Examination of Witnesses (Questions 60
-79)
WEDNESDAY 28 FEBRUARY 2001
MR PHILIP
FLETCHER, MR
MIKE SAUNDERS
AND DR
BILL EMERY
60. The second issue which puzzled us last time
is the use of the Reporters. This is really linked in with the
debate about asset maintenance. If you are so heavily dependent
on the information provided by the Reporters, yet you are not
fully in control of the appointment of the Reporters and the Reporters
are on contract to the companies, you have said that you have
influence over the appointments, but it just seemed to us to be
a very peculiar if not a unique arrangement whereby you needed
the information, but the companies actually appointed the Reporters.
Could you tell us what your thinking is on that and whether there
is any move to clarify the contractual position vis-a"-vis
the Reporters?
(Mr Fletcher) I do not think that this is altogether
unprecedented. I would suggest that it is not very unlike the
relationship between a company and an auditor and the others who
depend on that auditor for true and fair opinion of the accounts
of that company. Of course the auditor is himself liable to finish
up in court if he in any way fails in his professional duty. Ofwat
has actually had a review carried out by KPMG of the Reporter
system, which established that there is a duty of care both to
the company and to Ofwat and in KPMG's view this does work appropriately,
that both the company and Ofwat can have confidence in the opinion
of this professional officer whose professional reputation—they
come of course from leading engineering consultancies usually—is
very dear to him and not to be influenced or biased either by
Ofwat or by the company. We took full account of the Committee's
recommendation and actually made it something we talked about
to our stakeholders who came to our workshop on our draft forward
programme. We are still absorbing the lessons from that. We are
looking to publish the final forward programme by the end of the
coming month, before the new financial year begins. There was
a very clear view emerging there from Reporters and broadly from
companies, though they are not unanimous, and from other stakeholders
that the present arrangement does work well and should be retained.
They pay, so it is in their interests to ensure that their systems
and their setup make a Reporter's life easy, just as an auditor.
They can set it up so a Reporter can do his job, can reach his
unbiased professional opinion, either with a great deal of work
if they are making a mess of it, or not too much if they are doing
it all properly. They will pay less if the work is being done
properly, whereas the duty of care is still left to Ofwat. We
find it very valuable that the Reporters go in, look from the
inside at the company and give us this unbiased opinion.
61. Given there is a duty of care to two institutions
whose interests may be in conflict, are you saying categorically
that there has never been a conflict of interests for any Reporter
during the period of time this system has applied?
(Mr Fletcher) We have not been aware of such a conflict.
(Dr Emery) We are quite careful to make sure that
these conflicts do not occur. Occasionally a Reporter's firm has
started to become a main contractor type provider for the company.
In those instances we have required the Reporter to be changed,
required a new reporter to be employed and that has happened in
a couple of companies where these things happen. We place a great
deal of importance on the Reporter and his people not being involved
in any strategic or significant contractual way with the company
himself and establishing those Chinese walls. We are not aware
that any Reporter has been captured or this type of thing, and
they are very conscious of the need to establish with us that
they are independent. What we are trying to do here with the reporting
function is to get a kind of independent view on the accuracy
of the information presented by the companies, to avoid the kind
of model which existed possibly before 1989, where essentially
you had assessors from both the regulator and the company and
a doubling up of this kind of exercise. This model was an attempt
to have this job done once. The companies would probably say that
Ofwat actually decides who the Reporter is and we have been going
through an approval process for the new Reporters at the moment.
We require the companies to submit three names after a detailed
process. We choose those, we interview them and we have in several
instances not gone with the recommendation of the companies at
all. In a sense we are making sure that the prime client for the
Reporters is Ofwat. The Reporter is still there as part of a contractor
of the company as well, introducing slightly easier access in
and to the company than possibly if we just had an Ofwat auditor
going in. We think that there are positive benefits and that is
exactly what came out with the KPMG study where they looked at
the process and they concluded that it was robust, they were not
captured and the regulator could rely on the work which was done
by the Reporters and the advice and opinion they were getting.
It was reasonably successful.
62. In respect of the relationship between the
Reporters and employer and the company, particularly the extent
to which they have contracts, are specific criteria or guidelines
set down or is it entirely at your judgement or discretion?
(Dr Emery) We have a comprehensive protocol which
we have issued to the companies as to what the job is. We issue
guidance to them in writing in our normal reporting guidelines.
We issue supplementary guidance about particular issues in the
company. We talk directly during the year at workshops and they
come in to talk to our team leaders to focus on these things.
Their reports are seen by the company, so I do not think there
is any ...
63. Given that it is not an enormous pool of
people who do this job, it is certainly not an enormous pool of
companies, there is bound to be overlap and relationships developing,
as with any group of professionals operating in a fairly narrow
sphere. Do the protocol and the guidelines not specify some minimum
volume of work which a contractor may have with a water company
above which they cannot use a Reporter from that contractor?
(Dr Emery) They do not specify a minimum. If an exposure
is significant we clearly say that if it goes into any form of
advice about strategy, advice about carrying out work to inform
an asset inventory submission, that would be ruled out of court.
The main reporting firms, that is W S Atkins, Halcrows and Binnies,
have tended to set up separate business units completely isolated
from their main consultancy outfits. We have been out there and
one of my team leaders goes out and looks at what is actually
happening in these companies to see whether Chinese walls do exist.
As far as we can see, we have a process which is probably the
best of both worlds in a sense of keeping costs down but being
fully effective and it works. You are right to say that it is
a relatively small body of people. This particular reporting round
we have managed to get one new Reporter so far so it is slightly
expanding and we have been pushing that as we would do as a competition
type regulator.
Mr Thomas
64. When we were doing the report last year
an interesting proposal came forward from Kelda with respect to
Yorkshire Water which was very comprehensively turned down by
your predecessor. You have recently given the green light to the
Glas Cymru proposals for Welsh Water following the takeover of
the company by Western Power Distribution. May I ask you some
questions about that and also how it would affect other proposals
which may come forward within the general restructuring within
the industry? In giving the green light you said that there were
unique factors in the Glas deal which meant that you would not
stand in its way. The implication of the word "unique"
is that these factors could not happen in any other company or
in any other sort of procedure. Is that in fact the case or is
the Glas Cymru/Dwr Cymru deal really setting a precedent for how
other companies may wish to take alternative ways of financing
forward? Are you not really looking at this as a pilot project
for an alternative way forward for parts of the industry?
(Mr Fletcher) It was actually a week before Ian Byatt
handed over to me that he made his announcement about Kelda. It
was right that he should do so, otherwise Kelda might have been
waiting an age while I got my feet under the table. It was his
decision but he did consult me and I very much agreed with what
he said. There are genuine differences between the Kelda proposal
as put forward and the Glas proposal which led to the different
outcomes. Is it a precedent? Clearly it is a proposition that
others in the industry interested in the possibility of restructuring
for various reasons, including reducing their cost of capital,
will look at with interest to see how far what I have said matches
their situation. The things that it seemed to me were interestingly
different about the Glas proposition, briefly, a company limited
by guarantee, with no shareholders. The nearest analogy we have
been able to think of is BUPA in terms of current British companies
operating in this sort of way on a significant scale. Debt financed
holding. First of all, there was a very clear separation between
the seller of the company and the prospective buyer of the company.
Western Power Distribution (WPD) had bought Hyder, always intending
to focus on its energy business rather than its water business
and therefore were looking for an opportunity to sell on the water
business in an appropriate way and get right out of it. They were
obviously looking for a market price but they accepted a market
price significantly below the regulatory capital value of Dwr
Cymru. The regulatory capital value is the amount enshrined in
the Periodic Review and therefore the amount around which the
whole pricing structure works. A price below regulatory capital
value (RCV) means that the company starts with an effective cushion,
an equity cushion, even though it is an equity cushion no longer
held by the normal shareholders, which was one factor in the view
I took. One of the concerns I do have about this sort of company
is the potential for it to be brittle. It was one of the concerns
about Kelda. It is all very well to say you get the cost of capital
down, but if the consequence is a risk that the normal ups and
downs of business in this particular water sector might put the
company in trouble, as at least arguably Hyder had been in trouble,
then it should not just simply flow through into customers having
to carry the can for that. Another factor I was looking for which
Glas have actually proposed, is a very substantial level of reserves
to help guard against this potential brittleness. A further factor
was the point you raised earlier which was how far the people
of Wales were behind this. With all the reservations which I appreciate
about how far the ordinary customer really found this a fascinating
topic and was deeply into the differences, nonetheless, it did
seem to me that not least through the representative democratically
accountable body, the National Assembly, there was a very clear
move to say that this is what they would want. Although that by
no means decided the issue, it was a factor to take into account.
Those factors together, plus the care which Glas had devoted to
trying to develop their proposals, and a series of conditions
which I set and on which I am waiting a response but which I expect
to be one accepting the conditions. This includes other things
like directors whose pay structure will be all around delivering
performance and not simply sitting back, as we all know could
be the risk with a mutual type company: Just letting the revenues
roll in and then only doing the minimum necessary to deliver what
a regulator requires. So there are other factors there which make
me believe that if they can finance it, if they will sign up to
the conditions I have set, then this one should be allowed to
go forward.
65. The proposals had very strong support from
the National Assembly of Wales, very strong support.
(Mr Fletcher) Even though the Assembly itself said
subject to Mr Fletcher satisfying himself that they are not going
to fall on their face the moment they start business.
66. Yes. My understanding is that you had quite
an iterative process with the Glas company in putting questions
to them, particularly as regards what you have just mentioned
about the equity gap that they needed to have to start with. Being
highly critical you could say that if any company bid cheap and
had large political support it would therefore get the green light
from you. Is that a fair comment?
(Mr Fletcher) That would be altogether simplifying
things too much. Any English company, or come to that a Welsh
company, looking at the proposition would have to weigh very carefully
their own particular circumstances, not just in relation to this
regulator or to the other regulators, but, going back to it again,
the Drinking Water Inspector had to be happy that the licence
conditions imposed would satisfy him that he could still go in
and prosecute, the Environment Agency equally. All three of us
had to be satisfied that Dwr Cymru, which will outsource its business
as intended, will never lose control of its business, never be
able to hide behind a contractor and say "Not my fault something
went wrong. I'm not accountable". They will remain accountable.
Their licence modifications will insist on it. That was another
factor. Any company getting into this business is going to have
to go through the same sorts of hoops. The business of talking
to the companies is something I do all the time in confidential
circumstances if they want to put ideas to me before they are
ready to go public on them.
67. That is the company side of it as it were.
What about the customer side of it? In our earlier questions about
the consultation, by implication you said that it would not have
moved off base one really unless it could meet the customer protection
you were looking for. By implication therefore, Kelda in both
your predecessor's eyes and your own eyes did not have that ability.
What does Glas Cymru there and the particular range within Glas
Cymru have to offer to the customers in the Dwr Cymru area both
in Wales and England of course? You have touched on the efficiency
part of it in terms of the relationship with the directors' pay,
but what about protection from risk, the environmental quality,
the importance we attach in Wales to drinking water and beach
water quality? What had you seen in the Glas Cymru proposals and
the way they put their proposals together that was different from
the Kelda mutuality model which gave you more faith in this particular
model?
(Mr Fletcher) If I take the contracting out part of
it, where Glas Cymru will be a very small company in terms of
its staff and will be managing the business through contracts,
this introduces another element of potential risk into the equation
which concerns me. Outsourcing is common across the water industry
but here we are talking about a step change in which virtually
everything is outsourced, everything is managed through contractors.
It is therefore vital that the company manages that properly,
both in structuring the contracts to get best advantage, looking
to mature markets, sizing their contracts properly, having them
of the right duration to get best benefit, ensuring that the contractor
and the client, Dwr Cymru, together have an interest in driving
through efficiency. If it works well, they will be picking some
of the best companies in particular specialist lines where there
is customer care or operational maintenance and will be able to
go on building on the efficiency of the company. They do, incidentally,
have some way to go. They finish embarrassingly low in the Ofwat
league table at the moment on efficiency issues and therefore
have potentially a lot to gain from improvement. If you like,
there is a bit of a down side but there is an up side, if they
can get it to work properly. The other factor is that they are
looking to reduce their cost of capital by being wholly debt financed,
if they can make significant inroads into the cost of capital
that will be to the long-term benefit of their customers, provided
that they maintain that advantage, which is another question.
The financing costs are around one third of bills, so it does
not need to be a whole percentage point to make a very significant
potential gain. Reducing customer bills is not the first job of
Glas. Their first job is to ensure that they are managing the
company properly and that they are building up their reserves
to cope with the normal ups and downs of business life. Although
I am asking them to produce the equivalent of a dividend policy
statement—in a normal equity company that gives shareholders
a yardstick by which to judge whether their company is serving
them properly or not—I am looking to Glas to say they will
look to reduce bills by X over and above what the regulator is
asking for by such and such a date. They have to come back to
me to say whether they are prepared to sign up to that.
68. You mentioned earlier your conversation
with them around the directors' pay structure. My understanding
of the structure of the company, Glas Cymru, is that as well as
directors there will be something like 100 members of the company,
which the directors will appoint from the Great and the Good of
Wales—possibly England as well—to look after the interests
of the company and the customers. In the past your predecessor
said, if I remember rightly, that the equity model worked well.
(Mr Fletcher) I have said it and he said it too.
69. Continuity there as well. The shareholder
pressure was contributing to those efficiency savings and was
working well in the model. We have a completely different model
here. There is no shareholder pressure whatsoever. The only pressure
in effect is from yourselves I would suggest, as the regulator.
What new things can you suggest to the Committee you are considering
in order to ensure that pressure is still there on the company?
One hundred members of a company would not have any relationship
with the customers whatsoever and their only dedication is going
to be almost in terms of public service. It may be an old fashioned
idea that they are dedicated to seeing that this company works
for the good of its customers. Is that enough and what other pressures
can you bear on the company to ensure that it happens?
(Mr Fletcher) We are still talking primarily about
a monopoly business and we have yet to see whether competition
up front for customers is going to put a squeeze on the less efficient
companies in the water sector. I have views on that but that is
perhaps for another time. If I felt that the only pressure for
efficiency was coming from Ofwat, that would concern me greatly
because Ofwat basically is looking to ensure that all companies
are constantly pushed for efficiency. It is not our job to look
for that extra half, quarter, point one per cent over and above
what the regulator is demanding of everybody. It is my job rather
to try to set a level playing field within which all companies
will work and those which manage to beat me, so much the better,
because they are really pushing the efficiency hard. The members,
50 initially and then it may grow beyond that, do not have a financial
stake. Glas is saying they will be selected with a very clear
remit that they are not there to cozen the company into doing
things it should not, to spend all its money, however virtuously,
on rugby football or other good works, rather to ensure that they
are holding the directors to account for the overall performance
of the company. The board itself will have a majority of non-executive
members whose remit again will be to ensure that the executive
are very firmly focused on continuing to deliver that efficiency
gain. The bondholders will have a stake. It is not the same as
a shareholder; I entirely accept that. Their interest is just
in ensuring that the agreement with Glas, their interest payments
and the eventual repayment of capital is delivered. It is not
the same stake. I would not put too much weight on it, but they
are going in for what is called a credit wrapper, effectively
a guarantor of their credit rating status, almost an insurer is
the nearest analogy I can offer, who will be effectively very
much out of pocket were Glas to fail to maintain its credit rating
by poor performance. All those factors taken together do not entirely
reassure me. I am not saying this is the best in the best of all
possible worlds. I am saying here is a proposition which has been
put to me and which I have to weigh up and decide whether on balance
I think in the interests of customers and of my statutory duties
it should be allowed to go forward or not and on balance I think
it should.
70. I appreciate that. I must say that I am
not convinced either that there are sufficient pressures there
to make this company work in the best interests of all customers.
Could I ask you therefore whether you have looked at the draft
Water Bill to see whether there should be any legislative changes
or any changes in your operation or any changes for the future
of the industry? We could see more proposals like this coming
forward. The debt model, if it really is cheaper than the equity
model, will be looked at as an enticement by other companies.
Is it not time for the Water Bill now to be looking at what might
be happening in future restructuring and to be taking these things
on board and perhaps some other elements coming into the process
to ensure that the pressures remain there on the companies? You
opened this session by saying what achievements had been made
and we do not want to lose sight of that. If some changes and
restructuring happen, these must give us the same leverage on
the companies in the future.
(Mr Fletcher) The first obvious enough point to be
made is that it is any company's job however it is structured
to seek to ensure that it is getting its capital at the best rate
for it. That is very much the company's own job. I make assumptions
in the Periodic Review. It is up to the company to try to beat
those assumptions and those that are committed to the equity model
may nonetheless be considering whether their gearing is appropriate
and whether they should have more of a bias towards debt than
equity, taking account of the way the markets now work and are
structured. As for the Water Bill, there one of the issues again
is the gap. If we see significantly developing competition in
the water industry then at the very least there are important
issues which were consulted on by the Department of the Environment,
Transport and the Regions last year, in fact almost a year ago,
on which no answer has yet appeared, suggesting one set of issues
are around how the licence is constructed. It is very important
that however the licence is constructed there should be no doubt
about who is accountable, who is responsible for delivering the
safe high quality drinking water and all the other duties of the
company. It may be appropriate to have a rather clearer separation
of licences if, for example, an incoming company were only interested
in the retail end of the business rather than the distribution
or the initial supply end of the business. Those are all questions
which need to be worked through and would be relevant to questions
around restructuring as well. Meanwhile, I am confident that under
the legislation as we have it, we can maintain that accountability
by Glas or any company which might come along.
71. I think there is an element of piloting
and experimentation in this.
(Mr Fletcher) When the press have asked me about this
I very much try to avoid the word experiment which sounds as though
it is taking some sort of deliberate risk with the customers of
Wales. If we had thought we were taking such risks that a company
should not be asked to take, then the decision would have gone
the other way as it did for Kelda.
Chairman
72. Could you have stopped the Glas deal if
you had wanted to?
(Mr Fletcher) That is a nice question.
73. That sounds like a no.
(Mr Fletcher) It is noticeable that Kelda, having
got a very heavy frown from the regulator, immediately withdrew
its proposals rather than seeking some other way of pushing them
through against the regulator's wishes. The practical answer is
yes.
74. I accept that you are trying to steer away
from the word "experiment", but how long do you think
it will take before you have a clear idea whether the form of
ownership is a success.
(Mr Fletcher) I have talked about concerns if "significant"
numbers of English water companies were in the near future to
want to dive down the same path. I have deliberately not tried
to put a definition on "significant" or "near future".
Obviously the first thing which has to happen is whether Glas
succeeds in convincing the potential financiers that their money
is safe at the appropriate credit rating. That is not by any means
a foregone conclusion and it is up to them to make their case.
I have made it clear that the regulator is not in the business
of giving a soft deal to Glas. I shall regulate them as I regulate
the other water companies in England and Wales on a level playing
field. That is part of the regulatory framework which I have set
out in one of these circular managing director letters to be clear
to both Glas and anybody else who wants to read it how the system
will operate.
75. Will it become clear within your five-year
period whether this is successful or not?
(Mr Fletcher) I would have thought that at least initially
there will be lessons from that. The point which Mr Thomas was
raising and which is an absolutely legitimate concern is whether
a company of this sort, having started in a great burst of enthusiasm,
will keep that enthusiasm going without the shareholders constantly
niggling them to go on delivering and delivering and delivering.
I believe Glas is seeking to set itself up to achieve that virtuous
cycle but it will be quite a long time before we really know.
76. "Quite a long time" means ...?
(Mr Fletcher) Who knows.
77. Four or five years?
(Mr Fletcher) We will have some fairly clear lessons
from that. It is noticeable that companies, even in the water
sector, which ought to be a relatively low risk, relatively stable
environment, have turned over enormously since privatisation even.
78. In the meantime you are not encouraging
anybody else to go down this road.
(Mr Fletcher) I am certainly not pushing anybody else.
The equity model has actually got significant achievements to
its name over the last 11 years, which is not to say another model
is not a possibility. I am certainly not pushing any company which
thinks it is against its interest to look to restructure and advising
any company which wants to restructure that there are these very
significant questions they need to have addressed very carefully
before they come out with a public proposition.
Joan Walley
79. May I go right back to something which was
covered earlier about stakeholders and consultation with the public?
I wanted to flag up with you and get your response to a concern
that I have which is that I do not think many people in this country
really do realise what responsibilities they have as householders
in general in respect of the part of the sewer they are responsible
for, where it goes from their home right up to where it links
up to the main sewer and the financial responsibilities that there
are there. In view of the research which Mr Grieve referred to,
about what people want and how that then shapes what comes out
of the Periodic Review, does this concern you as well? Do you
think the Government perhaps or Ofwat or somebody ought to be
embarking on some kind of campaign as to what responsibility currently
householders have or should this be something which should perhaps
be of concern in your 11 serviceability standards and perhaps
looking at some ways of having an integrated system as happens
in other countries, possibly New Zealand? Is this a matter of
concern to you?
(Mr Fletcher) We do have a pretty integrated system.
My postbag to a degree bears out your point. It is one of the
major irritants when someone has problems of flooding for example,
which are down either to their pipe, or worse still somebody else's
private pipe rather than the pipe of the water company. Most companies
do offer to householders now either a free repair or some system
to help, bearing in mind that a householder sometimes really does
not know where to turn for a plumber or someone more serious in
the contracting line who has to dig up the garden to get at the
pipe. The whole business of education in water efficiency and
responsibility is one which is a duty on the water companies now
and which we believe, because we push them on it, they are taking
seriously. Their performance varies. You can turn to one of our
five regular annual reports to see our league table there of how
the companies respond. I was being questioned about this issue
by the Committee of Public Accounts earlier this month. One of
the things that the National Audit Office found for their study
in advance of the report to PAC, which is quite encouraging, is
that 88 per cent of customers reckon they are taking action to
save water. At least something, perhaps it was partly the drought
five years ago, which had all sorts of other down sides, has really
brought it home to people—a bit hard in the current deluge—that
saving water is an important thing and that as we move into more
unpredictable weather conditions which are likely to be linked
to global warming they cannot count on it going on raining for
ever and everybody needs to make their contribution.
Chairman: Thank you very much indeed
and also to your colleagues as well. We have had a very useful
session.
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