Oral evidence

Taken before the Environment, Food and Rural Affairs Committee on

Wednesday 5 November 2003

Members present:

Mr David Curry, in the Chair
Mr Colin Breed
Mr David Drew
Patrick Hall
Mr Michael Jack
Mr David Lepper
Mr Austin Mitchell
Diana Organ
Joan Ruddock
Alan Simpson
Paddy Tipping
Mr Bill Wiggin

 

__________

Memorandum submitted by the Environment Agency

Examination of Witnesses

Witnesses: MS BARBARA YOUNG, a Member of the House of Lords, (Chief Executive) and MR ANDREW SKINNER (Head of Environmental Quality), Environment Agency, examined.

 

Q84  Chairman: We understand that Lady Young is closeted at Defra on the subject of ghost ships. We will make suitable arrangements to have her decontaminated when she arrives! We trust that she will not be too long in doing that. Meanwhile, Mr Skinner, you are the Head of Environmental Quality at the Environment Agency. You know the background to this report and so let us begin by asking what exactly is the Environment Agency's role in determining the environmental controls that water and sewage companies are forced to undertake.

Mr Skinner: The Environment Agency's role is to provide advice to Ministers, and it is Ministers because there is a parallel process operating in Wales, on the environment programme for the period of review. We do that in conjunction with English Nature and also CCW in Wales, because many of the aspects of the programme are dealing with nature conservation issues on which they are the primary adviser to Ministers. We sit with fellow regulators, including the Drinking Water Inspectorate and of course Ofwat, as a group that seeks to propose a programme on which Ministers can make judgments and give advice to Ofwat in their stewardship of the process.

 

Q85  Chairman: A significant amount of the regulations themselves presumably are European Union regulations?

Mr Skinner: A large proportion of the regulations are European Directives. As we say in our final documents, over two-thirds of the schemes which we are proposing to Mrs Beckett for consideration stem directly from statutory requirements from European Directives; others stem from national. Targets set by Government through the PSA process.

 

Q86  Chairman: If you are submitting them to her for her consideration but they are statutory requirements flowing from European regulations, what choice has she got?

Mr Skinner: The programme is not entirely statutory-driven, and so there are choices. In the jargon of the exercise, there are choices to be made, and some of the proposals we have put forward are ones where we believe there are environmental and indeed social and economic benefits to be accrued from doing the schemes, but those are ones on which there is no statutory driver. In the case of those schemes that are statutory, the judgment is actually, in our view, about making sure that they are done in the most cost-effective way by the water companies to meet the environmental objectives. Another part of our dialogue with our partners in this process is actually helping in various ways the scrutiny of the companies' plans to make sure that, as far as one can judge, they are proposing cost-effective schemes to achieve necessary outcomes.

 

Q87  Chairman: Are you satisfied that all the requirements laid upon companies do actually represent value for money?

Mr Skinner: I am satisfied, and I say that with confidence because we have done an extensive exercise to satisfy ourselves on just that point. The comment has been made on previous iterations of this process that there had not been cost-benefit rigour applied to those situations where there were choices to be made. We have done a lot to make sure that could not be levelled this time. We have done an extensive programme of cost-benefit analysis. We have had our approaches assessed and peer-reviewed and challenged. It is by coincidence that today is the day that we are required to give Mrs Beckett our final advice on this matter. The schemes that will be in that final advice will be a smaller tranche of schemes than we started with because they have been weeded down by various processes of scrutiny, and one of those is cost-benefit assessment.

 

Q88  Chairman: Baroness Young will be able to kill two birds with one stone, will she not, while she is there! In past programmes, do you think there have been occasions where the incremental benefit to be gained has not been justified by the incremental cost in achieving it?

Mr Skinner: The retrospective on the programmes in the past is that they have provided a huge benefit to water quality and water environment. I think the programme has a huge and successful track record. The retrospective analysis has not been done in every case, and so I cannot give you that assurance. Of course, many of the schemes in the early parts of the programme were also statutorily driven and therefore there were not the choices to be made.

 

Q89  Chairman: So you will be perfectly happy if, let us say, the consumers in the south-west are all up in arms because of increases in their water bills and they are told that these increases flow from improvements in quality and all sorts of desirable things? You are perfectly happy to go down there and say to them, "It is, and it is for your benefit"?

Mr Skinner: I would and we do. Obviously the nature of the geography of the country is that the environmental burdens do not fall equitably, but we are talking about meeting environmental standards. In fact, in the south-west the environmental programme is actually quite small, and so I could and have very happily had that conversation.

 

Q90  Mr Jack: Let us just move on in an examination of the rigour with which you have come up with the programme. In paragraph 15 of the evidence to the Committee you say: "The Agency, English Nature and the Countryside Council for Wales have set out a programme that will require over 5000 actions at around 4000 sites from 2005 to 2010. The programme includes 3200 main actions to improve sewage treatment works....." and you go on and on. How did you work all this out?

Mr Skinner: We did that by quite a long and complicated process. It starts, as we have said, from the statutory drivers that need to be met, the statutory obligations on the country. That leads to a schedule of schemes, which are compiled locally in liaison between Agency staff, English Nature staff and water companies. That brings up a long list and that has then been put through a number of points of scrutiny: firstly, to establish whether in fact the environmental problem is something which has been caused by the water company in the first place, because there are many impacts on the water environment which are not for their accountability; secondly, to be confident that we know the answer to the problem and therefore can specify standards which the water companies need to meet; and thirdly, the cost-benefit scrutiny.

 

Q91  Mr Jack: May I just stop you there for a moment? Looking through A Good Deal for Water, and I must compliment you on the pretty pictures, they are very nice, I was struggling really to find in this document any kind of detailed economic analysis that would underpin the assertion that you make in the conclusion of your evidence to the Committee where you say that all of these improvements are only going to cost people I think it is on average 50p per household per week. It says that on page 12. We are intrigued to know how this great calculations was done when A Good Deal for Water seems to be an analysis-free zone.

Mr Skinner: The 110 pages of advice which we are giving to Mrs Beckett today contains a lot of what you are asking for - detailed schedules by various environmental drivers, as we call them, various issues to be changed. That will contain also the cost-benefit outcomes. All the methodology is in the public domain.

 

Q92  Mr Jack: Having produced this volume of work with the rigour of the analysis, which sadly is not displayed in A Good Deal for Water, in Table 1 in paragraph 36 you list the Plan A and Plan B totals for the work to be undertaken by the water companies listed. Are the figures there realistic, in your judgment; are they over-statements or under-statements of the true costs of doing all that is required to meet all these thousands of actions which you have detailed?

Mr Skinner: Those are figures from the water company plans, as you realise. We have made global judgments about the appropriateness of those figures.

 

Q93  Mr Jack: Global judgments? I ask the question because I am interested to know the validity of this 50p per week per household. I woke up this morning to discover that some judgment had been made by Ofwat in agreeing United Utilities' figure and one other. I was not certain whether that was an interim price review or whether it was the final version. We have to find out the numbers because there is a missing column from this document, and that is the water companies' own assessment of their figures. As you have done all this rigorous work, let us not be global; let us be specific. Company by company, who is charging the right amount and, if not, why?

Mr Skinner: I refer you to my colleagues who will follow afterwards because it is their job, at the end of the day, to assess those plans. Because we are concerned to be sure that what we are proposing is cost-efficient, we have done our own analysis. We can talk about the costs of individual schemes and the schemes in the company because we have some knowledge of that business. Translating those costs into individual amounts on bills is a complex process, which only Ofwat can do,

 

Q94  Mr Jack: You say in paragraph 36: "Some companies have costed programmes and solutions that go significantly beyond the Agency's recommended programme."

Mr Skinner: That is correct.

 

Q95  Mr Jack: The point is that I do not know which of these companies has gone beyond that. Can you tell us which has gone beyond your programme?

Mr Skinner: Various companies have dealt with this in various ways, and most of the figures which are in the common currency are from the companies' preferred strategies.

 

Q96  Mr Jack: Forgive me, Mr Skinner, if it is difficult to answer the question now. I asked a simple question: which of the companies listed in Table 1 in your evidence to the Committee have gone beyond the Agency's recommended programmes? I am trying to establish whether any of these water companies are trying to raise money other than is necessary to meet the recommended requirements under the various directives and national programmes to improve their water quality, which appears to be the message you have told the Committee: these are the drivers of this price increase. I want to know who the guilty parties are in the column headed "Company" which might be going over the top and, if they are going over the top, what are they going over the top with.

Mr Skinner: Some companies have proposed schemes which are not the ones to which we have given priority in their programmes, and some companies have proposed costs which we are, through Mrs Beckett, inviting Ofwat to scrutinise particularly carefully.

 

Q97  Mr Jack: Which companies are the ones that are the goodies and which are the baddies?

Mr Skinner: In our own assessment, we have identified concerns about the programmes of United Utilities and of Southern Water.

 

Q98  Mr Jack: Could you clarify this? The increase that United Utilities, for example, were given today, was that at the end of this process or was that something else?

Mr Skinner: No, that is something completely different. That relates to the management of the existing programme.

 

Q99  Mr Jack: It is the existing programme. I was bit surprised that two had been picked out. How would you classify the reasons behind United Utilities not following the programme?

Mr Skinner: It is partly to do with our judgments about the cost necessary to deliver the programme that we are asking Ofwat to scrutinise.

 

Q100  Mr Jack: One of the things we are anxious to establish is whether all of this represents to the water consumer good value for money. If we take the two that you have picked out, Southern and United Utilities, notwithstanding your concerns, do they represent good value for money?

Mr Skinner: There are schemes in the United Utilities' plans which include operations relating, for instance, to shellfish waters, which are not in our recommendations.

 

Q101  Mr Jack: They think it is a good idea. Just explain this to me. That is an environmental benefit. Why do you think they have put that in?

Mr Skinner: I do not know. I have not had the dialogue with them and so I do not know.

 

Q102  Mr Jack: If they took out of their programme the things that were not in your list, do we know by how much it would reduce their estimates?

Mr Skinner: Again, there are two points. One is the schemes in the programme and the other the unit costs to deliver them. The draft business plan is only two months old and that scrutiny has not been done.

 

Q103  Mr Jack: Just to conclude, as far as you are concerned, Southern Water and United Utilities have things in their programmes which would increase their costs beyond the Environment Agency's recommended programme of activities. Do I therefore conclude that the rest of the companies are compliant with your recommendations?

Mr Skinner: The two companies I have mentioned have costs in their programme which we have specifically suggested to Ofwat should be subject to their examination, though I am sure they will tell you they have examined all of them. I can supply a schedule, but it is actually in the material we will be giving to the Secretary of State later on today, which identifies which of the companies have met in various respects in the programme what we have asked for and where they have not.

 

Q104  Mr Drew: To be absolutely clear, Mr Skinner, what is the process of engagement you have with the companies to know what their cost structure really is and what their strategy is in terms of trying to make these environmental improvements and how do you then, when you are either satisfied or not satisfied, rebuild this back into their cost structures, in terms of the prices they will then set?

Mr Skinner: I do not do that last step. The structure is as follows. As I explained, at the early stages of this process, when the environmental programme is being assembled, that is done in dialogue between my colleagues in our various regions and their local companies. That leads to the programme, the programme which the Agency specifies and which Ofwat asks the companies to cost according to a structure of arrangements, which leads to these plans, A and B. That is then delivered and it was delivered two months ago. From our various perspectives, we are in the process of analysing that. Our advice to the Secretary of State lists our assessment of all those issues and goes into the detail, some of which we have touched upon in the previous exchange. The process is then that the Secretary of State gives guidance to Ofwat to instruct the companies to go through into their final business plans. Our role at that stage is to advise Ofwat, answer questions and help them develop a programme which meets the requirements which we have specified and which the Secretary of State has accepted in her guidance. It is quite a complicated process.

 

Q105  Mr Drew: To be clear, and I understand how you work with the companies, how would you describe your relationship with Ofwat at the different stages? It sounds as though you start quite informally with Ofwat and then you get into a formal arrangement. Presumably then this has to be enforced by the two organisations. What is the parallel relationship?

Mr Skinner: The structure of the process is that we and Ofwat, together with others, sit round the table at what is called the Regulators' Group, which is brokered by DEFRA officials. That means that there is a fair degree of formality about the process right from the start. The instructions to the companies about what they are asked to include in their plans go out under joint signature from the Agency and Ofwat saying, "This is what we would like you to do to follow this process". That all has a formality right from the start, although of course there is an awful lot of professional interaction of a much more informal nature as the process goes on, and of course we do not always agree.

 

Q106  Chairman: We welcome Baroness Young. I hope you have been suitably decontaminated on your way here and that you have sorted out the problems of the ghost vessels and all of that.

Ms Young: I would not bank on that, Chairman, but we are a step further forward. May I give a profuse apology.

 

Q107  Mr Mitchell: I thought your defence of what is said in the paragraph where you said that some companies have gone beyond the desired level is a bit lame. What are you actually going to say to the consumer because here are changes made in pursuance of a European directive and your own instructions, some of which have been added to by companies loading in other things which you say are unnecessary. Does that not really put a responsibility on you to tell the consumer that some companies are free-loading?

Mr Skinner: We will do so.

 

Q108  Mr Mitchell: Is that report saying, "Anglia should not be doing this and it should be doing that but it should not be doing it in the gold-plated way it is"?

Mr Skinner: The 110 pages which go to Mrs Beckett today include that information, and that is or will be a public document subsequently. We have been very open about that and Barbara Young has given a number of speeches in the last couple of weeks saying just those things at various public fora. At the end of the day, though, the decision is with Government, who will receive our advice, and advice from the Drinking Water Inspectorate on other aspects of the programme, and then commission Ofwat to discharge its duties within the scope of that advice. The track is for us in the public domain to be very open about what we are doing and why we are doing it, to give advice to Ministers.

 

Q109  Mr Mitchell: That is never going to reach the public, is it? Ofwat is going to come in with its usual technical gobbledegook and coefficients and percentages. The Minister is not going to produce a report. How is the consumer to know that he or she is being gypped because the company is over-charging for things that are not necessary?

Ms Young: I hope that the process in which we are involved will in fact mean that when we get to the point at which the consumer is actually faced with a bill, we have made sure that all of the environmental schemes that are in the programme are rigorous, fully tested, least-cost options, that anything that is extraneous and unnecessary is not in the programme, and that anywhere where costs look ostensibly too high or where the impact on bills looks higher than it ought to be, that has been stripped out. That is the important message we are giving to the Minister in our advice. That needs to be very high up in the discussions between ourselves, DEFRA and the economic regulator in the next few months, until such time as the Minister issues definitive advice. That goes to the end point in that.

 

Q110  Mr Mitchell: We all hope for a reasonable outcome.

Ms Young: I think it is premature to say that we ought to be winding customers up and saying that we do not want any gold-plating.

 

Q111  Mr Mitchell: This is challenging stuff that goes significantly beyond the Agency's recommended programme. If some of that still remains after going through the gobbledegook process, will you be telling the consumer that it should not be?

Ms Young: Certainly, if we felt the process was not working, we would be very clear and explicit about that, but I have confidence that the process will actually reach a point at which a sensible environmental programme is part of the process. There are other issues that impact, of course, on customers' bills. I do not know whether we have covered that already. The totality of the impact on customers' bills comes from a whole range of factors, some of which are in the environment programme, but only some of them. There are also taxation issues for the companies and issues to do with wanting to dig up the roads and the cost of that. There are issues to do with their own financing arrangements. There are other elements of the quality programme, like the Drinking Water Inspectorate Programme, and there are big costs associated with maintaining the serviceability of their assets. There is a whole load of drivers that will impact on customers' bills eventually. We think we are part of a process that will really hone down rigorously that environment programme to a point where it is big, and there is no doubt that it will have an impact on customers' bills, but that it is absolutely rigorously tested and therefore we do not have to go to the customer and say, "You ought to kick up a fuss about some elements of the environment part of the programme". It is only the environment part of the programme that we really are qualified to comment on.

 

Q112  Mr Mitchell: You have all these processes but the consumer is faced with other bills and you are blithely assuming that they will not mind paying an extra 50p a week, or whatever it is, for improvements in beaches, water and sewage elsewhere which they will not necessarily see at a time when the consumer is being asked for more on the rates, more on other taxes, more on other charges. This is going to produce some kind of consumer reaction, I would fear. At the end of the day, the consumers do not trust you; they do not trust the water companies; they do not trust Ofwat; they do not trust Government; and certainly, least of all, do they trust European directives. Are you not afraid that this is going to produce a kind of reaction with the accumulation of these charges?

Ms Young: Strangely enough, in that line up of villains, we are probably the one they trust most. We have a head start, or that is what our market research tells us anyway. It is a big issue in terms of the size of increases in average bills that may result from this pressure, but we always knew that. If you recall, five years ago when we were involved in this process, we were constantly saying that a big price reduction five years ago was simply going to store up trouble now, and here it is; it is happening now. If we had had a steady price rise over that period, it would have been a steady price rise from now on in, rather than the sort of curve that we might have to see as a result of the price cut that happened five years ago. What we are saying is that the market research, which we have all shared with the customers - ourselves, Ofwat, English Nature and Government - is not saying that the customers are not prepared to pay for environmental improvement. The customers are interested in environmental improvements.

Mr Mitchell: They tell us they will pay more taxes for better public services but when it comes down to it in the polling booth, they have a very different position.

 

Q113  Mr Lepper: Barbara, I think you are right when you say that of that line-up that Austin gave us, it is the Environment Agency that tends to be perhaps trusted more than others. It is usually the Environment Agency which is telling people that they ought to see rather more rather than rather less of something. Mr Skinner, you cited Southern Water as the other company where you thought there were some questions to be asked about their proposals. Could you just give us one or two examples of what Southern Water have in their plans at the moment that the Environment Agency feel are not perhaps absolutely necessary?

Mr Skinner: The issue which we are inviting Government and Ofwat to scrutinise is not so much the schemes in the programme but the way in which those schemes are stated to impact upon the customer bill. As has been explained by Barbara, there are all these various issues which come from company structures, company pressures and taxation. We are very happy to say that the environment programme is important and will cost money, but we do not want it to be overstated. We do have concerns from our own analysis, and Ofwat can do this more thoroughly than we can, as to whether in fact that is the right statement about the impact of the environment programme on costs.

 

Q114  Mr Lepper: It sounds to me as if you are saying that what Southern Water are doing is trying to offload on to the customer - they are asking the customer to pay for some of their environmental schemes - costs which they, as a company, have to meet but which ought to be met from somewhere other than the customers' bills?

Mr Skinner: No.

 

Q115  Mr Lepper: Then I have misunderstood.

Mr Skinner: There are two points. Firstly, we are merely suggesting to the economic regulator, whose job it is, that he should look at these issues more closely. It is not so much whether the costs will call on the question; the question is whether it is appropriate to allocate it as a cost caused by the environment programme.

 

Q116  Mr Lepper: All right, and so the essential thing you are saying is that it is about questions on Southern Water's figures?

Mr Skinner: Yes.

Ms Young: One of the lessons I think we have learnt from this price round, and I am sure Philip Fletcher will agree with this, is that there are some issues about what perhaps ought to be more transparently demonstrable in the way that companies present figures. It is part of a learning process and the refinement of the price round process but I think we do need to be able to disaggregate some of the financing costs more accurately from the elements of the environment programme.

 

Q117  Patrick Hall: May I explore the business about the costs to achieve the environmental improvements? You have flagged that up as being the cost one fizzy drink per week, which I think was referred to earlier as 50p per week, which is £26 a year. If one looks at the evidence that you have let us have, and at Table 1, could you explain if we are supposed to be seeing £26 for the whole year as the price increase on average for all of these water companies? Therefore, with Southern Trent's Plan A of £3, which is less than 6p per week, does that mean that there are no problems in that huge part of the country of Severn Trent or that that you have not set them proper standards to pursue, or that they do not want to do that? What do these figures actually mean? I really do want to know how this 50p, or whatever it is, has been arrived at, without reading Margaret Beckett's 10,000 page document to which you refer.

Mr Skinner: I will try to do it simply. The £26 relates directly to the column of figures headed Plan B, and it is an average figure; i.e. it is our judgment across the country. The fact that some companies have low numbers in here in some cases is due to the fact that there is not a large programme of need. Perhaps that has been satisfied in previous rounds under different geographical circumstances. There is a huge variation from region to region and company to company, which is translated through into the bills because of the circumstances of the region. If you do the average of Plan B, you will find it is higher than £26, and so we are saying that in our judgment, and we hope that Ofwat will be able to discover this, there is scope for the work being done more cheaply but, because the figure is low, that does not mean to say that we are necessarily unhappy with the programme.

 

Q118  Patrick Hall: And so in the Midlands and in the London area there is less pollution than there is in other places, which does surprise me.

Mr Skinner: You have named two regions that do not have any bathing beaches, and that is quite a significant driver on environmental pressures. Although we may have this differences about the numbers, there is no doubt that the programme in United Utilities is a big one, and that is, among other things, driven by coastal water quality issues.

 

Q119  Patrick Hall: But it is a programme that goes beyond what you think is sensible?

Mr Skinner: In that case, yes.

 

Q120  Patrick Hall: That is to clean up beaches?

Mr Skinner: In that particular case we are into shellfish waters.

 

Q121  Paddy Tipping: You have told us, and I think it is right, that most of these environmental improvements are driven by European directives. Are we at the end of the road? Are there more European directives to come and, if there are, what discussions are you having? Are you across there in Brussels talking about these things and giving advice and, most particularly, not just looking at the principles but looking at the practicalities and the end costs?

Mr Skinner: It is not the end of the road because there is the Water Framework Directive, which we discussed previously, which will increase in some cases the environmental standards to be met and place more focus on ecological issues. In our short version, and it is also in our long verison, we are suggesting to Government that there are important opportunities in this programme of improvements to make sure that the country is prepared for those new burdens. As far as being over in Europe, the answer is: yes, we are there a lot and very much, in the way in which you have described it, influencing the guidance. Although the Water Framework Directive is only about 30 or 40 pages, it has about 1000 pages of guidance sitting behind it. In those pages, if wrongly constructed, are costs, and perhaps even unnecessary costs to this country. The Agency, together with our colleagues in Scotland and Northern Ireland, working as a UK group, have put a lot of effort into what in shorthand we call fit for purpose implementation. That does not mean to say it will have zero costs but it will be what we believe to be effective, appropriate and consistent with our previous practice.

 

Q122  Paddy Tipping: The figure may be £26 for this review but the Water Framework Directive is coming on, and we have had discussions before about making sure these mesh together. How much more is it going to be? It might be nothing if you get your way.

Mr Skinner: I very much doubt if it will be nothing. The first point to make is that the Water Framework Directive cuts cross-sectorally across all polluters and we are only talking here about the impact on the water companies but it is clear that there will be additional burdens on water companies; the water companies' own publications have supported this. There will be successive periodic reviews and there will be comparable, perhaps not as big although this one is smaller than the last one, increases to bear by water companies.

 

Q123  Paddy Tipping: Barbara told us earlier on that the public loves you all and loves you more than other people; you are trusted. What are they saying to you about bills? What is your own research? Is £26 what people are prepared to pay? That is not what I have heard and it is not the research I have seen.

Ms Young: Certainly the research took a lowish range of possibilities about what people were prepared to pay and tested those. It did not test this scale of bills. The point to make about the longer term, however, is that one of the features of the environment programme is that much of it has no choice to it: we either have to do it or we will be in infraction under European directives or else we will fail to meet the Government's PSA targets. There is not a lot of discretion. You could say that you might want to slow it down and pace it out a bit more but the reality is that, if we do that, that last ten years of implementation of the Water Framework Directive, which will be covered by the next price round which is 2010 to 2015, will look like a mountain that is very hard to climb. I think we have got to keep moving through the programmes that we have now identified. In terms of affordability, you have to look at the range. The average is a £26 increase for the environment, but Thames only has a £3 increase; South-West Water, which currently has the highest bills, only has as £4 increase. It is very differential depending on the size of the programmes across the country. Also, if you look at the cost of water compared with other utility bills, it is comparatively low and we have not yet put in place proper measures for minimising the impact of water bill increases on poorer households. If we could get metering programmes up, that would both reduce demand and allow smart tariffs to come in that would allow people to get a slug of water for their basic needs which could be differentiated in charge if they were a poor household. We could find ways, and also through the Social Security system, of mitigating the impacts of bills. I think it would be a bit short-sighted in terms of the longer term need for environmental protection if we were to pitch the bills only at a level that could be afforded by the poorest household.

 

Q124  Paddy Tipping: You are saying that you think that the only way forward really is for customers, with mitigation and the kind of qualifications that you have given, to pick up the bill. What are the other things you could do? Surely the polluter ought to be paying all this, should he not?

Ms Young: There are several polluters around. If you take pollution in its wider sense, i.e. abstraction of water from viable wetlands, for example, or rivers, the great British public in drinking, irrigating their farms, filling their swimming pools or watering their gardens are the polluters, and so they are paying in that respect. In terms of some of the water quality issues, I think we do need to make sure that we are not paying twice, and so we do need action on the Common Agricultural Policy. There is, in particular, a real window of opportunity, if the new reforms come in, to get some decent shaping of both the basic subsidy payments and the incentive payments beyond that to make sure that farmers are minimising their impact on water quality, so that they also pay in a slightly different way; i.e. by doing things differently in return for the money they get. That will also have a knock-on effect to the next price round because if we can reduce the amount of pollution going into rivers, we will have to take less of it out at the other end, but we need action on both. It would be unrealistic to say, as some have said, that it has been the water companies who have done their bit over the last ten years and it is now time for the farmers to do it,

 

Q125  Paddy Tipping: What have you said in your submission to Mrs Beckett about that?

Ms Young: We have said exactly that.

 

Q126  Alan Simpson: No doubt it is true that you are more popular with the public than politicians are, but you are not likely to be the ones who cop it in the neck in the way that politicians are in respect of the public reaction to any price rises. I do not think you will find disagreement on this Committee about the need to comply with directives. The issues that we are trying to grapple with are about the most equitable ways of meeting those costs.. I would like to try and pick up from some of the questions raised perhaps before you arrived, Baroness Young, and just put the money figures together. What exactly do you expect the 50p to raise for the industry? Can we put some ball-park figures on this?

Ms Young: We are talking now about an environment programme - and this is a moving target because we are refining schemes all the way through and basically trying to pare out anything that is not either very clearly going to hit a real environmental outcome and produce real impact or cannot be justified at the cost - and so this number is going down all the time. I think we are at £3.5 billion for the overall programme, over which the Secretary of State has some discretion on about £0.75 billion. It is £3.5 billion with about £0.75 billion where she has choices to make. That was a number that originally was up at about £5 billion and we have successively pared that down. In fact, I always joke with Andrew Skinner that some of our staff are now at the point of saying that we are cutting too much out.

 

Q127  Alan Simpson: Can I ask you to take a step back from that? I am not asking you what the programme will cost. I am asking you what the 50p would raise. It seems to me that you cannot be sitting there saying that the 50p will be on the bills. Actually, the figure that it draws in is going to be less and less. I just want to know how much you have estimated.

Ms Young: Our leaflet with the can of fizzy drink was aimed at trying to help the public understand just the bare bones of what this is all about and what it would mean for them. That 50p would have raised £4.5 billion. Now that we have the programme heading down the way towards £3.5 billion, that is probably under 40p, and so it is still a fizzy drink, but it is Tesco's own brand rather than a Diet Coke.

 

Q128  Alan Simpson: I am not quibbling about that part. I just want to put some fairly static figures in place. On the original calculations, that would have raised 4.5 billion. For you, that was the total amount that would additionally have been incurred as costs for the industry over this period to 2010?

Ms Young: Yes, but we are now, as a result of a process that will go on right through to the final determination, reducing that figure; it is now £3.5 billion.

 

Q129  Alan Simpson: I understand but I want you to stick with me because I do not think it helps us if, every time we ask a question on a given set of figures, you try and move the goalposts to somewhere else. I think we are still trying to catch up with you on the figures that you put in. If we can accept that there will be improvements and savings and just stick to this set of figures, you were saying at the time of submission that 50p on average would raise £4.5 billion in terms of the costs over the period. That would cover the costs of those additional obligations faced by the industry in that period, and so it is about £1 billion of investment per year. Would that be on top of the investment that has been going into the industry anyway?

Mr Skinner: Yes.

 

Q130  Alan Simpson: Since 1990, about £3.5 billion per year has gone in as investment; you would be talking about an extra £1 billion and so it would be about £4.5 billion per year going in as investment. I am just concerned about the equity issue, about who pays, because the industry has squealed at us that these extra costs will be unaffordable. Have you looked at the industry's self-reward programme in terms of its dividend payment over the last few years?

Ms Young: Certainly we have been aware of the fact that water company dividends have held up remarkably.

 

Q131  Alan Simpson: In the last couple of years, dividends have been rising and the returns on the water industry have been 58 per cent head of the FT Share Index, and so it is hard to say that this is an industry on its knees and unable to reward its shareholders. I do not have any qualms about meeting these costs. I am just concerned about who you are asking to pay the costs.

Ms Young: That is an issue that you need to raise with the economic regulator; it is his job to construct a financial framework for the industry that allows them to run a satisfactory but not over-satisfactory business. Our job is to work out what the effective environment programme is and to have some sort of feel, working with the economic regulator on the economic regulation of the companies, as to what that would cost if it was delivered in the most cost-effective way. That is our job, as the Environmental Regulator, not to take a view about how that is funded. That is for the Economic Regulator to do following the guidance from ministers about the size of the environment programme that ministers are minded to see delivered as part of that process.

 

Q132  Alan Simpson: So would you accept that in the way that you have set out the explanation, all of your presumptions would lead members of the Committee, members of the public to believe that what you are saying is, "Here is the total cost of meeting these additional improvements and the public are the ones who are going to have to pay"? That is your 50p.

Ms Young: I think you need to address that question to the Economic Regulator because the way in which the figures are presented means that the costs of financing the company are spread across a number of these headings in terms of the way that costs are presented, so the costs of financing the company will be embedded in some of the total costs of these schemes and that is one of the issues that I think we would be wanting to lay on the table for the next price round in terms of a degree more transparency in the way in which the companies present their preferred business plans.

 

Q133  Alan Simpson: Does that mean that somewhere in these 10,000 words that you are passing across to the Secretary of State, you will be spelling out that she has a choice about where the costs are to be met and that choice need not presume that the entirety of the costs should be picked up by the consumer rather than self-financed by efficiency improvements or dividends foregone within the industry? Are you making it clear to the Secretary of State that she has that choice?

Ms Young: I do not think it is strictly true to say that the Secretary of State has that choice. Clearly it is an important issue that the Economic Regulator, in his decisions, produces a financial framework for the companies to operate within which does not over-favour any of the recipients of benefits in the equation, but he is an independent Economic Regulator, as I am sure he is going to tell you in a few minutes, and although the Secretary of State is able to give guidance on the environmental programme, he is at the end of the day able to make an independent decision about the way in which the structure of the water companies' financing takes place.

 

Q134  Alan Simpson: We will have the Economic Regulator in a moment.

Ms Young: He is your man.

 

Q135  Alan Simpson: I am just asking whether it is clear from what you are saying that it is not an automatic presumption that the costs should be met entirely by the consumer?

Ms Young: Again Philip will explain the way in which the costs are structured, but my belief is that at the moment some of those financing costs are infrastructure costs for the costs of all the various improvement programmes and, therefore, the costs of financing are embedded right across the range of programmes that are delivered to the price round. What you would see, therefore, if what you were saying was that you did not want so much of the profit to be passed on to shareholders, you would see a diminution in the cost of the environment programme, so it would still be met by bills, but it would be met at a lower level of cost. The thing I think that Philip will say, and I hate to put words into his mouth because we are not the Economic Regulator, we are the Environmental Regulator, is that whatever happens, we must end up at the end of the day with a bunch of water companies that are capable of standing up and being financed both through equity finance and through debt finance and if we do not end up with that, we are all in grave trouble if the water companies get into financial difficulties. Now, the Economic Regulator makes those decisions in an independent fashion and they are not decisions for us.

 

Q136  Mr Lepper: There has been some mention already about managing the demand for water. The water companies say demand will go on increasing. You talked about or mentioned Smart tariffs and metering. Now, metering, the impression I have, is not really very popular, but it is there and it is available. Is it really practical for the water companies to be doing more to manage demand?

Mr Skinner: Yes, we believe it is both by what they themselves do and the way in which they stimulate choices in their customers. In parallel with the process we have just been describing which is about the costs over the next five years, the water companies are putting in proposals to us for their long-term water resources plans and our general view on those, which we will be publishing next week, is that the companies, and it varies between company and company overall, have not got sufficient attention to demand management and water conservation issues, including such things as managing leakage in their own systems and that they are too heavily predicated towards investment in new reservoirs. We do believe that the companies could do more and we do believe that metering could be part of those future solutions and we also recognise that a greater penetration of metering would make available some of these options about choices and spreading the costs in the way that Barbara has described.

 

Q137  Mr Lepper: How widespread is metering at the moment? Can you give us a rough estimate?

Mr Skinner: I am sorry, I do not have a figure. My colleagues who follow will answer that question more than I can.

 

Q138  Mr Lepper: You mentioned leakage as well as an issue there and there is this issue, is there not, about the level at which it becomes economic to do rather more to deal with leakage than just simply let it continue. Are we at that level? You are suggesting that we are at that point where more should be done to deal with leakage.

Mr Skinner: The economic level of leakage is one of the key yardsticks which Ofwat use and clearly there has to be a breakpoint where investment does not produce benefits, but we believe in many cases that that has not yet been reached and that some of the longer-term proposals of the water companies, particularly those who are actually forecasting leakage to rise, not just holding steady which in many cases we think is insufficient, could do more. The economic level of leakage of course is a bit of a moving target as the environmental value of the assets which are affected by the abstraction increases and then of course the equation changes. Therefore, looking forward to the Water Framework Directive, looking at the kind of issues about the ecological quality of waters and, therefore, the value which will be placed upon them, we can only see that the issue of leakage is going to become one which has to be kept at.

 

Q139  Mr Lepper: Are there any companies which at the moment you feel are taking this issue as seriously as you would wish them to?

Mr Skinner: Yes.

 

Q140  Mr Lepper: Which are they?

Mr Skinner: There is a spectrum of performance in companies and the two companies who have got the highest leakage projections are Severn Trent and Thames, but other companies are managing it well and managing it down. Northumbrian is an example and that is an issue where water resources is not a high-pressure issue, so there are examples.

 

Q141  Mr Mitchell: I just want to ask you about leakage because one engineer said to me that leakage and investment are often alternatives. Governments push companies into dealing with leakage and the performance has been quite impressive in reducing leakage and it is now forecast to go up. You say that in some cases some companies propose a rise and most propose that leakage volumes will not reduce by 2030. Just as a layman, it could be that the companies are sensibly deciding, "We are better spending money on this rather than on dealing with leakage". With these two alternatives, why are you bashing the leakage argument when the question is that investment could be better used for other improvements?

Mr Skinner: Well, we bash it if the consequence of that is to bring forward the need for new water resources schemes which could either mean the construction of new reservoirs or possibly risk some environmental damage elsewhere and clearly just as there is a trade-off, as you describe, which the company made, there is a trade-off that we made in terms of the environmental pressure from new water resources schemes. We are of the view that the kind of predict-and-demand approach to water resources where you work out where it is going to be and you then go for it by new construction ought to be balanced by, where appropriate, an attack on leakage.

Ms Young: Could I comment also on the issue of timescale. We are at the moment in the midst of one of the most serious pre-drought situations I have experienced for some time. It may sound strange when it has started to rain, but the reality is that if we do not get 30 per cent more rain this winter than average, we will have water restrictions in many parts of the country in the spring and I think that one of the things about ignoring leakage, which can be a way of reducing water consumption, pretty well on an ongoing basis starting from now, as it were, and you have seen the figures, is that we can get action now, whereas if we are looking for building reservoirs, it takes at least ten years to get all the approvals and if they are not forthcoming at the end of ten years, we are in a worse position with climate change biting harder and no visible means of providing water for very legitimate uses and increasing dry summers and potentially sometimes followed on by dry winters. I think it is a bit risky quite frankly not to tackle leakage hard in the current circumstances, particularly in those areas of water shortage like the south-east where quite frankly we are now drier than Syria in available water per head of population.

Mr Mitchell: Well, this is an incredible, wonderful argument for privatisation, is it not? We privatise the water industry and we are forecasting droughts and a shortage of water next year. We privatise electricity and there are going to be black-outs next year. We privatise the railways and they all break down and the trains cannot run. What a lovely agenda for privatisation!

Chairman: To which you are not required to reply!

 

Q142  Diana Organ: As the Environmental Regulator, do you agree in the principle that the polluter pays?

Mr Skinner: Yes, we do.

 

Q143  Diana Organ: On that basis then, why is it that we are asking the consumer to pay to clear up the environment, the nitrates and phosphates in rivers, rather than actually taxing those that are causing that diffuse pollution to pay for the clean-up?

Mr Skinner: Well, we are not because nitrates and phosphates in rivers come partly from the water companies and, therefore, from the people who use their services and from other practices largely relative to agriculture.

 

Q144  Diana Organ: But there is substantial evidence that agricultural activity does increase the nitrates and phosphates in rivers.

Mr Skinner: Yes, absolutely.

 

Q145  Diana Organ: Do you not think that, as the Environment Agency, it is your job to tackle that kind of diffuse pollution rather than saying that the consumer has got to be paying the extra 50 pence to help clear up the environment?

Mr Skinner: Well, we want to do both.

 

Q146  Diana Organ: You cannot do both though, can you?

Mr Skinner: Well, we are constrained in doing what you are asking us to do in respect of agriculture because we do not really have the resources and drivers in place, but there is environmental damage being caused by nitrates and phosphates, particularly phosphates coming from the water industry and we have plans in the programme that we have been talking about which will tackle that and meet the European requirements. We, as we have said already in talking to Mr Tipping, have already advocated strongly to Defra that they ought to be working in parallel and to use the drivers that are possible in terms of agricultural reform. We think that the chance of CAP reform is a huge lost opportunity to provide a mechanism whereby other forms of water pollution are dealt with and in that case the land user is paying.

 

Q147  Diana Organ: Well, you have rather ducked it because you have rather said, "Oh, well, it's not really up to us", but it is because you are advocating the 50 pence a week. How much of that 50 pence a week are consumers in certain areas having to pay to clean up the nitrates and phosphates?

Mr Skinner: No, because we had designed the programme and set the targets so that they are only where the primary cause is coming from the water companies.

 

Q148  Diana Organ: But those programmes that you are saying that only the water industry needs to clean up were actually challenged last week in the evidence to us from the Chief Executive of Wessex Water where he said that this was not the case and they are being asked to do more than the pollution clear-up that is caused by the water industry.

Mr Skinner: Well, we disagree with him and that is a programme which we believe is necessary and has not been included in that particular water company's programme and is an example of a missing factor, but we are asking Wessex Water to address all the issues in the rivers of their catchment. We are asking Mrs Beckett, in parallel with deliberating on this issue, to set in place the mechanisms for a more aggressive way of tackling land-based pollution which one needs to anyway for the Water Framework Directive, so it is an issue which will face the country and since agricultural-derived pollution has a long lead time between the action being taken and the improvement being achieved, we think that should be started, if anything, sooner.

Ms Young: I should say that Defra is at the moment currently preparing its diffuse pollution strategy which we will play a strong role in and have advised on, but it will be absolutely fundamental to get agriculture subsidy to direct farmers in the right direction.

 

Q149  Diana Organ: Just on another issue of other diffuse pollution, occasionally you will know that there is crude discharge by households into water courses which causes a real problem of pollution into those water courses. Why does the Environment Agency not do more to enforce that this crude discharge does not continue?

Mr Skinner: Most of those discharges actually come through water company pipes and they are what we refer to as 'intermittent discharges'. There are very few direct discharges from households into water courses and where they are, we deal with them.

 

Q150  Diana Organ: Well, locally, I can tell you, in the Forest of Dean there are quite a lot.

Mr Skinner: Maybe I can pursue that with you.

Ms Young: Certainly if we were aware of a water quality issue that was substantially impacted on by household direct discharges, we would be taking action because we would be establishing that there was a real water quality failure issue.

 

Q151  Diana Organ: And would you expect the householder to pay for the pollution that they had caused?

Ms Young: If we discover that, for instance, they are wrongly connected so that their sewage pollution is going out through the wrong pipes, we would take enforcement action to ensure that they redirected it and got themselves repiped.

 

Q152  Joan Ruddock: I want to ask a bit about the process itself of the periodic review. Water UK in their evidence to us said, "It does not provide an effective mechanism for dealing with issues that are either long term or require co-ordination with other agencies". I wonder if you actually agree with that statement and, if so, what do you think are the drawbacks of the periodic review process for dealing with environmental issues?

Ms Young: I think the periodic review process is like one of these things, it is the least worst of all the options that we have looked at so far. It does involve a whole range of agencies, it involves government, there are very clear responsibilities allocated, there is a very clear timetable, it is reasonably transparent and it is getting better as we do it more often, so I think we ought not to say that the process is completely broken; it is far from that. I think the issue is the fact that it is a five-year process. We have challenges coming out of the Water Framework Directive that require us to take a much longer look and I think that will be useful for water companies in that they will get a feel for the sorts of environmental issues coming up over a longer timescale. I know that the Economic Regulator, in the way he designed the programme, is attempting to stretch it, as it were, in two directions to try and get early notification to water companies of schemes that they can do in the first year of the programme so that there is not a lag-time every time a new five-year programme is started and also so that we can get a better process, and I think there is still work to be done on this, on schemes that emerge during the course of the five-year review which I know is a concern to water companies, that if they do schemes, they may not get the reimbursement or may not get that taken into account in their funding formula until the next price round. There needs to be a better process for what is known as the logging up of those schemes that happen in an interim sense, but I suspect that it is not easy to get away from the periodic nature of the review other than by these mechanisms for stretching.

 

Q153  Joan Ruddock: So basically you do not think the regulatory regime needs to be modified?

Ms Young: I would find it quite difficult to know what else we could put in its place, to be honest. I think in a situation where there are a range of regulators and government all playing a role, this is probably as good as we can get.

 

Q154  Joan Ruddock: Do you think we could do better within the framework?

Ms Young: It is a learning experience. We have identified some things already. I think the logging-up process does need a bit of attention. There are concerns about it and there is quite a big chunk of the programme this time around for the habitats regulations where we will not be able to give the companies sufficient clarity until quite late on towards the determination and there is anxiety that those costs are going to be able to be taken into account. Quite often if we identify schemes that are not actually clear enough to put in a proper project, we ask companies to do investigations and again we would like to see some of those schemes where investigations come to fruition during the five-year period being able to be brought in as actions as soon as we know what the investigations have revealed. So there are issues with the logging-up process, there are issues, I think, with the way in which the company business plans are presented to allow us to analyse them with the Economic Regulator more effectively and to disaggregate out some of the impacts of financing costs. I am sure Andrew, because he has crawled all over these damned plans more than I have, will have thoughts about the process.

Mr Skinner: I was going to say on the point about the long-term perspective that I think we agree with the water industry that maybe the five year cycle needs some fine-tuning to deal with the issues Barbara has described, but the challenge is also to put the thing in the context of a long-term strategy which the Water Framework Directive will demand and which all the parties involved have to find a way of doing after the cycle is complete.

 

Q155  Joan Ruddock: Do you think the current framework will enable the Water Framework Directive requirements to be factored in?

Mr Skinner: I can see mechanisms whereby the contribution the water industry needs to make to let the country deliver the Water Framework Directive requirements could be accommodated within something which is quite like what we do now.

Chairman: We are going to have a vote very shortly indeed so I am going to suspend now so we can be ready for the vote and ask colleagues to come back as soon as possible afterwards when we will begin with Ofwat. Thank you two very much for coming, sorry you have had a fairly charged sort of day but no doubt you have been able to deliver the document to Mrs Beckett at the same time as bailing out the ships, and we look forward to the outcome of that with scarcely concealed interest. If there is anything you want to say which you have not, please let us know, and if we have further questions we will let you know.

The Committee suspended from 3.47 pm to 4.06 pm for a division in the House

 

Memorandum submitted by Ofwat

Examination of Witnesses

Witnesses: MR PHILIP FLETCHER, Director General of Water Services, MR BILL EMERY, Director of Costs and Performance and Chief Engineer, and MS FIONA PETHICK, Periodic Review Project Manager, Ofwat, examined.

 

Q156  Chairman: Technically we are not quorate so if you want to say you are not prepared to answer, you are perfectly entitled to, but I know from old experience what happens when votes interrupt business and no doubt the leakage will be reversed at some stage. We have before us, Philip Fletcher, Director General of Water Services, Bill Emery, Director of Costs and Performance and Chief Engineer, and Fiona Pethick is Periodic Review Project Manager. Can we start where we just wound up. The water companies said that although the whole process of the review had got more mature, useful and constructive, they thought we were pretty well at the end of where the present process would take us, and you have just heard from the Environment Agency they thought there had to be a way in which the process was able to accommodate rather longer-term perspectives and requirements. Where do you think it is going, Mr Fletcher? If somebody said to you, "You have run this system, we need to know where we go in future", what would your recommendations be?

Mr Fletcher: I would join with Barbara Young in saying that, like democracy, it is the least worst system, it is a good deal better than all the others. Yes, it is not perfect, and one of the obvious things which would be better in a long-term industry is if we could run the periodic review for a period longer than five years. We are going to review that point and all others concerned with how the process works immediately after this review, that is in 2005 when we may expect to have a new Water Services Regulation Authority, Ofwat II, and that will help us think about the period. It is going to be very difficult to make it a lot longer than five years because, as Barbara Young also pointed out, a lot of the demands on the industry are still being formulated even for the coming five years, before 2010, and I personally do not believe that for the crunch period for the Water Framework Directive, 2010-2015, we shall necessarily have everything lined up neatly in 2010 even for five years, and as it happens 2015 is as you know a big milestone date for the Water Framework Directive implementation. So it is always going to be a balance. It is desirable for the stability of an incentive-based regulatory system that you get a good platform on which the companies can perform when you set the price limits, but we also have safety valves, one of which Mr Jack referred to, interim determinations, because announcements have been made today on changes within the period, and we need to have mechanisms coming from the regulatory government end for changes that are unavoidable, however undesirable, during that five year period.

 

Q157  Chairman: Is that your scene-setting, or do you want to do some scene-setting as well?

Mr Fletcher: I really wanted, first of all, to welcome the Committee's investigation here but to say it is very early days. We are talking about draft business plans, about a year still to go before I set price limits, and it is inevitable at this stage that there is a lot of uncertainty which still has to be sorted out. That does not mean the process is wrong. I think actually, without being complacent, the process is working broadly as we in Ofwat had hoped it would at this stage. We have companies' draft preferred strategies, something we did not have five years ago, and we have two reference plans on different bases to give us a reasonable understanding of what changes when you make assumptions different from those preferred by the companies, on things like cost of capital and efficiency propositions and, one big driver of change, the scale of the environmental programme.

 

Q158  Chairman: Do you think we will come to the point when we have the environment as good as we need it to be? In other words the question is, will there be a continual environmental improvement continually driving up prices to the consumer, or is there a point where we say, "Hang on, it is good enough"?

Mr Fletcher: We have drinking water tests meeting the current standard 99.8 per cent plus, so they are creeping up. The Government announced, with a justified fanfare, yesterday yet more improvements on bathing beaches, with 99.8 per cent now fully meeting the current standard, of course there are further standards to come. I think the answer is that we will never be at the end of this process, there will always be things which drive us to another stage, but it is important that customers should feel that what is coming through is actually necessary and desirable in the interests of the improvement of the environment and all the other improvements they want to see, so that they have some stake, some share, in what certainly for this five years I fear will be price increases rather than price reductions.

 

Q159  Chairman: I have never yet had a constituent write to me to complain about the quality of the water which came out of the tap. I think all this is happening over the heads of the consumers. They are being told it is good for them but they did not think what was happening before was particularly bad for them.

Mr Fletcher: We have done joint work - which is another improvement this time round - where we, the Environment Agency, the other environmental regulators, the Government, the companies, Water Voice, the customer representatives, have all done joint research together, and phase one last year showed by and large customers were, as you say, content with the level of service they were receiving. For that reason, the companies in their draft business plans by and large are not proposing big service improvements in terms of their own direct service to the customers, but one important exception is sewer flooding where they do want more to be done and where I, frankly, share their view we ought to try and do more.

 

Q160  Chairman: Polluter pays, is that a relevant principle in this game?

Mr Fletcher: I think it is a highly relevant principle and yet it is a difficult one to grasp, but it is the old problem of the times do not always match up. The pollution which is now affecting some of the aquifers happened 20 years ago, or 200 years ago if you really look at the Industrial Revolution, and, as you know from other investigations, it is not easy to pin that on to a living polluter. Looking forward, the emphasis which everyone involved is putting on diffuse pollution and its control is going to be terribly important for the acceptance by water customers that any increase they face is justified and it is not them bearing the costs which ought to be borne by others.

 

Q161  Chairman: You are faced with Plan A, Plan B and preferred plans, how do you weigh the three of them when you come to do price determination?

Mr Fletcher: This goes back to the fact we are still in the early days. Before we get to the price determination we shall have seen a lot more work from the companies. We are, as they say, in dialogue with the companies at the moment; we are engaged in a pretty - I will not say "bruising"- constructive, critical dialogue between the two of us, meeting by meeting, which colleagues like Bill Emery take with each company, to test what they have put to us. At the end of that we shall have learnt something, they shall have learnt something, and we will get, I am convinced, much better final business plans next April than we would have done if we had not gone through this draft process now. That will be the focus, that will be what they actually want to do, taking account also of Mrs Beckett's key guidance to me and the water companies, hopefully in late January, on what she wants them to do to fulfil the UK's environmental obligations.

 

Q162  Chairman: So it is dialectical synthesis?

Mr Fletcher: Yes, Chairman.

 

Q163  Mr Mitchell: Listening to what you have said, there is a great deal of uncertainty about what the obligations of the water companies are going to be. You do not know beyond 2010, you do not even know some of them will go into the next period. When does that uncertainty end? Whose side do you err on? That of the companies? In other words, giving them greater income to deal with contingencies which may or may not arise? Or that of minimalism?

Mr Fletcher: Probably between the two. It is important in the context where we are going to see broadly prices going up, maybe substantially, that we are only doing properly what needs to be done. I share Barbara Young's view that we cannot stand still just because we face price increases, we need to keep going with the environmental improvements which are necessary. At the same time this is a long-term industry with a long-term perspective and the environmental improvements only have effect over a long time. In her initial guidance to me, the Secretary of State made it clear that even where there are statutory drivers, obviously a key point, nonetheless there may be choices about how and when it is done and about the synergy between various different elements in the programme. So I hope that the guidance, when it comes to me, will take full account of the point she has already made in her initial guidance.

 

Q164  Mr Mitchell: It depends on who defines "necessary" and what "necessary" means, does it not?

Mr Fletcher: It is right that the Government of the United Kingdom is the right person to assess what our obligations as a nation are under the international agreements we have entered into, including European directives. That is where I look for that bit of key guidance.

 

Q165  Mr Mitchell: There are specific directives, and that is clear, but on a general desire for an improved environment you cannot define how far it is going to be ----

Mr Fletcher: So it is important to pin it down, and I agree completely with that. The directives do a lot of that and the Water Framework Directive, as we all know, will provide an overarching frame in which all these individual elements can be properly looked at. What is already clear is with hindsight we have all got a lot to learn about regulatory impact assessment, and some of the assumptions made about what the directives will cost already start to look a little optimistic, shall we say.

 

Q166  Mr Mitchell: You mean exaggerated?

Mr Fletcher: I mean, on the contrary, far too low.

 

Q167  Mr Mitchell: I thought they would take the opportunity to whack a lot more on and blame it on Europe, which is a good tactic.

Mr Fletcher: There is a danger in blaming Europe here because, certainly with what has been done up to now, everybody takes credit for it - Ofwat takes credit for it, the companies take credit for it, so does the Environment Agency, so does the Government - which shows it has been a success and actually we all, probably rightly, share some credit for those improvements. On the Chairman's point, the incremental benefits do start to tail off after a while and it is very important to be able to persuade the customers they are still worthwhile doing.

 

Q168  Mr Mitchell: Everybody takes credit but I wonder if the consumer notices. However, let us not get into that. Let me move on. Why are there such marked regional differences in the price increases?

Mr Fletcher: This may be a bit because company boards in looking at the issues in front of them have chosen to take different approaches, for example, on capital maintenance. But a large part of the variations in the companies, both the reference plans and the preferred strategy, is due to the fact that different drivers have different impacts on different companies. If we take the one which is right out pretty well on its own at the extreme, that is United Utilities, which is on its preferred strategy proposing an increase of 70 per cent in real terms - it will be rather less if my announcement today on interim determinations does indeed take effect next year but that is no great comfort to customers - they face ageing, and not just ageing (Bill Emery upbraids me when I use the word ageing) infrastructure which needs to be overhauled and up-dated because, although it is performing perfectly well at the moment, we must not run the risk with that infrastructure of serious failure in the future. I think we have done pretty well so far. I think there is an argument which we need to listen to very hard from the companies that we may need a step up for the coming five years, and it is unfortunate that it coincides with the prospect of an environmental programme which we will still be driving ahead at a rate not very far distant from the first 15 years since privatisation.

 

Q169  Mr Mitchell: That is something you can measure, the age of the investment and when it needs to be renewed, but how on earth can you measure regional differences like the fact they have more beaches in the South West, whereas other areas have more reservoirs and a greater opportunity to supply water locally from them? These are God-ordained, God-given, differences which you cannot really measure.

Mr Emery: I think there are two ways of answering that. One is, in terms of trying to compare the efficiency of the companies, we try and take account of the different geographical situations each one faces, and use rather complicated statistical techniques which bring in these co-efficients you commented on earlier to try and tease out factors outside management control, whether they are efficient or not efficient, and those judgments feed into price determinations, and in terms of setting up the draft business plans we have fed our current assessments of those efficiencies into the Reference Plans A and B. So in terms of the efficiency judgments between companies, we have a method, and it is a proven method over two or three periodic reviews, that works quite well. In terms of the environment programmes, they are site-specific, discharge-specific, obligations-specific, and hence if there is a gap between the environmental expectations and the current consent on this particular one, and it is a very big works, that is why that particular company has a large step to make in this particular period. You can only really get a trend over a long period as to whether or not there has been a significant difference between the companies. In terms of saying, "Why are Severn-Trent not exposed", you have to go back a very long time to serving populations by inland rivers so they invested in substantial levels of treatment many decades ago, whereas coastal companies did not, and they are having to afford that now. So in terms of the impact on bills of the quality programme, it is down very much to the individual assets and current levels of performance and the gap in the environment performance needed, and that is why you get wide disparities between companies in the environment programme. You similarly get wide disparities between companies in terms of whether or not they are exposed to movements in population, because companies in the South East are subject to substantial needs to cater for the growth and change in populations, other companies are not. So when you look at all the component parts, it is not surprising you get quite different packages, and of course at the end of the day if you have a small company exposed to a large requirement to make the movement, then its customer base is small but the investment could be quite substantial, and there is only one place where the funding really comes from and that is supported by customers in the long-term.

 

Q170  Mr Mitchell: I can see that, there are lots of factors which you say are not measurable and I can accept that. In the first part of the answer, you seem to be saying you have devised a mathematical formula for measuring God's legacy to different parts of the country. I know a beneficent deity gave a very good legacy to Yorkshire and probably a less happy one to the South West, but I cannot really think how you can measure those factors by any mathematical formula, which is my real question: are the companies going to be able to dazzle you with science, or bluff you with geography really, when it comes to saying what they need to do for their area? Can you properly measure and regulate that?

Mr Fletcher: They cannot blind us because we have 23 of them and we can compare one with another. Yes, of course, there are all these geographical variations but we have been working for 15 years with the companies to try and ensure that the special factors can be ironed out and that we can really test the degree to which one is more efficient than another, and apply appropriate pressure for the less efficient to catch up with the best without doing what we must avoid, which is to drive a company inadvertently too hard to the point where it is impossible for them to carry on performing this long-term essential task.

 

Q171  Mr Jack: In paragraph 30 under "Financeability", you start your evidence by saying, "There are two strands to our duty to allow companies to finance their functions. One is to ensure that if a company is efficiently managed and financed it earns a return equal to the cost of capital. The second is do its revenues, profits and cash flows allow it to raise finance on reasonable terms in the capital markets." Both of those are very important statements. In the context of commenting on what might be deemed for a utility to be an acceptable financial profile, could you comment on why you think the companies' return should simply be equal to the cost of its capital?

Mr Fletcher: The point about financeability is partly to say, there is more than that. If they are to keep investors attracted to putting money into the industry on the scale which the current programmes require, then they need to raise capital and make a return to shareholders. Mr Simpson may have questions about whether those dividends are acceptable or not. We do not control the dividends and try and ensure only a company which is performing very efficiently will be in a position to keep its shareholders properly rewarded. At the same time we must ensure this sector does not fall through the cracks. If I could comment on Mr Simpson's earlier point, yes, the shares have performed well over the last few years but, as so often in these things, it depends on your starting point, and the starting point was the period immediately after the last review when they were performing very much below the market, partly as a consequence of the last decision by Ofwat to cut prices by 12 per cent in real terms in 1999 which led to a rate of return across the industry of under 6 per cent, which is not generally regarded as a hugely generous return for private capital bearing in mind the risk it must carry. So a variety of issues, but we must ensure we set the cost of capital at a point where an efficient company can expect to beat it in delivering its own motto (?).

 

Q172  Mr Jack: What dividends are you taking therefore in setting that cost of capital? How are you determining that, bearing in mind you are looking forward over a five year period?

Mr Fletcher: We are first of all thinking about a consistent structure to the industry. What we actually have, as you know, is a great variety of different structures from wholly debt financed to a company limited by guarantee in Wales, to a number of companies which still consider it right to have a very substantial tranche of conventional equity. In setting the cost of capital we will assume that the companies need to raise funds from a variety of sources for safety's sake, because the fact that debt is relatively cheap to raise at the moment may not persist over time, so we are not going to look at just a spot point in the market, we will be taking account of all the evidence which appears to us relevant on the immediate market position, future historic trends and assume some gearing, perhaps slightly more heavily weighted towards debt in the light of market developments, but still assuming an equity element as well which at the moment is a lot more expensive to raise for most companies than debt.

 

Q173  Mr Jack: Bearing in mind companies come to you, as you say, after 15 years and their debt/equity is what it is, they are faced with the reality of having to satisfy, in a company that has gone down the equity route, their shareholders. It is difficult, unless they go through some complex things like share buy-backs, to change the debt/equity ratios they have, therefore they are faced with a circular argument, are they not? If they do not look a good prospect in the market place, they are not going to have things like rights issues properly subscribed to, people will not put new capital into the company to meet their future obligations. Equally, if they have to go into the debt-raising side of things, they have to have a credit rating and therefore a performance rating which is attractive to lenders, and unless you get the numbers right they could be in difficulties. So do you look at individual companies? The point I was intrigued by was, "to find a return equal to the cost of capital". Do I deduce from that what you are saying is if you therefore want to pay a dividend that is more than a number which represents the return to capital, let's say for the sake of this discussion the 6 per cent you mentioned, if you want a return more than that or have capital growth of the company via the stock market, that the company is going to have to perform even better than it said to you it could do in order to generate those extra surpluses so its financial performance looks acceptable?

Mr Fletcher: If I take the first part of your question first, we do need to look at the state of the company individually. For example, a company which has a very large capital programme because it has been required of it and because we have accepted the need for it in the price limits, may well run into the buffers of various financial ratios which are essential to it if it is going to maintain its borrowing capacity, and we must take that into account. But we always, as you know, start with the need for the company to be efficient, we are not there to bail out an inefficient company whose credit rating or whose financial ratios are poor in the first place, and that company must take its chance in the market with anybody else who is under-performing. Yes, we do look at the circumstances of the individual companies. What we have said so far in relation to the cost of capital is that we do not expect it to be lower than the post-tax cost of capital figure we used at the last review, which is 5 per cent, and we shall be, in looking forward, taking a decision much nearer the time of the final price setting on whether that figure needs to increase or not bearing in mind the negative cash flow position of the vast majority of the companies.

 

Q174  Mr Jack: Looking back over time, what can you say about the track record of companies performing better, in terms of their efficiency and therefore their ability to generate extra returns in the case of those with shares to their shareholders, than they said to you at the time? If that occurred, how do you then deal with that? Because the suspicion in your mind must be, "If they could it once, they could do it again". The feeling I have, at this perhaps more malleable stage as I have been given to understand the process is, is that there is an element of horse-trading. Some elements of this are not exact, some you cannot put a precise number on, and from the consumer's point of view the consumer wants to be sure they are not being ripped off, they are not trying to slide something in under the carpet, which is where I suspect Mr Emery's ferocious and forensic gaze comes in. If you were talking not to the Select Committee but to water users, how do you reassure them that the companies are not pulling the wool over your eyes in financial terms and are being "fair" in the requests they are making in relation to the size of the financial/economic challenge which they have, which is to meet the requirements of the Environment Agency as well as, refreshingly new, the infrastructure for which they have responsibility?

Mr Fletcher: The very bare history of this, as you will recall, is that the companies greatly out-performed expectations after privatisation, and what was originally intended as a ten year period very quickly became necessarily a five year period because it would have been unacceptable for them to continue to make returns in many cases double the level of what they had made since 2000. They continued to out-perform a lot after the 1995 review, and the way the system worked and should work is that that was taken fully into account in the 1999 review and led to the reduction in prices of 12 per cent, a state of affairs which benefited everybody - customers got reductions, the environment got a continuing large and bigger programme, the Environment Agency at the time rejoiced to see the back of the Victorian sewerage system and everybody was happy. I fear this magician's wand is not available to me for the year 2004, but we can see the system working and the efficiencies made up to 1999 were returned to customers, mimicking the operation of a truly competitive market, in the year 2000 up to 2005.

 

Q175  Mr Jack: We look as if we are moving into a position where debt costs may be rising, and it does not look as if they are going to get any cheaper. How do you factor into your final determination of these matters possible long-term changes of interest rates? Because clearly it could have an important influence on this equation as to what is the right number to allow a company to increase its costs by if debt becomes less attractive and equity becomes more attractive part-way through the settlement period.

Mr Fletcher: This goes back to my earlier answer. As you would expect, we take proper financial advice, city advice and so on, so we are properly and expertly advised, but we are not assuming all the eggs go in one basket. We shall start from the assumption, whatever a company may actually do by way of structure, its eggs are properly spread to spread the risk, that there is an equity element and a debt element, and therefore whatever changes in the market it will not be so extreme as to invalidate the assumptions which underpin our price limits when we come to them.

 

Q176  Alan Simpson: I am fascinated by this. Are you a fisherman?

Mr Fletcher: No, I am not.

 

Q177  Alan Simpson: Nor am I, but if I wanted to make a start and skip the tedium of standing at the water's edge for hours, I ought to start with mackerel fishing because it is dead easy ---

Mr Fletcher: I have done that! Spinners over the back!

 

Q178  Alan Simpson: Yes, throw the lines out, it is money for old rope, you just pull them in hand over fist. Is that not the market you are describing for water? It is not a truly competitive market, is it? None of us are going to say, "We do not like the state of the market this year, we are going to skip water consumption." We are all over a barrel, are we not, as consumers?

Mr Fletcher: There are various different markets involved here. The people who do not have choice are us as water customers.

 

Q179  Alan Simpson: Yes.

Mr Fletcher: So there is no market there. The investors in the industry have absolute choice, there is no need for them to hold water bonds, shares or to lend as banks to water companies, and that is one of the factors I have to bear in mind. Ofwat is just there as a proxy - never a perfect proxy - for the operation of a true competitive market with open and transparent information available to all players. I do not think the water business will ever be quite like that, therefore I suspect Ofwat, or something like it, is going to be needed for quite a long time to come.

 

Q180  Alan Simpson: I do not have any doubts you are going to be needed for some considerable time to come, but it is this role as a proxy for a perfect market. I think you are also there as a proxy which protects the public interest.

Mr Fletcher: Absolutely.

 

Q181  Alan Simpson: We accept that. I know during the break we had you were kind enough to supply some figures about investments which had taken place in terms of new equity issues during the last five years. You have just said in response to Michael Jack that in terms of the equity element, the protection of that part in respect of dividends which you regard as legitimate has to reflect the fact the equity element is a lot more expensive to raise at the moment. As an explanation, that would make sense if people had been seeking to raise equity. Will you confirm what I think you said during the break, which is in the last five years there is only United Utilities which have come up with a new share issue and that is of £0.5 billion and another £0.5 billion to come?

Mr Fletcher: Yes, they are raising £1 billion and they have taken half of it in advance of the periodic review and effectively said that shareholders can think again when they know the outcome of the regulator's review next year. Yes, that is quite right, there has only been one rights issue, I believe, since privatisation, but that does not mean that effectively equity is not being raised because the equity base of the industry is still there and still effectively growing and affected by the prices which people will pay for the shares.

 

Q182  Alan Simpson: Let us be real about this. Once you have sold your shares, whatever market trading is taking place it is not coming back to you.

Mr Fletcher: They have their equity base there and they are drawing money from the debt markets. Of course if you talk to Glas Cymru they will say in a non-standard way they have equity too, the equivalent of equity in the shape of the lower price paid for the business relative to its assessed regulatory value. So there are proxies for equity besides the straightforward shares.

 

Q183  Alan Simpson: I am still at the stage of looking at this as money for old rope. My reading is that dividends paid out since privatisation have been over £18 billion, in the last five years in a difficult time they have paid themselves out over £7 billion for half a billion new equity issues. How, on the basis of that, can you justify putting the bill for the improvements that will take place entirely on the customers and not on the shareholders?

Mr Fletcher: Two quick factors on the dividends. First of all, the dividend goes with the capital value of the equity and the shareholder is looking for a reward on both, so if the share prices are depressed (and they have been running below the regulatory capital value since 1999) that is one factor. Another special factor is that a number of companies have been switching from equity to debt, and have paid special dividends, which I think are included in your figures, which are a rather special case. On your wider question, we must ensure that customers are not ripped off, and that is where I absolutely agree with you, and for the whole of the next year Ofwat will be giving its best shot to ensure that customers finish up with no more than they absolutely have to pay while the companies can finance these very big programmes going forward.

 

Q184  Alan Simpson: In that assessment you will be building in a presumption that those facing water poverty ought not to be pushed over the edge in whatever price rises come through?

Mr Fletcher: That raises a whole new set of issues around the whole business of water poverty. I am very concerned about customers who find it difficult to pay their bills and that is why the prices must not be over-high, but at the same time it is equally important that I stick to my statutory duty of enabling companies to finance their functions and do not hold prices at a completely artificially low level to the point where the stability of these companies is at any way put at risk.

 

Q185  Chairman: If you felt you wanted to expand on that point, perhaps you could do so in a note. I am sorry to squeeze you in between two bells, as it were, but I know from experience that we will not recover a quorum after a second vote. Thank you very much, all three of you, for coming and we look forward to inevitable and no doubt pleasurable further contact.

Mr Fletcher: Chairman, thank you. If there are any other written questions which members wish to put me, of course I will always try and respond to them.