Examination of Witnesses (Questions 40
- 62)
WEDNESDAY 20 OCTOBER 2004
MR PHILIP
FLETCHER, DR
BILL EMERY
AND MS
FIONA PETHICK
Q40 David Taylor: But as your engineering
projections and climatic changes azeotropically approach the reality,
it is no consolation to residents in Whitwick, Leicestershire,
that they sit between where your projections are and what is actually
happening in their area and they are ankle-deep in water in rooms
of estates which are quite some distance way from any water courses
that have never shown any inclination to act as they have done
in recent times. So it is all very convenient and comfortable
from the third floor of an office block in the centre of London
to be dealing with these sorts of things, but you want to get
out on the ground a little bit more.
Dr Emery: Certainly, I have myself
been working in the water industry since 1975, so in a sense I
have seen this at the sharp end, and I know that Mr Fletcher has
been out to see matters at the sharp end of sewer flooding, so
we are very conscious of the importance of sorting out sewer flooding.
That is why, in this particular draft determination, we have essentially
put forward a major programme of work for the companies to do.
In essence, we are looking to the companies to solve most of the
sewer problems that should be solved in this next five-year period.
Q41 David Taylor: My final question,
Chairman. I am sorry to interrupt, Dr Emery, but there are a lot
of questions people want to ask. I described the five-year review
as a dog's breakfast in terms of its ability to provide sufficient
capital funding for the necessary projects and the funds we are
projecting in terms of what was necessary. There is also this
question of research and development, is there not, that companies
need to provide for? Can you describe, one of the team, how the
five-year price review cycle does, in fact, allow companies to
conduct long-term research and development when they are bailing
out, if I can use that analogy, other aspects of their operations
at a vigorous rate?
Mr Fletcher: The companies should,
as part of their base operating expenditure, be carrying out appropriate
research to enable them to discharge their functions properly.
Customers, in my view, should not normally be coughing up for
projects that they ought to be doing as part of their normal business.
There is, as you probably know, an industry-wide research body
called UKWIR, where the companies, in consultation with Ofwat,
the Environment Agency and others, do draw up a programme which
is of common interest to the whole industry and which can therefore
be financed by the industry on a collective basis, on things like
sewer flooding, very much included, on climate change, and a number
of other issues; and I think that that is an appropriate way forward.
In addition, individual companies will obviously want to undertake
their own research, usually applied research, perhaps sometimes
to give them a competitive edge, which is fine; it is how the
system is meant to work and the customers should not, own the
whole, be paying too much towards it. In Mrs Beckett's final guidance
to me she has asked that I include provision for what amounts
to demonstration projects/research into the interesting and perhaps
concerning issue of endocrine disruption for fish, and I am going
to have to reach a conclusion on that in setting the final price
limits.
David Taylor: So this bogus market has
not, is not and never will deal with these sorts of problems.
That is the perception that I get, Chairman.
Q42 Paddy Tipping: So this is a big
issue. I get lots of complaints about sewers. All my colleagues
get complaints about sewers. It appears to be on the increase,
but I got the impression that you are a bit complacent about this?
Mr Fletcher: I would not want
to leave you with that impression.
Chairman: Can I follow that up: because
I had telephone call from, I think it was United Utilities, who
told me that in the context of their proposals and your initial
determination from their point of view, that they would not be
able to complete all their foul-flooding projects; and my view
is a bit like Mr Tipping's, that here we are in the twenty-first
century. You said at the opening, Mr Fletcher, that people wanted
a good, safe, high quality water supply. That is fine for what
comes into the house—
David Taylor: Not in the living room!
Q43 Chairman:—but they also
want to have a good, safe, guaranteed method of disposing as to
what goes out; and they do not want to see it bubbling up in the
streets, and yet we do not seem to have nailed all those problems
down. Why not?
Mr Fletcher: Because the problems
tend to crop up all over the place. I absolutely accept that sewer
flooding, especially in your home, is an extremely unpleasant
event. As Bill Emery has said, both of us have been out and seen
on the ground and talked to customers who have suffered from this,
and I know it is extremely nasty. The fact that it is a very small
proportion of householders is no excuse for complacency, but something
needs to be done to tackle that proportion. At the moment, I think,
and I will correct it in the transcript if it is wrong, it is
0.04% of households are vulnerable.
Q44 David Taylor: Annually?
Mr Fletcher: That is at risk.
That is on the at-risk register of one in 10 year events, and
that is where I need to check, because I am speaking from—
Q45 Chairman: Mr Fletcher, let me
put it to you in this way. If you adopted the same approach that
you have just outlined for water in, you would have people saying,
"Well, every so often the water goes off and I cannot get
the water into my house, and therefore I have a sort of spasmodic
and interruptible supply." It would be a phenomenon which,
I think, anybody who wants a mains water supply would object to.
So why can they not have an equivalent quality universal service
of water out?
Mr Fletcher: We do, first, have
a series of specific indicators of customer service, one of which
is interruptions to supply, which we have been running since privatisation
and which is an important contributory factor to the assessment
we make of the way in which the companies are doing their job,
along with a lot of others. I would suggest the sewer flooding
issue is not quite the same. There we are talking about households
at risk of a one in 10 year nasty event, and again, I stress,
it is a nasty event and merely because it is one in 10 years is
no excuse for it. The proposals in the draft determination would,
on our judgment, serve to reduce the number of properties on the
register by half to 0.02. Again, you may rightly say, "It
should not happen to anybody", but this is one of the problems.
It can first of all happen for reasons that are nothing to do
with the lack of capacity in the sewer—or the one in 30
year, 50 year, 10 year rainfall event; these can be a blockage
in the sewer arising from, often, grease and fat which has been
poured down, and there people will get flooded. You can either
blame the companies for poor maintenance or the customers who
poured the grease down.
Q46 David Taylor: 0.02% of 25 million
households is about 10,000 households, is it not?
Mr Fletcher: At risk of sewer
flooding. So, this is not the number that are affected by it.
Q47 David Taylor: An average of 15
per constituency. So it is a tiny problem?
Mr Fletcher: No, I am not saying
it is a tiny problem, because it is a concentrated problem. The
Chairman has mentioned the north-west. It is concentrated in London
and the north-west, although it affects most constituencies to
an extent, and I entirely accept that a great deal of progress
needs to be made on this problem in the five-year period we are
talking about, that customers collectively should be spending
money in their bills to relieve the customers directly affected
of the problem; the issue is: how much and just how is it judged,
which is one of the points that United Utilities have taken up
with the Chairman.
Q48 Paddy Tipping: You talked to
us earlier on about outputs. You are both keen on outputs?
Mr Fletcher: Yes.
Q49 Paddy Tipping: Let me ask you
this. If you come back to us, or your successor comes back to
us in five years' time, what is your output going to be on private
sewers?
Mr Fletcher: Halving. On sewer
flooding, at-risk register, halved; on the draft determinations,
halving the risk of sewer flooding.
Q50 Paddy Tipping: What about those
people who it is going to cost too much to do: because you were
going to tell us about the cap on it a minute ago and we moved
on. Remind me about that. Is it a £12,000 cap?
Mr Fletcher: No, £120,000.
Q51 Paddy Tipping: I am not very
good on sums!
Mr Fletcher: We definitely do
not relate it to the prices of property, because I think that
would tend to mean a bias towards solving the problems in the
prosperous areas and not solving them in the old inner cities;
so we do not relate it, but, nonetheless, that is two-thirds of
the average house price at the moment, even after the soaring
house prices we have been talking about. So it is a lot of money,
but that does not mean it should not be done. What we have said
in the draft determinations is that we think where it is that
expensive that the companies should still be able to do it—it
is their choice which are the highest priority schemes, but there
ought to be a cost benefit assessment showing the value of it,
and if it does not prove its value, then they should be going
for other means, which may include ameliorative measures, not
a perfect engineering solution, not something an engineer would
be terribly a proud of, but which would significantly reduce the
risk of being sewer flooded. We are going on thinking about these
issues, because they are not easy, before we get to the final
determination.
Q52 Patrick Hall: I would like to
follow the line of questioning that was started by Mr Taylor on
flooding and investment to deal with flooding, sewers in particular,
I think. I see in the evidence from the Environment Agency, under
a short section on page nine referring to climate change, and
it briefly refers to the expected higher frequency of intensive
periods of rainfall; it goes on in paragraph 37 to say, "While
the evidence is not sufficient to justify investment now, investigations
by companies are needed to look at the implications of climate
change, water supply and sewerage systems." I find the first
part of that sentence that I have just read out surprising. "The
evidence is not sufficient to justify investment now." That
is in the Environment Agency's evidence to this Committee. What
is Ofwat's view on that statement?
Mr Fletcher: A great deal of the
investment assumed in the draft price limits will help towards
dealing with the foreseen problems around climate change; sudden
or dramatic rainfall events. The work of capital maintenance,
which we see as a necessary increase in the level at which the
companies have been spending, will help ensure that the systems
are better able to cope with the sort of pressure applied on them
by sudden rainfall events; but, as Dr Emery was saying, that does
not mean at the moment an alteration to the basic assumption that
a sewer should be able to cope with a one in thirty year rainstorm.
We may need (collectively I am talking here—this is the
whole sector and its regulators) to move on from that, as the
evidence on climate change becomes clearer and the help from the
Met Office, the Hadleigh Centre, begins to be more relevant and
directly applicable in terms of where we can expect the problems:
because to invest now in a wholesale upgrade, apart from the astonishing
disruption it would cause in every street in the land, would not
be good value in terms of the level of investment and the outputs
associated with that investment. I think that is what the Environment
Agency means. There is not at the moment grounds to say just climate
change alone means an uplift of maintenance. That evidence may
come along. In the meanwhile, we are better off seeing the industry
investing in all the things and which will contribute to being
better able to deal with climate change.
Q53 Patrick Hall: So there is no
question in Ofwat's mind that climate change is a fact?
Mr Fletcher: No; no question.
Q54 Patrick Hall: Therefore does
it not follow that it is a good idea to anticipate the effects
of climate change by investing up front? Are we saying here .
. . This is an industry view. The companies have a view on this.
Perhaps I could ask you what you think, the companies' view on
this is, but you have an important role. Are we saying that we
accept that something is happening but we do not actually know
where and when and what it is, except in general terms, therefore
we hold back on investment other that repairing problems of the
past and dealing with a few other issues? That does not seem to
add up to adopting what the Chairman was trying to draw attention
to at the beginning of this questioning, a long-term view which
will put us all in a strong position rather than almost playing
catch-up and complaining about the cost? Surely we have the opportunity
now to say things and to do things that will help us in the next
few decades?
Mr Fletcher: The cost of the investment
in the industry is broadly spread across the generations, because
all the generations are going to benefit from them. So our bills
now include expenditure, include the financing costs for the investments
being undertaken, our children will still be paying for the investment
being undertaken over the next five years. So, whilst we should
not just be playing catch-up, and I entirely accept that, I do
think it is important that the investment that goes in should,
going back to my earlier answers to Mr Tipping, relate to specific
projects with clear outputs, clear prices and clear timetables.
We are not wasting our time or being niggardly in the level of
investment we are talking about, which is actually closely akin
to the much higher level of investment, a big step up, that took
place in 1990 on privatisation and has been running fast ever
since and is putting quite a strain on the financing costs of
the companies because of the negative cashflow issue. So significant
further steps up in capital expenditure will not just have a pro
rata consequence for bills, it will have a more than pro rata
consequences, because it is going to be more difficult, more risky,
more costly for the companies to finance it. You may regard that
as a bit of a red herring from your point, but it is one of the
factors I have to take into account. A lot of the investment that
is going in in the coming five years will help on climate change.
I mentioned in a somewhat dismissive way investment in fresh-water
fish, huge storm water tanks. To the extent they are necessary,
that is very directly related to the sort of the effect we expect
from climate change, more very heavy downfalls which swamp the
existing infrastructure, but this is the problem: we do not know,
nobody knows, where those heavy downpours are going to take place.
All we can do is seek to spot where the pinch points on the system
are now and deal with them, and that is just what the proposals
from the companies, our response to them, the inputs from the
other regulators, are designed to do, even though they are also
meeting the requirements of the various European directives, etcetera.
Q55 Patrick Hall: I have a fear,
not necessarily that there is complacency, but perhaps that the
very nature of the structure of the industry and the way it is
funded is simply unable to step up to meet the challenges of climate
change?
Mr Fletcher: I would just note
that in the private sector the industry has been better able to
invest than it proved to be in the public sector as nationalised
industries up to 1989. What, I think, is in little doubt—
Q56 Patrick Hall: We were not talking
about climate change in quite the same way?
Mr Fletcher: No, we were talking,
though, about the state of the assets; and the level of maintenance
of those assets at the end of the 1980s was something that—these
assets are long-living—they can last an awfully long time
without showing too much signs of breaking down—and I do
not want to be alarmist at all, and Bill Emery will correct me
on this so that I must not be alarmist, but, nonetheless, it was
an unsustainable level of investment in the public sector and
is now on a more sustainable level.
Q57 Patrick Hall: That is a slightly
different issue, because we were talking about running down the
publicly owned industry at the time, but my point was not an implicit
philosophical argument about public ownership or not, it was whether
or not the structure of the industry and the way it is funded
can meet the challenges of climate change; and by saying we do
not have enough evidence, which the industry seems to be saying—I
am not blaming you personally or Ofwat—it may be that the
industry is unable to meet that challenge, and, if that is the
case, then we need to be aware of this, talking about this now
so that the partnership that is needed, which will have to be—someone
is going to have to pay—is going to have to be talked about
up front much sooner, otherwise we will just be, as I say, playing
catch-up at the wrong times and people complaining all the time
as things get worse.
Mr Fletcher: Could I bring in
Dr Emery but make one point first, which is that in the area where
the bills are highest and have been all the way through, that
is the south-west, a large part of that is the very large environmental
programmes as well as capital maintenance which in that area has
been financed by the relatively small customer base of that company.
If you are seeing signs of strain, that is quite a sensitive place
to look, and obviously there does come a point, and I do not think
we have got there, when a government needs to think about taxpayer
help; and I am not suggesting that for this industry at this moment
in time. Can I bring in Dr Emery?
Dr Emery: I think the investment
in the industry over the last 15 years demonstrates a capability
to invest. There had been huge steps up in the late 1980s and
steps up in investment to meet the challenges of each periodic
review. If you are looking at what happened, one of the big concerns
of this or earlier committees around our last review was on the
ability of the companies to maintain the adequacy of their systems.
That led us to challenge the industry to develop a common frame
of capital maintenance. That was done. It was research done by
the industry and has been remarkably successful and implemented
in very quick order by the companies and led to an under-pinning,
in quite a large sense, of the capital maintenance requirements
that were in the business plans. We took the view that there was
still some work to do, but the industry has shown a capability
when facing the challenge, to do the work, and I suppose where
this industry is different when moved on in the last 15 years
is it is trying to have a sound information base for decisions
in the future such that it does not go ahead and invest inappropriately
and unnecessarily; and I think that you should have reasonable
confidence in this industry. When the evidence is there, it will
respond quickly and appropriately to meet the challenge of climate
change and the Water Framework Directive and other aspects. The
track-record is there that they will do joint research, they will
come up with appropriate means. We put the challenge down that
we think that in dealing with and understanding what the implications
of climate change are for both water resources and the continuous
supply of water to everybody and in terms of a sewerage system,
that is something we want to properly address through research
information to properly inform the next review of price limits.
In the meantime, they have a substantial challenge to deliver
in terms of the investment programmes to deal with today's problems.
Chairman: I want to draw our questioning
to a conclusion, but I would like to just pursue one aspect. You
can have a tiny postscript, one question, Mr Tipping, and then
we must come to a conclusion.
Q58 Paddy Tipping: My own concern
is private sewers. There is nothing in this price frame for private
sewers, but the Government increasingly is moving towards a solution.
Hopefully there will be an announcement, a long awaited announcement,
in the spring. Suppose the sewage undertakers, water undertakers,
are given the task, what are you going to do about it? How are
you going to fund this?
Mr Fletcher: My hope would be
that there would not be an instant transfer of a lot of what are
undoubtedly much poorer assets than those currently, in effect,
in the public service—those run by the sewerage companies.
Clearly there will be a cost associated with putting right what
in many cases has been no maintenance at all for decades; and
my hope will be that where the current owners of those assets
are financially able to do so, where they are corporations, for
example, maybe local authorities, that they make appropriate contributions
so that water customers are not left holding the can for what
could be a very significant additional burden. There is provision
in what we have called our "draft change protocol" whereby
new burdens that are assumed by the water and the sewerage companies
between 2005 and 2010 can look for appropriate financial uplift
if they are taking on commensurate new burdens; and private sewers
could be one such category.
Q59 Chairman: I want to close. If
you want to consider this and write to me about it you can do,
but in paragraph 27 of your evidence to us you talk about the
5.1% post tax in real terms cost of capital, which, if you gross
that up into pre-tax and real money terms, are you looking at
a yield of about seven odd per cent?
Mr Fletcher: Yes. If you look
at the pre-tax equity element, it is 7.8%.[2]
Q60 Chairman: One of the things that
I find unclear is the capital raising mechanisms. It is right
that you have a concern to ensure that the companies can raise
capital. What I do not know of the companies that are listed in
the tables at the end of your evidence is how many of them for
each pricing round, given their investment programmes, have to
go to the market with various bond, loan or even equity issue—very
few seem to go down the equity route, but there may well be a
bond issue—raise indebtedness; in other words, there is
a real job to raise new money to go in; and how many of them have
got sufficient in terms of their existing profitability to fund
out of revenue their investment plans? Obviously from the people
who have to go to the market, the rate of return is of very real
and immediate importance; for the others it is a different scenario.
Perhaps you might just give us a little commentary on that?
Mr Fletcher: I will write to you,
Chairman. Can I just offer you a very brief summary now? Negative
cash-flow for all the companies, as I indicated, outgoings exceeding
incomings, they are variously dependent on bank finance, and the
European Investment Bank is a key lender, on debt finance and
on equity, though only one company since privatisation has made
a rights issue, so it is mostly retained earnings; and this is
a crucial issue for the companies and for Ofwat in assessing how
high the revenues need to be and therefore customers' bills need
to be, is to assess the finance elements around that. Our basic
cost of capital is supplemented towards the end of the five-year
period, the last two years, by, for the water and sewerage companies,
who have generally the biggest programme, a small uplift which
varies depending on the circumstances confronting a company, to
recognise this stretched financial position in a way that gives
confidence, without over-confidence—a point for Mr Taylor—to
their investors, lenders, debt-holders.
Q61 David Taylor: One brief addendum,
Chairman. It links that very point, and as an accountant I am
interested in it. Mr Fletcher has acknowledged that the cost of
capital assumption is about 7% of balancing out equity and other
form of finance?
Mr Fletcher: By post tax—
David Taylor: Yes. If this was still
a publicly owned utility, the cost of capital to the Government
would be significantly less than that. You are saying that the
difference is justified, I believe, by the extra efficiency in
quality that the water industry has brought to all of this. Could
you, not now, but in the letter when you are writing to the Chairman,
put an appendix which demonstrates what I can say is a touching
belief in some sort of coherent financial structure that will
convince me?
Q62 Chairman: And, I think, to overlay
that, because part of my interest in asking this question, it
is one way of measuring whether in fact the rate of return is
a reasonable one in the context of the nature of the business
where there is no question there will be a permanent demand for
the services of the company, therefore the risk element from that
stand-point is relatively low, but, on the other hand, there are
risks in the business which are beyond the companies' control
which can affect the use of their capital; and we have touched
on those in the context of legislative risk and of climatic risk.
Can I thank you for your patience due to our interruptions and
for coming to see us? It is clearly a complex and, indeed, fascinating
matter. There may well be further questions that we want to write
to you about, both following this evidence session and, indeed,
when we talk to the company. We do accept that the nearer December
there may be constraints on what you can say, but, I think, as
you will see from our inquiries, we are anxious to understand
clearly the way in which you operate and adjudicate on these matters.
Thank you very much indeed for your help and coming to see us
today.
Mr Fletcher: Thank you, Chairman.
The 2 December is when I will publish the final determinations
which take this a step further.
Chairman: Thank you very much.
2 The pre-tax equivalent is 7.3% for the weighted
average cost of capital, which rises to 7.8% by 2007-08,allowing
for an additional element to maintain financeability. Back
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