Examination of Witnesses (Questions 40-59)
WEDNESDAY 11 JUNE
2003
MR PHILIP
FLETCHER AND
MR ROGER
DUNSHEA
Q40 Mr Mitchell: To follow up on
David's point about capital investment, it seems to be down. Are
you concerned about this?
Mr Fletcher: It has gone up now
from its lowest trough point. We are getting in, this month, the
evidence from the companies about their performance in 2002-03,
and I confidently expect to see that trough ending and higher
spending resulting. Whether it will be enough to deliver all the
outputs I am not sure, but the monitoring which we and environmental
regulators do suggests that the companies will not be too far
off what was being asked of them for the period 2000-05.
Q41 Paddy Tipping: Let us talk about
competition, the Water Bill and the thresholds. As I understand
it, present customers who have used more than 100 Megalitres can
have a choice. I think there are a couple of handfuls of people
who have done that. In the Water Bill the threshold is 50 Megalitres.
In your submission on the draft Water Bill talked about 10 Megalitres.
Can you give us some numbers? How many customers are there at
the 50 Megalitre threshold and the 10 Megalitre threshold?
Mr Fletcher: Can I say first of
all that Ofwat contributed, as part of, I believe, our proper
job as experts, to Government's thinking in the build-up for the
new regime set out in the Water Bill. It is not for me to say
what the appropriate threshold should be; that is very much a
matter for Parliament and Government. If we set aside the 100
Megalitres bit, which is about inset appointments, where we have
only done nine across the country at the moment so it is relatively
small—it is not the only possibility at present. At least
with the Competition Act, there is the prospect of competition
coming in in other ways. The Water Bill will effectively establish
a new regime across the board and will make it very clear, if
passed into law, that competition is not for the domestic consumer
in this particular sector. However, if we are to see competition
for at least the large business user, the question in my mind
is whether setting the threshold at 50 Megalitres a year, which
is the Government's proposition at the moment as the starting
point which, subject to secondary legislation, could be moved
down subsequently, and would be moved down if the review showed
that appropriately—there are only 2,000 eligible customers
in England and Wales; and a number of those will in practice not
be able to, or have no interest in taking advantage of a possible
alternative supplier. My concern is whether a pool of potentially
2,000 is big enough to encourage entrants really to get excited,
to make investments themselves in a speculative way, about the
prospects of winning large water businesses, as their customers;
or whether we might see a damp squib. You can go on down from
there. I do not have readily to hand the figures for lower areas.
Q42 Paddy Tipping: At 10 Megalitres
you were involved in submissions to the draft Water Bill. Is that
what you were suggesting—to go down to 10 Megalitres?
Mr Fletcher: Yes.
Q43 Paddy Tipping: You can let us
have that.
Mr Fletcher: Yes, I will. It will
be a very broad estimate.
Q44 Paddy Tipping: Is it significantly
more than 2000?
Mr Fletcher: If it came down to
ten, yes, we would be talking about very significantly more than
2,000. Fifty Megalitres a year means something like a very big
NHS trust, a university, a very large industrial plant. Getting
down below that to 10 Megalitres—here I would want to check
it, but it is likely to mean at least ten times that number, I
would think.[1]
Q45 Paddy Tipping: Do you think that
is sufficient?
Mr Fletcher: Nobody can really
judge. At the moment, the Competition Act and the Water Industry
Act do not fit terribly neatly together. The Competition Act,
a general act, takes no account of the rather special circumstances
of the Water Industry Act, formulated without much regard to competition.
The two do not really quite intersect and meet properly. Some
of the troubles we have been having concern trying to make sure
that they get as close as possible. Once you get a clearly set-out
new statutory regime, where everyone is clear where it stands,
that might make a real difference in whatever sector Parliament
and the Government together decide is appropriate for competition.
Q46 Paddy Tipping: Presumably, the
big players are going to benefit from that competitive regime.
What is the knock-on effect to people who are non-entitled because
they are below the threshold? Have you done some work on that?
Mr Fletcher: We have done some
work on that because our general approach on tariffs is to say
there should not be cross-subsidy between sectors. There is obviously
cross-subsidy within the domestic sector at the moment, with nearly
80% of us, as domestic customers, paying on the basis of rateable
value—and rateable value is an accrued progressive form
of taxation, so there is cross-subsidy. But it has always been
built-in and everyone has understood it. We are trying to ensure
there is not cross-subsidy from the industrial to the domestic
sector. However, where you take outside the tariff basket into
a wholly competitive regime, large businesses, they may well be
able to say: "Think this through again, oh water company.
I am a very big user of your services; I deserve proper recognition
for the sheer volume that I require of you, which must mean that
the overhead that is proportionate to me is much, much less than
you have been allowing in your standard tariffs." So there
would be some sort of effect working its way through. We would
police it to try and make sure that there was no sweetheart deal
indeed. We already have appropriate policing mechanisms in place.
With a threshold of 50 Megalitres a year, we suggested—and
I think this would be an absolute maximum—that bills should
not increase by more than Ö%, say 50 pence in a year on average
for each 10% of the contestable market that incumbents lose to
their competitors, which leave them with a bigger overhead and
a lower revenue correspondingly. That is perhaps a range of 0.3
to 0.9%. When you are down to 10 Megalitres a year, the range
might be 0.4 to 1.2—say 0.7%—so we are not talking
about big numbers here.
Q47 Paddy Tipping: How does that
link in with Defra's RIA, which suggests a different range of
figures?
Mr Fletcher: We offered these
figures in our response to the Defra consultation paper, and I
have to say this is an area where no-one has perfect knowledge,
it is pretty speculative at the moment. We do not think it would
be huge.
Q48 Paddy Tipping: But Defra's RIA
suggests higher figures than your figures. I would rather rely
on you than on Defra actually!
Mr Fletcher: The proof will only
come if the thing is tested.
Q49 Ms Atherton: I would like to
talk a little bit about mergers. It has been estimated that the
average household bill would be reduced by £195 per year
if there were more mergers in England and Wales—and that
would be deeply wonderful in the West Country. Would it be fair
to say that perhaps your opposition to mergers within this country
has helped to put our water companies in foreign hands?
Mr Fletcher: My opposition is
not to mergers as such; it is to the potential harm to the comparative
regime, and thence to customers, that might follow from it. I
may be wrong, but I think the estimates you have quoted probably
came from a study by a consultancy called Indepen.
Q50 Ms Atherton: Yes.
Mr Fletcher: This was, in my view,
a less than fully robust piece of intellectual work in that it
assumes—
Q51 Ms Atherton: You mean you do
not agree with it!
Mr Fletcher: I did not agree with
it. It assumes that you could go on making the same economies
of scale every time you had a merger. One of the questions about
economies of scale in the water sector is the extent to which
the costs of the industry are dictated not by its size but by
the accidents of geography and social disposition. If you have
a very widely dispersed rural population and you are reliant on
boreholes for getting the water to serve them, and on small sewage
treatment plants for treating their wastewater, you are going
to have high costs, which, as regulator, I need to allow for.
You cannot simply say, "merge that company with the next-door
one and you are instantly going to get huge economies of scale".
Of course you will get some at head office level, and maybe in
terms of your levels of regional management, but the evidence
of our comparative competition regime is that it is often not
the largest companies that are the most efficient. If we saw a
nice correlation between Thames, at one end of the scale, as the
most efficient, and Cambridge and Portsmouth down the other as
the least efficient, any attempt I made to hang on to my comparators
would, I think, be blown out of the water—but it is not
the case. It is sometimes the little companies that can show the
way to the bigger ones, in terms of their flexibility and fleetness
of foot.
Q52 Ms Atherton: Looking at it from
another perspective, if you keep these companies small, it makes
it even more difficult for them to compete internationally. I
know you say that Ofwat should not be a national champion, but
surely you should not be putting barriers in front of other companies
from actually going into the international markets.
Mr Fletcher: I entirely see the
point you have made, although Thames is hardly a small player
in anybody's terms. It is, nonetheless, in the ownership of a
giant, RWE, and is being used by them as their spearhead for international
investments. Whatever the special water regime, I would expect
there to be a major Competition Commission inquiry at the time
that took place—and certainly the management of Thames through
the 1990s, before I was involved, was urging merger. We would
have no doubt seen a much bigger player. Would we have seen a
much more efficient one? Would we have seen one which wiped the
floor with the opposition across the world in terms of international
business? I do not know, and nobody will ever know. What we can
say is that some of the international giants of water, like Suez
(as was), like Veolia (Vivendi as was) have found that they have
not been altogether the stock market's darlings over the last
few years, not least because of their international businesses
not performing quite as they had hoped. So there is a mixture
of potential here. Some of the British companies, as Mr Mitchell
was pointing out, have undertaken investment which has not always
proved quite as successful outside the regulated fence as they
had hoped. Returning to the basic point, I really do not think
it is the regulator's job to try to play God to say, "we
will create a national champion by doing this". It is just
my job to present evidence to the Competition Commission, established
by statute to look at the merger cases and decide where the public
interest lies. I know the public perception is that Ofwat is against
every single merger. We tried to move the debate on in the interesting
Veolia takeover of Southern, by saying, "could this happen
by creating a new comparator at the western end of Southern?"
If you can envisage it in your minds' eyes, it stretches in a
long thin strip right along the south coast, from the Isle of
Wight at one end to Margate at the other. That one, the Competition
Commission did not particularly like. It would have been perhaps
a bit artificial. But there may be scope for others to come up
with new ways of thinking about it that would still leave to a
degree in tact the comparative regime, while enabling mergers
to take place. I am always open to companies that want to come
and discuss potential propositions with me.
Q53 Ms Atherton: If you could see
storm clouds on the horizon, would you accept that with both the
Minister and the companies in opposition with you over the mergers,
that that is likely to change?
Mr Fletcher: It depends on the
nature of the storm cloud. If you have in mind particularly possible
increases in bills and the already high level of bills in South
West Water, I think any merger involving South West Water would
not solve the problem because the customers of whichever body
South West merged with—and of course South West was the
target of two merger references in the mid nineties that were
heard in front of the MMC, it would not have led to the subsidising
by those other customers—Wessex or Severn Trent, say—of
the customers of South West Water. They would not have stood for
it. I would have to say that though I am very sympathetic to South
West Water's customers, I cannot see that as a ready solution.
Q54 Alan Simpson: Over the last seven
years we have seen or overseen quite a dramatic shift in the basis
from which the companies have financed their activities from equity
funding to borrowing. In your report of October 2002, you warned
then of the increased risk of industry-wide failure. What assessments
have you made of the scale or likelihood of that risk?
Mr Fletcher: I think one point
to be made about debt is that it has an absolutely natural part
to play in this industry, going back to some of the characteristics
that I was referring to earlier—steady revenues, a specific
programme to carry out—there's a need to raise debt at relatively
low prices. My predecessor, at the last review, based his consistent
assumptions on the weighted average cost of capital on a range
of between 45% and 55% debt equity, or equity debt. At the moment,
advised by consultants who have already taken some guidance on
this, we have no reason to want to go for a particularly different
sum. This is not trying to tell you exactly where I will finish
up, but the indications are still that roughly half and half is
a good, solid, relatively safe area to be thinking about. I shall
want to ensure that if there is a short-term window in which debt
is cheaper to raise than equity, that does not drive me, in the
interests of keeping bills to the lowest possible level, of saying,
"right, everybody will raise debt", if it is at the
cost of saying, "thereby we create a whole industry whose
financing structure has got inherent weaknesses that might knock
it over in the event of some extraneous relatively mild or small
set of events". What I am saying is: "buyer beware".
Where companies are seeking to go for very big bond issues which
result in restructuring, I have made it very clear that the regulator
is not there to bale out a company or its shareholders or its
bondholders if they have, with eyes open, made investment, made
a loan, bought a bond, with a certain risk attached to it, where
it is for them to assess the risk. I shall go on watching very
closely, and seeking to ensure through the licence changes I referred
to earlier, where appropriate, that the customers are as well
protected as possible from the failure of a company which is nothing
to do with the customers and everything to do with an imprudent
structure. I am equally not in a position to play God and say,
"this structure is prudent, and that structure is imprudent".
It is for the company and all its other stakeholders to come up
with appropriate proposals for the City to assess—no taxpayer
involvement—whether they are going to finance this or not,
after appraising the risk; and then to see what happens. If we
look, for example, at Glas Cymru owning Welsh Water, so far the
company is both delivering its performance targets—although
admittedly it had quite a lot of ground to make up on some of
the English companies—and it is raising its capital and
continuing to be able to finance its capital requirements by returning,
when it needs to, to the City. One clear advantage which it has
enjoyed, and which some other companies are seeking to emulate,
is that it says: "Right, we are solely focussed on water.
We are not going to indulge in grand adventures on completely
unrelated investment. We are just going to concentrate on what
we know best—water and wastewater. You do not need to worry
that your money is at risk of some imprudent adventure elsewhere."
Q55 Alan Simpson: I am very pleased
with that last part. I would just say, Mr Fletcher, that I do
not have an aversion to public borrowing, or borrowing for infrastructure
investments. I wished my own Chancellor did not have that same
aversion! I wanted to know whether you had done your own risk
appraisal. It was helpful that you went on into the circumstances
relating to Glas Cymru because it does not sound as though, from
your assessment of that, the company has increased its risk of
market failure. I was trying to see whether you had done a broader
assessment of the risks of market failure. Can we put a ball-park
figure on it? I think the Committee is entitled to ask of you
the scale of risk you were thinking of when you flagged that up
in your report. Is it an increase of risk of market failure from
3% to 5% or from 30% to 50%? We need to understand the scale of
that risk in order to then understand how we need to respond to
it.
Mr Fletcher: We have not been
able to quantify it that precisely, but we have carried out a
study It is a public study and I would be very happy to send it
to the Committee. It was carried out by consultants respected
in the field—OXERA. We particularly asked them to look at
issues around capital structure and whether there is an optimal
capital structure, looking forward. Dr Dieter Helm, who is the
leading light for OXERA, himself has expressed in the past really
very severe reservations around a very highly geared structure
and the risks associated with it. The OXERA study came to the
conclusion that there is no one clear optimal structure which
would perhaps have focussed Ofwat's attention and the industry's
attention more. It is saying: "It is perfectly possible,
provided it is well managed, to run with a range of different
structures, including those that are around in the industry at
the moment. But it is appropriate to adopt a cautious approach."
I cannot answer with exact quantification for, for example, the
systemic risk, but if you get a number of companies all in the
same class, and some seismic change occurs in the markets that
makes it much more difficult for companies to raise debt in the
future, one of the risks associated with a very highly geared
structure is that you cannot repent of your decision readily,
and so that would go back to equity because equity investors will
probably in those circumstances, where you are under strain, be
keeping their money very firmly inside their own pockets. We will
certainly send you the report, but in looking to the review and
any further restructuring proposals that come to me, I shall approach
them as I have approached the other ones, with a sceptical eye,
with firm attention to licence changes to give customers as much
protection as I can, with a warning to bondholders that it is
their risk and they need to know that the regulator is not there
to bale them out at the expense of customers if they assess the
risk wrongly; but not to preclude private sector companies from
adopting whatever they think is the most efficient structure in
taking their business forward.
Q56 Alan Simpson: You have delivered
your warning to companies and to bondholders, but what is the
Ofwat contingency plan in the face then of a company going belly-up?
Mr Fletcher: We have a provision,
which is not enjoyed in all other regulated sectors, for special
administration, which I can operate with the consent of the Secretary
of State. If a company is failing to deliver its service to customers,
effectively I can ensure that the management of the company is
replaced. It has never been operated and we have never got even
near the point where it would be right to operate it over the
period since privatisation, and I have no reason to think that
it would need to be operated in the near or even distant future;
but it is there. It is there as a failsafe for customers to ensure
that if the management, for whatever reason, is simply unable
to do the job for customers, then that management can be substituted.
Q57 Alan Simpson: Chairman, if you
would just allow me one aside on this, I would like to ask a question
about a part of your report that we may not otherwise get round
to talking about, and that is progress on addressing the issue
of leaks. Obviously, this is a very sensitive issue for Parliament
at the moment. I am not talking about rogue elements within the
water industry, but it would be helpful for us to know what sort
of progress you feel is being made in relation to meeting the
targets about the amount of water that is just lost through the
defects and failures within the system. Are you in a position
to say the extent to which both overall and specifically, where
companies are and are not meeting the targets that you are setting
for them?
Mr Fletcher: The broad picture—and
I will supply a copy of this graph to the Committee, but you will
get the general sense of it even at this distance—is that
this is where the companies should be, within this lower left-hand
corner. Therefore, you will rightly get the impression that the
companies are getting much closer to the economic level of leakage
than they were in the period of maximum parliamentary concern,
which was immediately around the drought in the mid-nineties.
The economic level of leakage is the balancing point, where it
costs them more to put money into leakage control than it would
to undertake new investment to offset the loss of supply from
it. It is, if you like, from the point where I can say, "I
do not need to offer you, company, anything in bills here, because
it is in your own interest to get leakage down to the economic
level". But you are probably able to detect, even at that
distance, that up here there is one company, and that company
is Thames Water, which is way out of line with the industry at
large. The reasons for that are many. I think that Thames were
slow to fully address the issues of leakage. They did not take
advantage, as many companies did, of improvements in technology
early enough that effectively enable a company to get a grip on
the local areas of leakage. This is one where remote reading really
does help you to say, "the leak is occurring in this little
patch"—so you do not have to send operators out with
long listening sticks, just to detect the leaks; you can get a
good idea of where it is and then act much more promptly. Some
companies now have a very good grasp of their infrastructure,
just how it is working; and you can see it in their leakage control
figures. On the other side of the coin, in semi defence of Thames,
Thames, particularly in relation to London, with the London clay
and all the problems of operating in a very major capital city
which, in Victorian times, somehow with absence of foresight,
failed to allow for motor cars being parked and therefore the
parking in the street and all of that—Thames has had and
still has a severe problem. As you may have read from my report,
the multi-coloured varieties are our five annual reports on aspects
of performance by the companies. Thames is effectively operating
a special regime at the moment, which is on an agreed action plan,
where they are taking steps steadily to improve their control
of leakage. If they were here in the room with us, I think they
would say that their hope is that they are turning the corner.
They are certainly putting a great deal of investment into it.
For those of us who live in London, I am afraid we are bearing
the consequences because there is no way they can get on top of
it by replacing pipes, except by causing significant disruption
in certain parts of London. They are putting a lot of money in,
and we have been in discussions with them about just how to balance
up the costs that need properly to be borne by their shareholders
and their owners—because they were slow on the uptake—against
the proper fact that they have, particularly in London, a very
difficult infrastructure and a difficult environment, which is
costing a lot and will continue to cost a lot into the future,
and which will fall on customers as it comes through.
Q58 Alan Simpson: Let me ask you
about sewerage, which is a pretty horrendous issue. I think 5,000
properties were flooded in 2001-02. The annual report refers to
it. "We should solve or reduce the problem by 2010."
That is a long way away, is it not?
Mr Fletcher: This is uniquely
one area where I have said to the companies: "Normally it
is right that we should stick with whatever was said for the last
periodic review: there is huge strength in saying we can set the
playing-field and you play on it for a whole five-year period."
However, effectively I have said to the companies: "This
is an area where we cannot stand still." I have agreed with
the companies roughly to double the level of investment which
had specifically been provided for dealing with sewer flooding
in the last periodic review, simply because although the numbers
are going down, this is an event that is so unacceptable that
we must ensure that it is reduced to a sensible minimum as fast
as we prudently and sensibly can. That said, even here value-for-money
issues do come in. There will be some cases where two or three
properties might have very large six-figure sums to remove all
possibility of sewer flooding; and there will always be cases
where a sewer simply backs up, gets blocked, and a nasty event
occurs. What I am particularly seeking to address—and here
WaterVoice is urging me on with whips and scorpions—is to
ensure that those customers whose homes are at risk—say
a one in ten-year event—should be offered an early prospect
that their circumstances are going to be met. I have asked the
companies in the draft business plans that will appear this August
to exemplify what would be needed to take out all the one in ten
years; and I have actually asked them to go a step further and
think about the one in twenty year events as well, so that at
least we have that information in front of us—companies,
Government, me and everybody—as we come to the final stages
of the review. I think we are going to have to do more about it.
Q59 Alan Simpson: It is a priority
area.
Mr Fletcher: It is very much a
priority.
1 Estimated to be 12,000 customers. Back
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