APPENDIX 7
Memorandum from Dr Neil Summerton, CB
1. I am an independent non-executive director
of both Three Valleys Water and Folkestone and Dover Water Services,
both of which are subsidiaries of Veolia Water UK. In 1991-97
I was Director Water, and then Water and Land, in the Department
of the Environment. In 1997-2002 I was Director of the Oxford
Centre for the Environment, Ethics and Society at Mansfield College
Oxford and Director of the Oxford Centre for Water Research. I
was a specialist adviser to the Environmental Audit Committee's
inquiry into Water Prices and the Environment in Session 1999-2000.
2. I submitted evidence to the Environment,
Food and Rural Affairs Committee's inquiry into Water Pricing
(First Report, Session 2003-04). Paragraphs 21-31 are relevant
to the Environmental Audit Committee's present inquiry and they
are annexed.
KEY VARIABLES
FOR PRICE
LEVELS
3. The Committee's announcement of its inquiry
refers to the balance that needs to be struck between the size
of the environmental programme and price increases to customers,
and the proposal. To my mind, this is to put the matter too simply.
There is a number of interacting variables which have to be taken
into account in deciding the appropriate level of water prices
(bearing in mind the important statutory constraint that the regulator
must ensure that water companies properly carry out their functions
and must ensure that the companies have the necessary revenue
to enable them to do so (s. 2 of the Water Industry Act 1991)).
The main ones are:
(ii)
the environment (whether from upstream
risks of over-abstraction or from downstream risks of pollution)
This new investment can result from
the requirements of European law or of domestic law. The scope
for discretion in respect of the former tends to be limited. The
extent to which the latter is discretionary depends very much
on the structure of the particular legislation, in particular
the degree of discretion allowed to the Environment Agency and
other regulatory bodies concerned, and to sewerage companies in
so far as statutory duties may bear directly upon them.
(b)
The cost of maintaining and improving standards
of service (these cover a wide range of matters such as meeting
growing demand against the background of the effects of climate
change, customer care, water pressure, sewer flooding, containing
and reducing leakage, and so on). Statutory regulators judge and
penalise water companies on these matters.
(c)
capital and operational expenditure to maintain
networks and plant. System assets are crucial to effective
water and sewerage services which are highly capital intensive.
These assets have been acquired over two centuries with important
spurts at various points in the 20th century. Their lives vary
with the nature of the asset and the character and quality of
the original provision. They can also vary with the changing environment
of the network, eg, with changing ground conditions over time
and, where pipes are laid under the highway, with increasing traffic
volumes and axle weights. Generally water networks have long lives,
but they do not last for ever. Refurbishment and/or replacement
is necessary, as with the capital equipment of other industries
(which almost always have much shorter replacement cycles than
is the case with water). If refurbishment and replacement are
not done in a timely way, even with such long-lived assets, the
result will be deteriorating standards of service for customers
and/or greater operational costs to be borne by customers in order
to try to maintain a given standard of service.
(d)
The scope for efficiency savings on the part
of companies. There is an increasing recognition that the high
rate of efficiency savings achieved in the 15 years since privatisation
cannot be sustained into the future, though some will still be
possible. A once-for-all price cut was possible in 2000 as a result
of efficiency savings since 1989, but it is not likely to be repeatable.
(e)
The cost of capital, that is, the price that
must be paid in the capital markets in competition with other
demands for capital, to obtain the capital needed by the companies,
whether by way of equity money or loans. Clearly, customers should
not be burdened with a higher cost of capital than is necessary
to obtain the capital that is needed. Any regulated sector is
susceptible to what is seen by investors as "regulatory risk".
In this case if the regulator depresses the allowed cost too far
in his price determinations, the capital markets may be discouraged
from investing in the sector. As Dr Dieter Helm told the Environment,
Rood and Rural Affairs Committee last October the cost of capital
allowed in 2000 "induced a significant flight-from-equity"
(House of Commons Environment, Food and Rural Affairs Committee,
Water Pricing, First Report of Session 2003-04, Ev. 83,
para. 12).
4. At different stages in the Periodic Review,
attention tends to shift between these variables. At present,
the focus is on the level of new investment for quality purposes,
since the government must make what are quite rightly political
decisions about the level of new investment which the regulator
must take into account in reaching his price determination. But
it should not be forgotten that, for any given level of prices,
the variables are interactive. The regulator has a statutory duty
to enable each company to finance its functions. Statutorily speaking,
whether customers can afford the outcome does not come into the
matter. Politically and practically, of course, affordability
does matter, particularly as the protections hitherto afforded
to poorer customers are gradually eroded.
SCALE OF
NEW INVESTMENT
5. At this stage, the scale of new investment
required is critical. It has to be considered in the light of
the implications for price levels and for the other key variables.
The decisions must bear in mind the possibility that, in the interests
of keeping price levels down, the regulator will forced to make
unrealistic decisions about efficiency savings and the cost of
capital, and forced to cut back, yet again, on the necessary maintenance
and replacement of assets. The decision on new quality investment
is not easy, of course, precisely because of the extent to which
it is statutorily required. This is not a new phenomenon in Periodic
Reviews. Nor is this a question of demonising quality investment
(see recommendation (b) of the Committee's report of November
2000). It is to recognise that the matter should not be considered
in isolation.
MAINTENANCE AND
REPLACEMENT OF
ASSETS
6. The point about maintenance and replacement
of assets should be of particular concern to the Committee. In
November 2000 the Committee was particularly critical (recommendation
(l)) of the way in which the matter was treated in the 2000 Periodic
Review and it recommended a collaborative approach between those
concerned, to deal with the "intellectual neglect of this
important problem". The approach was to be "forward
looking and should enable the companies to adequately prepare
to renew and repair the cohorts of sewers and mains which will
come up for renewal/rehabilitation . . ." The regulators
and the companies have worked together closely to implement that
recommendation and I believe that it is accepted that, in general,
estimates of future requirements are better founded than in the
past. It would be a pity if decisions on other matters were again
to result in neglect of replacement and to frustrate the benefits
of the Committee's earlier recommendations on this topic.
7. More generally, the needs of clean water
supply should not be crowded out by pressure from the wastewater
side.
February 2004
Annex
Extract from evidence to the Environment,
Food and Rural Affairs Committee, October 2003
(a) Reasons for price increases
21. The main reason for rising prices in
real terms since 1989 has been the cost of investment to raise
standards of performance in a number of ways:
— Improvements in drinking water quality,
in particular investment to deal with nitrates, pesticides, lead
and parasites such as cryptosporidium. This investment has been
necessary to enable regulatory standards to be met. This has also
entailed extra operating costs.
— The costs of protecting the environment
in two ways:
Dealing with the effects of abstractions, including
improving flow in low-flow rivers and protecting and enhancing
wetland habitats
— Reducing environmental impacts of sewage
discharge and sludges. Here, a very wide range of regulatory requirements
have had to be met, ranging from the bathing waters directive,
the freshwater fish and shellfish waters directives, and the urban
wastewater treatment directive. These requirements have been exceptionally
heavy.
— Costs of raising quality of service in
a variety of ways—nothing equivalent to levels of service
requirements existed under the previous nationalised regime.
PROSPECTS FOR
THE 2005 REVIEW
22. At privatisation, there was a tendency
to regard extra investment as a hump that could be surmounted
within a decade or so. Thereafter, it was expected, cost pressure
would reduce, allowing water prices to fall back to a pattern
of RPI—X rather than the RPI + X needed in the first phase.
It is already clear however that this happy position will not
be achieved in the next review.
(a) Continuing cost pressures
23. There continues to be a wide variety
of pressures requiring further new investment, pressures which
will also result in new operating costs. Among the more important
are:
— Achieving the requirements of existing
EU directives.
— The Water Framework Directive.
— Protection of SSSIs and other EU
and domestic environmental areas.
— Climate change and water scarcity,
coupled with rising demand from domestic users.
— Eliminating lead from drinking water.
— The requirements of the Security
and Emergency Measures Directive.
Beyond this, is the risk of newly-perceived
health threats resulting from water re-use. There is also a variety
of other variables over which neither the industry nor regulators
have any control, such as levels of business rates after the next
revaluation, tax and NI changes, the prospect of statutory lane
rental charges for works in the highway, abstraction charges,
pensions costs, energy costs, general insurance costs, and so
on.
(b) Replacement and renewal
24. Additionally, replacement and renewal
cannot continue to be neglected. Water companies have to invest
in replacing underground networks and above ground plant. At replacement
cost, the total value of water assets now exceeds £204 billion.
While the life of some categories of this investment is long,
it does not and cannot last for ever. That provided in former
generations varied in quality through time and geographically.
Some old networks need surprisingly little maintenance; others
do not last as long or otherwise need replacement in order to
provide a good standard of service and reduce maintenance costs.
In general, above ground plant needs replacement more frequently
than networks.
25. Adequate levels of replacement are essential
if customers of the future are to receive good service. Assets
worth over £200 billion presuppose an annual replacement
cost in excess of the current peak rate of £1.7 billion,
if an appropriate spread of asset lives is assumed. As noted by
the Environmental Audit Committee in 2000, there was a tendency
in earlier reviews for OFWAT to neglect this aspect of investment.
Since 1999 there have been improvements in the system for identifying
these needs. It is important that regulators should recognise
the implications for investment levels.
(c) Implications for prices
26. These investment requirements are not
well understood by the public. Nor is it appreciated that, while
there is no charge for water as a raw material, the costs of networks
and treatment plants and operating them are inevitably substantial.
Price pressures derive from the extra costs of the service rather
than from profits per se, though the costs of capital must be
met (as they would have to be met in a publicly-funded service).
27. Many of the price pressures are on the
wastewater side. What is of particular concern to water suppliers
is the possible temptation to achieve environmental improvement
at the expense of investment in water supply, and replacement
and renewal generally—that the needs of the clean water
sector will be crowded out by the wastewater side. The regulator
must discharge his statutory duty company by company and he must
guard against the possibility of successful appeal to the Competition
Commission if he were to allow the needs of the wastewater side
to cloud his judgment about those of water suppliers. But it is
possible to contain pressures by taking a narrow view of the functions
of water suppliers.
FINANCIAL AND
EFFICIENCY VARIABLES
28. Prices also depend on assumptions about
a number of financial and other variables. Here again there are
limits to the regulator's room for manoeuvre.
29. First, the economic regulator has statutory
duties which cannot be ignored and have implications of price
levels:
— To ensure that water companies carry
out their functions; there is little room for manoeuvre to manipulate
interpretations of those functions.
— To ensure that these functions can
be financed, particularly but not exclusively as regards the cost
of capital. This is determined by the markets. If efforts are
made to squeeze margins below the level that the markets deem
acceptable, they will react accordingly. This is in essence what
happened following the 1999 price determination.
30. Since 1999 there has been extensive
revision of the financial structure of companies, increasing levels
of debt finance and reducing equity. To some extent, this has
been in the longer-term interests of customers, that is, if the
level of equity exceeded that necessary for entities with the
risk-profile of water companies. However, the result of squeezing
returns may have been to cause a reduction of equity beyond the
level that is wise. Equity capital in water companies represents
a buffer which protects customers from unforeseen or miscalculated
risks. If equity has been reduced to below the "right"
level, risks will have been increased for customers. These considerations
need to be borne very carefully in mind in the present price review,
especially in considering the temptation to keep down prices by
manipulating financial variables in the face of unavoidable investment
pressures.
31. A further variable which may be prayed
in aid to keep prices down in the face of other pressures is assumptions
on the efficiency gains which companies can be expected to make
in the next price period. Insofar as private companies can be
expected to be more efficient than nationalised companies (or
than the former statutory private companies), the period since
1989 ought to have been sufficient to enable the implicit step
change to have been completed. Henceforth, it is questionable
whether water companies can make greater efficiency gains than
private sector companies generally. In this context, two points
need to be borne in mind:
— The RPI subsumes the underlying rate
of efficiency gains across the economy as a whole. If there was
no extra investment and prices were restricted to the increase
in the RPI, companies would need to achieve at least the average
efficiency gain across the economy as a whole. The RPI—X
formula therefore requires regulated companies to achieve an additional
efficiency gain over and above the underlying average.
— As in the case of any company, water
companies have costs that they can control and costs (like tax,
rates and so on) which they cannot control or even influence.
The ratio of controllable to uncontrollable costs is roughly 80:20.
Efficiency gains must be concentrated in the area of controllable
costs. This means that if the regulator's efficiency assumption
is 4% overall, water companies must actually achieve a gain of
5% on controllable costs. This point is of significance if the
level of uncontrollable costs is comparatively high compared with
the activities which the regulator uses as the benchmark.
32. All this emphasises the need for the
Committee to be realistic both about the cost pressures on the
industry and the extent to which there is freedom nevertheless
to hold down prices in the face of these pressures.
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