Estimating Opex And Capex Efficiency

The Situation

In 2004, Ofwat conducted a price review in order to set allowed prices for water and sewerage companies in the UK for the next five-year price control period, 2005-2010. One key aspect of setting allowed prices is to estimate expected changes in operating cost and capital cost efficiencies over this period. NERA was asked by Water UK, which represents water and sewerage companies in the UK, to review the evidence on anticipated efficiencies in the UK water sector and other comparable sectors (e.g., electricity distribution networks). NERA then presented the results to a joint steering committee of Water UK and Ofwat.

NERA's Role

NERA's analysis of anticipated improvements in opex and capex efficiencies was based on a review of a large body of existing empirical research on efficiency improvements in the UK water industry and other comparable sectors. Drawing a consensus from the various existing studies, this report explicitly addresses the contentious issues related to interpreting historic data on efficiency improvements in the water sector. NERA's approach also followed the check-list of best practice for setting efficiency targets in an index-linked, price-capped regime, as developed by Water UK. In particular, this report differentiates between expected changes in productivity and changes in input prices, and attempts to reconcile "top-down" estimates of efficiency with "bottom-up" estimates.

The Result

NERA's report was submitted to the regulator to inform the setting of anticipated efficiency targets over the control period. In its price determination, Ofwat stated that NERA's report was "sound and helpfully explicit."