Select Committee on Environment, Transport and Regional Affairs Memoranda

Main Report


  1.  We agree with the Government's objectives—that the customer should be at the heart of economic regulation and that the regulatory process should be more open and transparent, accountable, predictable, consistent and effective. We believe that current and proposed legislation falls short of this ideal and our intention in this submission is to propose legislative provisions which would contribute to achieving our common objectives.

  2.  We note that increasing pressures on water resources and the impact of climate change cause ever more pervasive Government intervention in the activities of the water industry. This is no surprise in view of the industry's dual role as the provider of services to its customers and as guardian and protector of the environment. We believe that the resulting Government interventions need to be formalised in legislation to ensure that these reflect sound principles of regulation, and are open and transparent, accountable and predictable, consistent and effective.

  3.  The Environmental Audit Committee (EAC) Seventh Report recommended that the Director General should have a specific duty to have regard to sustainable development. It is proposed to create a new power for the Secretary of State to issue statutory guidance to the Director General on social and environmental matters. We do not support this proposal because it will blur accountabilities.

  4.  There are three elements of sustainability: economic, environmental and social. In broad outline, the first two elements of sustainability are the responsibility of the Director General and the Environment Agency (EA), and the third that of Government. The Drinking Water Inspectorate has a role to play in relation to public health and drinking water quality. We believe that this specific allocation of responsibility is useful but it is not right for unelected regulators to balance the three elements of sustainability, which should be a political decision for Government and the Government's responsibility.

  5.  We believe that such consideration of how best to pursue sustainability in the water industry is particularly relevant in the light of the proposals for abstraction licensing. We are concerned that Government is not putting in place the necessary building blocks—regulatory transparency and co-ordination between regulators—which would enable the new licensing regime to function satisfactorily. The resulting increased costs of the revised abstraction regime would be passed to water industry customers, who would therefore be funding Government's environmental policies.

  6.  Abstraction licences which damage the environment may be justified if they satisfy important needs of certain members of society. An adequate and reliable supply of water has been recognised as an important factor in the advances made in the last 150 years in public health and hygiene. Decisions on the granting and withdrawal of abstraction licences, like other decisions related to sustainability, involve balancing the complex environmental, social and economic needs of society. Strategic decisions on these issues should be taken by Government, which should then be reflected in the decisions made by regulators. Much of what we support in the proposed improvements to the regulatory framework of the water industry is for the purpose of improving the transparency and accountability of these balancing decisions.

  7.  Protecting the environment is a society objective. The potential conflicts between the environment and the needs of customers can be minimised if they are managed carefully in a co-ordinated way by the quality, environmental and economic regulators. The Bill must provide for this collaboration, overseen by DETR. This process would permit a continuous debate on sustainability issues. Without an effective debate the proposed revision of the abstraction licensing regime could be unnecessarily restrictive in terms of water supply, unresponsive to environmental needs, and expensive.

  8.  We have already highlighted the need for greater regulatory co-ordination in our evidence to the EAC, when we suggested that DETR and the regulators should provide a clearer long-term focus, and develop more "joined up" regulation. We felt a more strategic vision was needed, in which the periodic review process had a less dominating role, with all the disadvantages that that implies for an industry where long term vision is of key importance.

  9.  The EAC recommended "that the DETR, companies and the regulators ensure that the five year investment programmes of the periodic review are set within a comprehensive, clear framework of longer term policies and goals including those relating to water resources and environmental quality and serviceability goals." The EAC went on to say that it believed "that the DETR should take the lead in setting out the policy framework and environmental future at the outset of the periodic review process...".

  10.  Therefore, in the light of the strategic direction given by the DETR, there should be a joint duty on the EA and OFWAT, not only to consult, but to agree a common environment programme whereby the impact on investment and infrastructure of the abstraction licensing policy of the EA is fully accepted by OFWAT, and the EA does not impose requirements that are unfunded.

  11.  We also feel that many long-term issues need to be resolved through collaboration among regulators with Government oversight. We suggest that the best way to take this forward is for the Secretary of State to set up a national forum with the remit of looking at sustainability and long-term issues, and that the draft Water Bill should make this a requirement for the Secretary of State.


  12.  We are concerned by the proposals to reform the abstraction licensing regime, as we said in response to Government's original consultation in 1998. We are disappointed that our comments then do not appear to have been included in the current proposals.

  13.  We fully subscribe to the objectives of the reform—of improving the quality of the environment for all—but we believe that the proposals will result in a reduced reliability of water supply for domestic customers and greater costs, without necessarily being more effective in improving the environment.

  14.  The water industry has a statutory duty to supply water for domestic use and act as a supplier of last resort. So far, the industry's licensing rights have reflected its duty of supply of last resort, these rights and duties being two sides of the same coin. In this connection it must be recognised that the supply of water to customers is demand-led. Any significant reduction in the availability of abstraction licences could affect the ability of the industry to guarantee security of supply.

  15.  On security of supply, we are surprised by the proposal to revoke without compensation, licences which have not been used for four years (called "sleeper" licences). The industry keeps such licences in reserve for a variety of reasons, for instance to provide emergency supplies in case of drought. But droughts do not happen every four years and, therefore, the water industry needs to retain spare water abstraction rights which it may need only rarely.

  16.  The revocation of "sleeper" licences is particularly puzzling as the proposed Water Bill would make it a duty for companies to agree Drought Plans with the Environment Agency; these plans, which may rely on "sleeper" licences, may therefore be incapable of implementation if these licences are withdrawn.

  17.  It is also puzzling to see "sleeper" licences under threat since, by definition, they are not used and do not damage the environment. If the proposal was driven by consideration of competitive access to water, we believe that it is misguided at this stage. Competitive access to water needs a proper framework, on which Government has consulted on several occasions, with a decision document promised for later in the year. Meanwhile, patchwork intervention is unlikely to be productive.

  18.  The industry may have to strive to discharge its duty to supply at the same time as its abstraction rights are curtailed. The cost of abstracting water—as an inevitable consequence—would increase. One reason is that, as abstraction licences became short in duration and more uncertain, assets which the industry builds and maintains for abstraction purposes would need to be planned for the short term, with a short pay-back period. Its annual cost would therefore increase.

  19.  Also, because of increased uncertainty, water companies could not reap all the economies of scale and scope that they would otherwise be able to use. For instance, it may be efficient to anticipate increases in demand when building abstraction-related plants, but this would be pointless if the abstraction licence was short-term. Also, the existence of a greater risk to the supplies of raw water and increased planning challenges would increase the risks in the water supply business generally, which would increase the cost of capital.

  20.  Moreover, we are concerned that Government's proposals relating to compensation for the loss of licensing rights, would in fact further increase the amount of environmental costs which will be borne by customers. There are provisions at the moment which allow compensation to be paid to the water industry for the increased costs arising from the loss of abstraction rights. Such compensation would protect customers—to some extent—from the costs of the new abstraction licensing regime. However, Government is proposing that such compensation be paid by the Environment Agency out of the revenue it receives from abstraction licensing. This is a circular arrangement, which would increase the cost of the remaining abstraction licences to compensate for the loss of others.

  21.  We therefore find it difficult to believe Government's stated intention that its proposals should have a minimal impact on customer bills. We believe that Government is mistaken in this respect. We are particularly surprised by its regulatory appraisal in which it asserts that there will be few cases where abstraction licences do not cause environmental damage (paragraph 2.22). Our understanding is that the revised abstraction regime is proposed so as to curtail environmental damage where it exists. Government's regulatory appraisal is silent on both costs and benefits in such cases.

  22.  Moreover, we find it difficult to believe that the proposals will indeed incur little costs for customers, in the absence of a conclusive demonstration in the regulatory appraisal. Government has said that, when a non-time-limited abstraction licence is removed and replaced by a time-limited one, there will be a presumption of renewal unless there is environmental damage. We have two difficulties with this statement:

    —  There is no presumption of renewal included in the relevant clauses of the draft Bill.

    —  The Bill does not put any burden of the proof on the Environment Agency to demonstrate damage, but leaves it to the industry to demonstrate that no damage is committed; asking for such a negative proof is not consistent with a presumption of renewal.

  23.  We have already commented on the need for "joined-up" regulation, long-term planning and Government leadership on sustainability. Concerning regulation by the Environment Agency, we are therefore surprised to find that the regulatory reforms proposed in the draft Water Bill for OFWAT are not applied to the processes whereby the Environment Agency will make decisions on the allocation of abstraction licences. We believe that the EA should have a duty to make transparent and auditable decisions on the amount of water which it deems should stay in the environment and the amount available for abstractors. It should also have to demonstrate how, when making this assessment, it has discharged its duty under the Section 15(1) of the Water Resources Act 1991 to have regard to the water industry's duty to supply.


  24.  We agree with the proposal for an independent Consumer Council for Water, although we would prefer that it is named Customer Council (we have "Customer Services Committees" at the moment). "Consumer" is a vague term that blurs the distinction between the responsibilities that water companies have to the people whom they supply with water and sewerage services and their broader accountabilities to the country and its citizens, which are largely regulated by the Drinking Water Inspectorate, Environment Agency and the Government. The word "customer" would define the Council's stakeholders more accurately. It is used from now on in this memorandum.

  25.  The Council should represent domestic and business customers; this needs to be made explicit. Council members should demonstrate a genuine concern for customer issues, and its staff should have appropriate experience of customer service and complaints handling. Regulated companies should be asked to co-operate to ensure Council staff have extensive knowledge of the water industry.

Functions of the Customer Council

  26.  We agree that the Customer Council should act in an advisory role and not be part of the decision-making process. However, we believe that the Council should have a more important role in relation to service standards; it should be responsible for agreeing them with companies and, then, make recommendations to the regulator. The role of the regulator should be to approve and enforce the standards. [Similar arrangements are being used in postal services regulation where the regulators, the Postal Services Commission, has asked its independent customer body, the Consumer Council for Postal Services, to agree service standards with the Post Office and make recommendations to the Commission.]

  27.  Primary legislation should define the roles of the Council and the regulator. The Memorandum of Understanding between the Council and regulator should not undermine its independence.

Customer Complaints

  28.  Water UK agrees that the Council should take up a complaint only after the company concerned has had an opportunity to deal with it. We do not support the involvement of the regulator in developing a streamlined system for dealing with complaints. (This may confuse customers who will be unsure which body to complain to). The regulator's involvement in complaints should be limited to determining disputes as required by the Water Industry Act 1991, and determining policy issues on cases referred to it by the Council.


  29.  The draft Bill reintroduces clauses previously introduced in the Utilities Bill but subsequently dropped. Generally we agree with the Government's objectives—that the customer should be at the heart of economic regulation and that the regulatory process should be more open and transparent, accountable, predictable, consistent and effective. We have a number of suggestions for improvement set out below which aim to achieve better regulation.

  30.  Our concerns about the last water price review were put to the Environmental Audit Committee (EAC) inquiry into Water Prices and the Environment, which reported in November 2000. The detail of the draft Bill should be modified in the light of that report and the general principles established by the Competition Commission (CC) reports on Mid Kent Water and Sutton and East Surrey Water published in September 2000.

Duties of the regulator

  31.  It is important to consider whether, in the light of the CC and EAC reports, the balance of duties should be revisited. Greater emphasis should be given on protecting the long-term interests of customers, and on the obligation of the regulator to act transparently, predictably and consistently.

  32.  The regulator could be required to take proper account of available evidence on customer views and to ensure companies are adequately funded to maintain assets properly—these may be implicit in the existing duties of the regulator but given the experience of the last review they should be made explicit.

  33.  The CC established certain general principles in its two reports on Mid Kent and Sutton and East Surrey, some of which are outlined later in this submission. However we are concerned that the DG appears to take the view that the reports are specific to the two companies concerned, contrary to the view expressed by the Competition Commission.

  34.  The draft OFWAT forward work plan issued in November 2000 says "The Competition Commission broadly accepted OFWAT's approach to price setting but concluded that prices for customers of these two companies should be slightly higher than OFWAT had determined..." The recent draft interim price determinations for Tendring Hundred, Dwr Cymru (Welsh Water) and Anglian Water made selective use of the Competition Commission findings, although the changes between OFWAT's draft and final determinations are more reflective of Competition Commission principles.

  35.  For the avoidance of doubt, the DG should be under a duty to extend the general principles established in Competition Commission inquiries to all other companies at future price reviews.

  36.  It seems premature to drop the existing duty on the regulator to secure a reasonable rate of return on capital employed, given the high and continuing level of investment in the sector. It is still not clear whether the financial markets are prepared to finance the current investment programme at the cost of capital set by OFWAT in the 1999 review. Railtrack, for example, has been given a higher rate of return that reflects its need to raise equity as well as debt to fund the large investment programme it has to deliver.

  37.  In the Utilities Act there is a duty on the Secretary of State for Trade and Industry and Ofgem to consult the Health and Safety Commission on health and safety matters relevant to the carrying out of their functions. This should be extended to the Secretary of State for the Environment, Transport and the Regions and the water regulator, to ensure in particular that tough efficiency targets are not set for companies in price reviews that put safety at risk.

Getting the periodic review methodology right

  38.  In view of the criticisms of methodology that have been made by the CC and the EAC, in particular relating to the handling of capital maintenance, we think that the process for settling the methodology that OFWAT uses in price reviews should be more rigorous. At present OFWAT may "consult" but it can end up adopting a methodology that fails to achieve the right result.

  39.  The EAC's conclusion that OFWAT's treatment of capital maintenance amounts to "intellectual neglect" is damning, and of particular concern to the industry since we offered to work with OFWAT on this issue as early as 1996.

  40.  The CC was particularly critical of OFWAT's approach to broad equivalence—the proposition (principle?) that accounting depreciation charges and expected expenditure on maintaining assets should be the same over a reasonable period. The CC did not receive persuasive evidence to justify the adjustment, they were concerned at the way the introduction of broad equivalence was managed, and they criticised OFWAT's failure to share the calculations with the companies.

  41.  The CC also took the view that both the cost base analysis and the econometric modelling for capital maintenance may be subject to margins of error which could be material. Their efficiency adjustments were more cautious than OFWAT's.

  42.  In reviewing OFWAT's assessment of service performance the CC criticised OFWAT's retrospective approach. "We do not think it right that a price adjustment scheme based on relative scoring should be wholly or partially based on relative performance before the scheme had been sufficiently established by May 1998 for the company to know what was required of it in terms of service performance" (CC Report on Mid Kent (MK) paragraph 2.204). The principle of no retrospection is of key importance in all other areas of price setting or service standards where the aim is to influence incentives and performance.

  43.  The CC rejected OFWAT's long-standing doctrine that growth is self-financing. "We agree with the Director that companies operating in a competitive market would have to recover the growth investment costs from their customers in the long term without raising prices, unless there was a corresponding increase in the value of their product. However MKW does not operate in such a market" (MK paragraph 2.140).

  44.  Companies have also told us that OFWAT made last minute changes to their methodology without consultation in order to squeeze price limits.

Possible remedies

  45.  Our conclusion is that there needs to be a mechanism for independent review of OFWAT's methodologies well in advance of a final price determination. One possibility is that companies might have the right of appeal on particular methodologies, not just the package as a whole, to the Competition Commission or to the Advisory Panel planned under the Water Bill.

  46.  Another possibility is that OFWAT should formally commit to stated methodologies and agree a licence amendment with companies that codifies the principles to be used in price reviews. In the event that a company disagrees with this amendment, it could of course appeal to the Competition Commission.

  47.  The draft Water Bill provides an opportunity to put in place a process that achieves earlier resolution of methodological issues that, with respect to the 1999 review, we are still debating now and ensures that consultation is more of a two way process.

Predictability and consistency

  48.  We think it is important to achieve greater predictability and consistency of regulation. To quote from the Government's Green Paper on Utility Reform. "Regulation must be as predictable and consistent as possible in order to serve the long-term interests of consumers, companies and shareholders".

  49.  These are fine words, but in practice OFWAT has fallen well short of achieving this objective, to the extent that it appears that they have abandoned their commitment to the medium term basis of price regulation.

  50.  Although a number of changes to the tax system and to environmental and quality obligations were announced well before the 1999 review was complete the then DG refused to make proper allowance within price limits.

  51.  For example neither the climate change levy nor the supplementary business rate outlined in "Modernising local government finance" have been funded within current price limits. Nor has the extra cost of cryptosporidium monitoring and the schemes OFWAT rejected in 1999 which were sent back for "reappraisal".

  52.  The consequence of this is that prices have fallen initially but will be rising in future in part because of interim price determinations. The EAC roundly criticised "roller coaster prices (which) confuse customers". In addition, the EAC criticised Ministers for interfering in the process by suggesting that 10 per cent price cuts were feasible. They recommended "that in future Ministers should respect the role of the independent regulator".

Complexity and transparency

  53.  The CC were particularly concerned about process. They say "We also observe that the modelling of K has become extremely complicated, to the point where the precision sought in a number of areas appears to us to be disproportionate to the degree of estimation and judgement required in the Periodic Review process. The Director might wish to consider how this could be simplified" (MK paragraph 2.211), (CC report on Sutton and East Surrey (SES) paragraph 2.194). We hope that the DG will take this review forward immediately in full consultation with the industry.

  54.  This conclusion contrasts sharply with the outcome of the OFWAT review of the periodic review process (summarised in its letter MD 164), which claims that the process was successful and only the water companies felt it was less than perfect. OFWAT's review does however accept the process might be shortened to two years and that the issue of the transparency of the financial model should be looked at.

  55.  The EAC report in para 100 recommends "that OFWAT makes the full financial model as used for the periodic review, including equations, publicly available." This requirement should be included in the draft Water Bill.

  56.  We have argued repeatedly that OFWAT needs to share its financial model with companies. We put this to the last DG but he refused to do this. This has led to an excessive burden on companies in trying to understand OFWAT's sums, and a waste of public money because OFWAT used expensive consultants to validate their model even though peer review by companies and others would have been equally effective.

  57.  On broad evidence, the Competition Commission found that "the information available to MKW/SESW during the Periodic Review was not, in our view, sufficiently detailed to enable the company to challenge the Director's broad equivalence findings. In fact, MKW/SESW only received the relevant information during the course of our inquiry" (MK paragraph 2.191, SES paragraph 2.187).

  58.  The requirements to provide reasons for decisions included in the draft Water Bill should help but needs to be bolstered to alter OFWAT's behaviour and lead to better regulation.

Code of practice on decision making processes

  59.  In the July 1998 DTI response to consultation on utility regulation, in the section on transparency and predictability of regulation, conclusion 7.3 said "The Government confirms that it intends that each regulator will be placed under a statutory duty to consult on, publish and follow a code of practice governing their consultation and decision making processes." This commitment to prepare a code of practice has been omitted from the Water Bill.

  60.  In part OFWAT's "Having your Say" document on consultation processes meets this requirement, but nothing has emerged from OFWAT on "decision making processes". We think that OFWAT should now produce a code of conduct relating to their decision-making processes and it would be helpful if it became a requirement in the draft Bill. We have a number of suggestions about matters that might be included.

  61.  The principles set out in the draft Bill apply only to the economic regulator. We think the principles of better regulation, providing reasons for decisions for example, should be extended to the Environment Agency and the DWI, to ensure that they apply to all regulators whose activities affect costs and ultimately prices to water and sewerage customers.


Clause 22, Water Advisory Panel

  62.  We believe that the establishment of a Water Advisory Panel, to advise the Director General is a step forward, especially as the Secretary of State may require the Director to refer certain matters to this Panel. We look forward to hearing more about the expertise of the people who will be appointed to the Panel and hope that they will include people with experience of the industry.

  63.  We would like to see the Panel's advice published in line with the aim of achieving greater openness and transparency; at present the draft Bill does not provide for this.

Clause 26, forward work programme and annual reports

  64.  The DG is already attempting to comply with the requirement to produce and consult on forward work plans, and this is a helpful and welcome development.

Clause 27, objectives and duties

  65.  This Clause has already been discussed earlier in this submission. Generally we support the new three part primary duty, and we have made a number of suggestions that modify the secondary duties to clarify the responsibilities of the regulator.

Clause 28, guidance to DG on social and environmental matters

  66.  We understand that this guidance is designed to ensure that the economic regulator work towards sustainability together with other regulators. We welcome the objective of this Clause, as we said earlier. However, we do not believe that the issue of guidance is an efficient way of achieving this end. Beside the reasons discussed above, such as the need for explicit collaboration between the regulators, we are concerned about the principle of issuing guidance to which the regulator need only have regard.

  67.  Guidance on what is required needs to be clear and agreed between all parties. One concern we have relates to how this might be applied in practice. Recent guidance on social matters from DETR has not been well drafted, and OFWAT have had their own social agenda differing from that of DETR. Companies have been caught in the crossfire between the two.

  68.  In the case of environmental objectives OFWAT issued guidance on the handling of changes to companies' obligations in its final determinations document (Appendix E) that was not agreed with DETR or the Environment Agency. The EAC criticised this guidance in its report. We think that it is the responsibility of the DETR to lead on this guidance in consultation with all the regulators and the industry.

  69.  The cost of all new obligations needs to be funded within price limits. A continuing concern we have is that support for vulnerable groups that should be dealt with under the social security budget is being paid for by other water customers. This cross subsidy will prove to be increasingly impossible to maintain as competition develops in the water industry.

Clauses 29 and 30, standards of performance in relation to water and sewerage

  70.  Subject to what we said earlier about the role of the Customer Council in agreeing standards with companies, we are content with these clauses as long as regulatory impact assessments are properly conducted, and the Secretary of State seeks to balance the costs and benefits and minimise the regulatory burden. We suggest the Secretary of State should be placed under a duty to estimate the impact on prices to customers at the time a new standard is put forward.

Clause 36, financial penalties

  71.  This extends to the water industry provisions that are part of the Utilities Act for gas and electricity, which were widely criticised by the companies affected, the Electricity Association and the CBI. We consider this Clause ill judged.

  72.  Companies are already subject to penalties in the form of regulatory action at price reviews if they fail to deliver outputs, and under the guaranteed standards scheme they are required to provide compensation to customers if service standards are not achieved. Adding this clause to the draft Bill exposes companies to double or possibly triple jeopardy.

  73.  A clear concern is that the clause could encourage defensive behaviour by companies not in the wider interests of customers, given the uncertainty over the likely behaviour of the enforcement authority (OFWAT), and the very high upper limit on penalties.

  74.  We are concerned that the economic regulator can define the penalty regime without formal clearance by Government or Parliament. Section 22B(5) is particularly weak "an enforcement authority shall undertake such consultation as . . . it considers appropriate when preparing or revising . . . its statement of policy".

  75.  During the passage of the Utilities Act Ofgem published draft guidance on their policy towards penalties. There is no sign that OFWAT are planning to do this, but clearly they should do so as a matter of urgency before the Committee has completed its review of the draft Bill.

  76.  We are also concerned that appeal rights under the clause are limited to matters of process; it is important to extend appeals to matters of substance.

Clause 38, links between directors' pay and standards of performance

  77.  The industry has no difficulties with this proposal. Executive remuneration packages are already in part linked to performance targets based on service level parameters set by the regulator. Data on executive pay, and service levels are in the public domain already.

Clause 39, reasons for decisions

  78.  The industry supports this proposal and, as noted above, considers that the proposal should go further to include a code of practice relating to decision making processes; it should also be extended to the Environment Agency and the Drinking Water Inspectorate.


  79.  Government first announced a review of competition in the water industry in March 1999. It eventually published a consultation document in April 2000 asking for responses in June. It also published a separate consultation on the trading of abstraction licences (ie economic instruments) in April 2000 asking for responses in July 2000. Since then we have been expecting proposals on competition to appear in the draft Water Bill.

  80.  We are concerned that there is no indication that Government is making progress on competition. All that it is currently reported is work in progress, with further documents promised in the first half of 2001.

  81.  Government says that any Clause relevant to competition will be added to the Bill when it is introduced to Parliament. We think this is much too late. Clauses on competition should be introduced in advance, so that this Sub-committee has an opportunity to conduct an inquiry into it. It would be useful if the DETR could give such an undertaking.

  82.  Our position is summarised at the front of this submission. We include extracts from our June 2000 response below.

January 2001

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