Examination of Witnesses (Questions 80-99)
MR PHILIP FLETCHER, MR CALLUM MCCARTHY AND MR DAVID EDMONDS
WEDNESDAY 8 MAY 2002
80. Mr McCarthy, in terms of rates of return, obviously rates of return are expected by the market place, they take a benchmark in terms of long-term interest rates, and I wonder whether the rates of return implicit in your RPIX calculations are in danger of becoming obsolete in the time span of the RPIX setting period. Is that a problem?
(Mr McCarthy) It has not been a problem and we do not think it will be a problem. That is the short answer.
Geraint Davies: It is good it is short because I have run out of time.
81. Mr Fletcher, you have established a system of comparative regulation that has led you to argue against the mergers of Severn Trent and Wessex and South Water and Wessex unless some tariff reductions were achieved to offset the damage to your ability to compare the companies. By contrast, Mr McCarthy has happily permitted the rationalisation of his industry from 14 original owners to about nine. You have 23 companies by contrast in the water industry. Why has Mr McCarthy got it wrong and why have you got it right?
(Mr Fletcher) We are regulating different sectors. The number of companies has reduced from 39 to 23 plus one new entrant, 24, over the period since privatisation. The particular point is mergers between existing water companies and water and sewerage companies within England and Wales, and there both I and my predecessor have taken the view that the comparative regime, which gives us the ability to regulate by reference not to what we may think but to what the best companies in the sector are actually achieving, is an important strong point of regulation to the benefit of customers, and therefore to lose comparators is either something which should not happen or it should entail a price in terms of reduction of the price limits. What is right in a particular circumstance is not a question for me, it is a question for the Competition Commission because the Competition Commission will get a mandatory reference of any such merger proposal which may emerge. As you may have noticed in your newspapers today, Vivendi is proposing to acquire Southern Water and that would require, as I see it, a mandatory reference to the Competition Commission on the issues involved in that, because Vivendi already owns water-only companies, not waste water companies, in England and Wales.
82. But OFGEM has already clearly found a way to regulate utility monopolies without the comparative regime that you have, and they have achieved greater reductions in operating costs than you have managed to achieve in the water industry.
(Mr Fletcher) I think it is very difficult to make a comparison and say that one is "doing better than the other" given the very great differences between the sectors.
83. I was not saying that, I was pointing out there are alternative ways of viewing the industry and I was seeking to get you to justify your end.
(Mr Fletcher) The only point at issue is, should the regulator when a case goes before the Competition Commission lose interest in the comparators, in the benefits of the comparators for the customer, in terms of the gains that in a non-competitive industry, as water and sewerage basically is, need to be spurred on through economic regulation. I believe there will be a loss there. With water and sewerage companies there are only ten to start with, and to lose water and sewerage companies does run the risk of losing the leading edge ones, the ones which give me the confidence you can, if you like, push the companies on without pushing them to the point of failure which clearly is the art of regulation.
(Mr McCarthy) Could I add one point.
84. Perhaps I can give you the opportunity and then we will be more focused, Mr McCarthy. Could you perhaps say where you differ from Mr Fletcher's analysis and why you do not believe that a comparative regulatory framework is necessary in your industry?
(Mr McCarthy) I was just about, at the risk of volunteering an answer before it was asked for which is a great mistake clearly, to say we have recently published final proposals which were based on some proposals which we brought forward last year which are deliberately designed to recognise that there is a value in having a number of comparators in electricity distribution. It is a very interesting balance because it clearly is not in our interest, if there are genuine efficiencies coming from combining two companies which will be passed through to the customer, that we should do anything to stop that. Against that, it is undoubtedly easier, for reasons to which Philip was alluding, to do the price control of a number of distribution companies rather than to do the price control of NGC because it is possible to establish efficiency frontiers to get at least anecdotal information to do a `compare and contrast' exercise. Because of that we have proposed in future that if there is a combination between two companies that should be `taxed', if I can use that expression rather loosely, at a rate of £32 million per merger. We think that is something which will be a reduction in the allowable revenues of companies and will therefore pass through to the customers. We are therefore recognising after a degree of soul searching about the balance I described, that there is a valuable comparand, and we do not want to lose that. We do not want to say all mergers should stop because there are real economies that can come from them.
85. Thank you for that. I think that is helpful. You are taking me down a track I was not intending to go but let me just pursue it for a little way. First of all, I take it that the £32 million that you have identified is a tax, to use your own word, is greater than the economies of scale that would come through the merger, that is if you are using the same framework I believe Mr Fletcher uses. Is that correct?
(Mr McCarthy) The £32 million, which is based on a series of rather heroic assumptions, is based on a view of the cost to regulation and therefore the cost to the eventual consumer of having one fewer comperand companies and that is the basis on which we have attempted to calculate that.
86. I think I understand that. What I am trying to get at is that certainly within the water industry model, as I understand it, the tax that is put on is deliberately designed to be in excess of any economies of scale that would be achieved by the merger of the two companies.
(Mr McCarthy) In the electricity distribution companies, which is the area for which we have come forward to these proposals, we are not making a judgment on that. What we will do at the time of the next price review is look at the efficiency of the merged company and if it has made very significant savings we will seek to capture either all or part of those for the benefit of consumers by setting new price controls.
87. Okay, so your £32 million is straight in that it will apply irrespective of economies of scale and any economies of scale you indentify you would seek to capture through regulation for the consumer?
(Mr McCarthy) Yes.
88. Thank you. Given that you have now presented us with such an eloquent exposition of Mr Fletcher's theory, the next question I have to ask you is why are you such a late convert and do you feel that you have already allowed mergers to pass as water under the bridge where you have not captured that for the consumer or indeed levied the relevant tax that you should have against those companies?
(Mr McCarthy) The reason why we have taken some time to come to this decision is because of the judgment on the balance that I started by describing. We have not allowed companies which have merged simply to pocket for the shareholders the benefit of the economies of scale. We have picked those up at the time of the price review and, indeed, before this rather moreI am trying to avoid the expression "sophisticated".
(Mr McCarthy)Rather more thoughtful policy we took a rather simpler view of saying we thought there would be a saving of around £25 million and we would take half of it back. We had a rather rough rule of thumb before and we have, we believe, a rather more thoughtful approach now.
90. Thank you for that. It is an excursion from where I was heading but I hope a helpful one. Mr Fletcher, do you believe that investors are more wary of the water industry than of other utilities?
(Mr Fletcher) I doubt if the thing can be expressed totally on that basis. Can I perhaps lead with my chin and say I am very conscious that for a period before the last review and persisting until now share prices have been running at a discount to the regulatory capital value of the companies, which is one indicator of investor wariness in relation to a sector. One authority in this field suggests that share prices should be running equivalent to regulatory capital value or at a small premiumbecause if it is an excessive premium the regulator has allowed too generous in prices. It is a common feature of regulatory systems that at the time of a new price limit in the period leading up to it before you know the price limit and in the period after there seems such a dip. It is not surprising and there is nothing wrong with seeing such a discount. If it persisted for a very long time that will be a indicator and it is clearly something I will have to reflect very carefully about or the new OFWAT board will need to reflect very carefully about if the Government has managed to have a Water Act enacted by then in advance of the next periodic review.
91. Thank you. You talked about the regulatory capital value of the company. Could you perhaps tell the Committee what the difference is in the way in which a water utility company has its value assessed to the way in which you would normally value any other company in the FTSE, because this is a substantial difference?
(Mr Fletcher) It starts with the assessment at the time of privatisation of an average of the market value for the water and sewerage companies for the first 200 days they were listed and then that initial value has been rolled forward every year subsequently to take account of the changes in the sector. As part of the drive to make clearer our regulatory stance and as part of the transparency we are aiming for, I published prospective forward looking, regulatory capital values which hitherto we have treated as commercially sensitive information which we should not publish. We have secured the agreement of the sector that we should and that has helped to give clarity to the markets and the City about how to value the water companies.
92. Unfortunately I do not have time to press this as much as I would like. Perhaps you could provide the Committee with a fuller note about the valuation of the industry. I do want to press on to my last question and that is in Section 3.9 it talks of the "underlying resilience" of the networks. This means that it could take some time for inadequate or inefficient expenditure on maintaining and enhancing the networks to be reflected in declining quality of outputs. Does this mean it is inevitable there will be an investment cycle which shows tail off as declining quality and outputs become more manifest? If I might just tag on at the end of that question, which I know is a long one, what are you doing about it, if so?
94. Thank you very much. Can I ask one or two questions to wrap things up. Mr McCarthy, you referred to this investment incentives project which is designed to improve incentives for quality. When will this project be up and running?
(Mr McCarthy) It is up and running. We published our final proposals in December last year, and I am glad to say that all the companies accepted them in January of this year. It will have the effect of putting at risk up to 2 per cent of the revenue of the companies, that is around £4 million as an average, against their attaining particular standards on quality which are basically standards in terms of interruptions in total and interruptions per customer.
95. Mr Edmonds, you referred to the review of cost of capital. When will this be complete and what difference might it make?
(Mr Edmonds) It is an exercise which started in effect last month. The aim is to complete it during the course of this year. What I hope it will show is that the fundamental model is sound, but it will enable us to look at any differences, and the NAO Report pointed to some of the differences, so that clearly is an input into the study. If, at the end of the study, there are still differences we will I think be better able to justify them and rationalise them than perhaps we are at the moment.
96. Mr Fletcher, you said it was too early to tell whether the cost of capital was set too low in water. When will you know?
(Mr Fletcher) I am confident that the companies are going to go on being able to finance their functions through to the next review, so there is no question or need for any sort of interim price review which would be very bad for regulatory uncertainty. We shall look at all the issues afresh. Of course, we are part of the study to which David has referred, we are doing studies of our own about the optimum capital structure for the water industry which will also be completed during the course of this year, in good time to be taken fully into account by ourselves and the companies leading up to the review.
97. An interesting point has come up during this afternoon, and I am delighted David Rendel has come back because he particularly asked about it. This is what drives the public mad. Can you tell us more about what you are doingand perhaps you can each answer thisto do more joined-up work to ensure you share holes in the ground? It may seem a minor issue to you but it is important as far as the public is concerned. Also, what more joined-up work are you doing together to streamline your review processes so that you can reduce the cost of regulation on the companies? While you are answering that point, and this is a general wrap-up answer at the end of the session, there is a recommendation on page 9, number II, that you give clearer guidance on what regulated companies are expected to deliver. Can you take this forward? Those are the three questions, perhaps you can each answer them.
(Mr Edmonds) Can I reverse the order. On the recommendation, yes, of course, we accept the Report. We have looked at it in some considerable detail, and that is a recommendation we want to take forward. On joined-up working between the three of us and some of the other regulators and streamlining the review process: clearly there is a recommendation flowing from this, and my thought is that we would discuss it at the next meeting of the three of us and our colleagues. Clearly, where there are lessons to be learnt we ought to learn them. Your first question is much more difficult. In many areas we already encourage joint use of infrastructure. In the mobile industry I encourage it; use of masts in rural areas, it is there, it is a sector that I have a responsibility for. Cross-sectoral working, where people are doing things at different times, where there is a capital investment programme, where there are upgrade programmes, where the need to renew may not coincide, I think that is much more difficult and I am not sure it is the regulators' job to do it. However, given the pressure we have all clearly come under today, it is something I will take away with my colleagues and consider further.
(Mr McCarthy) Could I also answer the questions in the same order. In terms of quality, a great deal of the things we are doing move the whole concept of RPIX to something much closer to a contract between the amount which is allowed to a company in terms of revenue and what they undertake to deliver in terms of investment, in some instances where that investment will come and when it will come, and also in terms of quality of supply. We have set for the distribution companies, which are subject to part of the Report, tighter requirements in terms of customer minutes lost, in terms of loss per hundred customers. We have also set new requirements in terms of multiple interruptions for those customers where, even though the overall standards get better, you might find a small group of customers who are suffering particularly, and we are dealing with that. In terms of the joined-up working between the regulators, I think there are two sorts of things we look at. One is in terms of what I would call our bread and butter affairs, how we actually run our offices as efficiently as possible, questions of recruitment and retention of staff, things like that. Then there are a whole series of other things. We are doing work on the best practice in service delivery, we are doing work on price controls in terms of the capital asset pricing model, we are doing work on how you judge whether that has been an adequate transition from a regulated sector to a competitive market which, as you know from your comments on the NAO Report on competition in the energy markets, is a difficult set of subjects. We are doing work on regulatory accounts, how to disseminate comparative price information, and a piece of work on how we should each approach our social responsibilities. So there are a number of things like that which are outward looking pieces of joint work, and no doubt we will identify from time to time other pieces. On the question of the inconvenience to road users and the common use of a single hole in the road, I confess the only thing that we have done which brings us close to that is that it is particularly a problem in relation to the activities of Transco, and particularly in relation to their local distribution service. When we set the price control there we set particularly stringent requirements as to the allowable cost of the extensive digging up of roads involved in terms of the replacement of mains required to meet a Health and Safety Executive requirement. That is the most direct piece of work we have done on that.
(Mr Fletcher) I share all that my colleagues have said, to keep my answer short. For clarity on what the companies will deliver, I believe that we have been progressing steadily in understanding this since privatisation. We need to go on building on it. I have referred in earlier answers to the way the capital programme is constructed so the companies know what they need to deliver. In terms of efficiency gains I look to them to deliver the gains. I try not to specify too closely to them just how they should do it because they are better able to do it than I am. On joined up thinking, I take one lesson from Callum McCarthy in that the Gas and Electricity Authority as a regulatory board does seem to meet some of the problems there alway are about the personalisation of the regulator. I am very glad that the Government has agreed to a recommendation that the OFWAT Board should be constructed on the gas and electricity model. Callum and I are advised by common City advisers. That also helps to ensure we are doing things in relation to the City on a common understanding. Streamlining the process: again, we are looking to learn the lessons. We reviewed the last review and consulted all the stakeholders involved, the customers, companies and others. We believe there are lessons there in terms of streamlining the process. We are trying to set them in place for the coming review.
98. And holes in the ground?
(Mr Fletcher) I have been reflecting on Mr Rendel's questions and I still hold the fact we should not be trying to push them into a particular thing. It is about the whole history of the common trench. If I am being reluctant it is because my history in the Department of the Environment (and the Ministry of Works before it) goes back to the virtues of the common trench which have been so hard to put into practice because of the different requirements of the various companies, the various statutory undertakers and the fact that, for example, you must not get water into gas pipes as both Callum and I know.
99. Or a shock on the toilet!
(Mr Fletcher) There are all sorts of things that can quite seriously go wrong. It really is a very nasty event if water gets into the gas pipes and it has happened occasionally. We need to go on working on this. I do not want to pass the buck at all but this is also an issue for government and local government and for the companies themselves as they reflect on how they can make themselves more efficient and thus gain the extra points over our regulatory targets.
Chairman: Thank you, gentlemen. You are obviously a very impressive triumvirate. We are grateful for your evidence today. Thank you for what you have done to maintain investment and reduce prices. We look forward to further progress on dealing with the common trench. Thank you very much.
1 Ev 18-19, Appendix 1.
(Mr Fletcher) We look at the way in which the networks are performing. It goes back to the initial questions from the Chairman. What we are seeing is that the serviceability of those networks is broadly stable or improving, as one would hope it would be, both on the water side and on the sewerage side. That does not mean we are complacent about it. That is why we are launching a further consultation today as part of the preparations towards the next periodic review to ensure with the companies, on the basis of studies we have been carrying out with the companies and with the quality regulators, that the infrastructure is going to go on being well maintained and provide the service that is required of it, broadly an enhancing service rather than a deteriorating one.
93. But you disagreed with the companies' assessments of this infrastructure.
(Mr Fletcher) The nature of the process, of course, is that the companies would like the regulator to allow them larger capital programmes to grow the companies. If the regulator, my predecessor, had allowed the companies' figures in for the last two periodic reviews, we would be seeing vastly higher bills than we are. The 12.3 per cent cut which was made in 1999 would not have been possible but, although that is part of the regulatory judgment, it is tremendously important that this network, series of networks, should continue to deliver the essential service, and that is what I am trying to work towards with the companies. It is their job to manage the infrastructure properly, it is mine to challenge and spur them on to try and do it well.