House of Commons - Environmental Audit

Select Committee on Environmental Audit Minutes of Evidence

Memorandum from Water UK

SUMMARY

The periodic review process is of crucial importance to the water industry, its customers and regulators. It is the mechanism which set priorities, investment and prices for the whole water sector.

The periodic review process is not ideal—it is too convoluted and onerous, and needs clearer stronger management, more data sharing and a common vision from all participants. The process should result in a clear definition of outputs and the timescale for implementing them.

The 1999 review was designed from the outset to deliver a one-off price cut which is unsustainable in the medium term, we believe that prices will rise above inflation in the future to make up the deficit. Indeed there is still confusion among regulators about what is part of the programme and what has been left out.

The overall outcome of the review is extremely tight for companies—risk has been increased, so reducing the capacity of companies to carry out discretionary environmental work, and is leading to a restructuring in a number of companies to deal with the challenges of meeting the targets set by regulators.

Our main concerns are:

— The early view taken by both Ofwat and DETR that price cuts and additional environmental improvements could be achieved without squeezing other parts of the companies' activities too hard.

— A lack of joined up regulation.

— A failure on the part of DETR to take a stronger lead.

— An Ofwat driven timetable that others struggled to keep up with.

— A heavy burden of form filling that went well beyond what was really needed.

It is important to companies to have clear well defined obligations, with sensible timetables for delivery, and which are fully funded within realistic price limits. It is also important not to have "regulatory creep", the imposition of extra new obligations between reviews that are not properly funded.

The remedies that might help to improve the process in future include the following:

— DETR to take charge of the quadripartite process, adopt a stronger lead.

— More joined up regulation.

— Agreed roles and remits for all players.

— Agreed timetable and set of principles at outset of process.

— More resources for DWI to assist them to fully participate in the process.

— A reduction in information requirements.

— Companies to take the lead in preparing strategic business plans.

— Sharing of Ofwat's financial model.

1. INTRODUCTION

Water UK represents the United Kingdom water industry, comprising private companies in England and Wales, the three publicly owned water authorities in Scotland and the Northern Ireland Water Service, except Mid Kent.

The UK water industry is a key player in delivering environmental improvements. Over the last 10 years, the industry has invested £12 billion in environmental work.

Over the next five years we will deliver a further £7 billion worth of environmental improvements including 902 schemes to improve waste water quality, 75 schemes to meet bathing water standards, 24 schemes to protect the water environment by reducing abstraction, and 487 schemes to improve river water quality.

The industry manages hundreds of SSSIs, and many of those sites covered by the Habitats Directive rely on our careful management of water abstractions for public water supply and treated waste water discharges. We play a lead role in protecting and promoting UK biodiversity and the industry is the national sponsor of the otter.

Water is a long-term industry—managing part of the water cycle for human use requires careful planning and management to meet a number of objectives. Historically the industry has been able to plan to meet these objectives. But following the outcome of the 1999 periodic review there will be increased financial pressures and increased risks which will force the industry to put greater emphasis on short-term objectives.

The price cuts imposed by the economic regulator are damaging to the management of a long term industry with key public health and safety duties. They are not sustainable in the longer term, further price increases to fund future environmental improvements and other objectives are inevitable before 2005. The industry is a long-term business—and there is a need to improve the decision making on the balance between environmental improvement and price reductions.

2. BACKGROUND

The industry supports fully the basic principles behind medium-term, incentive-based regulation. Three independent regulators ensure that the industry in England and Wales delivers outputs in terms of price and value, drinking water quality and environmental protection.

Whilst it is essential that each regulator maintains independence, it is essential also that policies and intended outputs are complementary—in current terminology regulation must be "joined-up". The industry, along with other commentators, is concerned that this is not the case. Even after the 1999 final price determination, there is still confusion between regulators about which elements of the environmental programme have been allowed for.

It is relatively easy for regulators and other parties to agree on the high-level broad principles of the activities that need to be carried out, but in this agreement needs to continue through to the technical definitions of projects. Technical definitions are extremely important, as they affect costs in a major way. For instance cost drivers for wastewater improvements were differently defined by EA and Ofwat; this would be a simple administrative point to improve, through sharing agendas between the regulators at an earlier stage.

3. REVIEW PROCESS

(a) Roles of Players

Overall the 1999 review process didn't work as well as it should, either in terms of the timing of inputs from the industry or the weight the inputs were then given by regulators.

Whilst supporting the need for independent regulators, the periodic review process requires strong management and we believe that DETR should take a stronger lead in this process, in terms of timing, clarity of obligations and full funding.

DETR took a more direct role in the 1999 review than the DoE took in 1995, and we suggest they should play an even stronger role in the future, ensuring the process goes smoothly and providing opportunity for inputs from the different parties. A major lesson from this review has been that timing is crucial in terms of inputs to process and decisions.

We do not consider there is a need for legislation to manage the process, but it would be helpful if the roles and remits of the players were formalised, and a timetable and set of principles agreed between all parties at the beginning of the process.

The industry, as a whole and individual companies input to the process by responding to consultation papers, representations at one or two general meetings, bilateral meetings with Ofwat, and through a total of fourteen highly detailed and complex information returns (Annex 1).

Despite this the quadripartite process did not work well because of a lack of realism about how much environmental improvement was genuinely compatible with reduced prices, and a lack of early consultation by Government on its proposals, leading to last minute decisions.

In the spirit of open government, obligations need to be clear, properly funded and no policy documents should be issued without full sign-up from all regulators and DETR. Furthermore the process needs to be completed earlier, so that companies can implement the new pricing structure effectively and with minimum disruption.

(B) DATA REQUIREMENTS AND COLLECTION

The volume of data required by all regulators (but principally Ofwat) is huge.

A common data collection exercise for all three regulators would help, with one set of data being agreed on and provided to all regulators by companies. The system became almost inoperable due to the issue of untested and inappropriate data collection systems by Ofwat. These required many corrections and amendments by Ofwat while the industry was completing them, and were costly and difficult to complete to the required dates. The data collection methodology was flawed as the spreadsheets did not link up between regulators (and even parts of regulators), so much more thought needs to go into this. The industry would welcome the opportunity to contribute to the development and testing stages for data collection systems in the preparation for future reviews.

Indeed the whole Strategic Business Planning process collapsed under data requirements—so much detail was required that plans couldn't be strategic. We suggest that in the future companies should build their own plans, perhaps on a rolling basis. Regulators would then examine the gaps and ensure that their regulatory requirements were being met.

Whilst companies were required to share information on the most detailed aspects of their operations, Ofwat did not share its own information, particularly on its financial model.

We fully supported the constructive process of certifying data, but remain concerned that much of this data were ignored by Ofwat. Using Reporters as technical auditors in a sensible method of validation, but regulators should either trust them or drop them. In our experience, Ofwat were extremely selective in the use of reports, and transparency in the way that the process works would help prevent regulators quoting selectively from the work of independent Reporters.

The timetable for the review was set out by Ofwat in its Framework paper of February 1998 and is attached as Annex 2.

In principle the timetable seemed reasonable, but actual practice has fallen short of ideal, as Ofwat set the timetable and others had difficulty keeping up. DETR were supposed to respond to the Director General's open letter by July 1998 but their response slipped to September 1998. The EA tried to recapture some ground during the process but were unable to. In reality it was Ofwat's process, Ofwat's review and Ofwat's outcome.

The industry was alarmed at the under-resourcing evident in the Drinking Water Inspectorate for the periodic review, and the way that the water supply quality issues were put at a lower priority than the environmental agenda. The DWI appeared unable to get its agenda included properly, contributing to extensive under-funding for water supply improvements. It is likely that this imbalance will need to be corrected at the next price review.

(D) PREDICTING THE OUTCOME

We are concerned that in the 1999 review, the Director General appeared to have decided the outcome of the review at the outset. The process needs clear leadership which doesn't prejudice the outcome, with a clear timetable, clear inputs and clear data requirements. A number of wider issues need to be examined such as rolling AMP process, greater transparency about who pays, and the use of polluter pays principle.

Of more immediate concern to the industry is that not all obligations are properly funded, for example, £900 million has been left out of the final settlement without any proper explanation by the regulator.

(E) CUSTOMER RESEARCH

The industry's overall feeling is that customers have been cheated by the regulator who has largely ignored their opinions.

The review was informed by many different customer research studies. We believe that in general the national studies by DETR, Water UK, EA, and DWI were all well conducted. In particular, the studies carried out by DETR and Water UK were complementary. In addition all companies did their own surveys which provided a great deal of local detail.

Such customer research is essential—in itself it has a high value, but it is equally crucial that regulators and decision-makers listen to, and act on the research findings. For instance, sewer flooding was recognised as important to customers according to all of the research carried out during the review process, but it was not considered an obligation in the final determination. Furthermore, research must be carried out before the expected outcome of the review in the public domain. In the 1999 review, research was geared to proving/disproving Ofwat's policy intention of price cuts.

Almost everyone is a customer of the water industry. Customers are electors and citizens. Research needs to be focused on long term expectations, not only from "customers" views but from society's view of what is required from the industry over the longer term.

We are not convinced of the need for an independent customer survey to inform future reviews, although there may be benefits in more joint surveys, and exchanging views on the questions to be asked. We suggest that a framework survey could be developed with accredited questions which companies and regulators could then adapt for their own circumstances.

4. THE ENVIRONMENT PROGRAMME

(a) Timetable

The environment programme is challenging, and the timetable for implementing the work is ambitious, and some companies expressed concern which led to last minute changes by DETR.

Nevertheless all companies will deliver their obligations—most of the obligations arise from Europe, and are necessary to meet new legislation. But it is a myth that our programme is simply driven by European standards. The detail of the environment programme is driven by the DETR and government's interpretation of relevant directives and the implementation programme. Often these are over and above the requirements of the Directives themselves, and reflect national objectives for improving receiving waters.

(b) Prioritising the Programme

Regulators should ensure that they have carried out Cost Benefit Analysis or equivalent to ensure value for money on behalf of society before publishing the programmes for companies to deliver. After these decisions have been made, companies develop cost-effective ways of achieving the objectives, given the incentives under price cap regulation.

In this review the industry and others were not clear how the EA identified priorities for its programmes. Also it seems that the EA is not keen on costing the programme and expects the industry to deliver it, no matter what the cost.

The water industry is a major player in helping deliver environmental objectives. However we are one of many players in helping protecting and improving the water environment, and we are concerned that the EA should apply similar levels of energy to address diffuse sources and small private polluters.

(c) Delivering the Programme

In some respects companies act as environmental contractors, delivering those improvements Government regard as appropriate. But we also deliver what our customers tell us they want and sometimes there are conflicts between the two (for instance rates of improvement in protection from sewer flooding, mentioned earlier).

There is no discretion about outputs regulators expect to be delivered—companies have to appeal against those if they are not happy. However companies can choose combinations of inputs such as the type of plant invested in, as long as these deliver the required outputs.

Companies are keen to take a precautionary approach to environmental protection and improvement, but often this is impossible because of lack of funding, and a failure by regulators to take a precautionary approach eg deteriorating water quality. Regulators may regard environmental risks as business risks, and use the threat of prosecution as the main incentive mechanism.

(d) Monitoring

Targets for implementing the programme are set out in monitoring plans, and companies report annually through extensive June/July returns to Ofwat. This includes progress on environmental matters.

However we believe that the industry is best placed to manage the process of delivering the programme. Government and regulators should not get involved in the delivery of projects within each five year period—only set out what is expected by the end of the period. Flexibility for the delivery of projects is essential to allow companies to take flexible and efficient approaches.

The balance between spending on quality improvements and maintenance is crucial. Schemes are vital to improve environmental quality but the overall network needs to be maintained in order to avoid further problems. Whilst the quality side of the equation has received priority in the final determination, maintenance cannot be overlooked at the next review.

(e) Water Saving Trust

Water efficiency is of major importance to the industry as a whole, and in the last five years huge efforts have been made to educate customers in the wise use of water. All companies have water efficiency plans in place which provide a framework for education campaigns, provision of advice on water efficiency and free or subsidised water efficient devices.

However water efficiency differs from energy efficiency as there is a regional/local dimension in water resources. In some areas where resources are tight, it must take a high profile, in other areas without a resource problem the need to promote efficiency needs to be considered alongside other priorities.

Setting up a trust implies more bureaucracy and the centralisation of decisions best taken at the regional and local level.

5. FINAL DETERMINATIONS

(a) Stability

Stability is key for the industry and for customers—we need certainty in the projects that need to be delivered and their costs to customers. The financial capacity of the companies is much less than previously and this will effectively prevent new obligations thought up after 2000 from being implemented before 2005, without price increases.

In the 1999 review, the industry had looked towards an "L" profile, with small price cuts followed by stable regime. The regulator's initial price cut will lead to price rises above inflation in later years—essentially a "V" profile. Water industry consultation for the periodic review confirmed that customers preferred price stability to a short-term price reduction with increases later on, but this consensus view was not accepted by the regulator.

We therefore believe the review outcome is short-term, as it is inevitable that prices will rise in the future. We would have preferred an outcome closer to stable prices over the whole of the five-year period.

(b) Prices and Water use

Ofwat's view is that water demand is falling, because of large reductions in industrial use over the last 10-15 years due to a decline in heavy industry. This has offset increased demand from domestic customers. However there is a geographical split—savings due to lower industrial use have been made in the north and west of the UK. Domestic demand for water increasing due to population growth in the south and in East Anglia—where was resources are under greatest pressure. There has been no analysis of the likely effect of price reductions on overall demand for water. Previous studies have shown that demand for water is relatively inelastic to price, although metered customers typically use less water than those charged on a non-measured basis.

There is a need to distinguish between effects of bills and effects of volumetric charges. We believe that the fall in bills generally will not encourage water conservation and careful use by customers. However Ofwat has encouraged companies to reduce standing charges rather than volumetric charges to limit the negative effect of lower prices on consumption.

(c) Appeals

The industry would prefer a shorter, issues-specific appeals process, rather than having to open up the whole determination. Whilst the Competition Commission is a new and different body to the MMC, there is a feeling that as it is part of the Government, it is unlikely to go against a decision by the regulator, implicitly supported by Government.

Of major concern is the timetable for the appeals process, in particular the short time between the announcement of the determination and its implementation. Earlier determinations would allow a process of reflection and for companies to prepare appeals.

Furthermore the appeals process is expensive and onerous, outcome is uncertain, and this is reflected in the attitude of the City to those companies which launch an appeal.

(d) Interim Determinations

Companies would prefer the certainty of funding within the final determination of price limits to carry out all the work required in the review period, to avoid the cost and uncertainty arising from interim price adjustments. In practice, as is clear from the recent past, there is "regulatory creep", extra new obligations are imposed between prices reviews that are not funded in price limits.

Many political and regulatory risks are not accounted for in the 1999 price determinations, including new obligations and more competition. Some of these items may be picked up in interim price increases, but there is very little financial headroom within companies to cope with logging up (which is a mechanism that makes allowance for the extra costs at the next price review). There is a likelihood that companies will have to resist/appeal new obligations simply because they don't have the capacity to fund them.

(e) Maintenance

The industry's biggest concern for the longer term are cuts in maintenance spending. Water UK doesn't believe that Ofwat has successfully achieved its claims of "no deterioration". Our concern is that asset condition will worsen, building up problems which will have to be tackled in the future.

Independent work carried out by Professor Chris Binnie reinforces this point and a copy of the executive summary is attached as Annex 3.

The industry is concerned that Ofwat relied on poor quality capital maintenance efficiency models, and operated them in a non-transparent way. This has contributed critically to under-funding of asset maintenance for the new period, and risks of poor performance. A collaborative approach between the regulator and the industry to improve shared understanding of asset condition and maintenance should form part of the preparation for the next price review.

(f) Job Losses

Whilst companies are seeking to avoid job losses, they have been an inevitable consequence of the one-off price reduction. Indeed companies and independent commentators had predicted even greater job losses that have materialised to date.

The industry is determined that cuts in manpower should not compromise public health and the safety of remaining employees. However risks will have been increased.

Manpower was significantly reduced in the 1980s, when government set manpower reduction targets for the water authorities. Much of these savings were made by the introduction of new technology. In fact much of the technological advances in the industry are 20 years old. New systems are generally replacements, so that additional manpower savings are not gained by their introduction.

The HSE is surveying accidents in the industry to see whether they may be caused by manpower reductions.

6. CONCLUSIONS

The review process is not ideal—the process is too convoluted and onerous, it needs clearer stronger management, more data sharing and a common vision from all participants. The process should result in certainty for companies, including clear definition of outputs and the timescale for implementing them.

The 1999 review was designed from the outset to deliver a one-off price cut which is unsustainable in the medium term, we believe that prices will rise above inflation in the future to make up the deficit, and to fund any new environmental improvements that Government wishes to implement in future.

To summarise our main concerns are:

— The early view taken by both Ofwat and DETR that price cuts and additional environmental improvements could be achieved without squeezing other parts of the companies activities too hard.