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Water bills projection model - WT1557

The UK water industry has been the focus of significant policy and regulatory changes. These include the government’s market reform policies (upstream and retail competition) and measures in the Water Services Regulation Authority (Ofwat) 2014 Price Review (PR14).

The Department for Environment, Food and Rural Affairs (Defra), Ofwat and the Environment Agency (EA) are keen to assess the impact on water bills of these changes. Defra is therefore commissioning the development of a model to provide a robust assessment of the future trajectory of water bills. This is a high priority area with strong interest from our stakeholders. The project will be overseen by a Technical Steering Group (TSG) of technical experts from Defra, Ofwat, the EA and water companies; as well as representatives from the chosen contractor

The key project objective is to design, build and test an annually updatable water bills projection model to be used in-house by Defra, Ofwat and the EA. The model will be used to advise policy makers and stakeholders on the potential scale and likely distribution of impacts due to our policies. The model will be a valuable analytical tool for informing policy development and assessing second round impacts (such as cost pass through) of measures for economic impact assessments.

The model could be developed in two phases, as follows:

• Phase 1: Model specification: This phase will involve identifying and reviewing key data sources, drivers and scenarios, and establishing/constructing a model framework (in MS Excel).

• Phase 2: Model build, testing, reporting and delivery: This phase will involve fully building and testing the model, sensitivity analysis and quality assuring outputs. The final model will be delivered alongside projections (using scenario assumptions developed in conjunction with the project steering group) to a standard suitable for publication.
The project comprises of two phases. Both phases will require close interaction with the Technical Steering Group (TSG). This group will comprise technical experts from Defra, Ofwat, the EA and water companies; as well as representatives from the chosen contractor. Further detail on the core elements for each phase is provided below.

Phase 1: Model specification

Time horizon
The model should provide projected average water bills for the period 2015-2050. Outputs covering this overall period should be broken down into two component periods: 2015-2030; and 2030-2050. Annual projections with detailed information on drivers and sensitivity analysis should be provided for 2015-2030; while projections for the period 2030 to 2050 could be provided at a higher level, focusing on a few key drivers and at the four relevant five year intervals to reflect greater levels of uncertainty.

Key drivers and functionality
The model should have functionality to separate out individual and cumulative impacts of different drivers on average water bills (upward pressure/downward pressure and net impact) for the following core drivers:

Regulatory drivers: PR14 measures such as total expenditure (‘totex’) cost assessment; menu-based cost performance incentives; cost recovery, outcome- based delivery incentives and the abstraction incentive mechanism (AIM). Also include broader water company expenditure items covered by the regulatory framework including the composition of totex (investment versus maintenance expenditure), the effects of supply and demand balancing aligned with companies water resource management planning (reflecting assumptions about consumption, metering, climate change and housing growth), and the effects of providing enhanced service levels consistent with companies’ outcome performance commitments and statutory obligations funded in price limits (e.g. sewer flooding assumptions).

Environmental programmes funded via water bills, particularly the implementation of the Water Framework Directive (WFD), and River Basin Management Plans (RBMP). The modelling scenarios will need to ensure that impacts of environmental programmes likely to be funded by charges within water bills regardless of future policy choices in relation to the implementation of the WFD are captured within a baseline bill scenario.

Financing: covering cost of capital assumptions and impact of water company gearing consistent with allowed costs of capital in price limits, with an assessment of sustainable levels of debt and impact on the Regulatory Capital Value (RCV).

Retail market competition (from 2017) for all non-household customers in England.

Upstream market competition in water resources and treatment.

Abstraction license reform.
The expected timing for implementation of upstream competition and abstraction licence reform is from 2019 onwards. There is some uncertainty associated with this, which should be reflected in the development of scenario assumptions.

Sufficient flexibly should be built in to allow for future assessment of exogenous factors, such as:

Future policy scenarios, including alternative specifications of the core drivers described above. For example, the potential impact of stronger direct incentives for innovation, radical models for competition (including impact of more targeted price controls), assessing impact of de-integration etc.

Climate change, i.e. scope to build in alternative scenarios reflecting the impact of alternative longer term climate and weather scenarios on water supply and investment under different approaches to securing resilience.

Macroeconomic scenarios, including those relating to population and GDP growth, prices, interest rates and taxation.

Data sources

The 2014 price review will generate core data and modelling outputs for several of the key assumptions, covering the period 2015-2020. These will be based on water company business and asset management plans as well as a range of models used by Ofwat to inform their price determinations. Relevant data will need to be simplified and extracted from these sources (including models used by Ofwat to determine proposed price limits). These models and datasets are expected to start to become available from early April in line with Ofwat’s published timetable for the first stage of its price review . Water companies may also share modelling assumptions covering an extended period consistent with their published business plans.

Information on assumptions related to costs and benefits generated by retail competition, upstream competition and abstraction reform, as well as transfer of water supply pipes to water companies can be accessed from the Defra website.

Data on the profile of Water Framework Directive (WFD) related expenditures expected to be funded via bills in the water sector can be accessed via the EA.

Distributional impacts
For the period 2015-2030, the model should provide average water bill breakdowns for England and Wales, by water company region. The scope for providing average bill breakdowns by River Basin District boundaries, type of service (e.g. clean water versus wastewater versus drainage) and type of customer (e.g. household versus a group of standardised stylised non-household customers) should be assessed. We expect less detailed breakdowns for the period 2030-2050.

Phase Two: Model build, testing, reporting and delivery

The core model building and testing activity of this phase should be independent of specific scenarios which are run through the model.

Sensitivity analysis

Appropriate testing of uncertainty around assumptions related to the wider macroeconomic and weather/climate environment common to all policy alternatives should be undertaken, capturing internally-consistent alternative macro profiles, including inflation (RPI and CPI), nominal interest rates, economic growth, tax and construction price indices. Average bill figures should be derived in real and nominal terms.

Appropriate testing of uncertainty around assumptions related to the main policy choice drivers, particularly for the period beyond 2020 should be undertaken. This would translate into a range of estimates (low, expected and high). The projections should effectively capture increasing levels of uncertainty beyond 2020.

Quality assurance/peer review
Model projections will be published and used to inform policy hence it is essential that rigorous checks are applied. The validity of assumptions, sensitivity analysis, modelling approach and plausibility of results should be tested on an ongoing basis with the TSG. Further information on quality assurance is provided in paragraph 36.

Project Documents
• FRP - Final Report : WT1557 2 Cumulative impact of reg and policy on future water bills   (1325k)
• FRP - Final Report : WT1557 Developing a Water Bills Projection Model - Integrated Final Report   (2269k)
Time-Scale and Cost
From: 2014

To: 2015

Cost: £102,388
Contractor / Funded Organisations
NERA Economic Consulting
Water Supply