Examination of Witnesses (Questions 1-19)
WEDNESDAY 11 JUNE
2003
MR PHILIP
FLETCHER AND
MR ROGER
DUNSHEA
Q1 Chairman: Mr Fletcher and Mr Dunshea,
welcome to the Committee. I think I am right in saying that you
are the only regulator which falls within the Defra parish.
Mr Fletcher: If the Environment
Agency were here, we would have Baroness Young jumping up and
down saying, "I am a regulator too."
Q2 Chairman: Yes, she is right.
Mr Fletcher: I am the only economic
regulator.
Q3 Chairman: That is what I meant
by that because the Environment Agency is so many other disparate
things as well. We are grateful to you for coming and I hope,
Mr Fletcher, you are getting better from your brush with the doctor.
Mr Fletcher: Thank you. I have
the effect of a permanent wink; this is not intended to indicate
anything other than, at the moment, it has taken a bit of a battering.
Q4 Chairman: Can I begin with a compliment
which is, leaving aside whether we think the coverage and all
that is adequate, in terms of the sheer simplicity of prose and
style, this is the best report I have read for quite a long time.
It does actually say things in good, simple English and we are
profoundly grateful for that. As we will be doing the Defra annual
report quite soon, there will be an interesting contrast or comparison—we
must not prejudge it—to be made. What struck me on reading
this and not really having had a great deal of contact with the
sector previously was just how enormous your powers actually are.
I think to myself, why on earth would I want to be a managing
director of a water company when I can barely get out of bed without
getting the permission of Ofwat? Why would I want to buy shares
in the company when almost all its actions appear to be determined
by formula defined by Ofwat and when, if I am a British owner,
I have to decide whether I am a fit and proper person yet it appears
that French utilities can walk into the field at any stage without
any sort of similar scrutiny? Also, we are going to move into
common carriage, so we are going to have different people's water,
as it were, coming down the same pipes. Really, this is an extremely
powerful organisation. Being a former Financial Times journalist,
I noted that the Severn Trent results were out in the paper today
and Severn Trent was warning of the danger of water companies
depending more and more on debt and less and less on equity and
saying that the regulatory system is pushing them towards that
configuration. So, may I begin by asking you, what structure of
industry in Britain, in terms of corporate structure, is actually
a prerequisite for having the sort of competition in the industry
which presumably you were set up to ensure?
Mr Fletcher: When this industry
was privatised, certainly the indications in the founding statues—which
I think you would find any regulator would say and certainly I
would say is absolutely key to my job, I am a public servant,
I work within a context of statute—there was very little
thought in the then Government's mind about competition. Yes,
I have a duty to facilitate competition which is rather different
from that of some of my other regulator colleagues, but it is
noticeable that the Water Industry Act 1991 is rather less clear-cut
about how competition is to work in this sector than the parallel
legislation is in other sectors and it is also noticeable that
the Competition Act 1998 which does apply to water and the Water
Industry Act do not altogether fit neatly together. It is one
of the reasons why I welcome the fact that the Government is having
another go at a competition regime for water in the Water Bill
currently in front of the other House. As for my powers and the
structure of the industry and issues like that, I could bore you
forever but you will cut me off! First of all, yes, I accept,
which is one reason why I very much welcome being called—I
hope that is not too crawly—before the Committee this afternoon
to demonstrate not least that I am accountable to Parliament even
though independent of ministers and, secondly, it is never my
job to manage the industry. I was called this morning before the
Constitution Committee of the other House who are examining the
accountability of regulators and had occasion to mention this
hearing this afternoon, which I see as part of that accountability,
but I was seeking to explain to them that I see my job as challenging
not managing. It has to be through incentive-based regulation
to encourage this sector steadily to move forward and that is
the whole way in which Ofwat, almost from the word go, has sought
to do its job. If you had a company here in front of you, of course
it would have various grumbles and complaints, but I hope it would
see that that was the context.
Q5 Chairman: I think if I had a company
before me and they had used the phrase "incentive-based regulation",
I would ask them to go back to the simple English of their report
and tell me what they were talking about and I am going to do
exactly the same to you. My first question, which you have not,
with respect, answered, was, given your responsibilities and the
fact that you mentioned in the report that you have to decide
whether people are fit and proper and you have to make recommendations
or give advice to the competition authorities when mergers come
up and that becomes more formalised under the Water Bill as I
understand it, you must have a view as to what structures are
necessary to deliver a proper competitive sector and therefore
there must be a point at which you become wary as to the degrees
of consolidation which may take place in the industry. Would you
like to give us an idea as to what sort of geometry you think
is acceptable in the industry and what would take it beyond what
you would regard as being acceptable?
Mr Fletcher: Could I take that
in two parts?
Q6 Chairman: You can take it in as
many parts as you like, Mr Fletcher.
Mr Fletcher: Two points to start
with. Debt to start with. As you know, the industry was privatised
initially without any debt. That was partly in recognition of
the fact that it was going to have a large capital programme to
carry out for a very considerable future. That expectation has
been more than fully delivered and the companies' balance sheets
have had to change accordingly and are now much more reliant on
debt than they were. However, we do have concerns about excessive
reliance on debt and this is where this `challenge not manage'
part does become quite difficult. The most extreme example of
a company debt financed is actually not in England, it is in Wales,
Welsh Water, owned by Glas Cymru, a company limited by guarantee,
has no conventional equity at all. When that company was set up
on the demise of Hyder, the issue came before me then as a very
new regulator as to whether this was a fit structure to go forward
and there was a very vigorous debate involving both the UK Government,
Defra, and the Welsh Assembly Government and me with the decision
in the end effectively being mine—I think the company could
have tried to push it through against my opposition but it would
have been difficult—and I accept that it was not my job
to say, "This is precisely the structure any company in this
sector should have", but I did seek to ensure through various
protective measures for customers in the licence that the potential
deficiencies which we had foreseen in that structure were offset
as far as possible and, to give examples, we asked the company
to ensure that the remuneration of its top management had in it
incentives to perform since there was no possibility of a shareholder
coming along and pushing them, we published best-practice criteria
and we ensured that the rights proposed for bond holders did not
impede my duties under the Water Industry Act. So, various protective
mechanisms were put in place but, having said that, this was the
structure which was being proposed to me and I did not see enough
reason to try and block it altogether. The debate has continued
around debt; there are other companies now that are highly geared
including, for example, Anglian Water under AWG's ownership, is
very highly geared, and there is an issue long term about how
brittle such a structure may prove to be. I shall be seeking to
ensure that I do not force companies into a particular highly-geared
structure and therefore, in setting the weighted average cost
of capital, I shall be looking to achieve, as my predecessor did,
an appropriate balance between the cost of raising equity and
the cost of debt.
Q7 Chairman: I want to come back
to corporate structures, which I think is going to be the second
part of your answer, but am I right in saying—and I am looking
at the words on page 21 in this regard—that your main concern
about undue reliance on debt would be that, if a company were
to become then vulnerable to significant increases in interest
rate for example, the danger would be of finding someone in financial
difficulties and therefore unable to discharge its responsibility
to deliver water to consumers? Is that the heart of the problem
rather than a sort of lex type of interest, as it were, in the
internal dynamics of the structure of the company?
Mr Fletcher: Yes. Equity, as you
know, provides always a cushion against the normal ups and downs
of business life, including the activities of the regulator. If
the company succeeds in making a good profit, the shareholders
benefit. If they do not, it is the shareholders who suffer first.
That equity cushion seems to me extremely valuable in any sector
and fellow regulators, Ofgem for example, have commented in the
same way for theirs. Having said that, if, at a particular moment,
as long as this is not merely a passing market whim, when we are
talking about a very long-term industry as this clearly is, it
is right, in my view, that companies should be able to take advantage
of a market situation as it is to keep its cost of capital down.
It is part of the whole business of incentive, encouraging them
to meet and beat regulatory targets in order that they go on making
a profit but they go on staying in business and I can, or my successors
can, collar that gain, that efficiency gain, for the benefit of
customers at a later stage in the process.
Q8 Chairman: In terms of mergers
and acquisitions of the consolidation of the industry, we have
seen two tendencies, have we not? We have seen the acquisition
of water companies by some overseas utilities and we have also
seen a tendency to integrate vertically across the utilities in
order that people deliver different sorts of utility through the
same corporate structures. Given that you have a word in this
and given that the new Water Bill is going to crystallise that
responsibility rather more, is there a limit to this? Would it
be acceptable to have the entire British water industry owned
by Vivendi or a French company or an American company? I am just
interested to know where your responsibilities stop and start
and whether you have a view as to what is acceptable in terms
of this corporate activity.
Mr Fletcher: Could I take the
overseas ownership first and then the merger consolidation issue.
First of all, as you know, overseas ownership is not new in this
sector. The French in particular, Suez and Vivendi and the Saur
Group were buying up what were the statutory water companies,
now the water only companies, before 1989, before privatisation.
So, their interest in the sector goes back a very long way. We
do now see a wider interest. We have a Malaysian company owning
Wessex Water who bought it from a failed American company, indirectly
Enron. We have a Spanish owner of Cambridge Water; we have RWE
which owns Thames and so on. There is a very significant overseas
holding in our water sector. In my view, it is not certainly for
the water regulator to take a view on where a company's head office
may happen to be as an indicator of whether that particular company
is a fit and proper owner. Apart from anything else, that is something
that can readily be circumvented simply by where you choose to
locate your head office. The issue of national champions I think
is properly one for Government and this Government have said very
clearly, Patricia Hewitt for example, that they do not consider
it appropriate to achieve national champions by intervening in
the normal market process to create such an entity. What I am
interested in is efficiency and this is where the mergers issue
comes in. In 1989, we had 39 water companies; it is now down to
22 with one tiny one in darkest Wiltshire. So, there has been
a certain amount of consolidation, but it is true that we still
have ten sewerage companies as we had in 1989. There is in statute
a unique provision for the water sector which requires a reference
to the Competition Commission for any merger between companies
that already own a water company where they are proposing to acquire
another one and this is entirely without reference to ownership.
The last such mandatory reference was of Vivendi, now Veolia,
in their attempted acquisition of Southern Water, so it is without
regard to headquarters. The reason it is there—and it is
repeated in last year's Enterprise Act in a slightly different
form—is to safeguard the comparative regime which I operate
and that regime I regard as one of the main protections for customers
in water. It is not to say that mergers shall not happen—there
may well, in particular cases, be good reasons why a merger should—but
it is to say in this sector, "I enjoy the huge benefit that
I am not just constantly crossing swords with one big company."
I am able to say from my dirty concrete tower in Birmingham, "I
am regulating you not by my guess on what you can achieve and
not by my substituting my management judgment for yours but because,
Company X, I can already say that Company Y is doing better than
you because I measure it very closely, and I am asking you simply
to catch up with Company Y" and that is the way in which
the English and Welsh sector has been cheered on, driven, whipped
but encouraged by a combination of shareholder pressure, customer
interest and regulatory pressure to perform, let us say very obviously,
better than the publically owned sector in Scotland where my opposite
number has to say to the customers of Scottish Water, "I
am sorry, your bills are 60% higher than they would be in England
and Wales because this entity, Scottish Water, is not as efficient."
Q9 Chairman: May I finally—and
we are going to come back to these, as you can imagine—ask
one little final beginner. I notice on page 27 some magic words
when you are talking about the Water Bill and your new responsibility
and one of your key duties is going to be to deal with ".
. . customers whose premises are ineligible for supply by a licensed
water supplier." I think I have the constituency with the
largest number of private water sources in the country and I am
bombarded constantly by complaints that the Health and Safety
people are telling them that they need to improve the quality
of the water and nobody has the means—it is a tiny sort
of local co-operative—to fund these. Do you have anything
to say that will cheer them up?
Mr Fletcher: It is perhaps some
cheer that this is not really new. There has always been this
concern both about customers who are not on the main sewerage
networkand who have a private supply of water and it is only members
for constituencies such as yours who are aware of this; it is
not generally known that there are still many customers who have
their own little water supply. The cheer that I think I can give
them is a rather mixed picture. The way in which I would approach
the issue is in terms of John Stuart Mill, "The greatest
happiness to the greatest number". In some cases, the sheer
cost of putting customers on mains water may mean that it continues
to be something that just is not worthwhile. The local authorities
of course still regulate the quality of the private sector water
supplies, so there should not be a threat to public health coming
through. Nonetheless, both in this area and in the area of first-time
sewage, there are tensions and I am afraid that those may continue
for a while yet.
Q10 Mr Wiggin: Why is the description
of Ofwat's performance in the Annual Report not linked back to
the explanation of how it will achieve its vision and mission?
What was the value of the vision and mission statement?
Mr Fletcher: The vision and mission
statement is not there just because this is good corporate speak,
it is an attempt to say, "This, in a nutshell, is how we
see ourselves interpreting our statutory duties". You asked
a very reasonable question about performance indicators and I
would like to tackle that in some depth, but just to draw attention
to the fact that our vision, going back to the Chairman's question,
is not of a brilliant regulator. Our vision is of a brilliant
water industry which has been encouraged to get there partly by
our action but also by the action of a whole number of other forces
and organisations and our mission is to try and encourage that
result to happen and then we go onto the individual elements.
Performance indicators. I believe you have been supplied with
our forward programme, which in a sense complements the Annual
Report—the forward programme clearly enough looking forward
and then the Annual Report is in part an attempt to report on
last year's forward programme and whether we have hit what we
said we would do or not. In the forward programme and a matching
for the previous year entry in the Annual Report, there is a list
of outputs which you will find and I am looking at the forward
programme on page 8. The trouble with that list, as I will point
out before you very reasonably do, is that it is basically outputs;
it is not about outcomes. It is the outcomes in which I am really
interested and which I do find quite difficult to set down in
a form which would command universal assent and clarity, partly
because the outcomes cannot simply be dictated by Ofwat and I
have already probably boringly made it clear that I am one of
several, and partly because where I would want to get to, for
example, with my biggest immediate task, which is the periodic
review that will take effect in April 2005, I would want the outcome
to that to be bills that are as high as they need to be—my
primary statutory duty to enable the companies, if they are efficient,
to finance their functions—and yet no more than they have
to be—because these are customers who are effectively prisoners
of monopoly businesses—and the assessment of whether I have
achieved that or not will depend on a whole host of things. There
will be, maybe, appeals to the Competition Commission and whether
the Competition Commission endorses the outcome at which I arrive
will, in my view, be a very important test of whether Ofwat has
it right or not, and then there is a whole list of things and
the way we try and do things to be transparent which, amongst
other things, I think this Committee is properly the judge of.
Q11 Mr Wiggin: What comparisons have
you made between the service received by water customers in England
and Wales and by customers in other countries and therefore how
do you decide whether your service is world class?
Mr Fletcher: My new board in a
private discussion, so this is the first time I have revealed
this, said to me, "Come on, everybody says `world class'.
Put something down and make us believe you mean it", which
I thought was a very reasonable challenge. The answer is that
it is desperately difficult to demonstrate the world class part
but we can very clearly say that the customers of the companies
in England and Wales are much better off than their equivalents
in Scotland because we provide comparative information which enables
my opposite number in Scotland to do exactly the same comparative
job as we do of these 22 and he has found that Scottish Water
is a long way behind on efficiency. Northern Ireland is a special
case because effectively the taxpayer is very highly subsidising
the service received there, but we provide a benchmarking service
for Northern Ireland and it is quite clear that the water service
in Northern Ireland is a long way behind England and Wales in
terms of meeting the European requirements and so forth. We do
try to build up our intentional comparisons and we publish an
annual report on this, but we find it very difficult to replicate
the hydrological, constitutional, cultural and all sorts of issues.
So, our best comparisons have tended to come from Australia and,
to a much lesser extent, the Netherlands and yet they are not,
in our terms, true comparators. The comparisons are not close
enough to enable us to draw really hard and fast conclusions.
Q12 Mr Wiggin: What are you going
to do about that?
Mr Fletcher: We are going to go
on working with any regulators and companies of goodwill around
the world to try and ensure that our comparisons build up because
the merger regime, such that I referred to earlier, could be relaxed
considerably if we were really convinced that we had firm comparators,
hard-edged comparators, that we could rely on across the world.
If you look across the channel, just to take France as one example,
you see a totally different picture of assets still owned by public
bodies, local authority equivalents usually, of sometimes tiny
and sometimes quite big scale but serviced by three giant companies:
Veolia now/ex-Vivendi, Ondio/ex-Suez and, to a much lesser extent,
Saur Bouygues. So, it is an out-sourced business that has taken
on a completely different flavour from what we do here which makes
direct analogy quite difficult.
Q13 Paddy Tipping: You are good at
comparing the effective methods of different water and sewerage
companies but I wonder how you compare yourself against other
regulatory bodies. What measures are you taking to make sure that
you yourself/your office is performing?
Mr Fletcher: First of all, there
is no one in the world who exactly, either in person or in organisation,
fulfils just the role that Ofwat does here because of the unique
way in which the water sector was privatised in England and Wales.
So, although I have links with other regulators, they are not
all that strong, simply because of the different tasks that we
have. Within this country, we are all regulated by the Treasury
in terms of what we actually spend and what we, through the companies,
charge the customers and, each year, our budgets are properly
scrutinised by the Treasury. All staff in Ofwat except me are
civil servants and therefore subject to all the normal rules and
checks there. At the moment, I have a large number of appointments
in my gift but that will stop—and it is right that it should
stop—when the Water Bill is passed. They are not hugely
well remunerated and, for many of them, there are no salaries
at all—the members of the WaterVoice Committees—but
all of those I make are carried out according to Nolan
principles and are properly regulated accordingly. So, if you
like, in the low-level area—and I am subject to audit by
the National Audit Office and examined by the PAC—I believe
reasonable comparisons are made. There was a comparative study
which Treasury initiated carried out by WS Atkins which looked
at the main sectoral economic regulators two or three years back
that made that sort of comparison. What is very difficult is back
to quality again. It is how well we actually carry through the
task. There we have been trying to take the issues further forward
by initiating an independent survey—we paid for it but it
was carried out by an entirely independent company—conducting
telephone interviews with around 70 key people from all sorts
of walks of life: companies, WaterVoice Committees, the customer
representative body, journalists, members of parliament and others.
The outcome of that review, as we had hoped, gave us first of
all reasonable confidence that we are doing the job as people
expect us to do it. We are seen as professional. We are respected
for the way in which we do the job. We are seen, I think above
all, as actually working to get better at it. It also helped us
in that it signalled things that we need to get still better at.
We say that we are transparent. Well, effectively the message
back from the survey was, "Yes, all right, but you can do
better than that" and that is a challenge that I welcome
and that I think we will look to respond to.
Q14 Paddy Tipping: In your Annual
Report at the beginning of chapter 8 on resources, it says, "We
manage our resources prudently, working to deliver increasing
outputs effectively." How do we know that that is true? Do
you have a discussion with the Treasury once a year and they just
cast an eye over it? How do you justify this?
Mr Fletcher: There is a very broad
brush way of doing it, apart from the fact that you can say with
some confidence that the National Audit Office is there both to
do the standard financial audit and the value for money audit
as well which led, for example, last year to a report comparing
the work of Oftel, Ofgem and Ofwat in the area where we have most
in common, the regulation of distribution systems which are more
or less inherent monopolies and I am glad to say that the NAO
and then the PAC, while picking up things we could do better,
said that broadly all three are doing a good workmanlike job in
this area. In fact, nationally, this is a success story. The sorts
of issues they then had to look at is, if our expenditure is creeping
up? We have held our call on the customers absolutely level in
cash terms for about four years. This year, it goes up by around
£0.5 million from £11.9 to £12.6 million and our
budget is slightly higher still because we are spending the savings
made in previous years, with Parliament's permission of course.
I think it is very reasonable for customers, for this Committee
and for anybody else to look at that graph and ask, "What
is going on?" What is going on partly is that Parliament
has given us more to do. The competition regime launched by the
Competition Act 1998 took effect in early 2000 and is starting
to have more of an impact. Our legal department has had to double
in the last couple of years; it is tiny but effectively we are
up from two to four with ancillary costs attached.
Q15 Paddy Tipping: A 100% increase.
Mr Fletcher: Exactly so, and our
competition team, which is rather larger, has also increased by
at least two-thirds of the scale. So, that is about saying that
a new job must be done properly in a more litigious climate because
we are starting to get cases, which is entirely proper, appearing
in front of the Competition Appeals Tribunal and, for a small
organisation, six figure sums disappearing as they do in response
to a complaint/appeal are something that we have to allow for
in our budgets. If this turned into an annual occasion in front
of the Environment Committee, as I would rather hope it might,
then I would expect to be asked proper questions about that every
year and if we do not manage to bring it down again after the
next review, once this peak of work leading up to April 2005 is
complete, I would really expect, if I am still around, to have
some fairly severe testing in front of this Committee.
Q16 Paddy Tipping: Let me just ask
you about performance targets that you set yourself because, reading
the annual report, there are a set of timetables that you have
set and, in the forward plan that you are going to meet, there
is mention that you are going to reply to people's letters in
certain times, but the one that caught my eye was in your introduction,
Mr Fletcher, where you say, "In 2002-03 our cost to customers
remained at under 50p per connected property; as it will be 2003-04
. . ." Is that a benchmark with which you are going to continue?
Is it an actual benchmark that we can judge you against? Where
have you been against that 50p and where do you think it will
get to?
Mr Fletcher: We have been creeping
up underneath it but only very, very gently. It is always invidious
to make comparisons and I do not claim to know all the other pressures
on other regulators. It is a truth, universally to be acknowledged,
that Ofwat, which still incorporates the customer representation
arm which in most other regulators has now been carved off, has
kept its cost to a much lower level, which is partly a consequence
of the fact that competition is very slow to come in. I do not
treat 50p as any sort of magic marker. It is really intended to
give the casual reader a sort of indication that, well, 50p per
year, one penny a week, monopoly bodies, is this value? I would
not build too much on it. It is too easily made as a sort of cheap
point, but I felt that we ought to say something just to give
people a feel for it.
Q17 Mr Mitchell: Are you contemplating
price rises in the next quinquennial?
Mr Fletcher: I am afraid we are.
As the last review was a win all round in that companies will,
by the time this current period, 2005, is through, have spent
£50 billion since 1989. They have had a solid programme which
represents roughly double the level of the public sector spend
under Treasury clamps up to 1989. It needs to be at that level.
Much of it is to deliver necessary improvements in drinking water
and in environmental quality. The prospects are, driven partly
by European directives, that we shall be seeing another very substantial
capital programme next time round. What we will not have next
time round is the benefit of the efficiency gains very considerable
excess achievement of efficiency gains which were built up in
the 1990s and which my predecessor was able to use as the basis
for cutting prices in real terms in 1999 to customers by 12.5%.
Q18 Mr Mitchell: Why can you not
emulate that?
Mr Fletcher: I cannot emulate
it because, with my job of enabling efficient companies to finance
their functions . . . I am not there to act as a safety net to
an inefficient company but I am there to ensure that, if they
are doing the job properly, they will be able to go on raising
the money from the markets—there is no taxpayers' money
here—to enable them to keep the necessary programmes going
and, although I shall be pushing them—and I am building
up evidence to enable me to do so—to go on getting more
efficient and the preliminary evidence I have for the next review
is that there is still scope for this sector to do more to catch
up with the economy at large from their former nationalised industry
status, nonetheless I have to take account of the reality that
they are getting a whole lot of more things to do and they cannot
wave a magic wand and just generate extra efficiency. So, I have
to try and strike the price limit at the balancing point which
I referred to earlier, enough to enable them to keep going long
term doing their job, no more than, as monopoly companies, they
absolutely have to have to keep their job going and they can take
my decisions to the Competition Commission if they believe that
I have the judgment wrong.
Q19 Mr Mitchell: I wonder if you
are still are not being over-sympathetic to the companies and
their profits. Here is Elliot Morley in Utility Week for 6 June—it
is exciting material that we get here—saying that the investment
costs will not be as heavy from the European Directive as everybody
is complaining and these companies are making good profits and
have had a regime which has been very sympathetic to company profits
over the years, that is to their profits. Indeed, over-sympathetic
because they have been able to take money generated from profits
and generally screw up on overseas investment and diversification
where they have not been particularly successful. Managing water
is a dead-easy job, is it not? I mean, you just pump it into pipes!
It does not demand any great management skill, and it must still
be attractive for investment because everybody is wanting to take
them over. So, are you not going to be more sympathetic to profits
than really you should be if you are to serve the purpose of the
consumer?
Mr Fletcher: The starting point
is that I am very conscious that one of the dangers in my job
is of capture by those bodies I regulate. I seek to make very
sure that—
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