Select Committee on Environment, Transport and Regional Affairs Appendices to the Minutes of Evidence

Memorandum by the New Policy Institute (DWB 13(a))


  The New Policy Institute is an independent think tank, founded in 1996. Its mission is to further the cause of social justice in a market economy. The New Policy Institute has been working on water policy since 1997 and has produced two publications on the subject: Fair and Sustainable—Paying for Water (1997) and Water Charging and Social Charging—why politicians must act (2000). On a closely related subject, it also published Council Tax—the case for reform (1999).


  This submission focuses on the implications of the Bill with regard to water charging for domestic customers. This is an area of water industry policy in which customers' interests, social policy and environmental sustainability are intertwined.

  We welcome Part II of the new Bill and in particular:

    —  The proposals for the Consumer Council for Water (Clause 23). The Council is likely to put pressure on Ofwat to treat the needs of customers (including vulnerable customers) as a high priority.

    —  The Director General's new objective to protect the interests of consumers (Clause 27). We particularly welcome the specific obligation to take into account the interests of people on low income.

    —  The Director General's obligation to take into account Statutory Guidance on Social and Environmental matters (Clause 28). Although Ofwat already has specific duties associated with environment and social policy, this clause will enable the government to ensure that regulatory activities are compatible with environmental and social policy.

  However, it is important to note that people on low income make up a substantial minority of the population. On the government's own definition, the latest official figures show that nearly one in four people in the UK live in poverty, while many more people live on incomes only a little above this threshold. Against this background, only a fundamental reform of water charging can protect the interests of the substantial minority on low income. In our judgement, the proposed extension of the regulator's remit to include social, customer-care and environmental responsibilities can be the catalyst for this fundamental reform.

  This submission has three parts to it:

    —  A discussion of some of the key issues to do with domestic water charging.

    —  Proposals for alternative charging systems.

    —  A discussion of the relationship between charging and competition.

  In addition, an attachment, based on edited extracts of an earlier New Policy Institute paper considers in more detail the feature of a charging system that can satisfy both social, economic and environmental concerns.


How water is paid for

  There are currently two ways of paying for domestic water services:

    —  Around 20 per cent of households pay a variable or measured charge, based on level of water use, as measured by a meter.

    —  Around 80 per cent of households pay a charge that is independent of usage. In England and Wales, this is based on the rateable value (RV) of their homes.

  Almost all homes built since 1990 have meters fitted, while other households may opt (or if they use water for non-domestic purposes, may be required) to have a meter fitted. Bills usually consist of a standing charge and a volumetric element that rises in line with increasing water use.

  In England and Wales, almost all unmeasured charges are based on the rateable value (RV) of homes, which were last assessed in 1973 (as with measured charges, bills usually consist of a fixed standing charge, plus the element of the charge which is varied according to the RV). In 1998 the government decided to continue with this approach to unmeasured charges, even though it acknowledged that a large number of homes would remain on unmeasured charges for the foreseeable future, while over time, RVs will become more arbitrary and unfair as they become ever more out of date.

Charging according to "ability to pay".

  It is important that social considerations affect the terms on which customers are supplied water, because water and sewerage are "essential services", just like education and healthcare.

  At the moment the government's "social policy" for water currently encompasses three policies. In our view only the third offers an adequate approach to protecting the interests of low income customers.

    —  The right of universal access to water—it is now illegal for companies to cut off or limit water supplies. We believe, however, that this right needs to be accompanied by charging structures which make water services affordable, otherwise many customers will not pay their bills, leaving companies to shoulder the costs.

    —  "Safety Net" charging policies which protect the most vulnerable. The government has introduced regulations which protect very vulnerable metered customers who use large amounts of water. But the groups receiving help are small (people with certain medical conditions and large families on income support) and currently companies are only required to lower their charges to the average billing level. In our view this is not an approach which can provide security to the majority of families on low incomes or to the companies which provide them services.

    —  Building the "ability to pay" principle into the whole charging system. There is some evidence to believe that government now accepts that, because water is an essential service, it is legitimate to adopt a "public sector model" of equal access to services, with payment through charges which resemble progressive taxes. This approach, rather than special measures for particular customer groups, can ensure that water is affordable to the millions of customers on low incomes. While the government is committed to maintaining this approach in unmeasured charging, we believe that it has to consider how to extend it to measured charging.

The Instability of the two tier system

  The current two-tier system, where RV-based unmeasured charges and measured sit side by side, has a series of problems.

  Since the government came to power, it has placed a new emphasis on the rights of customers, by allowing unmetered customers to choose between charging systems, without interference from water companies (the same right has not been extended to most metered customers).

  Although this appears to entrench the existing two tier system for the foreseeable future, in fact this policy has created a highly unstable and inequitable situation. This is because it is currently in the interests of households in high-RV homes, who use little water, to switch to meters. As these families save money by shifting to meter, water companies also lose revenue. They are obliged to recover this revenue from all their customers (because they are not allowed to discriminate between measured and unmeasured customers) so unmeasured charges rise. A vicious circle follows: as unmeasured charges rise, so more high-RV homes switch to meters, forcing up all unmeasured charges still further. Meanwhile people in low-RV homes, who pay less than they would under a measured charge, have no choice but to pay more, either through the unmeasured bill, or by switching to a meter. This amounts to an indirect transfer of resources from poorer customers to richer ones, and the hidden unravelling of a century-old, socially equitable distribution of payment.


  Our recommendation is that the government introduce reform to stem the unravelling of socially equitable distributions of payments and develop charging structures which incorporate social, environmental and economic principles. In brief, there are two elements to the reform:

    —  Replace unmeasured charges based on RVs with ones based on Council Tax Liability.

    —  Replace current measured tariffs with a hybrid-system including an "ability to pay" component.

Replacement for unmeasured charges

  The government turned this option down in 1998, mainly on the grounds that reform would be administratively complicated and that transition to the new system would create many losers in the short term. But given that unmeasured charging is set to remain for the foreseeable future, this is an issue which will re-emerge—there will come a point when it is simply not tenable to use 40 or 50-year old valuations for assigning charges. In our view, issues of administration and confidentiality can be overcome. This would ensure that unmeasured charging remains on a footing that is fair and perceived to be fair for the foreseeable future.

  To implement this reform parliament would need to amend the Local Government Act 1992, which restricts the use of Council Tax data. It may also need to amend the Data Protection Act, although legal advice would need to be taken on the compatibility of individual companies' plans with the act. We recommend that any necessary amendments are included in the eventual Bill.

Replacement for current measured tariffs

  Council Tax data could also be used to introduce a social dimension to measured bills. The most straightforward approach would be to set standing charges according to Council Tax liability, and then apply a volumetric charge on top of that, with a built-in allowance of free or very cheap, water for essential use. This reconciles the "Level of Use" and "Ability to Pay" principles in a coherent way, providing protection for the environment, and allowing companies to recover their marginal costs, while also delivering socially equitable outcomes.

  The details of our proposals are discussed in the attachment, which is an edited extract from our 1997 report, Fair and Sustainable: Paying for Water.

  We are not aware of any legislative barriers to these proposals, beyond the restrictions on the use of Council Tax data. Once the new social and environmental objectives are in force, Ofwat could itself initiate—or be directed by the government to initiate—the process of charging scheme reform. We feel, however, that there may be merit in placing such a considerable reform on a statutory footing, through the inclusion of an additional clause in the eventual Bill.


  It is our assumption that the eventual Water Bill will include clauses providing the Regulator with a clear legislative framework for the regulation and approval of competition and restructuring within the water industry.

  Quality issues notwithstanding, water is essentially a standard product which is already freely available. From the consumer perspective, therefore, competition will only really have benefits if it results in reduced prices. If competition results in reduced costs which can lead to reduced prices to all consumers, then clearly this is to be welcomed. But our concern is that much of it may take the form of reduced prices to selected "profitable" consumers. Other things being equal, this would then create a pressure for higher prices to "less profitable" consumers, so that total revenues were maintained. In other words, competitors would "cherry pick" the "overcharged" customers to whom they can deliver price cuts, at a profit, leaving the incumbent company to struggle with the loss-making, "under-charged" customers.

  The government is aware of these problems. In the context of water, it is clear that it wants to introduce measures which (1) ensure that all have access to new entrants' services; (2) require new entrants to deliver the same "safety net" social tariffs as existing incumbents; and (3) continue to cross-subsidise customers in rural and urban areas by ensuring that bills do not vary according to geographic location.

  While these safeguards are welcome, we are concerned that very little has been said about the protection of existing differential tariffs which arise because RV-based charging already includes an element of "ability to pay". For example, if new entrants vigorously promote flat-rate unmeasured charges, or cheap measured charges, customers with high RVs but low water usage will take up these options, leaving incumbent companies with low RV customers, who they would then need to charge higher prices. This is, in other words, an acceleration of what is already happening in the 'competition' between metered water and unmetered water.

  The policies adopted to prevent cherry-picking in other regulated sectors would not prevent this problem, because such measures usually involve the requirement for all companies to offer a uniform price to all, regardless of circumstances. In water, because the dominant RV-based charging structure already includes an element of "ability to pay" this would actually drive cherry picking and the unravelling of socially desirable differential tariffs.

  We conclude that competition must be achieved on the basis of cost-effectiveness rather than the adoption of alternative tariff structures. In other words, the future regulatory regime must be such that competing companies all have to adopt broadly similar tariff structures. If a company can achieve lower costs, then it could then offer lower prices to all potential consumers.

  We conclude that settling the strategic shape of future tariff structures is a prerequisite to the introduction of widespread competition. Unless the government is prepared to see poorer customers, who are currently without meters, hit hard these tariffs will clearly need to include an 'ability to pay' element. As we have argued earlier, this implies the introduction of an ability to pay element into measured charges, probably based on Council Tax liability.



  The choice of a new charging system is a commercial decision for the water companies to make. But the unique status of water means that the decision has considerable social and environmental implications. The government therefore has a proper interest in the matter.

  Through OFWAT, the government already takes an interest in the overall level of charges to households. As a steward of the environment, it has an interest in seeing that there are incentives for the sensible use of water by both the water industry and consumers. For reasons of social justice, it also has an interest in the mix of charges between households.

  There is no reason to suppose that the public interest is necessarily or inevitably at odds with the water companies' interest. Instead of proceeding on this basis, assuming the problem to be an inherently adversarial one, the government could try to lead the water companies towards decisions that would command political and public support.

  We propose that the government should exercise its leadership by setting out criteria relating to the effects of any new system of payment. the Criteria we suggest are that a system of charging should:

    —  Be efficient in economic terms.

    —  Sustain the environment.

    —  Produce socially just outcomes.

  There are certainly other important attributes that any charging system should possess—for example, to be understandable to users—but criteria of efficiency, sustainability and justice are likely to be fundamental determinants of the acceptability or not of any system.

Applying the criteria

  One way of applying these criteria is to frame a set of more specific questions to ask of any particular charging system. In order to meet a particular criteria, a charging system must provide a satisfactory answer to all of the questions associated with it. For example:
CriterionQuestions to ask to establish whether the criterion is met. Does the system:
Economic efficiencyAllow for water to be appropriately priced at the margin?
Provide a balance of incentives for both households and water companies to use resources efficiently?
Sustain environmentHelp protect the ecosystem, in terms of both the quantity and quality of water?
Address the strategic water problems foreseen by the water company in its region?
Stimulate water companies to promote non-financial measures for the saving of water?
Social justiceProtect households from pressure to economise on water where health and hygiene could suffer?
Reflect consumers ability to pay for water to meet essential needs?
Include payment options to help with budgeting and arrangements for exemptions and rebates?

  Any system put forward to solve the strategic problems should be required to satisfy all the criteria and not just some.


Current charging system—the two extremes

  There are two extreme forms of water charging systems. One is where the bill is independent of the volume of water used and is wholly determined by the fixed charge. The other is where there is no fixed charge and where the bill is proportional to the volume of water used. Interestingly, these extremes are close to representing the two systems actually in existence for households in England and Wales at the moment:

    —  Most households currently pay for water via a fixed charge only, set according to rateable values (see .......... line in the diagram below).

    —  The minority of households who are now metered pay according to the volume of water they use, plus a small fixed charge (see - - - - - - - line in diagram below).


Intermediate examples

  Clearly, it is possible to "mix and match" the charges with a combination of fixed charge and volumetric charge. Two possible examples are:

    —  A tariff structure that combines a standing charge with a volumetric charge that only starts to apply above a given level of "basic" water usage (the - - - - - - - line overleaf).

    —  A block tariff structure, where the amount paid still depends on the volume of water used but does not vary continuously with it (the .......... line overleaf).


  This analysis highlights the observation that any water charging system combines a level of fixed charge with one or more volumetric charges for differing volumes of water usage. The practical questions in devising a particular tariff structure then concern:

    —  The relationship between the fixed charge and the volumetric charge(s).

    —  Whether any of them should vary between households.

    —  How the information necessary to set a particular household's tariff should be obtained.


Some Principles

  If the marginal price (which corresponds to the slope of the line in the diagrams above) is too low, then the consumer has little incentive to economise on usage. Conversely, if the marginal price is too high, then the supplier has little incentive to encourage its consumers to economise on usage. Theories of economic efficiency suggest that, over time, the price paid by the consumer for an extra litre of water at the margin should equal the cost incurred by the water company in providing that additional water (plus, perhaps, the environmental costs).

  Note that economic efficiency is only concerned with the cost at relatively high levels of usage (where the consumer is faced with a decision whether or not to use water) and not at lower levels of usage (where the consumer will use the water anyway). So any charging system where payment according to the volume used starts to apply above a certain level of consumption is in principle capable of satisfying this efficiency criterion.

  Like economic efficiency, environmental sustainability may also depend on the marginal price, because any element of charging for water according to volume used creates financial incentives for households to economise. But, as there is no reason to suppose that households will respond only to price incentives, it is important that water companies also have the incentive to encourage such economy by other, non-financial means. This requires that the marginal price paid by households be no greater than the marginal cost.

  Social justice on the other hand depends much more on the total bill (both volumetric and fixed charges). So, for example, the fixed charge should be such that it is affordable for poor families and the costs at low levels of usage should be such that no household is unable to afford the water for ordinary domestic usage that it needs for essential purposes.

Assessment of the current schemes

  Applying these principles shows that none of the present charging systems is adequate:

    —  Flat rate charging systems, such as the present ones based on rateable values or council tax bands, cannot satisfy either the economic or the environmental criteria because the marginal price of water is zero. On the other hand, the present flat rate systems are to some extent a proxy for the ability to pay, and may therefore meet the criterion of social justice.

    —  The present tariff for metered customers also seems to fail to satisfy the economic criterion, but for the different reason that its marginal (volumetric) price is arguably too high compared with the future long run marginal cost. As a result, the tariff structure does not provide a proper balance of financial incentives as it leaves water companies with little or no financial interest in households saving water. Moreover, as the fixed charge element is levied as a uniform fee per household, it also cannot meet the social justice criterion, as water bills are unrelated to customers' ability to pay.

Assessment of a hybrid scheme

  Although the present metered tariff does not meet the criteria, it is possible to see how it could be altered to ensure that it did. For example:

    —  First, if the volumetric charge for water were reduced to bring it into line with a revised view of the long run marginal cost of water, both the economic and the environmental criteria could be met.

    —  Second, if volumetric charging were only to begin once a household exceeded its "basic usage" (set to reflect essential water needs), this would contribute to the social justice criterion being met.

    —  Third, the fixed charge would need to be raised to offset the fall in the water companies' income, resulting from the two changes above. But if this higher standing charge were allocated among households according to some proxy for the ability to pay, for example, Council Tax banding, then the social justice criteria could still be met.

  We conclude that charging systems can be found that satisfy the multiple criteria of economic efficiency, environmental sustainability and social justice. But they have to be sophisticated systems. Whilst this implies widespread metering, the accompanying tariff must reflect social justice concerns in a way that the present metered tariff does not.


Opposition to metering

  There is continuing opposition to metering itself, usually from bodies representing the interests of consumers, whether in the water industry or more generally.

  We acknowledge—indeed we emphasise—that there are serious objections to an extension of metering on the present tariff; objections economic, environmental and social. But the fundamental fault lies with the tariff structure and the principles on which it has been constructed by the water companies, at the behest of the last government and OFWAT. We believe it is vital to distinguish between metering and the tariff structure, directing criticisms at the latter, because metering itself provides information on usage that will help manage society's use of water in the coming decades.

Practicalities of sophisticated charging systems

  There are also a number of problems which arise from the sophisticated tariff structure needed to meet multiple criteria. These include:

    —  The cost implications of gathering additional information and administering the system;

    —  The setting of household-specific thresholds (eg for basic usage);

    —  Concerns arising from the confidentiality of some of the information required.

  We recognise all of these as important issues which need to be addressed in any fully fledged solution. However, they should not be insuperable, given additional research, a realistic timescale for implementation and appropriate co-operation between the water companies and local authorities, who may have a significant role to play in overcoming some of these obstacles.

4   Edited extracts from Fair and Sustainable: Paying for Water, New Policy Institute, 1997. Back

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