APPENDIX 3
Memorandum from Dr Dieter Helm, New College,
Oxford and Director, OXERA Environmental Ltd
INTRODUCTION
1. This memorandum focuses on: the institutional
context of the water periodic review, the quadripartite process,
the role and incentives of the water companies, and the ways in
which the final determination incorporated environmental considerations
in general and the precautionary principle in particular.
2. It will be argued that there is a lack
of clarity in the roles of the Environment Agency and Ofwat; that
the quadripartite process failed to provide an open process or
to take full account of the sustainable development policies of
the government; that economic regulation creates incentives for
the companies to "game" the environmental process; and
that the final determination failed to incorporate fully and reflect
the ministerial decisions and the spirit (if not the letter) of
the outcomes of the quadripartite process. A series of recommendations
are presented to improve the periodic-review process in the future.
THE INSTITUTIONAL
CONTEXT
3. The privatisation of the water industry
required a separation between the private provision of water and
sewerage services, including the maintenance and renewals of assets;
the environmental regulatory functions; and economic regulation.
The solution adopted was to create the National Rivers Authority
(NRA) to take the lead on environmental functions, while Ofwat
would ensure that companies could finance these and other functions,
and be incentivised to be efficient. Government, in the form then
of the Department of the Environment, would set the standards,
in sympathy with the European framework.
4. This division of responsibility has been
eroded over time. The main causes have been:
— the inability for the NRA (and then
the Environment Agency) to focus on its environmental regulatory
functions, because of the distracting and overlapping responsibilities
deriving from its river-management and flood-defence functions.
The NRA never had the institutional structure to provide the necessary
attention to the periodic review. The Environment Agency continues
in this mode, as the recent DETR Select Committee report indicates;
— Ofwat has encroached into the NRA's
and then the Environment Agency's territory by enunciating the
principle of customer affordability, claiming that, only if the
costs can be properly demonstrated to be less than the measured
benefits, should environmentally driven projects be financed by
the price-cap mechanism (contrary to the precautionary principle);
— the desire of ministers to lower
prices for political reasons, independent of the setting of environmental
standards and the financing of functions.
5. This blurring of the roles of the three
main institutions has been detrimental, in that it has tended
to produce an answer which reflects the relative ability of the
key individuals in each body to influence the outcome, rather
than one which properly reflects the environmental and economic
objectives. (A clarification of roles may also entail significant
changes in the organisation and performance of the Environment
Agency.)
THE QUADRIPARTITE
PROCESS
6. The quadripartite process has the advantage
of creating a framework within which the main parties can debate
and discuss the core environmental issues. In the 1999 review,
its role became one which provided an input into the minister's
decision-making process, rather than the more powerful role it
played in 1994. It moved away from the concept of four parties
involved in making decisions, towards a tripartite advisory input.
7. The companies were included. They clearly
have an important input in providing operational expertise and
costs. However, the private and public interests are separate.
The private companies are essentially stakeholders, interested
in maximising profits. Their role is therefore different in kind
from the other three players.
8. The quadripartite process is, essentially,
a closed one. Other interested parties (environmentalists, academics,
customers, anglers, surfers) are all external players. It is far
from clear why companies should be included, while other stakeholders
are excluded.
9. The quadripartite process did not strive
to solicit advice and opinions from "outsiders", relying
on these parties acting directly with Ofwat, the Environment Agency
and ministers.
10. It is hard to reconcile the outcome
of the quadripartite process as consistent with the government's
sustainable development policy. Rather, there was a process which
sought to reach a largely pre-set answer. This was given by the
ministerial statement indicating that both environmental improvements
and a 10 per cent price cut might be the outcome. This statement
came well before the detailed work had been completed.
INCENTIVES ON
COMPANIES TO
"GAME" THE
ENVIRONMENTAL PROCESS
11. The role of the companies in the periodic
review is not neutral. As long as the rate of return exceeds the
cost of capital, profits increase with the level of capital expenditure.
Therefore, the companies have an incentive to encourage environmental
standards to be raised. However, once the total is set, profits
can be further increased if companies manage to spend less than
their total set, while delivering the output. Hence, it is in
their interests not only to have a large total, but also to have
higher cost estimates for each project.
12. This "gaming" opportunity
influences the advice they give in the quadripartite process.
Ofwat has attempted to moderate these incentives, but with limited
success. This core problem lies with the five-year, fixed-period
contract approach. It is far from ideal to have the environmental
(and other) capital investments fixed once every five years. A
more flexible approach to the determination of both the environmental
outputs and the economic regulation is desirable.
INCORPORATION OF
MINISTERIAL DECISIONS
IN THE
PRICE CAPS
13. The outcome of the periodic review was
presented as price cuts and stable prices thereafter. This is
not a completely accurate picture of the position for customers.
It was achieved by the incomplete financing of all the requirements
flowing from the ministerial decisions.
14. A number of environmental obligations
were not financed, on the grounds that the costs were either not
known or agreed. The absence of a proper provision enabled the
regulator to announce a price profile broadly in line with the
pre-indicated political outcome. However, these obligations will
not go away, and, hence, customers are likely to face higher prices
towards the end of the period than they currently expect. Given
the "surprise" element, there is bound to be resistance
to the environmental spend, and pressure for delay.
15. The failure to finance fully the programme
might, in normal circumstances, be regarded as sensible in view
of the uncertainties ahead. However, it arises in the context
in which the Director General of Water Services has been perceived
to be somewhat hostile to the environmental policy agenda, and
it is widely noted that the Chief Executive of the Environment
Agency and the Director General of Water Services have been in
considerable conflict. While the challenge to environmental objectives
is often helpful and productive, in this context it has created
a sense of conflict between environmental and economic objectives.
RECOMMENDATIONS
16. It is recommended that:
(i) the roles of the Environment Agency and
Ofwat are clarified, with Ofwat's role being confined to the efficient
financing of functions, given the environmental policy and standards
set by the minister, supported by the Environment Agency;
(ii) the Environment Agency's performance
would be greatly enhanced if its multiplicity of functions were
clarified. Its operational activities and sheer size reduces its
effectiveness in policy and standard-setting roles;
(iii) the roles of the Environment Agency
and Ofwat in the quadripartite process should be clarified, with
the DETR adopting the lead role;
(iv) the role of the companies in the quadripartite
process should not be on a par with those of Ofwat or the Environment
Agency. There is a good case for either confining the process
to the public institutions (the DETR, Environment Agency and Ofwat),
or including other stakeholders. There is no case for including
the water companies and excluding other stakeholders;
(v) the incentives for the companies to "game"
the process would be much diminished by moving away from five-year
fixed-period, fixed-price contracts;
(vi) the full environmental impact on prices
should have been made clear in the final determination announcements,
and in future better information should be provided to customers
and stakeholders;
(vii) the conflicts between Ofwat and the
Environment Agency are partly the consequence of the highly personalised
nature of British utility regulation. Further steps towards replacing
a single Director General with a board or authority (as was proposed
in the Utilities Bill when water was included) would help to diffuse
such clashes in future.
May 2000
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