The water margin

On 5 August, regulator Ofwat announced a sprawling capital programme for the water sector from 2005 to 2010. Water companies' draft asset management plans for the fourth five-year period since privatisation (AMP4) were set at £15.7bn - a figure on a par with what was ordered in 1999 for the period 2000 to 2005.
Similar to the NHS, expectations that the need to invest in water would dwindle a few years after privatisation have proved false. Which is great news for contractors and suppliers as the work bonanza goes on.
Hold the champagne, though. Probe a little deeper and the good news for contractors is tarnished. For one thing, the £15.7bn work programme sanctioned by Ofwat is well shy of the £21bn programme the water companies pitched for in their final business plans - documents submitted to the regulator in April setting out what they thought they needed to spend in 2005-10. For another, Ofwat has built far harsher than expected efficiency targets into its projections, which means contractor margins will be under increased pressure, and cost cutting will be order of the day.
There are four key work areas in the capital programme: capital maintenance; quality enhancement; balancing supply with demand; and improving the level of service delivered to customers.
Raising the standards
To ensure there is no deterioration in companies' service to customers or in their level of compliance with environmental regulations, £8.1bn (£600m more than was allotted in the 2000 to 2005 period) has been set aside for capital maintenance.
This will pay for: 22,000km of mains to be laid, renewed or relined; the replacement, renovation and laying of around 6,200km of sewers; and refurbishing or building of 520 water treatment works, 330 water pumping stations, 1,560 sewage works, 150 sludge treatment works and 610 sewage pumping stations.
Some £5.1bn is earmarked for quality (drinking water and environmental) enhancement. A further £2bn will be spent on water and the remaining £3.1bn on sewerage. The work will entail: improving 227 water treatment works and renovating 13,200km of mains to improve drinking water quality at the tap; dealing with the adverse affects of water abstraction at 20 vulnerable nature conservation sites and investigating 161 more; upgrading 794 sewage treatment works to meet tighter green consents; and improving 2,003 intermittent discharges and overflows from sewers to limit pollution damage to the environment.
Funding to balance supply and demand is up 60% on the current period to £2.1bn, in particular to cater for population and housing growth in London and the South East. The work programme will include projects to cut leakage by 315 megalitres a day by 2010 (220 megalitres a day in London), connecting 900,000 new homes in the housing expansion areas, and investigating whether five new reservoirs and the extension of two further reservoirs will
be necessary.
Finally, £400m is set aside to enhance the level of service delivered to customers. The vast majority will be spent on reducing sewer flooding, solving 8,490 known problems and dealing with 3,840 emerging problems. Other work areas include water pressure, water softening, and taste and odour improvements.
Complaints initiative
Ofwat set aside around £1bn of the total capital programme in December 2003 as part of its 'early start' initiative. This is its plan to address contractors' complaints of peaks and troughs in workload arising from the five-yearly pricing and AMP structure. The idea was to identify a number of schemes ahead of the full AMP4 programme, so water firms could assign the work early and hence start work directly in 2005. Some 237 water schemes valued at £515m and 804 sewerage schemes valued at £468m fall under the early start banner. The rest of AMP4 will be rolled out from now, with the inevitable consequence that the bulk of the work will continue to take place in the last few years of the period.
Ofwat director general Philip Fletcher says water bills will have to rise by 13% (£33) to £282 before inflation over the five years to pay for the spend. This will vary enormously by region, however, which partially reflects the different size of each company's capital programme (see box).
The table shows how Ofwat's capital programme figures compare with those in the water companies' final business plans, along with both parties' operating expenditure figures. Most companies are tight-lipped on the cuts, claiming they need to scrutinise them in detail before commenting. But we can assume the sentiments of many are well summed up by Thames Water's managing director John Sexton. He says Thames is "very concerned that it will not enable us to deliver the improvements we know are necessary to maintain our service to customers in the years ahead".
On top of the cuts, Ofwat has built tough efficiency assumptions into its AMP4 decisions. It demands efficiencies of 3% a year over the five years, which will save customers £21 by 2010 (bills would have to rise by £54 instead of £33 if the savings were
not made).
So what does all this mean for contractors? Well, there's still plenty of work on the table, just not as much as many originally thought.
David Smith, general manager, business development and strategy, at consultant MWH, says: "We expected it [the capital programme] to come back at less than the business plans, but we are surprised by how much it has been reduced." More optimistically, he notes: "Overall, the outlook for suppliers hasn't changed much. There's still an enormous amount of work to be completed in AMP4, so allocation of work shouldn't be affected too greatly. Indeed, we're pleased overall because our expertise meets many of the resulting requirements."
But the implications of the efficiency targets will be crucial to how well contractors do out
of AMP4.
Squeezing profits
Paul Mullord, a director at water contractor and supplier trade body British Water, warns that contractor profit margins will be squeezed even more than they are already as water companies battle to get their costs down.
He points the finger in particular at Southern Water, claiming it is trying to get contractors to work for no profit in AMP4, and is critical of Thames for restructuring the way it plans to distribute outperformance rewards.
Mullord says in AMP3, Thames had a common pot for gains, which it shared with its partners, but in AMP4 it will keep the gains itself and pay flat
rate profits.
MWH's Smith is positive about the role of contractors in keeping costs down. He says: "We see a major role suppliers can play in helping deliver increased efficiency. We expect the focus to be on capital maintenance, asset optimisation and innovative project management approaches, such as lean
construction."
Mullord echoes this view, provided that water companies let contractors help: "Some will call in their partners and say 'how can we do this?'. But more than half probably won't. They'll just cut their margins."
Mullord adds slim or non-existent margins could drive some contractors out of the water sector altogether, and that low salaries are likely to ensure the best people leave for pastures new.
The point is echoed by trade union Unison, which says it is "concerned that where water companies have already cut costs back to the bone, they will be forced to cut back on staff and reduce the quality of the service by contracting out more work to the cheapest providers".
As for how the work programme will be structured, it looks set to vary across the country. The AMP3 trend towards fewer contractors taking on more comprehensive work programmes rather than individual projects looks set to continue, but the details will vary from one water company to another.
Welsh wizard
Top in Mullord's good books is Welsh Water, which he says has become "positively evangelical" about partnering with its contractors. Indeed, under AMP3 it went one step beyond a framework agreement by setting up a Capital Alliance - a strategic partnering team formed to deliver 60% of Welsh Water's £1.2b 2000-05 investment programme.
Mullord says Yorkshire Water is "well clued up" and will be tweaking the partnering arrangements it had in place for AMP3 in AMP4 for the benefit of all. He describes Severn Trent as "very good", predicting it will embrace partnering in AMP4, having made steady, careful progress towards collaborative working throughout AMP3. Mullord says Northumbrian Water is also set to start partnering arrangements, although he cautions it seems this is because other companies are doing it rather than because Northumbrian has a true understanding of the benefits.
It is likely to be business as usual at South West Water, while new management at Anglian Water and United Utilities imparts uncertainty in the East and North West. Both Wessex and Thames have gone against the industry trend. Wessex is taking all responsibility back in-house, and Thames is doing likewise with design responsibility. Mullord concludes it seems Southern Water "has no idea how to organise itself
for AMP4".
Stakeholders have until 13 October to present their views on Ofwat's draft water prices and capital programme. The regulator will make final decisions on
2 December. o