House of Commons - Public Accounts

Select Committee on Public Accounts Thirty-Sixth Report

THE WATER INDUSTRY IN ENGLAND AND WALES: REGULATING THE QUALITY OF SERVICES TO CUSTOMERS

FINANCIAL ISSUES

Investment by companies

48. One of the statutory duties of OFWAT is to secure that the water companies are able to finance the proper carrying-out of their water and sewerage functions.[70] We asked them whether the quality of service provided by the companies is dependent on investment levels, and on securing sufficient finance to modernise and upgrade the water network.[71] They said that a good deal of what the companies spent was to improve the quality of drinking water and waste water. In the ten year period, 1995 to 2005, for which they have set price limits, something of the order of £15 billion would be spent on water quality rather than the quality of service.

49. OFWAT accepted, however, that investment was very important. They told us that the companies were now investing around £3 billion a year, compared to £1¾ billion a year in the 1980s, so that it was possible both to bring the quality of the system up to modern standards and to meet objectives, largely from European Directives, for better water.[72] At the same time the companies were investing in aspects of the quality of service that were quite expensive, such as reducing problems of pressure and flooding from sewers, and there were some very substantial reductions in the number of people who were experiencing these problems. While a year or so ago OFWAT had been concerned about the level of investment, in 1996-97 investment levels were up 20 per cent, and information they had about 1997-98 showed about another ten per cent increase. They were now cautiously confident.[73]

Profits, dividends and the financial consequences for companies of providing an unsatisfactory service

50. When OFWAT's routine monitoring of the quality of service provided by companies suggests that a company has provided an unsatisfactory service, OFWAT carry out an investigation before taking formal sanctions.[74] Three such investigations have been carried out, into North West Water, South West Water and Yorkshire Water.[75] The investigation into Yorkshire Water included consideration of the difficulties encountered by the company during the 1995 drought.

51. The investigation into Yorkshire Water concluded that there had been serious failures by the company in its arrangements for maintaining adequate supplies of water, in particular in controlling leakage, and for minimising supply interruptions and flooding from sewers.[76] It concluded that the company had not paid sufficient attention to those matters and did not have adequate plans to deal with them.

52. The Committee asked OFWAT what pressure had been put on Yorkshire Water as a result. They told us that there was very considerable pressure from OFWAT, and that they had pegged the company's price limits.[77] They said that Yorkshire Water had lost financially very considerably as a result of that episode; the pegging of their price limit had cost them £40 million and the company had also reported a provision in its accounts of £48 million (at 1996-97 prices) for costs relating to the drought.[78] OFWAT had also set the company performance targets which would also have cost them a considerable amount of money.[79] They said that Yorkshire Water's Chief Executive had involuntarily changed his job. They believed the management of the company was now better, as a result in part of political pressure and in part from regulatory action.[80]

53. When we asked about the effect of their action on the profits of Yorkshire Water, OFWAT told us that the company's operating profit in 1996-97 had been £190.8 million, representing a return on capital employed in that year of 12.2 per cent.[81] Dividends and investment in 1996-97 were £64.4 million and £355.6 million respectively.

54. South West Water had also been criticised by OFWAT, for delays in their programme of improvements, and we asked about the level of their profits.[82] They told us that between 199091 and 199697 the company had made total profits of £615.5 million, but that they had also invested £1,232.2 million (Figure 3).[83] Dividends had totalled £316.5 million.

Figure 3: South West Water Services Ltd: Financial performance since privatisation

Total since privatisation (1990-91 to 1996-97) (£ million at 1996-97 prices)

Turnover 1,511.5

Current cost operating profit 615.5

Dividends 316.5

Investment 1,232.2

Average annual return on capital employed 16.2 per cent

55. The Committee asked OFWAT whether there had been excessive profit taking and dividend payments since privatisation.[84] They told us that the companies' price limits had been set by the then Secretary of State in 1989 and OFWAT had reset them for very much lower increases in 1994. And they said that a great deal of money was made under the price limits set by the Secretary of State before they could be reviewed by OFWAT.[85] When OFWAT had intervened in 1994, they had set price limits at a very much lower level so that instead of prices rising at nearly four per cent a year above the rate of inflation, they moved for the five years from 1995 at 1.4 per cent and at a lower rate for the full ten year period of the revised price limits from 1995 to 2005.[86]

56. OFWAT told us that, in setting the revised price limits in 1994, they had assumed that the profits of the water companies would remain stable and would fall as a percentage of capital as the companies' capital base rose because of the high investment levels.[87] They had had a target that, by the end of the price-limit period, the rate of return would fall to what they had regarded as an acceptable level of around five to six per cent, but, in the meantime, the companies did have significant profits that OFWAT believed would be sensibly ploughed back into investment.[88] They said that the companies had chosen to spend rather more in dividends than OFWAT had allowed for, so OFWAT concluded that at the next review it would be better to move down to a reasonable return on profit right at the beginning.

57. OFWAT told the Committee that the return on capital was now of the order of ten per cent.[89] They believed it could come down to something of the order of six per cent, and would do so at the next price review. That could mean a real reduction in the level of bills for customers.[90]

58. OFWAT said that the industry had been floated with no debt, the Government of the day having believed that that was necessary to float the companies successfully. OFWAT told us that it was now quite clear that the companies could bear a great deal more debt than had been assumed then, and they had set price limits on that basis.[91] They were not keen to control dividends because they believed that that led to inefficiency; the history of the former statutory water companies, where dividends had been controlled, was a history of growing inefficiency. But they believed that some of the companies had paid dividends which did not show a proper concern for their customers and they agreed that dividends were often unsustainable and too large.[92]

The use of rateable values as a basis for charging customers

59. We asked OFWAT about the current plans for charging for water for customers without meters after 2000, when under current legislation the continued basing of charges on rateable values would no longer be permitted.[93] They told us that the previous Government said that it would extend the period during which rateable values could be used and that the present Government were reviewing charging methods.

60. OFWAT said that the sensible thing to do was to extend the use of rateable values for charging purposes because no better method had been found for unmeasured customers and there would be a large number of such customers in 2000.[94] They were extremely nervous of anything that changed the distribution of charges for no particular purpose. If one went, for example, to charging on the basis of council tax bands, quite a lot of people in low rateable value property, many of whom do not have much money, would be paying more. They were in favour of continuing the present arrangements.

The write-off of debt

61. Prior to the privatisation of the water and sewerage companies, £5 billion of debt owed by the former water authorities to the National Loans Fund was written off.[95] This was one of several measures to see that the companies started operations on a reasonable enough basis to finance their capital investment programmes.[96]

62. We asked OFWAT about the effect of the write-off, and of the interest saved by the companies as a result, on the companies' profits and prices. They told us that the then Secretary of State had set the price limits in 1989, but they believed that the lower interest payments would have been taken into account.[97] This was not an area in which they were involved and was not part of their responsibilities.[98]

63. The Treasury told us that, when the National Loans Fund debt was written-off, the Exchequer automatically lost the right to both the outstanding principal and the interest which would have been payable on the loans until such time as the original debt would have fallen due for repayment.[99] Repayments of capital and interest could not therefore be used as an offset to the Government's future funding requirements. The effect was to increase the burden on the Exchequer and the taxpayer. Most of the debt had an initial maturity period of 25 years, which spread the impact of this effect over many years.

Conclusions

64. As a result of an investigation of the performance of Yorkshire Water, and of its difficulties during the 1995 drought, OFWAT pegged the company's prices at a cost to the company of some £40 million. In addition, the company has reported a provision in its accounts of £48 million (at 1996-97 prices) for costs relating to the drought. We regard the imposition of financial sanctions where companies have failed to provide a satisfactory service to be important and we expect OFWAT to consider carefully the application of such sanctions if circumstances warrant them.

65. Following the privatisation of the water and sewerage companies in 1989, all the companies were subject to price limits set by the then Secretary of State. We note that OFWAT reset the limits in 1994 with the aim that the rate of return of the companies would fall over the ten-year period of the price limits to what they regarded as an acceptable level of five to six per cent by 2005. OFWAT's adoption of this gradualist approach has contributed to the companies currently achieving a rate of return on capital of around ten per cent, which is substantially above the level of about six per cent to which OFWAT consider it could be reduced. We note that in OFWAT's next review of prices, in 1999, they will set prices so as to reduce immediately to that lower level the rate of return on capital achieved by the companies. The high returns currently being enjoyed by the companies are an additional reason why OFWAT should press very hard for a satisfactory quality of service from them.

66. We note that OFWAT consider the level of dividends paid by some companies to have been unacceptable and unsustainable. Such dividends might put at risk investment and the quality of service to customers. We therefore recommend that OFWAT consider whether further safeguards are required to protect customers.

70 C&AG's Report Appendix 1 Back

71 Q16-17 Back

72 Q20 Back

73 Q22-23 Back

74 C&AG's Report paragraphs 3.17-3.18 Back

75 Q151, C&AG's Report paragraph 3.18 Back

76 C&AG's Report paragraph 3.19 Back

77 Q101 Back

78 Q102, Q110, Evidence, Appendix 1, p19 Back

79 Q110 Back

80 Q102-103 Back

81 OFWAT Evidence, Appendix 1, p19 Back