Examination of Witnesses (Questions 140
- 159)
WEDNESDAY 3 NOVEMBER 2004
MR ROY
POINTER, MR
JOHN SEXTON
AND MR
JOHN ROBERTS
Q140 Mr Mitchell: What do you see
as the long-term impact of these cutbacks on the kind of service
you are going to provide and on customers' bills? Are they saving
money now to increase bills later?
Mr Pointer: It may be good to
go on to some of the longer-term issues because I think that,
in the short term, there is this issue about how we work in five-yearly
chunks at the moment and the question has to be asked, what is
the right length of programme? On the one hand, you want a level
of certainty. Customers must know where bills are going for this
work and therefore one is weighing up certainty. On the other
hand, there is an investment programme which will deal with the
short-term issues. However, we have to have in our mind all the
time the longer-term issues of climate change and the Water Framework
Directive, which are very, very big issues and the sense we have
is that, once this periodic review is out of the way, it will
be good for the industry and other stakeholders to sit down and
look at the water industry in a longer-term planning framework.
One should not sound alarm bells at this stage but, particularly
with the Water Framework Directive which is known where tremendous
improvements have to be made to the water environment, not all
of which can be delivered through the water industry because most
of this will relate to diffuse components, diffuse pollution and
so on. So, there is a longer-term issue and that will need to
be confronted as we get past the periodic review. I used the analogy
with some of these things that, if you think about the maintenance
of the infrastructure, which is still far and away the biggest
element, maintenance is always a very, very important thing to
do and, if you think of maintaining a car, the easier way to maintain
the car is regularly in accordance with its needs rather than
waiting until the wheels fall off or the brakes fail and then
doing it in one fell swoop. We have made great strides in the
industry, again working with Ofwat and working with the quality
regulators, on developing better methodologies to deal with this
very difficult topic because we are talking about very long-life
assets and what is the right level of capital maintenance to be
put on them. We have made great strides in these five years and
that has been recognised by Ofwat and been recognised by other
stakeholders but there is more to be done.
Q141 Alan Simpson: I think most of
our constituents would agree that the most important outputs to
be allowed (sic) would be the outputs of sewage back on to their
streets, but I am intrigued about the difference in perceptions
about your submission between yourselves and Ofwat: your claims
that your proposals were well supported, worthwhile and relatively
inexpensive and the response from Ofwat that they were not fully
specified or were very costly. Has the independent reporter commented
on this disparity and, if they have not, how do we explain and
understand the disparity?
Mr Pointer: I think, very much
as John Roberts said earlier, all of these schemes/all of our
capital investment is reviewed by an independent reporter completely
separate from the company. The issue with the sewer flooding is
that they will vary in their location and the benefits that they
will provide and, very often, the sewer flooding cases will be
in heavily built-up urban areas where they will be extremely expensive
to cure and where it is often quite difficult to estimate the
exact amount of work that will be required. So, one can get sewer
flooding which occurs in an urban area that will be of a completely
different nature and type to that which would occurs in a rural
area.
Q142 Alan Simpson: But what you have
just said is significantly different from what you wrote. I understand
if you are saying to me that some of these schemes are going to
be expensive but that is not what you were claiming in your submission;
you were claiming that they were relatively inexpensive. I think
it will be helpful to know whether the disagreement between yourselves
and Ofwat is in terms of the worthwhile nature of that remedial
work or disagreements about the basis upon which it has been costed.
Mr Pointer: The difference is
essentially the worthwhileness of the scheme as it has been put
forward: what does it deliver for the cost involved? So, it is
the cost to benefit ratio rather than an absolute scheme cost
and inexpensive in that context can refer to inexpensive in terms
of the benefits to costs.
Mr Sexton: I think there are these
two different categories: one is about output and we have given
examples of those and I have for the Thames case, but there is
also a difference in view about how much a scheme should cost
and both those features are part of our process. I suppose the
good thing about the process we have with the draft determination
from Ofwat is that it does at least enable the companies to understand
where their case has been accepted and where there are differences
and then the process whereby we can make representations as well
as third parties. The reporters that we have talked about also
can look and focus on those areas of difference and, in some cases,
it may be that we have not explained what we want to do well enough
and therefore there is another chance to make sure that, before
a final decision is made, it is actually on good grounds.
Q143 Alan Simpson: One of the criticisms
of the industry has been that, in the years following privatisation,
what you are keenest on is dividend outputs rather than eliminating
sewage outputs. What would you do if, rather than having this
capped £120,000 per property as a fixed figure, the Regulator
said, "Fine, you can go ahead with you schemes but the only
allowable figure as far as water pricing will be concerned is
the £120,000. By all means do it, but that is something you
ought to be doing before you start to pay dividends out of the
industry"?
Mr Roberts: I think you have to
view the financing of the industry as a whole and what we are
trying to do in the way we put together the financing of the industry
is to keep our cost of financing as low as we possibly can in
aggregate. Part of that is having shareholders having equity because,
in part, there is a risk in the business, part of it is having
debt and raising money from the debt market, and the residual
is through prices and we try to keep the part that relates to
prices as low as we can. If we diminish the dividend-paying capacity
of the industry, then it is conceivable that that, as a source
of finance, would go away and, if that went away, ultimately it
would increase the overall cost of financing the industry. So,
I think you have to look at that as a package as a whole and try
to achieve a balance for the overall funding of our capital programme.
We do have some discretionary schemes that we can do out of savings
that we make through efficiency and we have done that in United
Utilities in the current AMP 3 programme where we have made efficiency
savings in one area and we have used that money in another area
to improve performance. So, it has not automatically gone to shareholders.
The point I would make is that, in the longer term, we have to
finance very substantial investment programmes and therefore we
have to make sure that we can access properly all the relevant
sources of finance to the business.
Q144 Alan Simpson: I am aware of
that; I just wanted to know whether you have done any comparisons
about the savings that could be gained in terms of the internal
costs of capital as opposed to the external costs of capital and
I think that was one of the issues that came up earlier in our
discussions with the Regulator as well.
Mr Roberts: We have made efficiency
savings and, as I have said, where appropriate, we have redirected
those savings to do other things for the benefit of the consumer.
Q145 Chairman: When you first started
out on this process and you took, if you like, the first scenario,
did the rate of return on the capital that you have invested in
the business vary? In other words, did it start at a number that
was bigger at the beginning than that at which it has ended up?
Obviously what you have told us is that the amount of new capital
that you are going to have to deploy has, by definition, been
reducing over time. So, you do not need, by definition, to get
as much money to service the debt. Did the capital return come
down over time?
Mr Pointer: A number of research
studies were undertaken at the time as to what should be the appropriate
cost of capital to be used in the industry and both the Regulator
and the industry went forward with research at that time and obviously
rates do change over time and that has been the history that we
have seen in this periodic review.
Q146 Chairman: I am sorry, I may
not have made myself clear, Mr Pointer. At the beginning of this
process, you were making a return to the investors in your business,
whether it be on any kind of debt financing or in terms of equity
investors, of whatever the yield was and you would have looked
very carefully at any of the programmes you have put forward to
ensure that your yield remained competitive to attract, if necessary,
new investment into the business. The question I asked was, in
the context of those yield returns, did they vary as you reconstructed
your bid in the light of different scenarios?
Mr Pointer: Not significantly
because the returns made for us are based on the rate of return
on an asset-base value. So, as the asset base changes, then that
will change simply because of the investment programme going forward
and, as the investment programme is changed, then that would bring
about that difference.
Q147 Paddy Tipping: Mr Roberts, you
have been back to the market, have you not?
Mr Roberts: Yes.
Q148 Paddy Tipping: Just explain
what you did.
Mr Roberts: We looked at what
we thought was going to be our capital requirement for AMP 4 and,
compared with a lot of the other water companies, we still have
a significant part of our programme which is new investment which
we would regard as slightly more risky than maintenance and therefore
more appropriately financed by equity rather than by debt. We
took a view that to maintain a credit rating that would enable
us to access all markets, we would need to keep the ratio of debt
to the total value of the business gearing to around about 55%.
Taking into account the likely scale of the investment programme,
we decided that we would need to raise about £1 billion of
funds from our shareholders in order that we still have the right
sort of credit rating and the right sort of gearing and we could
still access that market for the balance. So, we went to the market
in June of last year and we raised £500 million and we will
raise another £500 million in June of next year and that
will all be injected into the regulated business. That, hopefully,
will overall keep our credit rating at a reasonable level and
that in turn will mean that our overall cost of funding will be
cut back.
Q149 Chairman: How did you manage
to make the right statements in terms of the stock market and
raising the money without knowing what the final determination
was going to be?
Mr Roberts: We basically explained
to the market that we had a view of where we thought it would
lie and, within those broad estimates, what the real impact on
gearing would be. We also made reference to the Regulator's duty
to ensure that we can finance our activities and, taken together,
would mean that we should be able to earn a reasonable rate of
return on our new investment and that would enable us to get the
rights issue away.
Chairman: Ladies and gentlemen, we are
going to have to adjourn the Committee because some colleagues
want to go and vote on these matters. I am going to suggest to
the members of the Committee that, as there may be a series of
votes, it may be more sensible to adjourn for 30 minutes in order
that we can allow the voting process to be completed rather than
us rushing backwards and forwards. So, can I apologise to our
current and future witnesses but these are matters, as I say,
beyond our control. If the process of voting ceases earlier, we
will come back earlier.
The Committee suspended from 4.53 pm to 5.23
pm for a division in the House
Chairman: One of our members has a very
important point that they want to raise and I want to move to
that but Mr Tipping wants to ask a question in a few minutes about
rates of return but, in deference to Ms Ruddock, would you like
to put your question.
Q150 Joan Ruddock: I wanted to turn
in general to the issue of efficiency savings and I think Mr Roberts
has already touched on that point. If I may first of all ask of
Thames Water, Mr Sexton said that the programme which the company
wanted to undertake on leakages had been rejected. As a London
Member, this is of immense concern and is a very, very big issue
for us. The company, we know from Government ministers, is not
actually meeting its targets, nowhere near meeting its targets,
on leakages. So, what is it that Ofwat is requiring of you in
order that you can do what the Government ask you to do?
Mr Sexton: I think I need to be
clear that they have not rejected pipe replacement out of hand.
There are two issues: one is rate of travel, how fast can we make
progress with pipe replacement, and we have put forward an ambitious
programme trying to get leakage off the agenda and to do a substantial
amount in the next ten years. Ofwat have taken a view that less
should be done and they have also taken a very hard view, in my
view, of the unit costs that that work could be done for and therefore
have allowed a financial sum that it is not far off half the amount
that we are actually paying today having gone to competitive tender
for that work. So, if you take both into account, if we were managed
by a cash sum, then they would be putting huge reductions in the
programme, but they are not saying, "You do not have to hit
leakage targets", they are not saying, "Pipe replacement
is the wrong thing", I think strategy, 100% agreement, so
its rate of travel and cost of achieving is where our differences
are but I hope very much that, with the extra information that
we have given to Ofwat, they are going to move their position
substantially by early December.
Q151 Joan Ruddock: If they did not,
would you meet Government targets?
Mr Sexton: If we were left with
the draft determination, I am confident that we could not.
Q152 Joan Ruddock: You could not?
Mr Sexton: No.
Q153 Joan Ruddock: Even with efficiency
savings?
Mr Sexton: We simply cannot reduce
by half the amount that we are spending on the streets today.
We have every incentive to get lowest possible rates. The pipe
replacements we have been doing for the last year have been totally
at shareholders' expense, there has been no customer money in
at all, and we have had every incentive to do that as efficiently
as we could. We have put forward an efficiency saving because,
as we do more of it, we will get better at it. We are not saying
there is no scope for more efficiency but I am absolutely clear
that I cannot deliver it for the amount that Ofwat have assumed
in their draft determination.
Q154 Joan Ruddock: If I may just
deal with the more general points about the efficiency savings,
I think the suggestion has been made by the companies that Ofwat
regard the scope for efficiency savings from water companies to
be vastly greater than is required of the economy in general and
that, I think the quote is, it goes well beyond the available
evidence. On what basis do you believe that Ofwat has gone beyond
the available evidence in setting the efficiency targets?
Mr Pointer: Can I start and John
Roberts may add to what I am going to say. There has been a lot
of study of efficiency that is available in the industry, studies
by both Ofwat and the companies variously and through Water UK,
and that is well documented and has been shared with Ofwat and
with the industry and the fact is that the efficiency targets
that have been taken in the draft determinations are almost double
the available research that we have. No one is sitting here and
we will not be sitting here and saying, "There is no scope
for efficiency in these businesses", of course there always
is, but necessarily there were major efficiency achievements achieved
immediately post-privatisation, lots of costs came out of the
business and one is on a downward curve, one is never sure exactly
where you are on that downward curve but necessarily, with the
passage of time, the distance from the privatisation effect which
was quite marked earlier on, there will not be the scope, in our
judgment, still to come out. That does not mean to say that the
companies will not be striving for efficiency, they clearly will
because it is an incentive-based regime and efficiencies are good
for the companies in the short term and good for the customer
in the longer term because it will revolve into charges.
Q155 Joan Ruddock: Can somebody say
what the realistic target might be in your view.
Mr Roberts: We have offered one%
improvement in efficiency. Ofwat themselves have undertaken or
had undertaken on their behalf a number of studies which would
lead you to believe at best there is one-and-a-half to two% maximum.
In fact, what they have said is that they have adopted a carrot
and stick approach by building in a certain level of efficiency,
that is the stick, and then leaving us, if you like, the opportunity
to out-perform that and that is the carrot, but they have assumed
such a high level of implicit efficiency to start with that it
becomes all stick and there is absolutely no carrot at all. It
is a little odd because they have done this in a very systematic
way and, in most other parts of their analysis where they have
done systematic work, they have followed through the consequences
of that. In this case, they have come up with a number which is
at variance with the analysis they have had done for them and
we cannot understand why.
Q156 Joan Ruddock: If you had your
corporate way on this with the realistic targets that you would
want to put into place, what would be the effect on customers'
bills?
Mr Roberts: I think I would have
to have notice of that one. You would have to work it through
in detail. Perhaps we could come back to you on that. I would
not like to just give you an off the top of the head response
to that.
Mr Pointer: We could also share
the various analyses that have been done for both Ofwat and ourselves,
so you could see the pattern and where that sits with the targets
taken in the draft determination.
Q157 Paddy Tipping: Mr Roberts, before
the break, the bells were ringing and I maybe did not pick up
entirely what you were telling us. I think you said you had had
an equity of £500 million in July of last year and there
is another issue to be made . . .
Mr Roberts: In June of next year,
2005.
Q158 Paddy Tipping: You have all
been talking to us about the efficiency squeeze and I think you
just told us that it was all stick and no carrot. Why will investors
come to you? You raise £500 million, you have another issue
coming. What kind of people is it? Is it existing shareholders
or increasing the share—?
Mr Roberts: It is a combination.
Q159 Paddy Tipping: Make a sell to
me!
Mr Roberts: At the moment, we
have a business that is relatively low risk; we have a regulator
who has a legal statutory obligation that he must enable us to
finance our statutory functions; we have a methodology paper from
the Regulator that he published in March 2003 that states very
clearly that he would look to financeability as being one of his
key criteria. Taking all those together, what we have is a relatively
low-risk business which does not earn huge returns but earns steady
returns. There are investors out there, pension funds, unit trusts,
who are looking for reliable, regularly, steady returns. This
is the kind of investment that would give them those returns.
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