Select Committee on Environment, Food and Rural Affairs Written Evidence

Memorandum submitted by Dr Dieter Helm, University of Oxford

  1.  The water periodic review currently under way has raised substantive issues about the nature of the regulatory regime, as well as the appropriateness of proposed price increases, and its impact on current and future customers.

  2.  This memorandum summarises the causes of the proposed price increases for the period 2005-10, and considers the consequences of the flight-from-equity which has followed the 2000 periodic review outcome. A number of recommendations for the conduct of the current review and the future regulation of the water industry are made.

  3.  The last periodic review in 1999-2000 imposed a one-off price reduction on the industry, pruned back the capital programme on the basis of Ofwat's assessment of "affordability", and limited future price increases to around the rate of inflation. The consequence was to reduce substantially the market values of the companies to below their regulatory asset bases. Notwithstanding a degree of out performance on capital and operating costs, the market values remain subdued, and returns have been low.

  4.  The current proposed price increases are caused by:

      —  the operating and maintenance costs of the existing networks;

      —  the enhancement of capital expenditures to meet environmental and water quality objectives;

      —  the cost of capital to induce investors to provide sufficient funds to finance the industry.

  These continuing requirements have produced a sharp rise in prices because:

    —  there are no longer substantial efficiency gains;

    —  the networks require considerable maintenance and replacement investment which were pruned back in the last periodic review;

    —  the cost of capital was set at too low a level at the last periodic review.

  A "roller-coaster" of volatile prices is to a considerable extent the result of regulatory failures. The prices set for 2000-05 was unsustainable: customers could not indefinitely have lower prices and higher investment. Without the price cuts imposed in 2000, the current projections for 2005-10 could have been financed by roughly constant real prices.

  5.  The consequence of setting the cost of capital at a level below that of the cost of equity (but above the cost of debt) has been to induce a flight from equity.

  6.  The growth of debt finance and gearing has had radical consequences. Bank finance brings different incentives, constraints and managerial focus. Banks are concerned with two things: getting their money back and getting the interest paid. They do not have an interest in capital gains, and have limited ability to absorb shocks. The companies with higher gearing will tend to be more short-term in focus and less inclined to invest at the margin. Over time, it will become increasingly apparent that, as financial ratios deteriorate, future investment will require rights issues if the continued capital investment programme is to be financed in the private sector.

  7.  The flight from equity does not mean, however, that equity risk has gone away-it has been transferred to customers and taxpayers. These changes have not generally been in the long-term interests of customers, the environment or government, and efforts should be made to preserve equity within the sector.

  8.  In addition to encouraging returns, which facilitate rights issues, the regulatory and political risks that remain within the sector could be further reduced. These risks arise from the discretion of governments and regulators and the way it is exercised. Examples include the ways in which the periodic reviews are determined; the treatment of IDOKs; and the interpretation of European Directives. Good regulation is typically predictable regulation. The outcome of the periodic review is far from predictable, and this uncertainty is reflected in share prices and debt premia. Ultimately these are costs, which customers will bear.

  9.  A particular focus of regulatory uncertainty centres on the IDOK process. The instrument was designed to take account of unanticipated changes outside the control of management. There may be rather more items which fall under this description, and the process itself could be further regularised. With more predictable elements of cost pass through, the regime could begin to evolve towards a more flexible and adaptive system, allowing a more rational approach to investment planning.

  10.  The periodic-review process truncates a longer-term investment and management horizon into five-year discrete periods. This is unfortunate for several reasons. It creates set-piece artificial decision points, focuses management on the short term, and encourages game playing. It would be better to take a longer-term view, comprising an overarching policy framework, ten-year fundamental reviews, and much more reliance on the IDOK process to allow flexibility within periods.

  11.  In the determination of capital expenditure, the original concept was that the National Rivers Authority (and now the Environment Agency (EA)) would decide these issues in consultation and under guidance from the environment department. During the 1995 and 2000 periodic reviews, Ofwat subverted this process, taking the leading role, rather than technically implementing the Agency's decisions. Although there are substantive issues in relation to the way environmental requirements are evaluated, and it is important to respond to the willingness and ability to pay of customers, the roles of the EA and Ofwat have become confused and opaque. A reassessment of the relative powers, duties and roles with respect to the water industry is likely to improve the performance of the regulatory regime.

  12.  In conclusion:

    —  a major cause of the proposed sharp price increases is the significant regulatory failures at the last periodic review in 2000, and in particular the price cut then imposed;

    —  the 2000 price review set a cost of capital which was below the cost of equity, and induced a significant flight-from-equity;

    —  the water sector has, consequentially, come increasingly under the influence of banks and other debt holders, with less incentives to invest and less focus on the longer-term;

    —  the IDOK process provides a limited element of flexibility within the regime.

  13.  It is recommended that:

    —  the 2005 review process raises the cost of capital to a level sufficient to reward equity and thereby facilitate rights issues;

    —  the IDOK regime is further clarified and extended;

    —  a longer-term framework for the sector is further developed by Defra;

    —  the five year set piece reviews are replaced by longer periods, with greater flexibility with periods through an extended IDOK process.

17 October 2003

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