Examination of Witnesses (Questions 20
- 39)
WEDNESDAY 20 OCTOBER 2004
MR PHILIP
FLETCHER, DR
BILL EMERY
AND MS
FIONA PETHICK
Q20 Paddy Tipping: Are you making
a slightly broader point about EU regulations that are very good
in policy terms and conceptual terms but were not so good in actually
looking at the consequences, the practical issues and the costs
of those regulations?
Mr Fletcher: We are all very conscious—back
to the Chairman's long-term point and other studies which the
Committee has made—that the Water Framework Directive is
very important and absolutely right in its focus on outcomes.
Nonetheless, the crucial issue is, what benefits are going to
be there? What is it going to cost? Who is going to pay those
costs? Hopefully, learning from the past, we will all of us, certainly
including Ofwat, get better at it as we go forward.
Q21 Mr Lepper: The Chairman has mentioned
the question of affordability already and you have told us about
the costs of the environmental scheme in terms of increases and
you will be aware that our earlier report on the review referred
to some two to four million householders who cannot afford their
water bills already and you acknowledged that in your evidence
to us and mentioned the fact that Ofwat is contributing to the
Defra review of options for helping those who find difficulty
in paying their water bills. Could you give us some indication
of what you will be contributing to that Defra review. How should
the problem of affordability of our water bills be addressed?
Mr Fletcher: Would you mind if
I started with your first point, that is affordability itself.
Overall, water customers are paying about 1% of their income towards
their water bill. So, any bill and any bill going up is very unpopular,
I absolutely appreciate that, but it is not a huge proportion
and it is a very much smaller proportion than, for example in
most of the developing world, customers are paying for water.
That said, we entirely accept that, in the very high bill areas—and
the most obvious example is South-West England—for least
well off customers, we are already seeing bills that are likely
to represent a significant proportion of their incomes, in many
cases 3% or more, and, subject to the issue around metering which
you may want to bring me back—
Q22 Mr Lepper: I was going to in
a while, yes.
Mr Fletcher: There is a real tension
there. The contribution which Ofwat is making to the Government's
review is to be very much part of the expert evidence to that
review. We are ourselves a Government, though a non-ministerial,
Department. Clearly, it would be duplication for Defra itself
to have all of its knowledge. We supply the knowledge we have
which includes the work we have done with Water Voice, who are
formally at the moment still linked to Ofwat and still part of
the same organisation as the customers' representatives and we
have done quite a lot of review work on debt issues with the companies,
on issues around affordability, on issues of good practice in
companies managing debt, keeping it down but paying attention
to those customers who find it the most difficult to pay in order
that they are properly treated and so on. That has been our main
focus in this review so far.
Q23 Mr Lepper: Can we come to this
question of metered and unmetered waters. I know that the National
Consumer Council says that it is extremely concerned about the
difference in charge between metered and non-metered customers.
Do you share those concerns? Why is there this difference between
metered and non-metered customers?
Mr Fletcher: Seventy-five per
cent of us as householders still pay our bills on an unmeasured
basis using the rateable value of our houses and this is about
the only purpose for which rateable value is still generally used
and no one would claim it is a perfect proxy for the use you make
of water services, it is a rough and ready, broadly progressive,
which is important, form of tax applied in this different category.
The measured bills, apart from a standing charge to represent
the overall cost that the customer imposes on the company's assets,
quite apart from the amount of water used or disposed of, does
focus on what the customer is actually using. By definition that
it is metered and that means that it is in the interests of very
large numbers of customers to switch from rateable value to metering
which, under the 1999 legislation they are free to do at no cost
to them individually. The cost falls on customers as a body, the
cost of installing the meters and the loss of revenue that then
follows because customers have not just moved from, in most cases,
a high-ish rateable value perhaps with relatively low use to a
measured use on relatively low use still and then some of them
on top of that will use less, which is good from a conservation
perspective but reduces the revenue. So, that is why you get this
mismatch. It is because the characteristics of the customers in
the 75% are different from the characteristics of the customers
in the 25%.
Q24 Mr Lepper: I am just thinking
about these two to four million—and I take your point about
the proportion of the household the water bill forms—householders
who are already having problems because a switch to metering—and
some of those households are fairly large households perhaps—is
not necessarily going to be beneficial to them, I would have imagined,
and would indeed exacerbate the problems of affordability.
Mr Fletcher: I am afraid you are
absolutely right. It is the logical consequence of the legislation
passed five years ago that people who can freely transfer to a
meter will tend to do it if it is in their financial interest
to do so. Therefore, the subsidy which high rateable value low-use
customers are at the moment effectively paying to the rest of
the body, including the less well-off customers, is disappearing
through the transfer and, as it disappears, a greater burden is
imposed on those customers who are left in the rateable value
category.
Q25 Chairman: I am going to bring
David Taylor in in a second, but I just want to ask you a question
which arose out of some of your evidence. I wonder if you could
give us a little commentary—unfortunately, you did not put
numbers on your memorandum—on page 4 where there is a chart
showing actual and projected net capital investment. I would be
grateful for some explanation. You have in the period from 2004
through to 2010 a chart which shows the directors of the water
companies projected capital maintenance and then, on top of that,
you have the directors projected quality and other enhancements,
which I suppose looks roughly, taken overall, about 50/50 and
then a strange little mountainous bit that sits above this projection
called "Companies quality and other enhancement projections"
which seem to replicate directors projected or are the directors
saying something and the companies saying something else? I am
a little confused. What am I supposed to derive from that picture?
Mr Fletcher: The companies in
aggregate in their final business plans were saying, "The
capital expenditure that we need to carry out will cost £20.7
billion over the five-year period." Ofwat came up with a
figure of £15.7 billion. The difference between the two is
not simply efficiency. That only accounts for £0.8 billion
of the difference. The main differences are first of all this
element of parked schemes to which I have already referred in
answer to Mr Tipping of things that we have not included in price
limits yet, £1.4 billion, and £2.8 billion which, in
a very broad category, is change of scope and a lot of that means
that we have concluded that the proposal as presented to us by
the company in its final business plan is not yet clear enough
to take into the price limits—it is the point I was making
earlier, no clear outputs and no clear timetable—and, in
those cases, although the vast majority have an element included
in the draft price limits, very often that will be about investigations,
relatively small costs, to define the output more precisely.
Q26 Chairman: One of the things that
comes out of that explanation is that in a world where the normal
competitive forces prevail, companies, in their pricing polices,
are acutely aware of what is going on in the marketplace, what
the market will bear and what their overall commercial objectives
are and they juggle those in finding a competitive price. If they
do not get the competitive price, they do not get the goods, so
the price comes down, etc, etc. In this case, you are the surrogate
for that process and what you have described to us here is about
£5 billion and it almost sounds like overbidding. I get that
flavour because you have, on a number of occasions in response
to questions so far, told us that the companies had schemes which
either could be questioned upon analysis because the components
of that scheme were not actually required to meet a particular
legislative development, a European director or whatever, of the
companies were over-ambitious. These companies are answerable
at the end of the day to their shareholders, in the main with
some of the bigger water companies, some of the private ones are
perhaps driven by different parameters but I am just a little
concerned and I would be interested in your opinion as to the
investment decision-making process within the companies that lead
them to accumulate, if you like, almost on a bottom-up basis which
says, "We will start from a position of adding in everything
that we would like to do" and then leaving it to you to use
your knowledge to knock it back because you might argue that either
there is something fundamentally wrong about the way that we are
trying to implement improvements in water legislation between
those the company thinks it needs to do to keep its customers
happy and those that it needs to do to fulfil a legislative requirement
and therefore I am wondering whether in fact the whole process
of dialogue and discussion about what the companies obligations
are is somewhat flawed if it leads to the fact of a £5 billion
difference between what the companies bid for and what you say
they actually need to do.
Mr Fletcher: First, I entirely
accept that what we are trying to do is mimicking the way a market
would work. An out-performing company will make a greater return
for its shareholders or their equivalents and that is the system
that is supposed to work. We then claw the gain back after the
five-year period for the benefit of customers as a competitive
market would in rather shorter order. What is noticeable is that
the companies did not all take the same approach in their final
plans. Some of them almost under protest said in their final plans,
"We are putting some schemes in which we would really rather
not do but we have been told that we ought to put them in for
environmental reasons" and some of those have found their
way into the category of parked schemes.
Q27 Chairman: Who told them?
Mr Fletcher: Those elements were
included in the lists associated with the Secretary of State's
principal guidance.
Q28 Chairman: So, they are looking
at what the Secretary of State said and are saying, "This
is what Mrs Beckett is telling us to do" and then we have
Mrs Beckett's evidence saying, "I don't really want these
bills to be unaffordable", but she has already given evidence
which has been interpreted by the companies which have pushed
up the bids because they thought they were doing the right thing.
Do you see what I am getting at about understanding? Is there
a flaw—and I am sorry to go off at a slight tangent—in
the way that the Secretary of State explains her requirements
and the way that the companies are interpreting them because,
if you are saying that is driving the pricing bids, then there
is something wrong?
Mr Fletcher: We are talking about
an iterative process and all of us learn from that iterative process
as we go along. So, Mrs Beckett's final guidance takes here a
step on from the principal guidance in certain important respects
and all of us, by challenging each other, which can sometimes
be quite uncomfortable, I believe will finish up with a much better
outcome for the customer and the environment than we started off
with a year or two back. You are quite right, if you take a cut/slice
at any one point in time, there are these imperfections around
because of the artificiality associated with it.
Q29 Chairman: So, almost one could
say that the Secretary of State's first cockshy flushes out the
companies into a big bid and then the Secretary of State panics
when she adds it all up and says, "My God, I do not think
politically the bills are going to be at an acceptable level",
so we do not have more conservative advice coming out to trim
back a bit.
Mr Fletcher: I am glad to say
that I do not have to speak for ministers and no doubt they will
be in front of you to do so, but I do not think it was quite like
that. They get advice from experts, notably the Drinking Water
Inspector, English Nature and the Environment Agency. There is
a process of dialogue involving all of us in what is always a
tension, wanting to have the best for the environment and what
it will cost and, out of all that, sandpapered by the underlying
legislative requirement, will come some sort of final view which,
I would hope, is as satisfactory as we will ever get because there
will always be dissatisfaction. It is not perfect.
Chairman: Excuse us while we adjourn
to rush over and vote and then we will return. I fear it may mean
that we have to sadly curtail your evidence because we will have
effectively lost half-an-hour, but we will do a quick squeeze
at the end. We will be back shortly.
The Committee suspended from 3.39 p.m. until
4.00 p.m. for a Division in the House
Chairman: I will invite Mr Taylor to
resume our batting.
Q30 David Taylor: Thank you, Chairman.
I was late into the session, so if I ask anything which has been
covered I know you will stop me or divert the questioning. Mr
Fletcher, as to privatisation out of the full circle of stakeholders,
the long-suffering tax-payer, the environment, water consumer
and the shareholder or shareholders, the shareholders have done
pretty well, have they not? Do you think that is something to
the credit of Ofwat?
Mr Fletcher: Shareholders have
made a return which was very high in the early part of the 1990s
and which has been a lot less in the last five years or so. Going
back into what is now the historic period, I think it astonished
the companies and the other stakeholders how much it was possible
to gain in terms of efficiency in the early years after privatisation
and therefore, with the hindsight now available to us, the challenge
perhaps was not as tight as it might have been in that early period.
Q31 David Taylor: You have got a
vested interest in saying that, though, have you not?
Mr Fletcher: I am sorry?
Q32 David Taylor: You have got a
vested interest in saying that?
Mr Fletcher: I hope I am just
saying it objectively. The issue now is that shareholders and
the other financiers of these very big water investments need
to have an adequate return if the water companies, who run on
negative cashflow, their outgoings, ever since privatisation,
have exceeded their incomes, and Ofwat is there in the middle
on behalf of customers, replicating, mimicking the markets, to
seek to ensure, through its price limits and the rest of its regulatory
activities, that companies are only making a significantly higher
return than we have assumed here if they are at the same time
significantly outperforming the assumptions that we have made.
If they do significantly outperform, that is to the benefit of
everybody, including customers, because Ofwat, trying to mimic
the market, comes in at these five-yearly intervals effectively
to cream that excess.
Q33 David Taylor: It is a market
failure though, is it not?
Mr Fletcher: It is a market?
Q34 David Taylor: It is a market
failure, is it not?
Mr Fletcher: No, it is not. It
is a market failure in the sense that it is inherently a market
failure. We are talking about something which is as close as you
can get to a natural monopoly. Ever since the water wars in the
early nineteenth century in London it has not made sense for the
provision of services to most customers to replicate, duplicate,
sewers or water mains. Therefore, that is the inherent monopoly
bit.
Q35 David Taylor: But the five-year
price review mechanism is a dog's breakfast, is it not? It is
not adequately providing for the capital investment that is needed
in infrastructure. You blame the water companies in terms of inaccuracies
and failure to provide, and they blame you and the Government
with similar charges. To what extent do you think the price review
does allow companies to plan ahead for longer term expenditure,
and should you be advising them very strongly where it is deviating
so significantly, as this graph shows and as the Chairman mentioned
before the two divisions that we have just had?
Mr Fletcher: I would not accept
for a moment that it is a dog's breakfast. It is a proper process
in which you would expect to see tension. Tension does not equal
dog's breakfast. What you would expect to see at the end of it,
as you have following previous price reviews, is significant capital
expenditure which does not just exist in its own right but produces
significant benefits in terms, where it is capital maintenance,
of the sustainability, the long-term serviceability of the networks
of pipes, sewers and water mains, and the above ground assets,
and we are seeing that. We are seeing the same with serviceability.
We think the companies need to spend more going forward. You would
expect to see an environmental programme that is not just money
into the ground that produces very big gains in terms of our environment.
It has produced just that. If you look back to 1990 and the state
of our rivers, our bathing waters, our coastal waters at that
stage and what they are now, huge improvement.
Q36 David Taylor: How about flooding.
Have we got time for a very brief example, Chairman? North west
Leicestershire is about as far from the sea as you can get, and
most of the constituencies are absolutely remote from major water
courses, and in recent years we have seen the incidence of flash
floods that have affected areas in the Coalville area and elsewhere
near East Midland's Airport on quite a regular basis, and Severn
Trent, in whose patch we lie, talk about these things being in
a once in a 200 year time-frame irrespective of the fact that
it is quite clear now that the global warming evidence is with
us, climate change is a fact and that they need to invest at a
rather greater level and in greater amounts than would normally
be the case if this was just to protect against a one in 200-year
incident rate. There is something going adrift here, is there
not? Who should be carrying the can for this and actually getting
a grip of the problems that are affecting areas like my own and,
indeed, much worse towns, like Shrewsbury, Worcester, and so on,
where flooding has been not unusual over recent decade, but it
is hitting ordinary constituencies now. You are saying that the
companies are bringing forward projects. Name some that you are
aware of, major scale ones, that Severn Trent, for instance, have
brought forward in recent times to tackle the impact and effects
of climate change?
Mr Fletcher: If we are talking
about river flooding, that is primarily something which the Environment
Agency under government direction is in charge.
Q37 David Taylor: It is not rivers,
it is—
Mr Fletcher: I was thinking of
your reference to rivers. Where it is a matter of flooding through
the sewers which serve, especially in the older areas, usually
two purposes: they are both rain water drains and sewers for foul
water, and that is at the heart of the problem. When you are building
fresh, then it makes sense to separate the two out. The Victorians
did not, and from their point of view you can understand why:
it was something that cost a lot of money. Complete separation
on a retro-fitting basis seldom makes sense. Therefore, it is
important that the companies do more to correct for the problem
of sewer flooding, and they have put forward in their plans extensive
proposals. They have put forward proposals accounting for nearly
1.5 billion in their plans to us. At the moment we have in
the draft determinations allowed significantly less than that
because we are saying, although it is possible for less than half
the cost to deal with over 80% of the problems, in doing that
we have provided a sort of top challenge so that those schemes
which cost £120,000 per house, which is quite a lot per house—
Q38 David Taylor: We are talking
about urban areas.
Mr Fletcher: This is very often,
in fact usually, urban areas that sewer flooding occurs; because
that is where the sewers are effectively acting as rain water
drains.
Q39 David Taylor: I understand what
you are saying, and I am sorry to interrupt, but can I direct
this question to your chief engineer then, to your left as I look
at you? Are the water companies upgrading their assumptions and
their projections in terms of rainfall, not just in annual terms,
of course, but in terms of the maximum number of heavy storms
that there might be and therefore looking at capacity from that
perspective? Are they doing that? How much lead-in time is necessary
to alter whatever capital works they might have planned over the
next three to five years when the assumption needs to be upgraded
in that way? What sort of lead in time are we talking about, Dr
Emery?
Dr Emery: Most companies are not
at this stage in a position when they are upgrading the storm
profiles, and so at the moment they are recognising there are
a number of instances of intense storms, so they are at an information
stage where they are yet to make what design criteria should be
for future major investments in the sewerage systems—they
are not quite there yet—and that is appropriate because
we are not quite certain as to what will the most appropriate
design characteristics to assume. Everybody recognises that climate
change is happening, but it is a matter of the pace of that and
what is the right response. The lead-in time, which is your question,
is, if it does involve a substantial change to the sewerage system
and upgrading of the sewerage system, then that is going to be
a decade, several decades, of work to do. It is clearly something
that the companies—and it is one of the issues we have flagged
up in our draft determination document, that in the next period
we will be looking to companies to start to get a better handle
on this and start to develop long-term plans for the sewerage
infrastructure, and that is similar to the kind of findings of
the recent NAO report on these matters. I think at the moment
there is not sufficient evidence as to which sewers to do first.
The focus of the work on the sewerage system is twofold in this
next period, and that is to deal with the immediate quality problems
associated with problem discharges to the water environment, and
that is intermittent discharges from the sewerage system, and
to deal with a large number of existing problems on the sewer
network created by sewer flooding. Deal with those and you will
at the time be looking at what is an appropriate patch to do on
that particular sewerage system.
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