a 2.3% reduction inour June plan. Plan expenditure (totex) In August, Ofwat announced that it would reflect part of our proposed totexexclusions as an adjustment to its baseline in the DD. This included partialacceptance of totex adjustments in respect of projects at our Davyhulmewastewater treatment works and for Bathing Water and Biodiversity drivers,worth £156 million and was reflected in the DD. The remaining totex gap between our June business plan submission and the DDwas around £1 billion, comprising just under £800 million for wastewater andjust over £200 million for water. Our response to the DD reflects adjustmentsto our business plan which reduce planned totex by around £370 million. This includes reduced activity of around £90 million primarily associated with2020-25 early start projects under the National Environment Programme (NEP5)and trunk mains resilience activity. The remaining proposed reduction of around£280 million relates to cost efficiencies which bring our overall proposedwholesale totex, for the 2015-20 period, down to £5.52 billion from £5.89billion in June. Revised totex exclusions supported by evidence and assurance Following the plan revisions set out above, we are now proposing that Ofwatallows £628 million of totex, in addition to the aforementioned £156 millionalready included in the DD. This comprises the following items: Water * £143 million for the major Thirlmere project to address supply and demand issues in West Cumbria, which will arise from the revocation of our abstraction licence at Ennerdale Water. This is driven by the Habitats Directive, to protect a declining population of endangered freshwater mussels. Proposed costs for the project have been independently assessed as upper quartile efficiency. The amount sought is £72 million lower than in the June plan, following an independent assessment of the implicit allowance already provided for within Ofwat's totex models. Wastewater * £191 million of NEP5 wastewater projects, which are driven by environmental legislation, such as the Water Framework Directive, after removing early start activity and adjusting costs to a level consistent with Ofwat's upper quartile efficiency challenge; * £188 million of wastewater base totex adjustments to reflect the particular characteristics of the North West region (outlined in detail with our June business plan), not captured in Ofwat's totex modelling; and * £106 million relating to specific large integrated schemes, driven by legislation and customer demand, and other activity, after reductions to account for implicit allowances and the upper quartile efficiency challenge. In the DD, Ofwat asked the company to provide further evidence and assurance tosupport its claim for additional costs above Ofwat's assessed totex baseline.We have provided Ofwat with a comprehensive response comprising furtherindependent evidence and information to support our proposed model exclusionsand the quantum of our revised cost proposals. We have responded specificallyto all of the areas where Ofwat indicated we had not provided sufficientevidence. This information covers need, cost benefit analysis and robustsupport for our costs, as required, on a project-by-project basis. Supported bythird party assurance, we have also provided our assessment of the implicitallowances contained within Ofwat's totex models. Pay-as-you-go (PAYG) We have adjusted the wholesale business PAYG ratio in light of our revisedproposed totex and have increased this overall ratio by 2% to 56%. The PAYG ratio for the water service is 65%, an increase of 2%, and the PAYGratio for the wastewater service is now 50%, an increase of 3%. The ratio islower for the wastewater service reflecting the significant enhancementrequirements in this area, largely driven by new environmental obligations. Household Retail Reflecting the impact of the extreme levels of deprivation in the North West onour costs, we sought an adjustment to the household retail average cost toserve of around £19 million per annum. We are pleased that Ofwat has acceptedthis claim, although the DD represents a significant cost challenge for thisarea of our business. Our DD response addresses aspects of Ofwat's average costto serve calculation and its assumption not to allow any inflationary costincreases. We have also provided further evidence to Ofwat to support our costproposals. Non-household retail Having already separated our household and non-household retail businesses, webelieve our costs are accurately represented. Ofwat has applied an additionalefficiency assumption to our cost base and our DD response proposes that, in acompetitive environment, our charges need to be cost reflective. We believethat the company should have greater flexibility in setting customer charges tohelp ensure that it can recover its costs and earn the allowed margin throughthe default tariffs. Given the uncertainty relating to the market fully openingto competition, we have also proposed that an annual re-assessment isundertaken to enable any cost and margin implications to be periodicallyreviewed. Return on capital Our revised proposals are based on the weighted average cost of capital (WACC)provided by Ofwat in its risk and reward guidance and assumed in the DD inAugust. This is a real, vanilla WACC of 3.7% for our wholesale business, plusretail margin. We believe it is important that this level of WACC is maintainedto support the financeability of our plan. Outcome delivery incentives (ODIs) In our June plan, we revised our ODI package so that it was more symmetric,having both rewards as well as penalties, along with better alignment offinancial returns to the value delivered to customers. This followed furtherengagement with the Customer Challenge Group and reflected customers'priorities and willingness to pay. In the DD, Ofwat amended certain ODI targetsand reward/penalty ranges, compared with our June plan, and we have consideredthese changes in formulating our response. There are nine ODIs which relate to the water service and cover performance inareas such as reliability of supply, water quality, leakage and river qualityimprovements. We propose that the total reward incentive is retained at around£100 million, with a total penalty risk of around £190 million (similar to ourJune plan), based on potential outcomes covering 80% of the probability range.In particular, we believe that the parameters relating to the water quality ODIin the DD need to be changed to provide a suitable incentive mechanism toreflect the regional differences in the North West. There are nine ODIs which relate to the wastewater service and coverperformance in areas such as sewer flooding, bathing waters, private sewers andsludge disposal. We now propose that the total reward incentive is reduced toaround £60 million (from around £100 million in our June plan), with anincrease in the total penalty risk to around £250 million (from around £190million in our June plan), based on potential outcomes covering 80% of theprobability range. In particular, we believe that the parameters relating tothe sewer flooding ODI in the DD need to be changed to provide a suitableincentive mechanism to reflect our regional differences and deliver aperformance level in line with customer preferences. Recognising customers' preference for bill predictability and stability, weplan to make any performance adjustments relating to our ODIs at the end of the2015-20 regulatory period. Adjustments relating to the 2010-15 period In the DD, Ofwat largely accepted our proposed adjustments (relating to areassuch as the opex incentive allowance and the revenue correction mechanism) andallowed £123 million. We are seeking amendments to a small number of relativelyminor specific issues. Next steps We will continue to engage with Ofwat and our other regulators and stakeholdersbetween now and publication of final determinations on 12 December 2014. United Utilities contacts For further information on the day, please contact: Gaynor Kenyon - Corporate Affairs Director +44 (0) 7753 622282Darren Jameson - Head of Investor Relations +44 (0) 1925 237033 Peter Hewer / Martin Pengelley - Tulchan Communications +44 (0) 20 7353 4200