20 October 2016 Trust in water 1 Agenda Agenda Item Time 10:00 - PowerPoint PPT Presentation

Welcome to 7 th sludge working group meeting 20 October 2016 Trust in water 1

Agenda Agenda Item Time 10:00 to 1 Introductions 10.15am Non-regulated revenue: charging and transfer pricing, facilitated by 10:15am to 2 Khaled Diaw (Ofwat), Stewart Carter (Thames), Frank Grimshaw 12:30pm (UU) and Phil Wickens (Wessex) Sludge market information update, facilitated by Frank Grimshaw 12:30 to 3 (UU) 1:00pm Lunch 1:00 to 1:45pm Allocation of RCV, facilitated by Ofwat, Kevin Wightman (Southern) 4 1:45 to 3:00pm and Frank Grimshaw (UU) Actions and setting future working group sessions (facilitated by 5 3:00 to 3:30pm Ofwat) Trust in water 2

Sludge Working Group: Transfer Pricing Khaled Diaw, Principal 20 October 2016 Trust in water 1

ISSUES • Encourage greater efficiency and innovation in bio- WHAT resources, to deliver better outcomes to consumers • Have separate control for bio-resources • Have WaSCs bear volume risk in bio-resource control HOW • Promote new markets in bio-resources services • Promote new markets in bio-resource services This  Transfer pricing between appointed and non- presentation appointed bio-resource services Trust in water 2

Bio-resource market (most likely scenario?) WaSC A offering bio-resources WaSC B offering bio-resource Other (Firm C) treatment (non-appointed) treatment (non-appointed) offering bio- using appointed assets in using appointed assets in resource services certain areas, seeking same certain areas, seeking same Potential service in others service in others Market Appointed bio- Appointed bio- participants resources resources Rest of Rest of Business e.g. waste firm business Non appointed Non-appointed bio-resources bio-resources Values Incremental cost of supplying non-appointed services in certain areas Firm Cs total costs and Avoided costs from outsourcing appointed services in other areas market/contract prices relevant to transactions Market/contract prices charged by WaSCs/Waste firms to other WaSCs for non-appointed services Trades should occur where a firm’s avoided cost from outsourcing treatment of its bio - resources is greater than the costs incurred by a potential supplier of the service. The terms ‘cost’ should be interpreted in a wide sense to include transaction costs, risks, and any other Decisions in costs on the business created by the transaction. Where such costs exist, trade will not the market merely occur because of difference in treatment costs. Trust in water 3

Transfer price between appointed and non-appointed WaSC A bio-resource WaSC B bio-resource Appointed Non-appointed Appointed only Market/contract Total Retail costs Fixed common price paid by B to A bio- (if any) cost Total price paid to WaSC A resource Variable cost appointed costs Variable cost Transfer price non-appointed -Transfer price (negative cost) Water bills Water bills WaSCs ’ Economic returns from Allowed returns from bio-resource control Profits non-appointed bio-resource control (based on efficient cost net of transfer price) + = Market price profits (based on ‘efficient’ cost net of transfer price of appointed sludge only net of any retail costs No obligation on Bear ‘efficient’ cost of Water Bear full cost of bio-resource (appointed WaSC A to share appointed bio-resource plus non appointed) net of transfer price customers these profits with (not price paid by B to A) water customers Trust in water 4

Our objectives Promote (efficient) But markets Trust in water 5

Aspects for discussion today Wide range of transfer prices • From short-run marginal cost (SRMC) • Up to highest of FAC, LRIC, LRMC, etc. • Market, arm’s length prices, mixed options Wide range of further considerations, e.g. • Promoting markets (e.g. what prices for transactions?) • Cross-subsidization, cost efficiency, make/buy decisions • Unintended consequences: foreclosure, incentives Practicalities and potential constraints • Information about (local) bio-resource costs • Regulatory costs: e.g. verification, monitoring • Legal constraints (e.g. WIA91, RAG 5.06) Trust in water 6

The rest of this morning’s session • Three presentations that will try to address the issues • Please have in mind these issues during the presentations. Discussions will be facilitated by the presenters • Sludge cost assessment (Thames Water) • Pricing- both transfer pricing and market prices (United Utilities) • Transfer Pricing and Trading (Wessex Water) Trust in water 7

Sludge price control Issues for cost assessment October 2016 Draft for discussion 8

Introduction We understand that Ofwat is setting up a specific sub-group to look at Sludge cost assessment These slides provide some relevant background and set out important issues for this working group to consider: – Lessons from PR09 and PR14 – Ofwat cost assessment working group – Nature of sludge costs – Types of technologies available – Issues to be resolved • Sludge boundary • Returned liquors • Treatment of enhancement expenditure • Approach to special factors • Appointed vs. non-appointed Draft for discussion 9 Trust in water 9

Lessons from PR09 – For PR09, Ofwat developed a simple unit cost model for sludge treatment & disposal opex (see below) – Ofwat stated that industry data was inadequate to support the development of a sludge econometric model or improved unit cost model – even after three years of development • Issues mentioned include data inconsistency, cost allocation and differences in disposal routes between companies and over time – Ofwat stated an advantage of a single unit cost model was that it recognised the impact of management control on the choice and mix of treatment type and disposal route Source: Ofwat, “Relative efficiency assessment 2008 -09 – supporting information” Draft for discussion 10 Trust in water 10

Lessons from PR14 – For PR14, Ofwat developed more complex econometric models for Wastewater base expenditure (opex + base capex) • included ‘ translog ’ (quadratic & interaction) terms for density, load and sewer length to recognise that these cost drivers might have an effect on costs that is non-linear and varies by company – Ofwat developed unit cost models for enhancement, including sludge enhancements (£ per additional sludge ttds) – CMA made a number of observations on the econometric approach (during Bristol Water review), which are also applicable to wastewater – e.g. suggested collecting data for more disaggregated modelling, checking model variables met economic and engineering expectations “Treatment” includes sewage treatment & sludge Model variables included density, load and regional wage Source: CEPA, “Cost assessment – advanced econometric models” Draft for discussion 11 Trust in water 11

Ofwat cost assessment working group – Ofwat has collected historical Wastewater data from all WaSCs for cost assessment modelling – For sludge, the financial data includes: » Opex and capex for sludge transport, treatment and disposal » Sludge enhancement (quality) and enhancement (growth) capex – The non-financial data includes: • Volumes of sludge produced and disposed (split by incumbents and third parties) • Volumes x distances (ttds.km) for intersiting and disposal (split by truck and tanker) • Sludge produced at STWs split by primary, secondary humus and secondary surplus activated • Sludge treatment by process (e.g. untreated, liming, AD, incineration, etc) • Sludge disposal by route (e.g. landfill, restoration/reclamation, farmland, etc) • Energy consumption from sludge – The company data is being checked and corrected for any inconsistencies, before being used for modelling Draft for discussion 12 Trust in water 12

Nature of sludge costs – Sludge transport and disposal costs are opex-intensive – should vary by volume & distance – Sludge treatment costs are very capex- intensive – so will be more fixed • most cost is base capex to maintain current service levels • opex costs are net of income from energy production – How should different treatment technologies be reflected in the cost assessment? Draft for discussion 13 Trust in water 13

Types of technologies available • The most common forms of treatment are: − Raw sludge liming − Incineration of raw sludge − Conventional Anaerobic digestion − Advanced Anaerobic digestion • The most common disposal routes for unincinerated sludge are: − Land restoration / reclamation − Farmland • Types of sludge processes have very different costs so differences between WaSCs mean they face very different costs of treatment & energy production potential • To what extent do these differences reflect underlying external drivers or to what extent are the choices of technology within company control? Draft for discussion 14 Trust in water 14