Select Committee on Environment, Transport and Regional Affairs Memoranda

Memorandum by Bannock Consulting (DWB 23)


  1.1  Bannock Consulting welcomes the opportunity to submit to the House of Commons Environment Sub-committee evidence in relation to its Inquiry into the draft Water Bill published by the Department of the Environment, Transport and the Regions in November 2000. We believe that this Inquiry and the draft Bill into which it is to be held are both important and timely. The industry is undergoing its greatest period of changes since privatisation in 1989, changes which are set to continue for much of this decade and which will be of the utmost importance to the industry itself and to the consumers of the vital natural resource of which it is the custodian. The draft Bill and your Inquiry into it presents a valuable opportunity to examine the nature and trend of those changes and to give consideration to the strategy by which they are guided and the precise form which they might take. It is therefore an opportunity to assess the likely future of the industry, to evaluate its ability to meet the challenges it will face in the future and to examine the appropriateness of the proposed legislative framework within which it will operate. Your Inquiry should therefore provide a useful "stock-take" of the current and likely future position and provide indicative guidance for the future development of public policy in relation to the industry.

  1.2  Bannock Consulting in an economics and management consultancy firm whose staff and associates have many years experience of working with the water industry, either as practitioners or advisers to its various component parts. In broader terms we also provide consultancy services in the fields of regulation and de-regulation, industrial and sector economics, inter-sectoral and—institutional relationships and the development and implementation of public policy. We operate in the UK and overseas and hence have a clear appreciation of the industry in the UK but also an internationally-based understanding of the issues with which we deal. Although we work for a wide variety of clients in the public and private sectors this submission is not made on behalf of any of those clients but is based on our professional views and experience. It is therefore intended to assist your Inquiry by providing an objective assessment, in so far as we are able to do so, of the issues we feel are of importance to it.

  1.3  The draft Water Bill is a long and complex piece of proposed legislation that will have significant long-term implications for the industry and its customers. It is, however, incomplete and may therefore become still longer and more complex in ways that cannot yet be known. It is nevertheless appropriate that you should inquire into its current and potential provisions to ensure that they receive an advance degree of scrutiny to which they might not otherwise be subjected in the course of the normal legislative process. However, it is our respectful view that your Inquiry should be conducted at both strategic and detailed levels. We feel that only such an approach will enable the context of the draft Bill to be fully understood and for the implications and appropriateness of its detail (and lack thereof in parts) to be assessed. We have therefore structured our submission to incorporate this suggested approach, providing our assessment of the context within which the draft Bill should be evaluated as well as commentary of those parts of its detail, which we feel to be of importance.

  1.4  Our submission is set out in seven substantive sections. These relate to the way in which the industry is or may in the future be structured, the commercial environment in which it operates or may do so in the future and the specific parameters that are or may be placed upon its operations by government and the regulators. They are presented under the headings of:

    —  Industry and Firm Structures.
    —  The Competition Agenda.
    —  Water Abstraction.
    —  Bulk Supplies.
    —  Regulatory structures, risks, costs and consumer prioritisation.
    —  Performance and Penalties.
    —  Social and Environmental Duties.

  As the Sub-committee may appreciate from the above, our submission should not be regarded as an exhaustive commentary on the draft Bill. Rather it is one which concentrates only on those parts of its proposed provisions (and omissions) which we feel are both important and potentially controversial and which fall within those fields where we feel our experience and expertise enable us to make legitimate comment and raise questions we feel to be pertinent. There are of course other areas of importance which are not (or ought not to be) controversial and other areas of potential controversy upon which we do not feel able to comment. For the Sub-committee's convenience we have drafted our submission in so far as possible with a non-specialist audience in mind but should you so wish we would be happy to explain or exemplify this submission in more detail during the course of your Inquiry.


  2.1  In 1989 the industry was privatised to form 10 vertically-integrated regional water and sewerage monopolies, interspersed with which were 19 previously-statutory vertically-integrated water companies. Due to a virtual prohibition on mergers and acquisitions, at least as regards water and sewerage companies of each other, this is still largely the structure of the industry. The ownership pattern created was one of shareholder equity and this pattern too has persisted. The sustainability and suitability of both, however, are now matters of debate. It is surprising, therefore, that the draft Bill (or at least Part 1 of the Consultation Paper setting out the context for its provisions) is silent on them. They go to the heart of what one must assume to be the Government's strategy for the industry and that of each of the firms within it. Their determination will have a major impact on the future of the industry and hence on the shape of the object to which the draft Bill will be supplied. They are therefore highly relevant to your Inquiry in forming a major part of its inescapable context. We make comment on each below.

Industry Structures.

  2.2  The industry structure referred to above is more the result of historical evolution and accident than of policy as it was applied in 1989. Its domination by 10 vertically-integrated regional monopolies previously in the public sector is the result of its development by local government and subsequent agglomeration into arms-length units based on river basins in the 1974 local government re-organisation. The ancillary role of the 19 (now 15) previously statutory water-only companies represents the legacy of pre-privatisation private sector involvement in that small part of the industry where it was commercially viable for it to do so. The continuation of this structure in 1989, when river basin management and hence much of the rationale for existing boundaries was split from the industry, reflected merely that policy was one of privatisation, not liberalisation. This has since been perpetuated on the grounds that, at least as far as the Director General is concerned, any substantial diminution in the number of separately-measurable companies would compromise the robustness of the system of comparative competition upon which regulation is based, the implication being that were it to be so compromised companies would be less efficient and customers would pay higher prices.

  2.3  The consequence of this has been that none of the 10 major players in the industry has been taken over by or merged with their counterparts elsewhere within England and Wales. This is, of course, not to say that there have not been take-overs and mergers. There has been a number, but all have been foreign-led (by companies in France, Germany and the US), have involved companies outside the industry or have been relatively minor incorporations of statutory companies. This has led to the gradual take-over of the industry by much larger overseas utility corporations against which it has been difficult for incumbents to mount a defence, to the creation of integrated utilities which seek to realise efficiencies across industries rather than within the water industry and to a partial tidying-up of historically-determined patterns of ownership distribution. This represents a markedly different pattern of change to that in other privatised or regulated industries. It is questionable whether this has been in the long-term interests of consumers and the UK, or whether some other pattern of change, ever were it to have undermined some of the existing indicators used for the purposes of comparative competition, might not have served their interests more fully. In particular, the market distortions which the Director General has been able to impose on the industry may well have led to a failure to realise economies of scale and cope, under-investment in research and development and hence a lower-than-achievable rate of innovation and a loss of competitiveness in international markets. You way wish to question whether this is a potential price worth paying by consumers and the UK economy for the maintenance of an unchanging set of indicators.

  2.4  It is clearly a matter for government to set out the policy framework within which regulation is to take place, but on this aspect of the framework the government has been silent, thereby allowing the Director General to set policy by default. This is a surprising omission given the significance of the changes proposed or to be proposed in the draft Bill and one about which you may wish to question the government. In so doing there are three points which you may wish to bear in mind. These are that:

    —  the efficiency gains available within the existing structure of the industry and which are induced through the application of comparative competition ought by now to have been realised or should be so within the lifetime of the third quinquennial tariff limits which have already been set. To not achieve these after what will have been 15 years of the application of regulation to a largely fixed structure would strongly suggest that regulation had failed. Therefore either the system of regulation should be altered or further efficiency gains should be sought through a relaxation of the controls on industry structure;

    —  best-practice in other sectors suggests that regulatory indicators should be out-put and out-come based rather than input and process based. Those used for the purposes of comparative competition would therefore seem to be overdue a review, in particular to allow comparisons across industries and countries rather than the purely internal comparisons currently used, the discrepancies in which are the result as much of varying operating circumstances as of objective efficiency of performance. Were this to be done there would be no need to maintain such a large number of separately-measurable companies on the somewhat dubious pretext that the performance of the water industry in England and Wales was incomparable with that of other places or industries. The operation of the market in determining the industry structure would therefore be made consistent with the protection of consumers' interests through the regulatory system;

    —  if the UK is to compete within the increasingly competitive European utility market and the developing world market it must be allowed to develop structures within the UK appropriate to those markets as well as to that of the UK. This will almost inevitably mean a much smaller number of much larger companies emerging, ones able to compete with those overseas competitors who have already gained such a sizeable foothold in the UK. To deliberately prevent this, as is being done by current policy, is to risk having an efficient but essentially anachronistic UK industry, one which would not best serve the interests of consumers in the long-term even were it to be so at any given point in time.

Firm Structures.

  2.5  Debate within the industry regarding the structure of individual firms, irrespective of how the industry overall is structured, is of more recent origin. The model of structure adopted in 1989, that of shareholder equity, had been largely uncontroversial until less than 12 months ago (at most). It is therefore unsurprising that this part of the context to the draft Bill is not reflected in the Consultation Paper or in any of its specific provisions. Nevertheless, it may be appropriate to include it within any consideration of the draft Bill because the debate has its origins in the outcome of the last Periodic Review, in particular in the perceived difficulty on the part of some firms in financing required capital expenditure within the price limits they were set. It is therefore of central relevance to any review of the regulatory system.

  2.6  You will presumably be receiving evidence on this matter from many of those involved in this debate and we would therefore not wish to rehearse the arguments of others in full by way of explanation of our considered view. This is that the structure of individual firms is of no interest per se and that therefore the debate comes down to three essential issues. These are that:

    —  During the course of and since the last Periodic Review there have clearly been disagreements between the Director General and companies regarding the cost of capital. As a result of those disagreements some companies chose an appellate recourse to the Competition Commission (with partial success) whilst other chose a structural response to seek to lower their cost of capital (with, thus far, no success unless one counts the sale of Thames Water as such). That structural response would, if allowed, totally change the structure of firms within the industry and require a fundamental reappraisal of regulatory policy. Therefore resolving the issue of the cost of capital, and disagreements over it, is essential to the future of the industry and is central to the proposals in the draft Bill. Were a mutually-acceptable mechanism for doing so to be put in place by the draft Bill then it might be the case that the debate of firm structures would simply dissolve. On the face of the draft Bill there is no stated provision for doing this (though one would hardly expect it). However, it may be that the provisions relating to the establishment of an Advisory Council (Clause 22) will provide such a mechanism, a possibility you may wish to question.

    —  During the subsequent debate on the structure of firms the Director General has (quite rightly) raised the issue of where the burden of financial, operational and regulatory risk would lie under the types of arrangement being proposed. In particular, the distribution of risk between license-holders and operators and different operators in the water and sewerage process has been indicated to be problematic. Thus far the Director General has sought to address these concerns through licence changes or, where this has not proved possible, by denying consent to changes in firms' structures. This is understandable within the constraints of the current regulatory system but one would have hoped that the opportunity would have been taken of imminent legislation to address this issue directly to ensure that a robust and considered legal framework is put in place which would accommodate a multiplicity of ownership structures and relationships rather than continuing with a system based on the assumption that the shareholder equity model is to be preferred.

    —  A concern expressed by the Director General during the course of consultations on company re-structuring has been the impact these might have on the number of comparators available for the purposes of comparative competition and for ensuring the financial robustness of companies. As has been expressed above, this concern partly arises out of the, in our view, mistaken practice of operating a "closed" system based on outmoded indicators. It would therefore be pertinent to inquire as to whether or not it is envisaged that the new powers contained in draft Clauses 29 and 30 will be used in such a way as to upgrade the regulatory system to obviate these concerns with regard to performance and whether additional specific arrangements need putting in place with respect to financial indicators.


  3.1  Although the transfer to private ownership of integrated water and sewerage undertakers in 1989 was as much the result of ease of so doing as of policy, it nevertheless reflected the prevailing view that competition in the industry was impracticable on anything other than a minimal scale. The industry has a high fixed cost ratio in anything other than the very long term and it has therefore been assumed to be a classical natural monopoly. This is shown by the very low rates of return on capital achieved when measured on a Modern Equivalent Asset current cost basis and the considerable discrepancy between this and the Regulated Asset Value valuation of the industry which is used to make the industry appear profitable at current price levels. This was acknowledged in 1989 in the very substantial discount at which the industry was sold, and in the structure—duty to supply coupled with protection from competition—which was created. Such competition as could be envisaged was limited to Inset Appointments, the low number of which attests to the limits to competition within the system as created.

  3.2  In recent years this view has changed and it is now envisaged that it is possible to introduce competition not just at the geographical margins of supply areas but within processes and for customers. The industry could thus evolve into one more akin to the energy sector in which companies could vertically disaggregate and customers could choose between suppliers. Thus far movement in this direction has been limited to the introduction of common carriage for customers using above 100ml per annum but it is clear from the Consultation Paper that further moves are envisaged. Unfortunately the draft Bill is silent on the matter at this stage, although further clauses are promised in due course.

  3.3  Whilst the introduction of competition per se would be welcome were it to lead to further efficiency savings and hence lower prices to consumers in the longer term it would nevertheless represent a revolution within the industry. It should therefore not be undertaken without full consideration. The introduction of competition in other industries has had a significant impact (for instance encumbering British Gas as was with uneconomic long-term supply contracts, the elimination of many rural bus routes and most recently operating difficulties in the railway industry). There is good reason to suppose that the potential impact on the water industry will have a similar magnitude of impact and the Sub-committee may wish to take the opportunity of your Inquiry to examine some fundamental considerations relating to it, even in the absence of detailed proposals at this stage, to ensure that problems encountered in other industries are avoided.

  3.4  In doing so we fell that there are six major areas of concern that the Sub-committee may wish to examine. These are:

    —  the danger that incumbent undertakers may become the supplier of last resort;

    —  the unravelling of existing cross-subsidies;

    —  the undermining of security of supply;

    —  the stranding of assets;

    —  the failure to achieve savings through structural rigidities; and

    —  potential impacts on public health.

  Each is considered below.

Suppliers of Last Resort

  3.5  Current incumbents have a duty to supply and to do so at prices that do not discriminate between one class of customer and another. This means that in practice all customers are charged on the same basis even though the costs of supplying them may differ. There is the danger that under a competitive framework new entrants would seek to supply only those customers whom it was most profitable to supply, leaving incumbents with the high-cost tail of customers whose charges would rise to maintain the financial viability of incumbents. Were those charges to become unaffordable, incumbents would have no way of recovering them other than through the civil recovery process, thereby leading to further increases in charges. The danger might therefore arise that the industry develops two classes of customer and two classes of company—each respectively low cost and profitable and high cost and unprofitable. Competition would therefore not occur within one industry as such, but only within one half of what would in reality have become two industries (as is the case in the energy industry). The Sub-committee may feel that in order to prevent this and to ensure that the benefits of competition are shared by all customers the promised new draft Clauses should include provisions whereby the implicit costs of the duty to supply are shared between all suppliers, not just those upon whom the duty current falls.

The Unravelling of Cross-Subsidies

  3.6  Notwithstanding the previous Director General's efforts to secure cost-reflectivity and the disallowance of undue discrimination certain classes of consumer are currently subsidised by others. The most obvious case in point in those in receipt of protection under section 5 of the Water Industry Act 1999. Numerically, however, the largest cross-subsidy, both by number and by scale, is of rural consumers by those living in urban conurbations. There would be a clear possibility in a competitive framework that new entrants would seek to target those paying such subsidies and to exclude those in receipt of them, thereby enabling them to lower their own average price (even at the same level of costs as incumbents). There could therefore be a switching pattern between companies the effect of which would be to unravel existing cross-subsidies. This would have a significant impact on those groups currently subsidised on an explicit or implicit basis. The impact on the former could, relatively easily, be compensated for through the tax and benefit system but compensation for the latter (by far the larger number) would be more problematic since it would require a wholly new mechanism. The Sub-committee may therefore feel that the promised new draft Clauses should include provision for this and that, in addition, the Regulatory Appraisal should include a detailed costing of the impacts on classes of consumers by exemplification of existing and intended cross-subsidies.

The Undermining of Security of Supply

  3.7  Security of supply is currently provided for through a mixture of the duty to supply, the ban on domestic disconnections and the maintenance by incumbents of sufficient spare capacity to meet foreseeable demand except in times of drought, in which circumstances Drought Orders are intended to safeguard supply for essential uses. Under a competitive framework there is the danger that the costs of maintaining the margin of capacity necessary to guarantee security of supply would fall only on those customers who remained with the incumbent which held that capacity. This would increase the costs of incumbents and create an incentive to switch away from them, leaving them as only providers of that margin of capacity rather than as primarily suppliers. This can be avoided only if some mechanism is put in place to ensure that the costs of maintaining margins of capacity for the purposes of security of supply are shared between all suppliers. Moreover, if the duty to supply is to remain, incumbents will require a margin of capacity not just to guarantee security of supply as at present but sufficient extra margin to cover the capacity of those companies that do not have a duty to supply This will result in additional costs to incumbents above and beyond existing costs which will have to be included in the cost-sharing mechanism. The Sub-committee may therefore wish to see such a mechanism provided for in the promised new draft Clauses.

Stranding of Assets

  3.8  It is axiomatic that water is the long-term industry par excellence. It relies for supply on large-scale civil engineering projects and the utilisation of aquifers, the replenishment of which takes decades. Its cost structures reflect this in very high fixed cost ratios. Short-term price signals are therefore inappropriate market signals upon which to base decisions for the long term future of the industry and individual firms within it. Were they to be so used investment would be either too high, with resulting effects on prices, or too low, with a resulting threat to the security of supply. Notwithstanding this, competition for customers would almost inevitably be driven by short-term prices. This has been the case in energy and telecoms markets and there is no reason to suppose that it would be otherwise in the water industry. In those markets, falling world prices and increasing demand have enabled their smooth operation (thus far). However, in the water industry the long-term price trend is upward (as a result of demographic and environmental pressures) whilst the existing level of demand is fully met. Therefore new entrants would be required to displace existing suppliers, and to do so on the basis of prices which are set in the short term. This would have the effect of stranding the assets of incumbents and reducing their long-term investment. Neither is in the long-term interests of the consumer. It would therefore be appropriate to ensure that if competition is to be introduced at customer level mechanisms are incorporated within the competitive framework to ensure that new entrants as well as incumbents are required to adopt a long-term approach rather than, say, simply exploit the short-term price advantages that would result from a succession of wet years.

Structural Rigidities

  3.9  As set out above, the rate of structural change in the industry has been comparatively slow as a result of restrictions imposed by the Director General. This has acted to reduce the rate at which efficiency savings are made (and can therefore be passed on to customers). Were these restrictions to continue within a competitive framework it is likely that the rate of structural change engendered by competition would be similarly diminished, thereby reducing the efficiency gains available through that framework. In other markets the introduction of competition has been accompanied by a relaxation of structural (and other) controls as a means of facilitating the flexibility on which effective competition depends. It might therefore be anticipated that the same would occur in the water industry. In particular, the relaxation of restrictions to allow vertical disintegration and horizontal integration within and across the boundaries of existing supply areas would be necessary to allow economies of scale and scope to be made to their furthest possible extent. The Sub-committee may feel it appropriate to inquire as to how this might be achieved within the context of Clause 27 of the draft Bill.

Potential Impacts on Public Health

  3.10  The securing and maintenance of public health through the adequate supply of wholesome drinking water and the provision of effective sewerage services is the underlying reason for there being a water industry. This has long been recognised and continues to be so, not least in the requirement that undertakers be licensed as a means of ensuring that they are fit and proper bodies to operate in the industry. This licensing requirement is the basis for the preventative rather than reparatory approach taken to securing the public health objective, one which has ensured that, post-privatisation, the industry's standard of performance in this respect has not reverted to that of its 19th Century private sector predecessors. Compliance with this requirement would, however, represent a barrier to entry in a competitive framework, a barrier that has been recognised and objected to by prospective new entrants within the existing but limited competitive framework. It is, nevertheless, a barrier without which there can be no preventive approach to securing the public health objective. Its non-removal might therefore reasonably be taken for granted if that approach is to continue to be taken. There is no indication in the Consultation Paper of the draft Bill that this might not be so bad neither is there an indication that it will. The Sub-committee may therefore wish to satisfy that this requirement will remain even though it represents a barrier to competition.


  4.1  The current framework for, and pattern, of water abstraction in England and Wales are the complicated and often arbitrary result of the historical evolution of the industry. It is unquestionable that were on to start with a clean sheet to set out objectives for abstraction policy and to design a regulatory system to achieve these one would not re-create current circumstances. That the draft Bill has recognised this and that it has set out proposals for root and branch reform of the system is one of its strengths. Unfortunately, as is so often the case where legislation represents a compromise between competing interests (although in this case they are largely the different regulatory bodies) the proposals go both too far in some respects and not far enough in others, whilst not actually resolving those competing interests.

  4.2  The proposals will effectively give the Environment Agency long-term control of water resources, enabling it to set and achieve goals in accordance with public policy. This will no doubt be objected to by those in the water industry whose decision-making powers independently of public control will be diminished. This is not a matter on which we hold a view. However, in certain respects these powers could result in conflict with the ability of OFWAT to set and achieve its parallel goals in accordance with public policy, and with the ability of water undertakers to deliver those goals, leaving them in a position of double jeopardy. There are three respects in which this may be so. These are:

    —  the mis-alignment of the automatic duration of licences and the life-cycle of investments made in relation to them and the removal of rights to compensation for variations within the period of a licence will increase the risk involved in the industries investment programme, increasing its cost of capital and shortening required pay-back periods. This will lead to an increase in the average price of water to consumers and so conflict with the price-minimisation goals set for OFWAT.

    —  the placing of liability for the adverse effects of abstraction on abstractors will additionally lead to higher prices and hence to a further conflict of goals. In so far as this ensures that the polluter pays we would regard this as unexceptionable but the current proposals will leave abstractors open to liability in circumstances where the adverse effects of abstraction could reasonably have been foreseen by the Environment Agency and where it should not therefore have granted the licence in the first place. This we would regard as exceptionable;

    —  the diminution in the period of non-use of a licence qualifying it for re-allocation may act so as to undermine the security of supply by allowing the use for other purposes of licences which represent access to a strategic reserve for use in periods of drought or where an abstractor wishes to change the source of supply in the long term.

  4.3  Whilst therefore there are grounds on which to question the proposals as going too far in subjugating the interests of consumers to the environment there are other grounds for questioning whether the proposals do not go far enough and so subjugate the interests of consumers to those of licence-holders, particularly within the context of a competitive environment. There are two respects in which this may be so. These are:

    —  there are no powers given to OFWAT analogous to those given to the Environment Agency to enable it to transfer or vary licences in the interests of economy;

    —  the provision for compensation where licences are transferred would, were transfers to be made on grounds of economy, compensate companies for such degree of inefficiency as justified the transfer of the license, thereby preventing the increased efficiency so gained from feeding through into prices.

  It is therefore our view that the Sub-committee should review the proposals in relation to the regulation of abstraction to ensure that their content and balance are appropriate.


  5.1  Clause 21 of the draft Bill, that which gives the Environment Agency a considerable suasive power to require a water undertaker to take bulk supplies from another, is a special case of the preceding section and one to which we feel the Sub-committee should give particular attention. As presently framed, the proposed suasive power would be used to achieve "the proper use of water resource" as environmentally determined. No indication is given, however, as to the balance that would be struck between environmental and cost considerations in the consultation that would take place with the Director General, or of the negotiating position of the two commercial parties to the agreement. This could lead to price increases for consumers of the bulk transferee and surplus profits for the bulk transferer (which may or may not be passed on to its consumers). The Sub-committee may therefore wish to examine this balance and relationship.

  5.2  Again as with the preceding section we also feel that in some respects the proposed powers do not go far enough and that the Director General should be given an analogous power to make similar requirements "to further the consumer interest" as set out in 27(1)(2)(2A)(a). This would allow the pursuit not only of the best environmental option but also of the least cost option where choices were otherwise environmentally neutral or where environmental considerations were outweighed by those of cost. This would clearly be of benefit to consumers and could be the more so in the long term by encouraging the development of bulk transfer systems and therefore give an impetus to competition in line with the Director General's duty at 27(1)(2)(2B). In the long term it would facilitate the development of an industry-wide least cost planning system (similar to that, for instance in the US energy industry) which would be of benefit to both consumers and the environment whilst rewarding those firms which were the most efficient in the industry rather than simply in a given supply area.


  6.1  Clauses 22 to 42 of the draft Bill would significantly alter the regulatory mechanisms of the industry and introduce new purposes to regulation. The existing three regulatory bodies (OFWAT, the Environment Agency and the DWI) would be increased to five with the addition of a separate and independent Consumer Council and the creation of a Water Advisory Panel. We have no comment to make on these bodies or their functions as such but their number and (in some cases) wide and overlapping remits must give cause for concern regarding the purposefulness and effectiveness of regulation when split between so many bodies. It has become apparent since 1989 that the existing number of bodies creates opportunities for conflict and confusion and would be concerned were the increase in their number to create more such opportunities. It is our experience elsewhere in the world that the trend is to create fewer, not more, regulatory bodies and, in so doing, to aim to make them more effective.

  6.2  Accepting, however, that their number and powers to be increased this can only result in increased regulatory risk to companies in (or wishing to enter) the industry (under a competitive framework) with the overall result that costs, and hence prices to the consumer, will increase above what they otherwise might have been. It might therefore be considered unfortunate that the Regulatory Assessment makes no estimate of the costs which this increased regulatory risk might entail either to companies or to consumers, an omission the Sub-committee may wish to question.

  6.3  Notwithstanding the cost of regulatory risk it would seem reasonable to assume that compliance costs will increase because of the overlapping and possibly non-uniform nature of the powers and duties of the bodies in the new regulatory structure. It is recognised in the Regulatory Assessment (paragraph 3.19) that these will be significant, but no estimate is given of the extent of that significance. A comparison with new regulatory requirements in other sectors of the economy, however, would suggest that total costs of regulation and compliance could rise by the order of £50 million per annum, although this would be highly dependent on the degree of flexibility of which the new bodies would wish to avail themselves. Moreover, it is likely that these costs would fall disproportionately on smaller companies or those wishing to enter the market (under a competitive framework), therefore acting to slow the rate at which competition can be introduced.

  6.4  It is within this context that the Sub-committee may wish to examine:

    —  whether the stated commitment to prioritisation of consumers' interests will be served best by the creation of a more, rather than less, complex regulatory system with higher, rather than lower, costs which will ultimately be born by consumers; and

    —  whether the creation of competition between regulators will result in the long-term interests of consumers being subordinated to the short-term positional actions of the different regulators under the guise of the protection of consumers' interests.


  7.1  Clauses 36 and 37 of the draft Bill would create new powers whereby the Director General will be able to impose fines on undertakers who fail to meet specified standards of performance to a limit of 10 per cent of their turnover. This would, in practice, have meant that had these powers currently existed the Director General would have been able to impose fines of up to £700 million on the industry in 1999-2000, ranging from £650,000 on Hartlepool Water to £110 million on Thames Water, and against which companies would have had no statutory right of appeal. We feel sure the Sub-committee will feel, as indeed do we, that this is a significant new power the existence of which will act a powerful spur to meeting performance standards. However, we feel that although such a type of power may be appropriate its precise nature and extent are in this instance mis-specified and should be subject to further examination to evaluate their fairness and efficacy.

  7.2  The model for this power has been taken from those contained within the Competition Act, although duties under that Act to which the penalties relate would still be enforced under that Act and not under the intended Water Act. The question which must therefore arise is whether an appropriate penalty for the purposes of enforcement under one Act is also appropriate for the purposes of enforcement of different provisions under another Act.

  7.3  In terms of it being an appropriate type of measure to apply to the water industry this is unlikely to be so for three reasons, These are:

    —  whilst non-competitive practices might be assumed to increase turnover and therefore make it an appropriate benchmark for penalties (although in fact in theory the reverse is the case) there is no logical link between performance and turnover. Under the current regulatory system a more appropriate benchmark would be the profits earned surplus to those assumed in successive Periodic Reviews and which had been provided for in the meeting of future performance standards;

    —  the differences in operating circumstances of different companies produces a wide divergence in unit costs with the effect that were turnover to be used as the basis for penalties that applied in one area would be different to that applied in another area for exactly the same degree of non-performance and could indeed by greater in one area than that in another for a lesser degree of non-performance. This disparity is self evident in terms of turnover but is amplified when one examines penalties in relation to profitability or return on assets when not only would the amount but also the percentage differ. A differential incentive to meet specified standards of performance would therefore be introduced which might reasonably be seen as unfair by those companies subject to proportionately the most severe penalties;

    —  these differences in operating circumstances also result in different performance itself. Were the performance standards, non-compliance with which would act as the trigger for penalties, to be uniformly applied across the industry then those companies facing the most difficult operating circumstances would therefore be most at risk of having penalties imposed. No account would have been taken of value-added in performance and indeed higher performance-value-added companies could still face higher penalties than lower performance-value-added companies. Fairness and transparency would therefore be sacrificed to simplicity.

  7.4  This is a problem which has been encountered in other sectors, most notably education where crude performance indicators have been replaced by ones based on value-added. We would therefore feel it appropriate to ask whether 22A(3)(c) would be used to produce a value-added level playing field and whether companies could make requests for this to be so done under 22(A)(3)(d).

  7.5  In might also be felt that it is not an appropriate extent of measure to apply to performance standards in the water industry. Although it lies within the private sector the water industry is a public service, as is attested to by its close regulation. It therefore might be more appropriate to apply to it those sorts of non-performance penalties that are felt appropriate to other public services. Those of most immediate relevance are the ones being developed in the local government sector under Best Value and in the Civil Service in relation to Public Service agreements. Whilst doing so falls outside the scope of this submission the Sub-committee may find it useful to request a comparative evaluation of the types of penalties which are applied in the private and public sectors for services which are of a similar nature.


  8.1  Clauses 27 and 28 of the draft Bill provide powers for the Secretary of State and the Director General to have regard to the interests of specified and unspecified groups and to social and environmental objectives in regulating the industry. This is clearly a matter of public policy and not one, therefore we would wish to comment on as such, although others may wish to comment on the appropriateness of using the regulation of private companies to achieve public goals outside of the functions of those companies.

  8.2  However, the Sub-committee will be aware that, as regards social objectives, powers already exist under Parts 4 and 5 of the Water Industry Act 1999 to provide some measure of protection (in the form of affordability) to the socially excluded as defined under that Act. 18 months after the passage of that Act the Sub-committee might find it relevant to inquire as to the use to which those powers have been put and the need for powers additional to them which one must now assume to be felt necessary.

  8.3  As regards Part 4 of the 1999 Act, there are existing powers to introduce social tariffs for specified groups of consumers who are charged for water on a non-metered basis. This power provides an opportunity to achieve water affordability for all such consumers irrespective of ability to pay. Although no substantive guidance has been given to companies by either the Secretary of State or the Director General of the form implementation may take a number of companies have brought forward proposals for such a social tariff as part of their annual tariff reviews. All such proposals have been rejected by the Director General on the grounds of undue discrimination and/or cost non-reflectivity. One might therefore question why the power was introduced in the first place if the Secretary of State and the Director General clearly do not intend to take a lead in implementing it and if water companies who wish to take a lead are prevented from so doing. One might then question the need for powers additional to this existing one which has not been used, unless it is the result of the unlikely event of the existing power having been mis-drafted in the 1999 Act or of the equally unlikely even of the Director General having frustrated its implementation for reasons other than the discharge of his statutory duties.

  8.4  As regards Part 5 of the 1999 Act, there are existing powers to introduce social tariffs for specified groups of consumers who are charged for water on a metered basis. Unlike the power under Part 4 of the 1999 Act, this power has been implemented, although it is our view that this fact might be under-appreciated either in general or by those groups at whom protection was targeted under it. The Sub-committee may therefore wish to inquire into the success or otherwise of the implementation of this section of the 1999 Act, into what powers its operation has shown are additionally needed, and how likely it is therefore that the new powers sought under the draft Bill will be either used or effectively implemented.

January 2001

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